An Introduction to: Advance Payments in Construction Contracts

Advance payment arrangements are increasingly being provided for under construction contracts. This article discusses the concept of advance payment regimes, why they are beneficial for contractors, the risks for employers and typical employer protections.

Construction projects, particularly larger and more complex projects, may require a contractor to commit significant sums up-front in preparation for the works, such as mobilisation costs, the purchase of long lead time materials and specialist equipment, or to instruct the off-site fabrication of bespoke components.

Conventionally, contractors are paid in arrears by instalments (usually on a monthly basis) for work that has been completed, and therefore when commencing a project (and continuing through to practical completion) a contractor must have sufficient liquidity to cover its costs until invoiced and paid by the employer.

If upfront costs are significant, a contractor may look for an advance payment from an employer with a view to decreasing its financial risk and to assist with cashflow. Arrangements around payment of advance sums and repayment can differ depending on the precise commercial agreement, however, often such sums are typically repaid over time either through deductions from interim payments over the construction period or at agreed project milestones. It is important contract terms are clear as to the agreed commercial arrangement, including an adequate mechanism for repayment within a suitable timeframe. Many standard form contracts include advance payment regimes as an option (e.g. SBCC/JCT, NEC & FIDIC).

Whilst reaching an agreement for advanced payment can be advantageous for both the contractor and the employer (the contractor can proceed with the certainty that pre-construction, materials and long lead time item costs are secured whilst the employer benefits from the project proceeding as programmed), in decreasing the risk for the contractor, greater risk is placed on the employer. The primary risk being that the advance payment is not repaid to or recovered by the employer, for example, due to contractor insolvency.

If an advance payment is for a significant sum or percentage of the overall contract value, an employer may look for additional contractual protections. The most appropriate protection will depend on the circumstances and what is available to the contractor, however, may include the following:

Advance payment bond
This is the most typical form of employer protection. It is a bond procured by the contractor from an independent surety (usually a bank, insurance company or bondsman) and covers the amount of the advance payment.
Advance payment bonds are typically ‘on demand’ forms of bond, meaning that the bond can be called at any time by the employer without having to demonstrate that loss has been suffered or evidence that the contractor has breached the terms of the contract or become insolvent. The value of the bond typically reduces as the advance payment is repaid.

Advance payment bonds are also typically drafted with an expiry date, which can take effect on the earlier of either when the advance payment has been fully repaid to the employer, at practical completion of the works, or on a fixed longstop date.
Off-site materials agreement (OSMA)
Where an advance payment is to be used by a contractor to purchase materials or procure fabrication of bespoke components which are to be held off-site the employer may seek an off-site materials agreement (or vesting certificate where English law applies) from the contractor and/or its supplier or sub-contractor. An OSMA typically provides that property in the goods/materials will pass to the employer upon payment.
For more information on off-site materials agreements please view the Brodies Insights article on this topic – Off-site materials agreements: title to goods and materials through a Scottish lens | Brodies LLP.

Other forms of performance security that are not specific to advance payment can also provide some protection: it should be considered whether these are sufficient in the relevant circumstances of the project/advanced payment to be made.
Performance bond

A performance bond is a financial guarantee commonly used in the construction industry as a means of insuring an employer against the risk of a contractor defaulting on any of its obligations through insolvency or otherwise. The surety or guarantor who provides the bond is an independent financial institution (often a bank or insurance company) and the amount of the security provided under the bond is typically around 10% of the underlying contract value. Bonds will be in place for the duration of the works, expiring at practical completion/ completion or in some cases, at the end of the defects rectification/ correction period. This would usually be a “default” bond and therefore not as favourable as an “on demand” advance payment bond.

For more information on performance bonds please view the Brodies Insights article on this topic – Performance Bonds: Practical considerations | Brodies LLP
Parent company guarantee (PCG)

If a contractor is a subsidiary of a larger group company an employer can seek a PCG from the ultimate parent company, guaranteeing the contractor’s obligations in respect of payment and performance (including in the event of contractor insolvency). Ultimately a PCG’s value is dependent on the strength and covenant of the parent company granting it, and there is a risk that if a contractor becomes insolvent the parent company becomes insolvent also.

Whilst advance payment regimes can prove beneficial to both contractors and employers, it is important the commercial agreement is clearly reflected under the terms of the construction contract, including a suitable arrangement for repayment. Employers should also consider what other additional protections they may require where any advance payment is for a significant sum and ensure that payment is conditional upon any such additional protection being delivered by the contractor in the required form.

If you would like any advice on this topic, please contact one of our construction lawyers: Kirsteen Milne, Harriet Rutherford or Richard Gallen.