A successful bidder (contractor) of a government tender for procurement of goods and/or services is usually required to provide a bank guarantee of up to 5-10% of the contract value as performance security. The cost of obtaining of a bank guarantee (BG) has shot up substantially in the recent years due to the rise of NPAs in India. The cash margin requirement for a BG, that is kept in the form of fixed deposits, has also increased from 15-20% to 40-100% of the amount of the BG. The requirement of a collateral for obtaining a BG blocks the cash flows of the contractors that could otherwise be utilised in the performance of the government procurement contract (GPC). Owing to such factors, the contractors had long been advocating the need for an alternative to BGs.
Offering a much-needed relief to the contractors, the Finance Minister, in the Union Budget 2022-23, announced that a surety bond (SB) can be used as a substitute for a BG in government procurement. An insurance company, upon satisfaction of financial strength of an entity procuring an SB, can issue one for a premium. Unlike a BG, an SB is neither required to be collateralised through cash margins nor needed to be renewed periodically. The premium for an SB can be paid from the working capital funds of the contractors and the lack of a collateral requirement for obtaining an SB gives it a clear advantage over BGs. Exercising the option of submitting an SB as security for a GPC will enable the contractors to manage their cash flows in a much efficient manner. Opting for SBs also frees the contractors from keeping idle cash reserves that were earlier set aside for providing cash margins for BGs.
The acceptance of SBs in government procurement will also provide an additional stream of income to the insurance companies. On January 3, 2022, the Insurance Regulatory and Development Authority of India had issued the IRDAI (Surety Insurance Contracts) Guidelines, 2022 (surety guidelines), to lay the foundation for the development of surety insurance business in India. The surety guidelines came into effect on April 1, 2022, and insurance companies will now be able to offer an alternative financial backstop to the contractors who had earlier been dependant solely on banks for procuring BGs.
While SBs have a clear advantage over BGs, the development of an SB-market in India will require certain clarifications on the ambiguity surrounding the recourse available to insurance companies in case of default by Contractors. While the Exposure Draft on IRDAI (surety insurance) guidelines, 2021 (issued on September 8, 2021), expressly provided for securing SBs through personal guarantees of the promoters, the same has not been provided in the final draft of the surety guidelines. The absence of clarity in this regard may have a direct bearing on the premium that will be required to be paid by contractors; a prompt resolution of this issue will bolster the growth of the SB-market in India.
The feasibility of SBs has already been successfully tested in the United States, Australia, Brazil, and Philippines, and the financial flexibility it offers may prove to be a game-changer in the way Contractors manage their cash flows. Once the success of SBs is established in government procurement space, the substitution of BGs with SBs may also be considered in contracts entered between private parties. While certain costs, such as premiums on SBs will still be incurred, the proof of advantage offered by SBs over BGs will be established only after the market for SBs has matured from its current embryonic state.
