How to secure contractual obligations in investment practice

Securing contractual obligations in investment practice is especially important in a volatile economic environment, when debt defaults and the project shutdowns in the corporate sector are common.

In this context, companies should pay attention to the proper enforcement of contracts through various financial and legal instruments, including those aimed at maintaining financial liquidity in case of late payments.

These mechanisms are used at the planning and contracting stage in the context of securing future obligations.

There are many promising tools for securing contractual obligations, but each of them has certain limitations in investment practice. This usually depends on the size of the business and the nature of the relationship between the parties.

In the case of contracts with well-known counterparties, other forms of securing contractual obligations are used than in the case of new contractors.

The use of one or another form of security also depends to a large extent on the costs of establishing this mechanism and formalities, as well as on the time required to achieve the goal.

However, the most important thing for any participant in an investment project is to remember to ensure their interests and use solutions aimed at protecting the fulfillment of contractual obligations.

Some of the most common forms of contract security are presented below.

Contractual penalty

One of the most popular forms of securing non-monetary contractual obligations by entrepreneurs is a penalty.

The parties may agree that in case of losses as a result of non-performance or improper performance of an obligation, compensation will be made by paying a certain amount of money (a contractual penalty). Various types of contractual penalties can be stipulated both in the event of a breach of an obligation by the debtor and the creditor, but they apply only to non-monetary obligations.

The contractual penalty may be specified by the parties in the form of an amount, a percentage, or both an amount and a percentage.

In investment practice, companies often define a contractual penalty as the amount of money charged for each day of delay. When determining the amount of the contractual penalty, the parties should keep in mind mutually acceptable criteria and formulas for calculating it.

An important issue is that the debtor cannot, without the consent of the creditor, be released from the obligation by paying a contractual penalty. In addition, the creditor is not entitled to demand payment of a contractual penalty in a situation where the penalty is reserved in case of failure to fulfill a specific type of obligation. However, the creditor may, at its discretion, choose either to demand performance of the obligation or to demand payment of a contractual penalty. Satisfaction of one of the creditor's claims excludes the possibility of satisfaction of another claim.

Thanks to the setting of a specific contractual penalty, in case of non-performance or improper performance of an obligation, the parties deal with a predetermined compensation.

This greatly simplifies lawsuits, since the parties do not need to prove the amount of the penalty.

Moreover, the creditor is not required to prove the fact of losses in the course of the lawsuit.

The contractual penalty does not require any special legal form, and setting it up in the contract does not involve any additional costs. However, in the case of choosing to secure contractual obligations in the form of a penalty, we must take into account the risk of insolvency of the contractor, which will leave little chance of recovering the debt.

Promissory note

A promissory note is one of the most popular ways to secure contractual obligations in investment practice, including the financing of large projects.

There is also a draft, or bill of exchange. In this document, the issuer instructs another person (the drawee) to pay the bill of exchange, and in the promissory note, the issuer undertakes to make the payment himself. In the case of issuing a bill, we will deal with bilateral obligations. At the time of issue of the bill, the issuer becomes a debtor who is obliged to pay a certain amount of money.



A promissory note is always a written obligation, one of the elements of which is the signature of the issuer. In most countries, the legislation does not limit the contracts to which promissory notes apply, nor does it establish a special blank.

This document can serve as a solid basis for claiming a debt in court, making it very convenient to secure contractual obligations with a bill of exchange.

Another advantage of a promissory note is that it does not need to be drawn up in some complicated legal form and does not entail any additional costs.

However, even effective and speedy legal proceedings do not guarantee the recovery of debt from an insolvent debtor. Of course, the company can sell the bill, but it will be difficult for it to find someone willing to buy the bill with a minimal chance of collecting the debt.

Mortgage

Mortgage is one of the ways to secure contractual obligations in investment practice, primarily serving to support the claims of banks and other financial institutions.

Mortgage allows the lender to demand the transfer of immovable property in payment of a debt that has arisen in connection with the financing of an investment project or other activity. The mortgage secures the obligations arising from securities and contracts of various types. In addition, a mortgage may also secure multiple obligations from different contracts, in favor of the same lender.

The most important advantage of a mortgage is that it provides a high chance of meeting the creditor's claim even in the event of bankruptcy of the debtor, since the mortgage will be repaid directly through the sale or transfer of property.

The disadvantage of this method of security, of course, is the lengthy process of litigation and the high cost of securing the contract.

Pledge

Another form of securing contractual obligations, which is important from the point of view of the implementation of investment projects, is a pledge.

Pledge refers to a limited property right that secures the fulfillment of certain obligations. It is executed with the help of a pledge agreement between a person (company) that has the right to dispose of the subject of pledge, and the creditor (pledge holder). In accordance with the laws of some countries, this type of relationship may need to be recorded in a special public register (the so-called registered pledge).

A creditor's claim secured by a pledge shall be subject to satisfaction on a priority basis over other claims.

This may take place not in the order of the court, but by the entry of the creditor into the ownership of the subject of pledge, or by selling the subject of pledge through an open auction.

Transfer of ownership

The transfer of ownership as security for contractual obligations means the transfer of assets to the creditor in order to satisfy his claims in the event of default by the debtor of his obligations.

On the other hand, it may be the obligation of the creditor to return the ownership of the assets if the debtor fulfills his obligations.

This mechanism is regulated by the financial and banking law of the host country, which should be taken into account when planning investment projects.

The debtor transfers ownership of his assets to the creditor, and the creditor undertakes to transfer ownership of those assets back to the debtor upon payment of the debt, often committing himself to use the property for a limited amount (the debtor needs an additional contract to redeem the assets). Until the debt is repaid, the creditor acts in the dual role of creditor and owner of the asset.

This can also be done in simpler ways, depending on the nature of the contractual obligations, the type and scale of the project, the local legislation and other factors.

Bank guarantees / insurance guarantees

The bank guarantee agreement is a written obligation of the bank (guarantor) to pay the so-called guarantee sum to other party (guarantee beneficiary) in the event that another party (guarantee principal) has not performed the specified service.

On the other hand, the insurance guarantee is a written commitment of the insurance company (guarantor) to pay the beneficiary of the guarantee (guarantor) a certain amount when an insured event occurs.

The agreement between the beneficiary and the principal may state that the principal enters into a guarantee agreement with a bank or insurance company to secure the claims of the beneficiary in case the principal fails to fulfill its obligations. The client concludes an agreement with a bank / insurance company on specific conditions for issuing a guarantee to the beneficiary, after which the beneficiary receives a written application from the bank / insurance company, which is a guarantee.

In investment practice, guarantors offer entrepreneurs different forms of guarantees depending on their needs.

For example, tender guarantees, performance bonds, advance payment guarantees or a payment guarantee (sometimes used for securing the payment for goods or services).

Guarantees significantly increase the security of transactions due to the fact that the guarantee sum is paid by the bank / insurance company, and not by the counterparty (the transaction is resistant to the possible bankruptcy of the partner).

Providing a guarantee also reduces the risk of going to court, but it cannot be ruled out that a bank may also refrain from paying a guarantee.

However, a significant drawback of guarantees is their high cost and complexity of the procedure.

Link Bridge Financial LTDA offers long-term financing for large investment projects around the world, including Spain, Germany, UK, USA, Brazil, Mexico, Saudi Arabia and other countries.

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