Contract Protections for Troubled Times: Part 3 How Third Parties Can Assure Performance
For practical and legal reasons, you may want a third party to assure the performance of a contract that you have with someone else.
The practical reason is that it will give you another place to turn, and another point of leverage on your contract party. The legal reason is that if your contract party becomes insolvent or files for bankruptcy, those events may not impair the third party and you can look to the third party to perform or to cover you for non-performance.
Here are some typical third-party protections:
- Guarantee by a Third Party. A third party, such as an investor or parent company, can guarantee the obligations of the other party. Most often, this is a payment guarantee. For example, banks often require an entrepreneur to personally guarantee any loans made to a startup. Or, a controlling shareholder might guarantee the obligations of one of its portfolio companies. These guarantees can provide a financial backstop if your contract party has financial difficulties. In addition, a personal guarantee makes the entrepreneur or controlling shareholder take direct financial risk, and this “skin in the game” is designed to make sure that they pay enough attention to performing the contract, without the ability to walk away.
- Letter of Credit by a Financial Institution. This is a type of guarantee. It typically is issued by a bank. If you receive a letter of credit (also called an “L/C”) and the other party breaches, then the bank pays the “face amount” of the L/C to you. The bank treats that payment as a loan from the bank to the other party, and looks to the other party to get paid back. The bank collects fees for each L/C, even if the L/C is not drawn. Letters of credit are typically used in international sales of goods, where the buyer and seller are in different countries and there is a risk of shoddy goods or non-payment. However, L/C’s can also be used in domestic transactions where money changes hands, and one party wants to make sure it is paid, even if the other party faces severe financial problems. Rarely is an L/C needed for domestic transactions, but I have used them on occasion. Of course, in this economic environment, you also need to consider the creditworthiness of the bank issuing the L/C.
- Required Insurance. Many contracts require the other party to obtain and maintain insurance in favor of the other party, such as commercial general liability insurance. In effect, this is a guarantee by a third party (the insurance company), with that third party paying off clams that the principal party cannot pay. For example, assume that Company A (such as a manufacturer) supplies a product to Company B (such as a distributor), but the product harms the customers and Company B is sued. Company A may not have enough assets to pay the product liability claims. To prevent this problem, Company B could require Company A to purchase insurance, with Company B as an “additional insured” on Company A’s insurance policy. That way, if Company B is sued, and Company A does not have enough assets of its own to pay the claims of the injured customers, the insurance company pays the claims. In effect, the insurance company has guaranteed certain obligations of Company A to Company B. This type of protection generally involves: (a) an indemnity from Company A to Company B, (b) a requirement that Company A purchase specific insurance coverages with specific policy limits in favor of Company B, and (c) having Company B named as an “additional insured” on Company A’s insurance policy, which enables Company B to make a claim directly to Company A’s insurance company.
In the next issue, I’ll discuss some myths and realities of bankruptcy in business transactions.