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Significant suppliers – managing cash flows and adjustment regimes

On significant construction contracts, contractors need to...

ByJock Hamilton

  1. On significant construction contracts, contractors often need to procure major supplies from suppliers, frequently at considerable cost. This presents challenges. The usual approach is that the Principal pays the Contractor for works performed. However, the Contractor will typically need to outlay a substantial deposit with the supplier upon issuing a purchase order. This can place the Contractor in a cash flow bind—requiring significant expenditure on a supplier without yet having received payment from the Principal.
  2. There A couple of options are available to contracting parties. The first is for the Principal to pay the Contractor before the Contractor pays the supplier, with the Contractor then providing the Principal with some form of security equivalent to the downstream payment (e.g. a bank guarantee). If the Contractor does not wish to procure a bank guarantee, then in some instances a supplier’s bank guarantee will be acceptable to the Principal (so, in effect, the Contractor is not out of pocket at all). The second option reverses the scenario: the Contractor pays the supplier downstream but obtains a form of letter of credit from the Principal, giving the Contractor security for the supplies procured.
  3. Another cash flow issue that needs to be considered is adjustments for:
    1. Foreign exchange;
    2. Commodity prices; and
    3. Shipping.
  5. A Contractor who does not wish to bear the risk of any of these issues may seek to pass the risk to the Principal—typically through an adjustment regime.
    1. A foreign exchange adjustment regime will require the Contractor to record the foreign exchange rate at the time of contract execution and to include the relevant adjustment formula in the contract.
    2. Similarly, a commodity price adjustment regime is usually pegged to the relevant exchange. For example, copper pricing may be pegged to the London Metals Exchange. The point of adjustment is typically when the Contractor places the order with the supplier—i.e. when the downstream price is locked in.
    3. Shipping can represent a significant cost to Contractors. A regime may be included to allow for adjustment of the shipping cost at the time the purchase order is issued to the sub-supplier.
  7. These kinds of adjustment mechanisms protect the Contractor’s margin, though they can result in either an increase or decrease in the value of the works. In either case, the Contractor’s margin should remain neutral and protected, provided the adjustment regimes have been properly implemented.

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