Construction contracts and bank guarantees

Most construction contracts for large scale infrastructure and commercial projects require contractors to provide a principal with an unconditional bank guarantee to secure due and proper performance under the contract.

From our perspective, we’ve been involved in three disputes regarding the giving and pulling of bank guarantees just this year, two of which have already resulted in Court proceedings.

  • In the first, we were successful in obtaining orders, on an urgent basis, restraining a principal from cashing down on a $10m bank guarantee;
  • In the second, we were successful in making a summary judgment application requiring a head contractor to disgorge to the Court the funds it obtained from cashing down on a bank guarantee given by a sub-contractor client;
  • As to the third, we’ve given our client advice that the principal is, at this point in time, unable to cash down on a bank guarantee, and it remains to be seen what will eventuate  in that matter.

We’ve also been involved in a fourth matter late last year which resulted in an application for rapid adjudication under the Construction Contracts Act, and a subsequent appeal to the State Administrative Tribunal.  That resulted from the pulling of a bank guarantee in an effort to satisfy a disputed claim for liquidated damages alleged to arise by virtue of late completion.

So tonight, I’ll give my talk against that backdrop by initially explaining the likely matrix of contractual provisions that deal with the provision of security by a contractor and then, by relating examples from some of our recent matters, illustrate the legal options available to a party when it is the subject of an actual or threatened  claim for draw down on an unconditional bank guarantee.

For the principal, the value of any bank guarantee is tied to its irrevocable nature.  A principal  usually takes comfort from the fact that if it presents the guarantee to the relevant bank, the bank will honour the undertaking without concerning itself with the underlying contractual issues or dispute between  it and the contractor.

If it is the intention of the parties that the bank guarantee should be ‘as good as cash’ then there should be no limits or preconditions included in the express contract terms regarding the principal’s recourse to it.  If that’s the case, the principal’s entitlement to cash the guarantee won’t be subject to it establishing some form of entitlement under the contract to do so.

But rarely is this the position in practice.

In today’s era where bespoke construction contracts are the norm rather than the exception, it is important for both parties, almost on a project by project basis, to have a good handle on the processes and mechanisms set out in the relevant contract that govern the draw down of any security.

These provisions will, of course, define whether a principal is entitled to cash in security in any given set of circumstances, or whether a contractor might be successful in seeking an order from a Court restraining a principal from doing so.

Everyone of course is familiar with the provisions that exist in almost every construction contract that provide for the giving of security.  Such clauses impose the obligation on the contractor to give security, and will invariably set out the amount required, the form in which the security is to be given, as well as the time by which it is required.

Coupled with that, and depending on how the contract is drafted, will be a clause that sets out when it is that the principal is entitled to have recourse to that security.

In my experience, it is normal for a bespoke contract to contain a clause such as the following:

  • That clause does two things.
    • Firstly, sub-paragraph (a) provides what is no more than a general right of the principal to have recourse to security if other provisions in the contract allow it to do so.  And in the normal course, there is usually a very widely drawn provision that entitles the principal to draw down on the security if the contractor is in ‘default’.  Of course, the word ‘default’ is then defined, allowing the parties to identify with some precision the triggers for cashing the security;
    • Secondly, sub-paragraph (b) sets out a mechanism that must be followed if the principal intends to cash the security with reference to one of those other clauses.  In this respect, the principal is required to give the contractor five days notice of its intention to cash the security, should it consider it has an entitlement to do so.

We all know that sometimes guarantees are pulled more for tactical reasons than reasons which are bona fide.  Inevitably, that action will result in significant commercial consequence for the contractor, not the least of which is the cash flow and liquidity issues that arise.  In some cases, there will also be reputational harm as well.

In such circumstances, it is incumbent on the contractor to move fast and assess its position with respect to any potential call on the bank guarantees within the relevant notice period.  In this example, that notice period is five days.

That means that the contractor, in effect, has no more than five days to assess the merits of the principal’s position and, if it is arguable that the principal has no entitlement to have recourse to the security, make an application to the Supreme Court to seek orders injuncting the principal from drawing down.  Otherwise, the principal will inevitably proceed to cash the bank guarantee, meaning that the damage will be done and the contractor may find that its legal options to attempt to right the ship may be comparatively slow and expensive.

It is also worth noting that clauses dealing with the reduction or return of the security are also very important.

In practice, these provisions are often relied on by a contractor as a basis to argue that if the security ought, according to the terms of the contract, have been returned at some earlier point in time, there is no entitlement for the principal to draw down on it.

I’ll revisit that issue a little later in the context of dealing with our example of obtaining an injunction to restrain the cashing of a bank guarantee.

But in terms of injunctions, and the ability of a party to get one to restrain the other from cashing the bank guarantee, the authorities suggest that there are generally 3 circumstances in which a court will intervene.

These principles are most conveniently set out in these recent authorities.

There is also very recent UK authority that supports those principles, but it also goes further and suggests that irrespective of the terms or the unqualified nature of the bank guarantee itself, a party is not entitled to have recourse to it if to do so would be in breach of the terms of the contract.

Distilling the relevant principles, it is apparent that a Court may intervene:

  • Where the party calling on the bank guarantee would be acting fraudulently;
  • Where the party calling on the bank guarantee would be acting unconscionably.

Or where the party calling on the guarantee would be doing so in circumstances where it would be acting in breach of a promise not to.

Very rarely, if ever, in practice would a party be in a position to rely, let alone succeed, on the fraud or unconscionable grounds.  Given that, I’ll concentrate on the third ground as the basis for an injunction.

We used the third ground earlier this year as the basis for formulating two successful arguments, in two separate matters before the Supreme Court, for orders relating to the pulling of bank guarantees:

  • In the first matter, we obtained an injunction restraining a principal from calling on our client’s bank guarantee;
  • In the second, we obtained orders requiring a principal to disgorge funds it had obtained from already having cashed down on our client’s bank guarantee.

In respect of the injunction matter, the principal threatened  to draw down on our client’s guarantee on a certain day should our client fail to pay certain monies that the principal considered were due and owing to it.  Those monies were calculated by reference to the costs the principal alleged it would incur in rectifying certain defective works that it had purportedly taken out of our client’s hands through the show cause notice procedure set out in the contract.

The contract was a complex, bespoke one.  Not only was our client required to provide security in the form of several bank guarantees, but the principal was also entitled to retention monies.

It is important to note that the total of those retention monies held by the principal was approximately $7.5m, and that exceeded the amount that the principal claimed was due and owing to it to rectify the alleged defects, which was approximately $1.75m.

That costs claim of $1.75m was no more than an estimate, and it had not been properly quantified or calculated with any particularity or certainty.

In seeking to draw down on the guarantee, what the principal was effectively attempting to do was to preserve, untouched, presumably for another day, the $7.5m in retention monies, whilst paying itself the $1.75m from the bank guarantee.

Special Condition 35 in their contract provided as follows:

  • We argued that the last two lines of clause 35 contained a prohibition on, or qualification of, the right of the principal to make a claim on the bank guarantee;
  • We said that the qualification, properly understood, meant that a call could only be made on the bank guarantee if the amount of the retention monies was insufficient to secure the principal for the costs it alleged it was owed;
  • On the facts, given that the principal considered it was owed $1.75m, but held retention monies to the tune of $7.5m, we argued that the proper construction of clause 35 meant that there was no entitlement to call on the bank guarantee – the principal had more than adequate  security by reference to the total of the retention monies it held.

In upholding our claim and awarding the injunction, the Judge agreed that there was a serious question that clause 35, properly construed, did affect the principal’s right to call on the bank guarantee, and that, on the proper construction of that clause, a principal was only able to call on the bank guarantee if there were insufficient retention monies to satisfy its alleged claim.

The practical effect of that was that the Court construed clause 35 in a way that meant the principal was only entitled to have recourse to the bank guarantee if it had arguable claims exceeding $7.5m.

And even then, it could only cash the guarantee in a sum equal to the extra over amount.

Given that the principal threatened  to draw down on the bank guarantee, the Court was satisfied that if it proceeded to do so, it would be breaching clause 35 of the contract.

Against that background our client also led evidence that it would suffer material prejudice to its reputation if the guarantee was cashed, and the Court had regard to that evidence in weighing up whether to grant the injunction we sought.  It ultimately decided that, because of that perceived prejudice, the balance of convenience favoured the issue of an injunction to restrain the principal from cashing down the guarantee.

This question of where the balance of convenience lay was, and will always be, a critical factor in the success of any application for an injunction.

In our example, the Court was particularly persuaded that it ought to grant the injunction because of the evidence we put forward about the potential that our client would suffer irreparable harm or prejudice to its reputation if the bank guarantee was cashed.  Evidence to that effect was given by our client’s managing director, and without going into too much confidential detail in respect of that, it was relatively extensive and substantial.

An important takeaway in relation to that is that similar evidence, or other evidence that a contractor would suffer some material detriment if a bank guarantee was cashed, is almost essential to establishing an entitlement to an injunction.

I should also say in conclusion that our client disputed its liability to pay the principal the $1.75m amount claimed in respect of remedial works.  As things sit now, those issues, along with others, remain ongoing, but obtaining the injunction was and is a matter of some tactical importance for us in the overall context of this dispute.

The second recent case example that we’ve been involved with highlights the fact that there are still useful, practical remedies available to a contractor where it may not have been quick enough, or for whatever reason wasn’t able to, obtain an injunction to prevent the drawing down of a bank guarantee.

In this case, we succeeded in obtaining orders from the Supreme Court that required a party to disgorge funds that it had obtained from cashing a bank guarantee previously given to it by our client.

The provisions in this contract required the principal to return the bank guarantee at practical completion.

Needless to say that didn’t happen, and part way through the defects liability period, the principal began to formulate claims for the costs of rectifying allegedly defective work.

When those weren’t paid, the principal had recourse to the bank guarantee and paid itself those monies from those funds.

We argued that as the principal was not entitled to retain the bank guarantee at the time it cashed it, that meant, by extension, that it had no contractual right, at that time, to have recourse to it at all, and that by doing so, it had breached the contract.

This argument was consistent with the rationale in the Lucas Drilling case that I referred to earlier, and we relied on that case to support our proposition.

Rather than this matter proceeding to a full trial, we took the step of issuing a Writ and making an immediate application for summary judgment.  We took that view because, in our minds, the principal had no defence to our claim that it had breached the contract by drawing down on the bank guarantees when there was no real doubt that they ought to have been returned to our client some time before.

The Court agreed, and in doing so said that, on the affidavit evidence we led, there was no arguable defence to our claim that the principal had breached the contract.

The remedy we obtained was an order that required the principal to repay the funds it received from cashing the guarantee.

What this case illustrates is that, in the right circumstances, there is still practical, quick and cost effective relief available to a contractor where it may otherwise have appeared, at first glance, to be too late to do anything meaningful.

Similar arguments could also be made for the return of cashed funds where, arguably, the principal went too far and cashed a guarantee for an amount in excess of what it was otherwise entitled to claim.

By way of example:

  • If a principal held a bank guarantee in the sum of $5m;
  • Believed it was entitled to claim a sum of $3m from the contractor;
  • But cashed the full bank guarantee and received the full $5m in funds;
  • The contractor would arguably be entitled, in the absence of any justification for the principal retaining the extra $2m, to make a similar application for summary judgment for orders requiring the principal to return the extra $2m.

The basis for that argument would be no different to our real case example – that is, that the principal was not entitled to draw down the extra $2m of funds and that it did so in breach of contract.

What this illustrates is that even claims for the partial return of some of the cashed funds may be open.

So it is always important to consider, both before and after any attempt to cash the guarantee, whether any relief might be available.

Just to conclude by tying the subject of bank guarantees to our next topic on termination, it is also important for a contractor who might be considering whether to terminate a contract, to give serious thought to what the principal might then do with the bank guarantees.

Experience would tell most of us that if a contractor did terminate a contract, the principal would likely be quick to formulate some type of claim that it considered might entitle it to cash down on those bank guarantees.