The ‘purpose’ of performance security

In construction contracts, performance security is not only common, but it is a critical part of the commercial deal. This article looks at the relevance or importance of the link between the documented purpose of performance security and a beneficiary’s ability to have recourse to it.

At a basic level, the purpose often stated for providing performance security in the context of a construction contract is to ‘ensure the due and proper performance of the contractor’s obligations under the contract’ (or wording to that effect).

To use Australian Standard contracts as an example:

1. AS2124 provides a stated purpose for security in clause 5.1:  “Security, retention moneys and performance undertakings are for the purpose of ensuring the due and proper performance of the Contract.”

2. However, both AS4000 and the draft AS11000 do not contain any similar provision (i.e. no purpose for security is expressed).

Including a statement as to the purpose of the performance security (as above) is often seen as limiting when read in conjunction with a broadly drafted clause setting out entitlements to have recourse to the performance security.  For example, a lawyer drafting a contract for a principal may include a provision entitling recourse to performance security as follows:

“The Principal may have recourse to the Security without notice to the Contractor at any time it claims that the Contractor is indebted to the Principal, in relation to the Contract or otherwise.”

If the contract was also to include a statement as to the purpose of the security such as the generally accepted ‘to ensure the due and proper performance of the contractor’s obligations under the contract’, this would be inconsistent with the recourse provision, which would (in isolation) allow the principal to have recourse to the performance security even though the contractor may be properly performing its obligations under the contract.  This would be a problem if and when the beneficiary seeks to have recourse to that security, and the inevitable injunction is sought by its provider.  This is because, when determining whether to restrain a principal from calling on a contractor’s security, courts will not only look at the express recourse provisions under the contract, but also consider the purpose of the security.

Based on this reasoning, a lawyer acting on behalf of a contractor will often insist on a statement as to the purpose of the performance security (as above) being inserted into the contract, while the lawyer acting for a principal will often push for its deletion (as well as including a broadly drafted recourse provision).

So is the purpose of performance security, in today’s climate, really about ensuring the contractor’s due and proper performance of its obligations under the contract?  Do principals only require recourse to security where there has been a demonstrated failure by the contractor to perform (i.e. a breach of contract)?  When the contractor fronts up to court and seeks to injunct the principal from cashing a bank guarantee, and the court requires the principal to prove the contractor’s failure to perform, will the principal be able to do this, given the urgency and immediacy surrounding these claims in practice?

In practice, holding performance security is really more about reducing the beneficiary’s risk of immediate financial exposure in the event that the parties fall into dispute.  Fundamentally, performance securities are instruments of risk allocation.  So can beneficiaries ensure that their contracts align with this purpose?

What the courts say

Throughout Australia, there is a substantial amount of case law considering whether or not a party is entitled to have recourse to performance security.  The reasoning and relevant contractual provisions in some of the key cases are considered in more detail below.

Clough Engineering

In Clough Engineering Ltd v Oil and Natural Gas Corporation Ltd [2008] FCAFC 136, Clough sought an injunction to prevent Oil and Natural Gas Corporation (ONGC) from calling on an unconditional and irrevocable performance guarantee relating to oil and gas field development works in India. The security clause was drafted as follows:

“3.3.1. This irrevocable Performance Bank Guarantee shall be drawn in favour of the Company

…

3.3.3: The Company shall have the right under this guarantee to invoke the Banker’s guarantee and claim the amount there under [sic] in the event of the Contractor failing to honour any of the commitments entered into under this Contract.”

The performance guarantee itself contained the express reservation “…notwithstanding any dispute(s) pending”, without reference to the contractor and “without any demur, reservation, contest or protest”.

Disputes arose between Clough and ONGC. ONGC subsequently called upon the performance bonds.  Clough argued that the call on the performance bonds was unconscionable under s 51AA of the TPA as the alleged defaults in question were caused by ONGC and/or alternatively involved a call on the performance bonds in circumstances whether other mechanisms protected ONGC for the specific defaults.

Clough set out the principles to be followed when construing the purpose of a security clause:

1. subject to the exceptions of fraud and unconscionability, the beneficiary of a performance guarantee granted in its favour as a risk allocation device, will be entitled to call upon the guarantee even if it turns out, ultimately, that the other party was not in default (at [80]);
2. the contract should be considered against the national and international commercial background (at [81]);
3. a court should not too readily favour a construction which is inconsistent with an agreed allocation of risk as to who is to be out of pocket pending resolution of a dispute (at [82]);
4. clear words will be required to support a construction which inhibits a beneficiary from calling on a performance guarantee where a breach is alleged in good faith (at [83]); and
5. the proper construction of the beneficiary’s right to call on the guarantee must be informed by a consideration of the prescribed form of the guarantees (at [90]).

The court concluded that upon the proper construction of clause 3.3.3, when read together with the performance guarantee, show that the commercial purpose of the contract was to allocate the risk of who should be out of pocket notwithstanding that there may be a genuine dispute as to whether Clough had failed to honour commitments under the Contract. The risk was allocated to Clough, there being no clear words to inhibit ONGC as the beneficiary of the guarantee from invoking it. The court therefore refused the injunction sought by Clough.

Redline Contracting

Redline Contracting Pty Ltd v MCC Mining (Western Australia) Pty Ltd (No 2) [2012] FCA 1 concerned the construction of pipelines for the Sino Iron Project in WA. Redline provided four unconditional undertakings to MCC Mining for $1.66m each (being an aggregate of 10% of the contract price). MCC Mining terminated the contract and claimed Redline owed it $1.29m for an outstanding balance of an advance payment by MCC and unpaid fuel invoices. MCC Mining gave notice of intention to have recourse under clause 5 of the contract, and Redline sought an injunction from calling upon any or all of four unconditional undertakings given to MCC Mining.

Clause 5.2 of the contract stated:

“Security shall be subject to recourse by a party who remains unpaid after the time for payment where at least 5 days have elapsed since the party notified the other party of intention to have recourse.”

Redline argued that the words “unpaid after the time for payment” as referring to the payment of a sum which is ‘due and payable’ and, therefore, did not contemplate the circumstance of MCC Mining calling upon the unconditional undertakings in support of a disputed claim for unliquidated damages. The time for any damages had not yet arisen until there was judgment in favour of MCC Mining or an agreement with Redline.

MCC Mining argued the commercial purpose behind clause 5 was to allocate risk and it was entitled to call upon the unconditional undertakings in respect of its unliquidated damages claim, notwithstanding that the parties were in dispute as to the existence and the amount of the claim.

The court agreed that the proper characterisation of clause 5 is a risk allocation clause stating at [48]:

“…resort to the security by MCC Mining is not conditioned upon there being an undisputed amount due and payable by Redline. It is sufficient, in my view, that MCC Mining bona fide believed that it had such a claim… the resort by MCC Mining to the unconditional undertakings will not be precluded, by reason only, that the disputed claim is in respect of an unliquidated amount as damages.”

The court held that Redline failed to demonstrate it as entitled to restrain MCC Mining from resorting to the unconditional undertakings for the full amount of the security, either on the grounds of an implied negative stipulation in the contract or on unconscionability grounds.

Walton Construction

The court in Walton Construction Pty Ltd v Pines Living Pty Ltd [2013] ACTSC 237seemed to shift the law from requiring a need for no prohibition to call on the security, to needing a positive right to call on the security. The decision concerned a contract in the form of PC-1. The security clause was silent about when Pines Living might call upon any security. In accordance with the contract, Walton provided two bank guarantees of $190,000 each.

Walton argued in the absence of an express term dealing with the circumstances in which recourse could be had to security, the parties could not have intended that the right to call upon the bank guarantees be unconditional and unqualified. This term would not satisfy the criteria ordinarily considered when implying contractual terms.

Pines Living argued that it is evident from both the bank guarantees and the construction contract that the parties intended to make demand on the bank guarantees unconditional and unqualified. Further, authorities had established that in the absence of a clear negative stipulation in the contract, it was entitled to call upon the bank guarantees.

The court held that as the contract did not include an express right to call on the bank guarantee, it did not serve the “allocation of risk” purpose stating:

”…in the absence of any express provision in the contract itself relating to the circumstances in which recourse might be had to the guarantee, in my view the fact that the guarantee is an unconditional one would not, even if, as in Clough, incorporated into the contract, be a circumstance which would permit it to serve the allocation of risk purpose… I do not accept the submission made by Pines that in the absence of a clear negative stipulation a party may not be enjoined from calling on an unconditional guarantee except where there is fraud or unconscionability.”

His Honour held that a term would have to be implied in order to be able to have recourse to the security in the absence of an express right to do so, and the facts of the case did not give rise to such an implied term.  The court granted an injunction to restrain Pines Living from calling on the guarantees.

Sugar Australia

In Sugar Australia Pty Ltd v Lend Lease Services Pty Ltd [2015] VSCA 98, Lend Lease agreed to design, construct, supply and install a new refined sugar plant for Sugar Australia. The contract required Lend Lease to provide security in the form of two unconditional bank guarantees for an amount representing five per cent of the original contract sum, being $4,190,000 in aggregate. A dispute arose between the parties during the performance of the contract works, and both parties purported to terminate the agreement. Sugar Australia issued a notice that it intended to have recourse to the bank guarantees.

The recourse to security clause was as follows:

”5.2 Any security provided by the Contractor in accordance with the Contract shall be available to the Principal whenever the Principal may claim (acting reasonably) to be entitled to:

(i)    the payment of monies or an indemnity by the Contractor under or in consequence of or in connection with the Contract;

(ii)    reimbursement of any monies paid to others under or in connection with the Contract; or

(iii)   other monies payable by the Contractor to the Principal (whether by way of set off or otherwise).

Recourse to security shall only be subject to the Principal having given the Contractor five days’ notice of its intention to have recourse to the security for the purpose of allowing the Contractor to replace the security with cash where it has been issued in a form other than cash.  Where the Principal has recourse to security in accordance with clause 37.3, the Contractor shall provide replacement security in accordance with clause 37.3.”

Lend Lease submitted Sugar Australia was not entitled to seek recourse to the bank guarantees because:

1. Sugar Australia was not acting reasonably as required by clause 5.2;
2. the recourse notice provided was invalid; and
3. should Sugar Australia have recourse to the bank guarantees, Lend Lease would suffer significant commercial and reputational damage in the building industry.

Sugar Australia submitted that it was acting reasonably in having recourse to the bank guarantees.

The court considered one of the issue for determination was whether clause 5.2 only permits Sugar Australia to have recourse to the performance bonds for reimbursement of moneys presently due or expended by Sugar Australia or whether, on the other hand, recourse might be had in respect of moneys payable in the future.

Agreeing with Kaye JA, Osborn and Ferguson JJA relevantly stated:

”[21] If a provision in a building contract requiring a performance bond is intended to operate as a risk allocation device pending the final determination of the dispute between the parties then that intention must be fundamental to a consideration of the justice of an application made to restrain recourse to such a bond pending final determination of the dispute.

…

[25] The fact that a performance bond is intended to operate as a risk allocation device is not, of course, necessarily determinative of the right of a party to have recourse to it.  It may be subject to a contractual qualification or limitation upon the circumstances in which recourse may be had.  Nevertheless, the fundamental characteristic of a risk allocation device informs the task which the Court must undertake in resolving whether or not to grant an injunction.”

Osborn and Ferguson JJA concluded that the parties had entered into a commercial agreement as to when and how the performance bonds might be called upon.  In doing so, they effectively determined which of them would bear the financial risk without the need for Sugar Australia to prove an entitlement to be paid. The safeguard negotiated and agreed by the parties was that Sugar Australia must act reasonably when claiming an entitlement to payment and calling on the bonds.  One important commercial effect of this was that Sugar Australia did not have to wait until trial for payment of some amount by Lend Lease.

In agreeing with the majority, Kaye JA relevantly stated:

”[139] In the present case, clause 5.2 contains three preconditions to the exercise by the appellant of its right to access a security specified in clause 5.1.  First, the appellant must be ‘acting reasonably’ in making the claim to the entitlement to payment or reimbursement.  Secondly, the claim by the appellant must be in relation to an entitlement to one of the three categories of payment, reimbursement or indemnity, specified in sub-clauses (i), (ii) and (iii) of clause 5.2.  Thirdly, the appellant must first give the respondent five days’ notice of its intention to have recourse to the security.

…

[141] … it is important to bear in mind, first, that that provision does not require the appellant to establish or demonstrate an entitlement to the payment, indemnity or reimbursement referred to in the clause.  Rather, it is sufficient that the appellant has a ‘claim’ to such an entitlement… the security, provided under clause 5.2, was intended to serve both purposes described by Callaway JA in Fletcher Construction, namely, to provide security to the appellant, and also to allocate the risk to the respondent as the party which should be out of pocket pending resolution of any dispute between the parties.”

Rather, the qualification is expressed to require that the appellant be ‘acting reasonably’ in making the claim. This does not require the claim itself to be reasonable.  The court held that the balance of convenience did not support the grant to Lend Lease of an injunction restraining Sugar Australia from accessing the bank guarantees.

Conclusion

In practice, holding performance security is often about reducing the beneficiary’s risk of immediate financial exposure in the event that the parties fall into dispute.  Fundamentally, in such circumstances, performance securities are instruments of risk allocation.

In Clough, the court held that if the purpose of the security clause is a risk allocation device, then subject to the exceptions of fraud and unconscionability, the beneficiary of a performance guarantee granted in its favour will be entitled to call upon the guarantee even if it turns out that the other party was not in default.

Recent judicial authority on the consideration of a security’s purpose have demonstrated the purpose of a security clause will depend upon the wording of the clause, the wording of the security provided (if any) and those clauses which impact upon the potential to have recourse to security (such as dispute resolution or termination clauses).

For the avoidance of ambiguity, parties should draft security clauses which clearly identify the intention of the clause as a risk allocation mechanism (if appropriate) and the circumstances of when a party may have recourse to the security. If acting for a principal, it is preferable to draft the clause with this stated purpose so as benefit from a wide and essentially unfettered ability to access security. This clause should be drafted as widely as possible, and without reference to damages or amounts agreed or otherwise.