Performance bonds: preventing payment
Alan L Tyree

A performance bond is a unilateral promise by a bank or other financial institution to pay a beneficiary upon the presentation of specified documents. Performance bonds are also called 'demand guarantees', 'first demand guarantees' or, when in the form of a letter of credit, 'standby credits'. For the purposes of this article, there is no practical difference between a performance bond and a standby credit. For simplicity, both will be called 'demand guarantees'.

The "beneficiary" is the person to whom the promise is made, the "applicant" is the party whose obligation is supported by the guarantee.

Demand guarantees are subject to several common law concepts that originated with documentary credits. In particular, the 'autonomy principle' states that the promise of the bank embodied in the bank guarantee is independent of the contract between the parties which gave rise to the guarantee. The bank's promise is to pay against a complying presentation of documents. In the absence of fraud, the bank is neither obliged nor entitled to consider the contract between the parties.

The International Chamber of Commerce has provided terms and conditions for demand guarantees and for standby credits: URDG758 and ISP98. Neither of these documents have attained the universal acceptance of the Uniform Customs and Practices for Documentary Credits (the UCP). However, like the UCP, the URDG758 and ISP98 rules are codifications of law and banking practice.

Demand guarantees serve three common functions:

• to protect the beneficiary from the insolvency of the counterparty;
• to ensure the the beneficiary will 'hold the funds' in the event of a dispute between the parties, that is, an allocation of risk when there is a dispute; and
• as an alternative to a cash deposit.

There won't be a demand guarantee unless the bargaining position of the beneficiary is strong enough to obtain one. This commercial reality is important in analysing contracts, for when the beneficiary's position is that strong, it is almost certainly strong enough to call for a cash deposit.

The demand guarantee serves an extremely important commercial function: it relieves the account party of the need to make a cash deposit, and it does it more economically and reliably than borrowing funds.

Courts have, at one time or another, recognised all three functions of the demand guarantee, but have, for some reason, come to treat the first function as primary and the others as secondary.

The demand guarantee can only serve all three functions if it is 'as good as cash'. If the value of the demand guarantee is degraded, contracting parties will insist on cash deposits.

When there is a contractual dispute, the applicant will want to stop the bank from making payment under the demand guarantee. Because of the autonomy principle, it is almost impossible to prevent the bank from paying against a proper presentation of documents.

As an alternative, the applicant will seek to prevent the beneficiary from presenting documentation calling on the guarantee. Injunctions against beneficiaries have been granted in four circumstances:

• where the demand is fraudulent;¹
• where the demand is unconscionable;²
• if the contract between the parties contains conditions preventing the beneficiary from calling on the guarantee (the 'negative pledge');³ and
• where the contract between the parties is illegal.⁴

This note is concerned with the negative pledge. A negative pledge exists where a condition, if not satisfied, will operate to prevent the making of a claim under the documentary credit. The unsatisfied condition is a basis for the Court to enjoin the beneficiary from proceeding with a demand against the bank.⁵

In Australia, the origins of the negative pledge lie in the dicta of the High Court in Wood Hall Ltd v The Pipeline Authority [1979] HCA 21 where it was argued that the beneficiary was in breach of contract by calling on the guarantee. The High Court held that it was not, but Stephens J noted (at para 11):

Had the construction contract itself contained some qualification upon the Authority's power to make a demand under a performance guarantee, the position might well have been different. In fact the contract is silent on the matter.

A negative pledge may be stated in clear terms: 'the beneficiary will not call on the credit in the event of a dispute.' Less extreme, the beneficiary 'will not demand more than the money in arrears under this deed…'.⁶

Such a clear case is unusual. Two recent cases show the different approaches taken by courts when the clauses impose some condition on drawing: Lucas Stuart Pty Ltd v Hemmes Hermitage Pty Ltd [2010] NSWCA 283 and Clough Engineering Ltd v Oil & Natural Gas Corporation Ltd [2008] FCAFC 136.

In Clough Engineering the only relevant clause permitted the beneficiary to draw on the guarantee 'in the event of the Contractor failing to honour any of the commitments entered into under this Contract.'

In Lucas Stuart, the relevant clause was 'If the contractor has not materially complied with its obligations under this contract, the principal may give a written notice to the contractor stating…' and then call on the guarantee.

In both Clough Engineering and Lucas Stuart the beneficiary had an honest belief that the conditions for drawing had been met.

Two issues arise in these cases:

• is the beneficiary permitted to draw on the guarantee in the event of a dispute, that is, where the parties disagree about whether the condition for drawing has been met? and
• if so, is a genuine belief on the part of the beneficiary sufficient or must there be some objective measure?

Note that if there were a cash deposit, neither of these issues would arise since the cash would already be in the hands of the beneficiary.

Clough Engineering set out principles to be followed when construing a contract to determine if there is a 'negative pledge':

• the contract should be considered against the national and international commercial background (at para 81);
• 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 para 82);
• 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 para 83); and
• 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 para 90).

Applying these principles, the court refused an injunction.

In Lucas Macfarlane JA reiterated the first two goals of performance bonds, noting that not every contract seeks to achieve both. He then noted 'The present is one in which only the first is sought to be achieved.' The reason, apparently, is that the contract only entitled the beneficiary to call on the bonds if, as a matter of objective fact, the counterparty had not 'materially complied with its obligations', a matter of interpretation by the court.

There is, of course, no significant difference between the clause in the Clough Engineering case and that in Lucas Stuart. The difference is one of how to consider the purpose for giving a demand guarantee:

• in Lucas Stuart, the Court took as a starting point the existence of only the first purpose, looking for indications that might support the second;
• in Clough Engineering the Court, having regard to the nature of the unconditional undertaking, presumed that both purposes were intended unless expressly qualified.

Lucas Stuart was followed in Universal Publishers Pty Ltd v Australian Executor Trustees Limited [2013] NSWSC 2021. The only relevant clause in the contract provided that the bank guarantee was to provide for the performance of the applicant's obligations and 'no further purpose for the security is identified' (at para 60). Since the clause did not expressly provide for the allocation of risk, such a purpose was denied by the court.

The contract in Clough Engineering contained a pro-forma guarantee that obliged the bank to pay 'on breach of Contract by Contractor', but also stipulated that a demand made by the beneficiary was conclusive evidence binding on the bank notwithstanding any dispute pending.

The Court held that it was plain that the proper construction was that the beneficiary had the right to call on the guarantee. In so finding, it considered the terms of the guarantee, particularly that it was payable despite disputes and that the written demand was conclusive evidence against the bank.

The court in Lucas Stuart found that the clause required that it be objectively established that the contractor had not materially complied with its obligations. The Court expressed doubts about the correctness of Clough Engineering on this issue.

The Court of Appeal noted that in Clough Engineering the contract contained the pro forma demand guarantee and distinguished it on the ground that the guarantee contained words effectively qualifying the terms of the contract.

This is entirely unconvincing since demand guarantees will always contain terms similar to those in Clough Engineering. Commercial people know this when they agree to a demand guarantee. Since that is obviously the case, why are not the terms of the contract 'qualified' in much the same way as in Clough Engineering?

In Walton Construction Pty Ltd v Pines Living Pty Ltd [2013] ACTSC 237, the contract was silent on the circumstances in which the beneficiary could have recourse to the bank guarantee. The court considered that the outcome would depend upon whether it was possible to imply a term that 'covers both the security and risk allocation purposes', finding that it was impossible to imply such a term.

The approach in Walton Construction is bewildering. An easy extension of the logic shows that the beneficiary never has the right to call upon the bank guarantee. Why is it assumed that every guarantee fulfills the first purpose but not the second? If it is not so assumed, is it necessary to find an implied term that the guarantee is intended for the first purpose? Is an implied term relating to the first purpose any easier to find than one for the second?

The argument that 'the beneficiary has no right to call on the guarantee' unless the contract specifically states the conditions seems absurd at first glance. Yet the argument has been treated seriously.

The contract in ALYK (HK) Limited v Caprock Commodities Trading Limited [2012] NSWSC 1558 was silent as to the circumstances under which the beneficiary could make a demand on the standby credit. The contract did call for a credit in a form 'acceptable to the seller', and a later memorandum showed that the parties had accepted the unqualified terms of the credit.

The court held that the parties, having accepted the form of the letter of credit, had agreed that the credit would operate according to its terms. In effect, the terms of the credit were incorporated into the contract and provided the conditions under which the credit would operate.

Once again, commercial people know the form of a demand guarantee. It is not necessary to find some formal mechanism to incorporate the terms into the contract.

It is submitted that Lucas Stuart is wrong in suggesting that 'not every contract seeks to achieve both goals.' The parties have agreed to the use of a demand guarantee. Both parties know that the terms of the guarantee will oblige the bank to pay on demand. Both parties know that the bank's obligation is to pay despite any disputes between the parties.

In other words, simply by agreeing to the use of a demand guarantee, both parties know that it will be in terms similar to the pro forma demand guarantee contained in the Clough Engineering contract, and both parties know that the guarantee will be interpreted along the lines of URDG758 even if, as common in Australia, the URDG758 is not formally incorporated into the bank guarantee.

In truth, the parties agree to the issue of a performance bond for all three reasons mentioned above. The two often mentioned by the courts, protection against insolvency and risk management, and the use of the guarantee to ease cash flow problems. There is no reason or sense in analysing the contract minutely to say that one purpose is valid, the other not.

So, for example, in Lucas Stuart, if the parties did not intend for the demand guarantee to be used as a risk management device, they would not have agreed to a demand guarantee. They would have provided for some other form of security.

It is further submitted that it is wrong to demand an 'objective' standard when interpreting contractual restrictions on the beneficiary. The practical effect of the Lucas Stuart approach is to reduce the demand guarantee to an ordinary guarantee. A dispute will always be a dispute. If there were 'objective' evidence it wouldn't be a dispute.

There is, of course a conceptual difference between granting an injunction to prevent the bank from paying and granting one to prevent the beneficiary from demanding payment. In the first case, the injunction prevents the bank from fulfilling its obligation; in the second, it requires the beneficiary to meet its contractual commitment.

The nice conceptual difference is totally irrelevant to the beneficiary and to the commercial community. In both cases, the demand guarantee is no longer 'as good as cash'. If the courts, particularly the NSW courts, continue to make it easier to prevent payment of a demand guarantee then their usefulness will diminish, an outcome that is detrimental to all parties and to the general economic community.

The point was made in the Woodhall Pipeline case. Speaking of a demand guarantee, Stephen J noted (at para 7) 'Being 'as good as cash' in the eyes of those to whom it is issued is essential to its function.'

It can hardly be said that the securities in Lucas Stuart and similar cases were 'as good as cash'.

Donaldson J expressed it well in Bolivinter Oil SA v Chase Manhattan Bank NA [1984] 1 Lloyd's Rep 251. He was addressing an application to prevent the bank from paying, but the same comments apply where an injunction is sought against the beneficiary:

The unique value of such a letter, bond or guarantee is that the beneficiary can be completely satisfied that, whatever disputes may thereafter arise between him and the bank's customer in relation to the performance or indeed existence of the underlying contract, the bank is personally undertaking to pay him provided that the specified conditions are met. In requesting his bank to issue such a letter, bond or guarantee, the customer is seeking to take advantage of this unique characteristic. If, save in the most exceptional cases, he is to be allowed to derogate from the bank's personal and irrevocable undertaking, given be it again noted at his request, by obtaining an injunction restraining the bank from honouring that undertaking, he will undermine what is the bank's greatest asset, however large and rich it may be, namely its reputation for financial and contractual probity. Furthermore, if this happens at all frequently, the value of all irrevocable letters of credit and performance bonds and guarantees will be undermined.

The last sentence says it all.