Alan L Tyree

Performance bonds and s51AA TPA

Can it be unconscionable to call on a performance bond? At first blush, most of us would answer 'No'. After all, think of the reported cases where injunctions have been refused. In Edward Owen Engineering Ltd v Barclays Bank International Ltd and Umma Bank [1978] QB 159 the account party (Edward Owen) claimed that the beneficiary was preventing it from continuing the project. There was an exclusive jurisdiction clause providing that all disputes were to be heard by a Libyan tribunal, but the Libyan government was refusing to grant visas. The English Court of Appeal, while obviously sympathetic, could find no reason to interfere. Lord Denning MR described performance bonds as 'virtually promissory notes payable on demand'. [at 170. ]

1. The fraud exception

It is well established that fraud by the beneficiary may provide an exception. Indeed, the UK Court of Appeal has suggested that fraud of the beneficiary known to the bank is the 'wholly exceptional' case where an injunction should be granted to prevent payment. [Bolivinter Oil SA v Chase Manhatton Bank NA [1984] 1 All ER 351. ] However, the Court also noted that the evidence must be clear, both as to the fact of fraud and to the bank's knowledge of it. The difficulty of establishing fraud is well illustrated by the facts in Discount Ltd v Barclays Bank Ltd. [[1975] 1 WLR 315 ] The goods supplied were largely rubbish (literally), and virtually none of the goods related to the contract. Yet, the Court of Appeal refused an injunction.

There is good commercial reason for this reluctance to issue injunctions. Letters of credit and performance bonds are seen by the commercial community as iron-clad securities. The fraud exception actually represents a limitation on the issuer's undertaking. The promise of the issuing bank is not to pay on demand, but to pay non-fraudulent claims on demand. If it pays a claim that is known to be fraudulent, then it is not entitled to reimbursement by the account party since it has acted beyond its authority.

This puts the bank in a very unenviable position. The bank is normally obliged to pay promptly against either a demand or against specified documentation. There is little time for investigation and the bank is ill-equipped to make decisions as to the validity of claims of fraud. The position is tolerable because of the very high standard of proof required by the courts before acknowledging 'fraud'.

2. Skodaexport

The question arose in Olex Focas Pty Ltd v Skodaexport Co Ltd. [[1996] 70 ALJR 983 ] The defendant was a Czech company who had been named as head contractor for the construction of an oil pipeline in India. The plaintiff was an Australian company that specialised in the design and provision of communications systems. The defendant contracted with the plaintiff to supply the communications systems related to the pipeline. The contract price was nearly US$22 million.

As part of the contract, the defendant agreed to provide 'mobilisation advances' to the plaintiff. These advances were to be in two parts with a total of 15% of the total contract price. The plaintiff was obliged to obtain first demand bank guarantees to secure the repayment of the mobilisation advances. Thre were six such guarantees, totalling nearly A$7 million.

The plaintiff was also required to procure performance guarantees for approximately A$4.5 million. These could be drawn on by the defendant upon a written declaration that the plaintiff had not maintained the schedule imposed by the contract.

Disputes arose between the parties. These were referred to arbitration, but the outcome was apparently unsatisfactory. Although the evidence was not entirely clear, the plaintiff alleged that the defendant threatened to call upon all the guarantees in an attempt to force a reasonable settlement. This, it was alleged by the plaintiff, amounted to fraud.

The account party sought injunctions on the grounds of this alleged fraud and, more interestingly, on the grounds that drawing on the bonds would be 'unconscionable' within the meaning of s51AA of the Trade Practices Act 1974.

Batt J considered that there were no grounds for granting the injunction at common law. He noted that there were only three circumstances in which a documentary credit would be restrained. These are (1) when there is a clear case of fraud of which the bank is aware at (probably) the time of payment; (2) where the documents are forged; and (3) possibly where the underlying contract is illegal. Batt J was of the view that the principles of restraining performance bonds were the same as those relating to letters of credit, noting that the case of forged documents is unlikely to be relevant to the performance bond.

3. Unconscionability

As to the question of 'unconscionability', Batt J considered that there was no reason to restrain the beneficiary with respect to the performance bonds. He noted that calling on performance bonds with a view to exerting commercial pressure on the account party was not, of itself, unconscionable. He noted Wood Hall Ltd v Pipeline Authority [(1979) 141 CLR 443 ] where the High Court upheld a right to demand even though work was nearly finished and the avowed purpose was to exert pressure to force the account party into a more favourable settlement of the dispute. Similar results were reached in Burleigh Forest Estate Management Pty Ltd v Cigna Insurance Australia Ltd. [[1992] 2 Qd R 54 ]

However, Batt J was of the view that the Trade Practices Act 1974 made 'substantial inroad' into the law of letters of credit and performance bonds. He noted that acting within one's strict legal rights might be 'unconscionable' for the purposes of s51AA: Stern v McArthur. [(1988) 165 CLR 489 ]

The factual peculiarity of the 'mobilisation' bonds were that 90% of the advances guaranteed had already been repaid. The guarantees were with respect to these advances only, and the beneficiary's interest could have been protected by a partial demand or by a full demand under only one of the guarantees.

Under these somewhat special circumstances, Batt J was willing, reluctantly it must be said, to grant an injunction pending a hearing by the Court of Appeal. The injunction was only to the extent that the advances had already been repaid, so that the beneficiary was free to call upon the bonds for the amounts that had no been repaid.

The Court of Appeal refused to extend the injunctions to the other performance bonds. The beneficiaries gave an undertaking that they would not call upon the mobilisation guarantees beyond the amount of the advances outstanding. A request by the account party that undertakings be required with respect to the proceeds of any demand was refused. Charles JA noted that in his view, the only circumstances in which an injunction was justified at common law was where the demand was clearly fraudulent, citing Bolivantar Oil SA v Chase Manhatten Bank. [[1984] 1 Lloyd's Rep 251 ] The High Court rejected an application for leave to appeal.

4. Effect of Skodaexport

It remains to be seen if there are other circumstances in which the courts will find that it is 'unconscionable' to draw against a performance bond. The factual circumstances in Skodaexport were unusual in that it was easy to determine that the purpose of the bonds could be fulfilled while still granting a partial injunction. It is noteworthy that Batt J refused to grant an injunction against drawing against the performance bonds even though the plaintiff alleged that some 95% of the equipment and 78% of the design had already been provided.

It would be unlikely that a court will find drawing to be 'unconscionable' where the fulfillment of purpose is not so clearly demonstrable.

If, however, Batt J is correct in his conclusion that the TPA radically alters the law relating to performance bonds and letters of credit, then the proposed changes to the Act must be considered. The Trade Practices Amendment (Fair Trading) Bill 1997 proposes the introduction of a new s51AA. The new section provides:

A corportation must not, in trade or commerce, engage in conduct that is, in all the circumstances, unfair.

The proposed s51AA(2) contains a list of factors to consider when determining whether the disputed conduct is 'unfair', but, as with the existing list in the existing s51AA(2), the list is not exhaustive. One of the new factors is whether the conduct in in compliance with an approved industry code of practice. The amendments will also give the ACCC power to approve codes of practice for fair dealing.

While is it certainly possible that 'unfair' is wider than 'unconscionable' in some circumstances, it seems unlikely that there is any difference in the context of performance bonds and letters of credit. If bankers are concerned about the effect of the Skodaexport ruling, the new amendment offers the possibility of establishing a 'Performance Bond and Letter of Credit Code of Conduct'. In my opinion, a Code of Conduct that sets out existing law and practice of performance bonds and letters of credit should receive approval of the ACCC.