Performance guarantees in construction contracts

By Andrew Stephenson and Patrick Daley.

Key Points:
If parties wish to impose limitations upon the circumstances in which a performance guarantee may be accessed, it is necessary to take care to include clear and specific language.

The Federal Court has recently reviewed the circumstances in which a court will prevent a party from calling on a performance guarantee. The case of Clough Engineering Limited v Oil & Natural Gas Corporation Limited [2008] FCAFC 136 reinforces the general principle that courts are reluctant to interfere except in limited circumstances, such as fraud.

A performance guarantee is a form of financial security provided by a person to secure the performance of the contractual obligations of another. It usually provides for a monetary amount that may be called upon by the beneficiary of the guarantee in the event of a contractor's failure to perform its obligations under the contract.

Why require a performance guarantee?

Commercially, there are two major reasons why a party to a contract may require a performance guarantee. These are:

• to provide security when there is a proven claim under a contract and difficulties arise in recovering from the party in default; and
• to allow the beneficiary to make a call when it makes a bare claim, that is before any determination as to the entitlement to claim. Such clauses allocate the risk of who will be out of pocket pending the resolution of a dispute. In these circumstances, the beneficiary can call upon the guarantee even if it later turns out that the other party was not in default. In those circumstances the beneficiary will be required to pay the money back.

In this case, the Court emphasised the distinction between these alternatives, stating that, while the contract must be interpreted on its face, the commercial background of a contract will inform that interpretation. It was also suggested that without clear words to the contrary, courts will generally construe a contract in line with the latter alternative, given the unconditional nature of the guarantee.

Facts of the case

Clough Engineering Limited, an Australian company, contracted with Oil & Natural Gas Corporation Limited (ONGC), an Indian corporation, to construct infrastructure for an oil and gas field off the coast of India. Clough was required to provide security to ONGC with an unconditional and irrevocable performance guarantee equal to 10 percent of the contract price. Under the contract, ONGC could invoke the performance guarantee if Clough failed to honour any of its contractual commitments.

Clough contended that

• implicit in the provision allowing access to the guarantee when Clough was in default, was a negative covenant by ONGC that it would not call on the performance guarantee unless there was an actual (ie. proven or admitted) breach of contract; and
• that if there was a dispute as to whether there had been a breach of contract, such a term would support an application for an interim injunction, preventing a call on the guarantee until the dispute was resolved. If such an injunction was granted then ONGC could not obtain the funds until the dispute was resolved, which may take many years.

Disputes arose over a number of matters regarding the granting of extensions of time and the performance of the contract. ONGC terminated the contract and made demand upon the banks who had given the guarantees.

Clough successfully sought an injunction. ONGC later filed a successful motion to have that injunction discharged. However the discharge of the injunction was stayed, pending an appeal to the Full Bench of the Federal Court. This note is concerned with the outcome of the appeal.

When will the courts prevent recovery under a performance guarantee?

On appeal, the Court stated that it would only prevent a party from calling upon a performance guarantee where the party in whose favour the performance guarantee is given:

• is acting fraudulently;
• is acting unconscionably; or
• has made a contract not to call upon the guarantee.

The last exception recognises that in determining whether a party can call upon a performance guarantee, the primary focus will be the proper construction of the contract.

Clough relied on the wording of the contract, arguing that the construction contract contained a negative covenant that ONGC would not call on the guarantee unless it had an entitlement to be paid money by the contractor. Clough contended that no such entitlement existed and therefore Clough was entitled to an injunction, pending the resolution of the dispute as to ONGC's entitlement.

The Court noted that the contract required Clough to provide ONGC with a guarantee that was "unconditional and irrevocable" and that although the performance guarantee stated that it was to be invoked "on breach of the Contract", the guarantee could be invoked "notwithstanding any dispute(s) pending". The form of the guarantee was annexed to the Contract and therefore needed to be considered to determine the objective intention of the parties, even though the final version gave rise to legal obligations independent of the Contract.

The latter words "notwithstanding and disputes pending" coupled with the requirement that the guarantee be "unconditional and irrevocable" demonstrated the objective intention of the parties. There was no intention to fetter the beneficiary's capacity to call until after a binding determination had been made in respect of whether there had been a breach of contract. This was reinforced by the Court's statement that, "clear words will be required to support a construction which inhibits a beneficiary from calling on a performance bond where a breach is alleged in good faith, ie. non fraudulently".

The Court considered the contract allocated 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. ONGC was therefore able to invoke the performance guarantee where it had made a claim, in good faith and on a bona fide basis.

Conclusion

This case emphasises the need for contracting parties to be alert to the language used concerning the inclusion of a performance guarantee in a contractual arrangement. If the parties wish to impose limitations upon the circumstances in which the performance guarantee may be accessed, it is necessary to take care to include clear and specific language.

For further information, please contact Andrew Stephenson.