Performance guarantees - traps and pitfalls

by David Lester, Alan Maguire

06 Feb 2004

Performance guarantees are a common form of support used in commercial transactions, but before simply asking for a performance guarantee, careful consideration needs to be given to various factors.

Often in commercial transactions, a party will require one of their counterparties to back up its obligations with additional support. This support might be in the form of security - for example, a mortgage over real property or a charge over all or part of the assets of the corporate counterparty. Alternatively, it may be considered that a performance guarantee from a third party is sufficient. This article discusses some traps and pitfalls that should be kept in mind when asking for a performance guarantee.

What are you seeking?
The first issue to resolve is exactly what form of support is required. There are many forms of support that can be provided and even more confusing jargon and terminology. The jargon includes terms such as performance bonds, bank guarantees, insurance bonds, performance guarantees, parent company guarantees, letters of credit and letters of comfort. Each of these may provide varying levels of comfort and support to a transaction and the legal and commercial consequences of each ranges widely. They are described below.

Performance bonds
"Performance bond" is a generic term that has a range of possible meanings. It is generally accepted that a performance bond is an undertaking, under seal, from an entity guaranteeing the performance of a third party's obligations. However, such bonds may be conditional or unconditional.

If a bond is conditional then it is a form of guarantee and, accordingly, a secondary obligation accessible only upon proof of breach of the guaranteed or principal obligation. It also means the issuer is entitled to a range of common law and equitable defences available to a guarantor. For example, if the underlying contract is varied or the counterparty is granted an extension of time then, without clear agreement to the contrary, the liability of the guarantor may be discharged.

While it is not free from doubt, it is generally accepted that an unconditional performance bond is not a secondary obligation in the nature of a guarantee and is not dependent upon proof of breach of the guaranteed or principal obligation. The issuer is undertaking to simply pay an agreed amount on demand.

Bank guarantee/undertaking
Generally speaking, "bank guarantee" or "bank undertaking" or "first demand guarantee" refer to an unconditional performance bond from a bank, - ie. an undertaking from a bank to make a payment upon presentation of a demand. However, the terms and conditions of these documents may differ from bank to bank and from transaction to transaction, so the terms of the document must be closely examined. In particular, care should be taken to ensure that the conditions needed to be satisfied before the bank will make payment are easily achievable. In accepting documents of this nature, the beneficiary is accepting the credit risk of the issuing bank.

Insurance bonds
These are usually unconditional performance bonds issued by insurance companies. The same issues that arise with bank guarantees arise with these documents, however, the credit risk lies with an insurer, rather than a bank.

Letters of credit
A "letter of credit", "documentary credit" or "credit" refer to an arrangement where a bank agrees to make a payment to, or to the order of, a beneficiary, or to accept and pay bills of exchange drawn by the beneficiary, or authorises another bank to effect such payment, or to accept and pay such drafts, against stipulated documents, provided that the specified terms and conditions are complied with. The bank need only be concerned with the terms of the credit itself and not the underlying transaction. There is a whole range of different types of credits including confirmed credits, sight credits, revolving credits and standby credits. Letters of credit are traditionally used to secure payments under international trade contracts, although a simple bank guarantee is likely to be a form of standby letter of credit.

Letters of comfort
Letters of comfort are generally considered to be a softer alternative to a guarantee or performance bond. The terms of a letter of comfort will vary from transaction to transaction, but usually encompass representations that the issuer will ensure the entity the subject of the letter will meet its obligations and will remain solvent and/or that the issuer will not reduce its shareholding in the counterparty. The question of whether a letter of comfort is legally binding on the issuer will generally depend on whether:

  • the representations in the letter are sufficiently promissory in nature to be contractual; and
  • there is an intention to create legal obligations between the parties.

What is a performance guarantee?
Performance guarantees are a form of conditional performance bond ie. a secondary obligation in the nature of a guarantee used to secure performance of contractual obligations. Usually these are taken from a parent or related company of the counterparty.

What is the nature of the obligations to be secured?
Is it simply the payment of money or the performance of an obligation to do something that is being secured? For example, contrast a guarantee of the payment of the purchase price by the purchaser under a gas supply agreement with a guarantee of the supply of gas by the vendor under that same agreement.

Guaranteeing the performance of an obligation to do something can create a conditional debt obligation on the part of the guarantor. Under a performance guarantee for the completion of construction, the guarantor is guaranteeing that the completion of a project occurs by a specified date, but if the contractor fails to achieve this date then the guarantor may simply be liable in damages.

However, if the purpose of the performance guarantee is for the guarantor to cure a default or invest equity into a project if certain performance targets are not satisfied, then the terms of the guarantee need to be drafted in a way which requires this to be done.

What are the risks of a performance guarantee?
Not security: Performance guarantees do not give the beneficiary an interest in any property. They are simply a contractual undertaking by one party to another.

Insolvency risk: Upon enforcement the beneficiary is just another unsecured creditor. Should the guarantor become insolvent the beneficiary under that guarantee will have to stand in line with the other unsecured creditors.

Credit risk: By taking a performance guarantee the credit risk of the guarantor is not removed from a transaction, but simply enhanced by the worth of the counterparty.

Performance risk: Consideration needs to be given to whether the guarantor can actually perform the obligation it is guaranteeing. For example, in Queensland, if the principal under a building contract insisted that the holding company of the contractor complete construction, it may find the parent does not have the requisite license to do so and performance by that company (or even agreeing to perform that work) may be illegal.

Guarantee risks: As previously mentioned, a performance guarantee is only a secondary obligation and is dependent upon proof of breach of the primary obligation by the counterparty. The guarantor may be entitled to all of the rights given to a guarantor by common law and equity.

Enforcement risk: Apart from the risk of insolvency of the guarantor, it may be that the parent company of the counterparty is a foreign company. If this is the case, then there is a new set of risks relating to the beneficiary's ability to enforce the obligations of the guarantor, not the least of which is the risk that the guarantee document is not legally recognised and enforceable under the laws of the other jurisdiction.

Corporate benefit: How does the giving of the performance guarantee benefit the guarantor? A guarantee that does not benefit the company, and therefore breaches a director's fiduciary duty, may be voidable by the company. This is less of an issue where a parent guarantees the obligations of a subsidiary, however, it may be harder to show corporate benefit if a subsidiary is guaranteeing the obligations of its parent (although section 187 of the Corporations Act may provide some assistance for 100 per cent owned subsidiaries).

Related party transactions: While it does not void the transaction, it is a breach of the Corporations Act, unless certain requirements are met, for a public company (or an entity that the public company controls) to give a financial benefit (which would include providing a guarantee) to a related party. This means careful consideration needs to be given before a public company gives a performance guarantee to support the obligations of its own directors (or their spouses), its parent entity, any sibling entities, the parent of its public company parent or the directors (or their spouses) of those entities.

Performance guarantees are a common form of support used in commercial transactions. However, before simply asking for a performance guarantee, careful consideration needs to be given to the particular circumstances, the level of support that is required, the terms upon which that support is to be provided and which entity is most appropriate to give that support.

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