Parent company guarantees - "pay now, argue later", or "argue now, not argue later"?

17 Sep 2020
Security is often required under a contract to guarantee the performance of contractual obligations and/or provide comfort in relation to payment obligations. Where security is provided, parties should ensure the nature and terms of the security are unambiguous.

A recent decision of the Western Australian Supreme Court of Appeal, JKC Australia LNG Pty Ltd v CH2M Hill Companies Ltd [No 2] [2020] WASCA 112, confirmed that parent company guarantees do not necessarily create instantaneous "pay now, argue later" obligations on the guarantor, rather, liability may be subject to any defence, set-off or counterclaim. The Court considered the express terms, context and purpose of the guarantees provided and ultimately determined that the guarantors were not liable to respond to the claims under the guarantees in the circumstances. The decision highlights that careful consideration should be given to the drafting of parent company guarantees to ensure that a party has recourse to the security as intended.

Interpretations of the parent company guarantees

The case concerned the construction of the onshore production facility for the Ichthys LNG Project in the Northern Territory. INPEX Operations Australia Pty Ltd engaged JKC Australia LNG Pty Ltd (a joint venture between US engineering group KBR and Japanese groups JGC Corporation and Chiyoda Corporation) to engineer, procure, construct and commission the onshore LNG plant for the project.

JKC subcontracted a consortium to construct a combined cycle power plant on the site. Under the subcontract, the subcontractor was required to procure bank guarantees and three parent company guarantees (on identical terms) as security for due performance of the subcontractor's obligations. The three parent company guarantees were provided by CH2M Hill Companies Ltd, UGL Pty Limited and General Electric Company.

At the time of trial, the works contemplated by the subcontract had not been completed and were delayed. The subcontract was ultimately terminated and the subcontractor immediately removed their workers from the site. The parties were in dispute about who validly terminated the subcontract, and the amount of any additional costs and expenses necessary to complete the works. That dispute is the subject of an ongoing international arbitration. JKC gave notice to the subcontractor asserting that, in its reasonable opinion, the subcontractor had failed to discharge their liabilities by failing to pay certain cost claims.

Importantly, clause 3 of each of the parent company guarantees provided that if, "in [the] contractor's reasonable opinion", the subcontractor failed to perform any of its obligations under the subcontract, then the guarantors were required to perform those obligations "until the termination of the subcontract".

On JKC’s construction of clause 3, the parent company guarantees could be called upon if JKC formed a reasonable opinion that the subcontractor had failed to perform any of their obligations under the subcontract, regardless of any defence, set-off or counterclaim. JKC argued that the parent company guarantees provided a provisional remedy and evinced a purpose of risk allocation pending determination of any dispute. It claimed that the parent company guarantees were analogous to performance bonds and that it was entitled to seek payment from the parent companies "on demand", including in circumstances where primary liability under the subcontract had not yet been determined.

The subcontractor denied liability under the parent company guarantees, claiming that, on the proper construction of the parent company guarantees, JKC's claims in the arbitration for reimbursement of additional costs and expenses in completing the works must first be resolved and quantified before any liability on the part of the subcontractor crystallised. They rejected the argument that the parent company guarantees created an "on demand" obligation to pay.

The Supreme Court of Western Australia rejected JKC's arguments and differentiated the parent company guarantees with the bank guarantees provided by the subcontractor which were "payable on first demand". The Court held that the parent company guarantees did not create an independent "pay now, argue later" obligation, rather, liability under the parent company guarantees was subject to defence, set-off or counterclaim by the parent companies.

JKC appealed the decision, contending that the notice given under clause 3 of the parent company guarantees required the subcontractor to put JKC in the money in the amount claimed, even though the subcontractor's liability was disputed and the subject of ongoing international arbitration.

The Western Australian Supreme Court of Appeal unanimously dismissed JKC's appeal, with Buss P and Vaughan JA handing down a joint judgment and Beech JA delivering a separate judgment. The Court upheld the primary judge's decision that the parent company guarantees were not "payable on first demand" instruments and could be differentiated with other forms of security such as cash and bank guarantees.

Parent company guarantees not functionally equivalent to performance bonds or interim risk allocation devices

The Court rejected JKC's contention that the purpose clause of the guarantees given by the parent companies were functionally equivalent to a performance bond and evinced a purpose of interim risk allocation as between JKC and the subcontractor. In the Court's view, JKC's assertion that the guarantees given by the parent companies were the "functional equivalent of the bank guarantees" was not grounded in the language of the instruments.

"Reasonable opinion" requires an objective assessment

Under clause 3 of each of the parent company guarantees, JKC could seek recourse against the parent companies if it formed a "reasonable opinion" that the subcontractor failed to perform any of their obligations under the subcontract. JKC asserted that it would be sufficient if JKC subjectively considered its opinion to be reasonable. The Court disagreed, finding that whether JKC formed a "reasonable opinion" required an objective assessment based on the information and facts then known, or which ought reasonably to have been known, at the time. In this case, satisfaction of a "reasonable opinion" required "the satisfaction of an objective standard as a condition of JKC requiring the respondents to step in themselves [and] perform obligations and discharge liabilities under the Subcontract." The Court observed that "[o]rdinarily, concepts of reasonableness are construed as importing an objective standard". The objective standard was said to provide the subcontractor with a "measure of protection".

The Court determined that this position was consistent with clause 9.2 of the parent company guarantees, which allowed the parent companies to rely on any defence, set-off or counterclaim available to the subcontractor. The Court found that "[t]he availability of a defence, set-off or counterclaim ought to be taken into account in arriving at an opinion – one which is objectively reasonable based on the information and facts known or which reasonably ought to have been known – that the Subcontractor has failed to perform an obligation or discharge a liability under the Subcontract".

Construction of commercial contracts

The Court relied on well-established principles for construing a commercial contract, emphasising that the interpretation of a commercial document requires "attention to the language used by the parties, the commercial circumstances which the document addresses and the objects which it is intended to secure".

The Court found that JKC's approach (in arguing that the purpose of clause 3 was risk allocation, akin to a performance bond) had failed to recognise that the commercial purpose of a "reasonable opinion" clause is to be derived from the objective meaning of the contractual language read in context. The Court observed that it would be "impermissible" to approach a clause with a preconceived notion of its commercial objective and noted that:

"[a]ny other approach runs the risk of adopting a construction by mere bootstrapping from one party's subjective view as to the desirable contractual outcome from its perspective – it is assumed that the provision has a particular purpose and the provision is then construed to suit that purpose."

Where there is no express statement of purpose or object, the ascertainment of purpose cannot be neatly separated from the overall constructional task that the court is to perform. Identification of the purpose of the parent company guarantees was not necessarily bound up with ascertaining the proper construction of the provision. The extent to which each informs the other is part of the court's overall evaluative task in arriving at the proper construction. The court's task in determining the legal meaning of a written contract involves "weighing up the different considerations based on text, context and purpose", and often this necessitates an iterative approach checking each of the rival meanings against the other provisions of the instrument and investigating their respective commercial consequence. The Court found that the proper construction of clause 3 of the parent company guarantees was to be ascertained as a whole rather than by reference to various grounds – a piecemeal approach would simply not suffice.

Key takeaways

The decision provides a valuable reminder that not all forms of contractual security are analogous, and the contractual language employed in relation to the security remains all important in every case. Where security is being provided under a contract, parties should ensure that the nature of the security is unambiguous, keeping in mind that courts will always look first to the express terms of the instrument and will not be willing to make any presumptions based on the particular type of security instrument.

If parties intend that the security being granted is akin to cash and creates a "pay now, argue later" obligation on the guarantor, then this should be clearly stipulated.

Further, if the parties to a contract intend to give a party a subjective discretion on a particular matter, keep in mind that a "reasonable opinion" shall be construed as importing an objective standard.

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