15 Dec 2010

Calling on a performance security – When a bona fide belief is just not enough

by Mark Gillard, Louise Dargan

Where parties agree to a conditional performance security, principals should be aware of the possible limitations on their rights to call on it.

Two recent NSW decisions suggest that principals may face more restrictions in future when seeking to access performance securities, where access is conditional upon the principal having some form of claim against the contractor. Contrary to earlier authority, it appears that a mere bona fide belief in a claim against a contractor may no longer be sufficient for a principal to make a demand on a security.

This article considers the implications of Lucas Stuart Pty Ltd v Hemmes Hermitage Pty Ltd [2010] NSWCA 283 and FMT Aircraft Gate Support Systems AB v Sydney Ports Corporation [2010] NSWSC 1108 on the right of principals to make demands on performance securities under construction contracts, which may be relevant to assessing risk and pricing a contract.

The role of performance securities in construction contracts

The provision of some form of performance security is a common practice in construction contracts to protect the principal against the risk of the contractor failing to perform its obligations under a contract.

The most commonly identified purpose of a performance security is to allow the principal to call on funds immediately to cover the costs of rectifying any alleged defects in the contractor's work. This ensures cash flow to the principal during construction and prevents delay to the project. The fact that the principal has the right to call on the security is not dispositive of the final rights between the parties. The contractor may subsequently seek to recover the proceeds of the call where it is ultimately held that the contractor was not in default.

Performance securities are usually in the form of retention payments, unconditional undertakings, performance bonds or bank guarantees. Depending on the provisions of the particular contract, the right to access the security may be simply "on demand", or it may be conditional upon the occurrence of a triggering event. It is when securities are conditional that disputes often arise between the contractor and the principal as to whether the condition has been satisfied. Normally, conditions on the exercise of a security (either express or implied) are found in the relevant construction contract rather than in the security itself. This is because they are designed to impose obligations through the contract on the principal vis-à-vis the contractor, rather than on the bank holding the secured funds. A common form of condition is that the principal have some kind of claim or entitlement against the contractor.

Where the contractor maintains that one or more conditions to making a demand have not been satisfied, it may seek an injunction from the court enjoining the principal from calling on the security or enjoining the bank from releasing funds held under the security. However, the contractor will often not be aware of an attempt by the principal to call on the security. In these cases, where the contractor only learns of the demand once the bank has already released the funds, it may seek an injunction against the principal preventing it from using the funds.

Is a bona fide belief in a claim sufficient?

The principal's right to access security conditional upon default by the contractor was previously considered in Clough Engineering Ltd v Oil and Natural Gas Corp Ltd [2008] FCAFC 136.

Access to the performance guarantee in that case was conditional on the contractor "failing to honour any of the commitments" entered into under the contract. The court found that the commercial object of the performance guarantee was to allocate the risk of being out of pocket pending the resolution of any claims to the contractor. Thus, the principal was entitled to call on the security so long as it had a "bona fide claim" for breach of contract. Examples of claims which would not be bona fide might include where a principal does not believe that it has an entitlement to make a demand, or where it does so for the purpose of causing financial harm to the contractor.

FMT Aircraft - contrary to Clough

FMT Aircraft concerned a contract to design, manufacture and supervise the construction of a gangway at the Overseas Passenger Terminal at Circular Quay. The general conditions of the contract were based on an Australian Standard contract - AS4910-2002.

Clause 5.2 stated that the principal could call on the security where it had "any claim or entitlement to the payment of damages" under the contract. The NSW Supreme Court accepted that the commercial purpose of the clause was that the contractor, and not the principal, be out of pocket for expenses pending the resolution of any dispute. However, contrary to Clough Engineering, the Court held that it was not sufficient for the principal to have a mere honest or bona fide "belief" in a claim. What was required was an "arguable claim - one that is not specious, fanciful or untenable."

Lucas v Hemmes - Clough questioned

Shortly after the decision in FMT Aircraft was delivered, the NSW Court of Appeal in Lucas v Hemmes expressed reservations as to the correctness of the position in Clough Engineering.

Lucas v Hemmes concerned the validity of a Notice to Remedy. The respondents purported to issue a notice under a 3-stage-contract to construct the multi-storied retail bar, restaurant and function centre known as The Ivy. The contract stated that the principal could issue a notice if the contractor "has not materially complied with its obligations" under the contract. If the default identified in the notice was not remedied within a reasonable time, the principal was entitled to call on the security.

After considering what would constitute material non-compliance under the contract, the Court of Appeal considered how such non-compliance could be established. Distinguishing Clough Engineering, it held that performance securities could be required for at least two principal reasons:

  • to protect the principal if the contractor became insolvent; and
  • to enable the principal to obtain prompt payment pending the resolution of any dispute.

As the contract required the objective fact of material non-compliance, and not merely that the principal was of the view that there had been non-compliance, only the first of these reasons was found to apply. It was therefore open to the contractor to seek to restrain the principal from calling on the security where it maintained that the pre-condition to issuing a notice had not been satisfied. In so doing, the Court questioned whether Clough Engineering was correctly decided, without expressing a final view.


Where parties agree to a conditional performance security, principals need to be aware of the possible limitations on their rights to call on it. This will depend to a large extent on the wording of the particular clause in the context of the contract as a whole.

In light of these recent cases, principals should not assume that they will be entitled to call on security merely because of a belief that they have a genuine claim against a contractor. However, even adopting the construction favoured in Lucas v Hemmes and FMT Aircraft, in determining a principal's right to call on security, it will rarely be necessary or appropriate to determine the ultimate validity or quantification of the claim.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.