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08 Dec 2011

When can a party restrict the use of an unconditional performance guarantee?

by Michelle Larin

Courts prefer to interpret security instruments in their commercial context

When a party to a contract can restrict another party from calling upon the benefit of a performance guarantee has again been the subject of proceedings in the Federal Court of Australia.

The Federal Court has reaffirmed Clough Engineering Limited v Oil & Natural Gas Corporation Limited [2008] FCAFC 136, in the recent decision of Redline Contracting Pty Ltd v MCC Mining (Western Australia) Pty Ltd [2011] FCA 1337.

The decision confirms how important it is for contracting parties to use clear wording when imposing conditions on the use of performance guarantees and the modern preference of courts to interpret security instruments in their commercial context.

What is a performance guarantee?

Performance guarantees usually take the form of retention payments, unconditional undertakings, performance bonds or bank guarantees. These are types of financial security provided by one party in favour of another to secure the performance of contractual obligations. For example, a contract may allow a principal to have the benefit of a performance guarantee during a construction project where it requires funds to cover the costs of rectifying a contractor's defective works. The contract may provide for the principal to have access to such a security "on demand" or in specifically defined circumstances.

Redline: The facts

The Redline case concerned four unconditional undertakings given at Redline's request by Swiss RE International SE ("the surety") to MCC Mining for the massive Sino Iron project involving the construction and installation of three pipelines in Western Australia.

Clause 5.2 of the contract between the parties provided that MCC Mining could have recourse to these undertakings where it:

  • was owed money that remained unpaid after the due date; and
  • five days had passed since it had notified Redline of its intention to have recourse to them.

The four undertakings given by Redline were identical in terms to the pro forma undertaking annexed to the contract, which stated that the surety:

"unconditionally undertakes to pay on demand any sum or sums which may from time to time be demanded by the Principal to a maximum aggregate sum of [$1,659,200.43]".

In addition to various other complaints MCC Mining made against Redline, it alleged that Redline failed to pay $1.29 million for diesel fuel charges. It is for these charges that MCC Mining sought to call upon the performance of the undertakings.

Calling on an unconditional undertaking

In response to MCC Mining's demand to have recourse to the undertakings, Redline applied for an urgent interlocutory injunction to stop MCC from calling on the undertakings.

A court will only grant such an injunction where an applicant can demonstrate that:

  • it can make out a case for which it has reasonable prospects of succeeding; and
  • the balance of convenience favours the grant of the injunction (as Redline failed on the first element, the court did not address this).

Redline argued that MCC Mining was not entitled to call upon the unconditional undertakings because:

  • there had been no determination under the contract that they were owed the amounts they claimed and that, in any case, clause 5.2 could be construed so that the claim being made by MCC Mining was subject to being set off against the amounts claimed by Redline in its notice of dispute; and
  • it alleged that MMC had engaged in misleading and deceptive conduct in relation to the representations it had made in the specification to the contract regarding the tolerance standards of the pipe to be provided under the contract. Redline complained that those representations induced it to tender at a lower contractual price than it would otherwise have done.

Applying the principles from Clough Engineering

The Court rejected both of Redline's arguments. It was found that neither of the claims made by Redline had any likelihood of success. The principles applied were those set out in the 2008 decision of Clough Engineering, which provide that a court will not prevent a party from calling upon a performance guarantee unless the party in whose favour the performance guarantee is given:

  • is acting fraudulently;
  • is acting unconscionably; or
  • has made a contractual promise not to call upon the guarantee (and this is specifically stipulated in the contract).

Subject to the above three exceptions, a beneficiary of a performance guarantee is entitled to call upon that guarantee, even if it turns out that the other party was not in default.

The Court rejected Redline's claim and considered the importance of the construction of a contract, noting:

  • a contract is to be "construed in its commercial context";
  • where it provides for a performance guarantee, the parties are taken to have contracted in the knowledge of the "legal principles relating to the construction of contractual terms insofar as they affect the right of the beneficiary to call upon a performance bond"; and
  • the contract must be construed "in light of the whole contract and the language of the performance bond itself".

Having regard to the language and context of the contract between Redline and MCC Mining, it found that the parties had:

  • characterised the undertaking as "unconditional";
  • contracted for the undertaking to be supplied in the specific form annexed to the contract; and
  • used language in the contract providing that the surety "unconditionally undertakes" to pay "on demand" any sums of money demanded from time to time by MCC Mining and "unconditionally" agrees to make the payment demanded "without reference to [Redline] and notwithstanding any notice given by [Redline] not to pay the same".

For these reasons, the contract did not contain wording which could be interpreted to prevent MCC Mining from calling upon the unconditional undertaking on the basis of Redline's claim to a set-off.

Implications

The decision in Redline reconfirms that, in the absence of fraud or unconscionable conduct, a court will not prevent a party from calling upon a performance guarantee unless there are clear words in the contract restricting the circumstances in which it can be invoked.

Courts are very conscious of the need to interpret performance guarantees to uphold their commercial purpose. Accordingly, when drafting a performance guarantee, it is important that both parties carefully consider the circumstances in which the beneficiary of that guarantee should not be permitted to call upon it and to expressly state this in the contract.

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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.