Can you bank on it?

The question of whether a Principal has the right to call on a contractor’s bank guarantee for failure to perform was recently considered in the Court of Appeal of Victoria. Initially, the Supreme Court rejected the entitlement of the Principal to call on bank guarantees based on a strict construction of the contract.

This position was later reversed by the Victorian Court of Appeal.

The Facts

In June 2007, Lend Lease, the Contractor, and Sugar Australia (“Sugar”), the Principal, entered into a construction contract to upgrade a refined sugar facility at Yarraville in Victoria (“the Contract”).

Under the Contract, Lend Lease, provided two bank guarantees to Sugar as security in the amount of $4,190,000 for its performance.

Sugar alleged that Lend Lease did not comply with its lawful directions, delays and other breaches. As a consequence, Sugar provided Lend Lease with a five-day notice of its intention to call on the two bank guarantees to cover its losses (“the Notice”).

The Contract, which was a modified form of the General Conditions of Contract AS 4910-2002, also contained a clause requiring Sugar to ‘act reasonably’ when seeking recourse to the bank guarantees.

The Contract set out a number of stipulations in relation to how recourse notices were to be issued.

In response to the Notice, Lend Lease suspended works under the Contract claiming that Sugar did not show cause under the Notice and then terminated the Contract.

As a result of Lend Lease’s termination of the Contract, Sugar sought recourse to the bank guarantees.

The Injunction

Lend Lease applied for an interlocutory injunction seeking to restrain Sugar from cashing in the bank guarantees before the alleged breaches had been determined on the evidence after a trial.

Lend Lease claimed that Sugar had not sought recourse to the bank guarantees in compliance with the terms of the Contract, and had not ‘acted reasonably.’ Lend Lease agreed that an interlocutory injunction should be granted to Lend Lease as there was a serious question to be tried.

In response, Sugar claimed that the interlocutory injunction should not be granted, and that, as the issues involved contractual construction in the absence of an assessment of evidence, the court was obliged to finally determine the issue at the interlocutory stage of the proceeding.

The General Rule

As detailed in Cerasola TLS AG v Thiess Pty Ltd & John Holland [2011] QSC 115 (“Cersola”) which cited Clough Engineering Ltd v Oil and Gas Corporation Ltd (2008) 249 CLR 458, where a party seeks to call on a bank guarantee, the Court will generally not step in to prevent the issuer of the bank guarantee from performing its obligation to make payment, unless one of the following recognised exceptions applied:

• if the party calling on the bank guarantee has acted fraudulently;
• if the party calling on the bank guarantee has acted unconscionably in contravention of the Trade Practices Act 1974 (Cth) now Competition and Consumer Act 2010 (Cth), or
• where the contract in question provides for negative stipulations on calling on the bank guarantee and the negative stipulations are met.

The Decision

At first instance, Justice Vickery of the Supreme Court of Victoria:

• considered the relevance of the last exception of the general rule and also applied general construction principles in the proper interpretation of the words “act reasonably” as used in the Contract;
• held there was a serious issue to be tried;
• granted Lend Lease the injunction on the balance of convenience;
• found no payment would be available under the bank guarantees unless and until Sugar Australia proved that it was entitled to the damages which the bank guarantees were there to secure; and
• held that it was not necessary for the Court to determine contractual construction at the interlocutory stage. Such determination was an exercise of discretion by the Court after weighing relevant factors.

The Appeal

Sugar appealed to the Victorian Court of Appeal, which allowed the appeal.

Critically, the Victorian Court of Appeal reversed the Supreme Court of Victoria’s decision and discharged the injunction.

The Victorian Court of Appeal reaffirmed Fletcher Construction Australia Ltd v Varnsdorf Pty Ltd (1998) 3 VR 812 (“Fletcher”) which held that bank guarantees:

• provide security to the holder by allowing recourse against a third party bank, rather than having to recover directly against the party; and
• allocate the risk of which party should be out of pocket, pending resolution of any dispute that may arise.

On that basis, the Victorian Court of Appeal held it would defeat the purpose of bank guarantees if bank guarantees were not payable until determination of the very claims they are designed to secure.

As a consequence of the Court finding that Sugar had a genuine claim under the Contract, Sugar was entitled to call on the bank guarantees without first having to prove its claims against Lend Lease.

What are the implications in this case?

This decision, although in Victoria, provides principals with a basis to assert an entitlement to cash in a contractor’s bank guarantee if there is a genuine claim under a construction contract in circumstances where:

• the principal has an arguable claim against the contractor which could possibly succeed at a trial;
• recourse against the bond is reasonable in light of that arguable claim; and
• there is no reason in justice why the Court should prevent the principal’s recourse to the bond (for example, significant reputational damage to the contractor, a real risk that the principal will be unable to compensate the contractor for losses resulting from the pay-out should the principal’s claims fail and no real inconvenience to the principal if recourse to the bond monies were refused).

The case provides principals with some assurance and practical guidance on when a right to call in a bank guarantee can be exercised.