Bank or performance guarantees are critical in the risk allocation between parties to construction contracts. The precise wording of the requirement for such a guarantee and form it should take are, however, often overlooked in negotiations. Given the number of guarantees typically required, contractors and principals should pay close attention to the basis of each guarantee and that their intention is accurately recorded in the contract. Failure to do so can be disastrous as the new Chief Justice of the High Court, Justice French, points out in the decision of Clough Engineering Ltd v Oil and Natural Gas Corporation Ltd  FCAFC 136.
Clough Engineering Ltd (Clough) entered into a lump sum contract in the amount of US$215 million with Oil and Natural Gas Corporation Ltd (ONGC) for the development of oil and gas fields off the coast of Andhra Pradesh in India.
Clough, in accordance with the contract, provided unconditional and irrevocable performance guarantees in the amount of US$21 million from three Australian banks (CBA, HSBC and BNP Paribas). The contract provided that the guarantee would continue until either final completion or the extended date of final completion. ONGC had the right under the contract to call on the guarantees '...in the event of [Clough] failing to honour any of the commitments... under the contract'. ONGC also had the right to terminate the contract if Clough failed to furnish a guarantee. Each guarantee provided by Clough had an expiry date.
Disputes arose between Clough and ONGC over time extensions and, consequently, Clough did not extend the validity of the guarantees, arguing that ONGC had contributed to the delays. ONGC terminated the contract and attempted to make a call on the guarantees held by the banks. Clough immediately commenced interlocutory proceedings seeking to restrain ONGC from calling on the guarantees.
Clough submitted that on a proper construction of the contract, ONGC was not entitled to call on the guarantees because:
- The words 'failing to honour' required that ONGC establish that Clough had actually breached the contract and that a 'claim' by ONGC stating that Clough had breached the contract was not enough to trigger the entitlement.
- The call on the guarantees was unconscionable under the Trade Practices Act 1974 (Cth) as ONGC had waived its right to call on the guarantees in correspondence between executives to settle the dispute.
Clough also submitted that the right to call on the guarantees was qualified, that is, ONGC could only make a call on them where there was an arbitral decision providing a right to call on the guarantees, or where Clough had failed to pay amounts for rectification works or liquidated damages.
ONGC argued that it was entitled to call on the guarantees where it had a 'bona fide belief' that Clough had breached the contract.
Federal Court Rulings
The Federal Court held that a performance guarantee generally imposes no obligation on a bank to enquire into the principal's rights under a construction contract, and that a Court will not intervene unless either of the below occurs:
- The construction contract itself contains a qualification on the principal's power to call on the guarantee.
- The principal acts fraudulently or unconscionably.
The Federal Court rejected Clough's arguments, finding that there was no qualification on ONGC's power to call on the guarantees and that ONGC did not engage in unconscionable conduct.
The Federal Court concluded that ONGC was entitled to call upon the guarantees even where a genuine dispute existed as to whether or not Clough was in breach.
The Federal Court found that Clough had breached the contract by not extending the guarantees and, accordingly, ONGC was entitled to terminate and call on the guarantees where it had a bona fide belief of a breach by Clough.
Clough immediately appealed the decision to the Full Federal Court on the grounds that the condition contained in the entitlement to call on the guarantees required more than a bona fide belief in a breach by Clough. Clough argued that the entitlement was qualified and that it required an actual breach.
The Full Court considered that the guarantees should be an equivalent to cash, and that to introduce a qualification on the entitlement of the owner to call upon the guarantees would be to deprive them of the quality which gives them commercial currency.
The Full Court commented that the commercial background informs the construction of the contract but that the ultimate decision must be consistent with the agreed allocation of risk in the underlying contract.
In the Full Court's view, there was no qualification, and the contract did not indicate an intention to have an actual breach before the guarantee could be invoked. In this case the risk was allocated to Clough and there were no clear words inhibiting ONGC, as the beneficiary of the guarantees, from calling on them.
The Full Court held that ONGC was entitled to call on the guarantees regardless of the existence of a dispute between Clough and ONGC on whether Clough had 'failed to honour' any of its commitments under the contract.
In relation to the question of unconscionability, the Full Court commented that while ONGC's actions to call on the guarantees did not constitute unconscionable conduct under the Trade Practices Act 1974 (Cth), the Court did recognise that 'there may be extreme cases which would merge into the area of bad faith exercises of the power'.
This case highlights the need for principals and contractors to carefully consider any qualification they may want placed on the right to call on guarantees.
Unless clear and unambiguous wording is used to qualify a principal's entitlement to call on a guarantee, the presumption will be that a guarantee is equivalent to cash and allocates the risk of the principal being out of pocket pending the resolution of a dispute to the contractor.
Accordingly, for contractors wishing to qualify a principal's otherwise unqualified right to call on a bank guarantee, it is imperative that the contract (or the bank guarantee) clearly states the specific circumstances that will permit or preclude the principal's ability to make that demand.
For principals, it is important that a bank guarantee is unconditional, able to be called without the bank notifying the contractor, and that the entitlement to call on the guarantee is as unfettered as possible.
Phillips Fox has changed its name to DLA Phillips Fox because the firm entered into an exclusive alliance with DLA Piper, one of the largest legal services organisations in the world. We will retain our offices in every major commercial centre in Australia and New Zealand, with no operational change to your relationship with the firm. DLA Phillips Fox can now take your business one step further − by connecting you to a global network of legal experience, talent and knowledge.
This publication is intended as a first point of reference and should not be relied on as a substitute for professional advice. Specialist legal advice should always be sought in relation to any particular circumstances and no liability will be accepted for any losses incurred by those relying solely on this publication.