UK: Refund Guarantees

Last Updated: 23 August 2010
Article by Christopher Hill, Steve Abraham and Donald Warnock

In the following case the Court of Appeal had to consider the effect of a refund guarantee in the context of a shipbuilding contract.

Kookmin Bank v Rainy Sky SA & Others [2010] EWCA Civ 582

The buyers entered into six materially identical shipbuilding contracts made with Jinse Shipbuilding Co Ltd (the Builder). Kookmin Bank (the Bank) issued six materially identical on demand advance payment bonds or guarantees to secure certain obligations assumed by the Builder.

Each shipbuilding contract entitled the buyers to require the Builder to refund the full amount of all advance payments made in the event of the Builder's insolvency or the like.

The issue for the court was whether the obligation on the Builder to refund the advance payments following its insolvency was an obligation which was covered by the bonds issued by the Bank.

The ship-building contracts

Each shipbuilding contract was for the construction of a specified vessel for a price of US$33,300,000 and required 20% of the price (US$6,660,000) to be paid within three days of signing the contract. The remainder of the contract price was to be paid by three further 20% pre-delivery instalments at various stages during the construction of each vessel and a final payment on delivery.

Each shipbuilding contract entitled the buyer to require the Builder to refund the full amount of all advance payments made in the event of the Builder's insolvency or the like (Article XII.3).

The bonds

Each bond was in the form of a letter from the Bank to the buyer and was in the following terms:

(2) Pursuant to the terms of the Contract, you are entitled, upon your rejection of the Vessel in accordance with the terms of the Contract, your termination, cancellation or rescission of the Contract ... to repayment of the pre-delivery instalments of the Contract Price paid by you prior to such termination ... together with interest thereon at the rate of seven per cent (7%) per annum ....
(3) In consideration of your agreement to make the pre-delivery instalments under the Contract ..., we hereby, as primary obligor, irrevocably and unconditionally undertake to pay to you, your successors and assigns, on your first written demand, all such sums due to you under the Contract ... PROVIDED THAT the total amount recoverable ... under this Bond shall not exceed US$[26,640,000] ...."

The buyers paid the first instalments due under the contracts but the Builder then entered into or became subject to a "debt work out procedure" under the Korean Corporate Restructuring Programme Law 2007. As a result, the buyers required the immediate refund pursuant to Article XII.3 of the full amount of the instalments. When the Builder failed to pay, the buyers demanded repayment of the instalments from the Bank under the terms of the bond. The Bank declined to make payment on the basis that they were not obliged to under the provisions of each of the bonds.

The court at first instance gave summary judgment against the Bank and the matter went to the Court of Appeal.

The issue before the Court of Appeal

The Bank contended that the obligation in Article XII.3 of the contract requiring the Builder to refund the full amount of all advance payments in the event of the Builder's insolvency was not covered by the bond. The buyers conversely argued that the Bank guaranteed the Builder's obligation to repay those instalments.

Much of the argument before the Court of Appeal centred on whether the words "all such sums due to you under the Contract" in paragraph (3) of the advance payment bond could be construed as referring to:

  • the "pre-delivery instalments" at the beginning of paragraph (3); or
  • the repayments set out in paragraph (2) of the bond.

It was crucial to the Bank's argument that the construction of the words "all such sums due to you under the Contract" in paragraph (3) of the bond referred to the repayments in paragraph (2) of the bond. This was because paragraph (2) specifically provided for repayment in the event of rejection of the vessel, termination, cancellation or rescission of the contract, but not the insolvency of the Builder (since the Builder's insolvency did not give rise to a right to reject the vessel or terminate, cancel or rescind the contract under Article XII.3 of the contract).

The first instance judgment

The judge at first instance found in favour of the buyers on the basis that:

  • The Bank's obligations to pay arose under paragraph 3 of the bond and that it made better grammatical sense for the words "all such sums due to you under the Contract" to apply to the pre-delivery instruments in the same sentence rather than the repayment obligation in paragraph 2 (which the court considered to be in the nature of a preamble);
  • The Bank's construction had the "surprising and uncommercial result" that the buyers would not be able to call on the bond in the event of the Builder's insolvency.

The Court of Appeal decision: the minority view

Sir Simon Tuckey accepted that it was clear that first he court had to consider the words used in the bonds. If that led clearly to a conclusion as to the correct meaning of the bonds the court should give effect to it no matter how surprising or unreasonable the result might be. But if there were two possible constructions then in his view the court was entitled to reject the one which was unreasonable and, in a commercial context, the one which flouted business commonsense.

Sir Simon Tuckey accepted that there were two possible constructions of the bonds. He agreed with the trial judge's conclusion that the Bank's construction was surprising and uncommercial.

There was no credible commercial reason why the parties should have agreed that the bonds would cover the situation in which the buyer was entitled to a return or a refund of the advance payments apart from on the insolvency of the Builder. Had the parties intended this surprising result this would have been spelt out clearly in the contract and the bond.

The Court of Appeal decision: the majority view

The purpose of a contract was to define the limits of the parties' obligations. A dispute as to the meaning and scope of a contract could only be resolved by construing the words used in a way which gave them the meaning which the document would convey to a reasonable person knowing all the background knowledge which would have been available to the parties in the situation they were in at the time of the contract: see ICS Ltd v West Bromwich Building Society [1998] 1 WLR 896.

In some cases, a reference back to the matrix of fact might enable the court to make sense of language in the contract. Sometimes there were cases where, although there was no apparent drafting error, the words used might, if given a particular meaning, lead to consequences which are so extreme as to make it unlikely that the parties intended them to have that effect (Lord Hoffmann in ICS Ltd v West Bromwich Building Society). There were also cases where the words in question if given their natural meaning produced an arbitrary and irrational meaning (Lord Hoffman in Chartbrook Ltd v Persimmon Homes Ltd [2009] 1 AC 1101).

However, Patten LJ was clear that unless the most natural meaning of the words produced a result which was so extreme as to suggest that it was unintended, the court had no alternative but to give effect it its terms.

"To do otherwise would be to risk imposing obligations on one or other party which they were never willing to assume and in circumstances which amount to no more than guesswork on the part on the Court."

As a result the majority held that:

  • The draftsman intended the content of the phrase "all such sums due to you under the Contract" to be supplied by the "sums" to which it referred and the word "such" could not be ignored.
  • The word "sums" used in paragraph 3 of the bonds must refer to the pre-delivery instalments paid under the contract because the purpose of the bonds was to guarantee repayment of those instalments and nothing else.
  • The contract required the delivery of a bond as a condition precedent to payment of the first pre-delivery instalment. The contract went on to require the Builder to refund the pre-delivery payments if the vessel was rejected by the buyer or if the buyer terminated or rescinded the contract "pursuant to any of the provisions of this Contract specifically permitting the Buyer to do so." Article XII.3 required the Builder to refund the pre-delivery instalment in the event of its insolvency, but gave the Buyer no right to terminate the contract for insolvency.
  • The obvious purpose of paragraph (2) was to give a clear statement of the Builder's obligations under the contract which were to be covered by the guarantee and one which was consistent with the terms of the Builder's obligations to provide the bond. The obligation to repay in the event of the Builder's insolvency was not covered by the guarantee.
  • The difficulty with the buyers' construction (that the words "such sums" was a reference to all pre-delivery instalments due to the buyers under the contract including in the event of insolvency) was that it robbed paragraph 2 of any purpose. Paragraph 2 could have been omitted if the purpose of the bond was to provide a guarantee for the repayment of the pre-delivery instalments regardless of the circumstances in which they came to be repayable.
  • Whilst cover under the bonds for repayments in the event of insolvency was objectively speaking desirable, that was not sufficient to justify a departure from what would otherwise be a natural and obvious construction of the bonds.

As a result the Court of Appeal held that the bonds did not guarantee repayment of the instalments in the event of insolvency.

Editors' comments

The message from this case is clear. Contract drafters should ensure that their drafting is as precise as possible.

Although the Court of Appeal recognised that cover under the bonds for repayments in the event of insolvency was objectively desirable, the Court of Appeal was not prepared to speculate on the reasons for omitting repayments in such circumstances. In the court's view, the Bank's construction of the bond was the meaning that would be conveyed to a reasonable person reading the bond with the knowledge of the terms of the contract, that meaning was neither absurd nor irrational and the court had no alternative but to give effect to its terms.

The Court of Appeal's approach in this case is similar to the approach adopted in William Hare v Shepherd Construction Limited [2010] EWCA Civ 283 reported in our April 2010 Updater where the court took a literal meaning of the words used in the contract and was not persuaded that something had gone wrong with the drafting.

View: Kookmin Bank v Rainy Sky SA & Others [2010] EWCA Civ 582

This article was first published in the Norton Rose Construction and infrastructure updater July 2010

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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