Bank guarantees as security for performance

Bank guarantees are now more widely used than ever and most people involved in business and property transactions have come across them in one form or another. Nevertheless, we still see many instances of misunderstanding and uncertainty about how and when they can be called upon. One of the most common functions of a bank guarantee is to provide security for performance of obligations under a commercial agreement (we will refer to it as the underlying agreement).'  A good example is where a tenant (such as a retail business or an industrial company), instead of providing a cash bond to the landlord, provides a bank guarantee for an agreed amount, to secure the performance of its obligations under the lease.'  Another common example is where a builder provides a developer (usually the land owner) with a bank guarantee as security for performance of its obligations under the construction contract. In this article we explain how and when a bank guarantee provided as performance security can be called upon. But first lets explain what a bank guarantee is.

What is a bank guarantee?

There are three parties involved '€“ the bank and its customer, and the third party who has the benefit of the bank guarantee (e.g. a landlord or a developer) '€“ we will refer to them as the beneficiary.'  The customer asks its bank to issue a bank guarantee in favour of the beneficiary for a particular amount.'  If a bank issues a bank guarantee it will be at risk of having to make a payment under that guarantee and so it will require its customer to safeguard that risk, either by providing a cash deposit of an equivalent amount (this is called a 'cash backed bank guarantee') or some other form of security acceptable to the bank. The bank charges its customer a fee for providing the bank guarantee. A bank guarantee will usually have an expiry date, but not always.'  This is important to the customer because it will not be able to get its cash deposit returned (or other security arrangements released) until the bank guarantee expires or is returned to the bank.

As good as cash

There is a very important difference between bank guarantees and most normal guarantees.'  Under a normal guarantee the guarantor promises Party A that it will pay any amount that Party B owes to Party A, but fails to pay when due.'  A key issue here is the liability of Party B '€“ if Party B is not liable to pay the amount to Party A then the guarantor does not have to pay. However, under most bank guarantees the guarantor (i.e. the bank) promises Party A that it will pay a specific amount to Party A on demand, regardless of whether or not the amount is due by Party B, or is disputed by Party B.'  This is why bank guarantees are often referred to simply as "an unconditional promise to pay on demand". Within the business community bank guarantees in this form are regarded as being "as good as cash" because the bank must pay on demand, regardless of whether or not its customer owes the amount claimed, or disputes the amount claimed. ' This is sometimes referred to as the autonomy principle, meaning that the bank must act autonomously and regardless of what its customer might say. If this were not so then parties involved in business and commerce would not be confident of their ability to convert the bank guarantee into cash and might instead insist on a cash bond rather than a bank guarantee. A bank guarantee will usually make reference to the bank's customer and the underlying agreement between the customer and the beneficiary (e.g. a lease for specified premises or a construction contract for a particular project) but these references are usually only for context and background, and give the customer no rights under the bank guarantee. The majority of bank guarantees operate in this way, and this article deals with bank guarantees of that kind.'  However, a word of caution '€“ not all bank guarantees are the same.'  Some do include additional wording that can make them conditional or impose some qualifications on the bank's obligation to pay.'  So it is important to carefully study the precise wording of every bank guarantee, and not assume that they all operate in exactly the same way.. So, when asked to do so by a beneficiary, the bank must pay out the bank guarantee, no questions asked.'  It is an entirely different question however, as to whether the beneficiary is entitled, under the terms of the underlying agreement with the customer (the other party), to make the demand, and we deal with that in more detail below. A small matter of terminology '€“ in the context of claiming on a bank guarantee, a number of different expressions are commonly used, which all essentially have the same meaning '€“ "having recourse to'€¦" or "making a demand under'€¦.." or "claiming under'€¦" the bank guarantee, or simply "cashing the bank guarantee".'  For consistency and simplicity, in this article we will use the term "cash.." or "cashing'€¦" the bank guarantee. The cashing of a bank guarantee can be a very serious matter for the customer, especially with major projects or contracts where bank guarantees are issued for very substantial amounts of money.'  Apart from triggering the bank's access to its customer's cash or security resources backing the guarantee, the cashing of a bank guarantee can trigger an immediate breach of banking covenants with serious financial implications for the customer, and if the customer is part of a larger group, for other members of the group. For these reasons, among others, many parties over the years have sought urgent injunctions to stop banks from paying out on bank guarantees.'  The approach of the courts is clear '€“ as recently affirmed in the case of Lanskey Constructions Pty Ltd v Westrac Pty Ltd [2022] WASC 90 - that injunctions will only be considered in the following limited circumstances:

1. to prevent the beneficiary from acting fraudulently;
2. to prevent the beneficiary acting unconscionably in contravention of the Australian Consumer Law; and
3. to prevent the beneficiary from cashing the guarantee where they have made a contractual promise (for example in the underlying agreement) not to do so in the absence of certain specified circumstances.

We will now look more closely at the third point '€“ how and when the underlying agreement allows the beneficiary to cash the bank guarantee.

Entitlement to make a claim

The underlying agreement between the beneficiary and the customer (e.g. the lease or the construction contract) will in most cases include a clause explaining what the bank guarantee is for and how and when it can be used. In broad terms the courts have identified that there are two different types of approach in these clauses, and the rights of the beneficiary, as to how and when it can cash the bank guarantee, will depend on the intent of the parties, determined by a close examination of the particular wording of the clause. The two different types of approach are:

• one that operates as a performance security device; and
• one that operates as a risk allocation device.

Performance security device In this approach the function of the clause is to provide the beneficiary with security for costs and loss incurred as a result of breach of the underlying agreement by the customer.'  Depending on the wording of the clause, the correct interpretation could be that the beneficiary is not entitled to cash the bank guarantee unless and until its legal entitlement to costs and loss, and the quantum, have been established or finally determined legally.'  For example, if a customer disputed the alleged breach, or that the cost or loss suffered by the beneficiary was reasonable or legally due by the customer, it could be, depending on the wording of the clause, that the beneficiary is not entitled to cash the bank guarantee until those matters are finally resolved, including by legal proceedings if necessary. If this were the case the customer may be able to obtain an injunction to prevent the bank paying out the bank guarantee until those matters are finally resolved. Under this approach it could also be the case, again depending on the particular wording of the clause, that the beneficiary is only entitled to partially cash the bank guarantee, to meet the amount of the particular loss that is due, and no more. Risk allocation device In this approach the objective is to allocate to the customer (i.e. the party providing the bank guarantee) the risk of being "out of pocket" until the dispute between the parties (e.g. as to whether there is a breach, and/or the actual cost or loss that flow from the breach) is finally resolved or determined by legal proceedings.'  It does this by giving the beneficiary the right to immediately convert the bank guarantee to cash if it considers the customer is in breach of the underlying agreement without having to first prove the breach or the amount of loss suffered. ' Another way to look at this approach is that it puts the beneficiary in the same position as if it were holding the customer's cash instead of a bank guarantee. When the matter is finally resolved and the liability and quantum established, the beneficiary would be obliged to return the surplus, if any, unless the agreement makes it clear that any surplus is to be retained by the beneficiary as security for future claims. ' We also mention in passing that most agreements will include a requirement for "top up" '€“ i.e. the customer must provide a new bank guarantee to replace the one that has been cashed. The courts have upheld the "risk allocation" approach in a number of cases where it is clear from the wording of the underlying agreement that this is the intent of the parties, and the beneficiary acts in good faith in cashing the bank guarantee. The recent case of Lanskey Constructions referred to above has again confirmed this approach. In this case the underlying agreement was a construction contract where Lanskey Constructions sought an injunction to prevent Westrac Pty Ltd (the principal under the construction contract and the beneficiary under the bank guarantee) cashing the bank guarantee.'  The'  Supreme Court of Western Australia confirmed that the relevant clause in the construction contract was intended to operate as a "risk allocation device" with the effect that Lanskey Constructions would be "out of pocket" pending final resolution of the dispute with Westrac. The court made it clear that a beneficiary must have a bona fide claim to call upon the bank guarantee (bona fide meaning to do something in good faith or with an honest intention) and in this case found that the Westrac Pty Ltd (the beneficiary) acted honestly with the genuine belief that it was entitled to recover the amount claimed under the contract. Accordingly the court declined to grant an injunction and allowed the bank guarantee to be cashed.

Summary

A bank guarantee is a direct undertaking by the bank to pay the beneficiary on demand, without reference to its customer and regardless of any alleged dispute between the customer and the beneficiary. The courts will not prevent a beneficiary cashing a bank guarantee unless the beneficiary is acting fraudulently, unconscionably or the underlying agreement between the beneficiary and the customer prevents it from doing so. Whether the underlying agreement allows the beneficiary to cash the bank guarantee will depend on the intent of the parties which must be interpreted from the wording of the relevant provisions. When parties enter into an agreement that requires a bank guarantee to be provided as a form of security, it is important that the parties understand exactly how they want that provision to operate and that the wording is consistent with that objective and clear in its operation.

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~with' Philippa Thorne,' Graduate at Law