Cashing in on unconditional bank guarantees

Unconditional bank guarantees are sometimes used in construction contracts as security for a contractor’s performance. They are seen to be useful because they provide the holder of the bank guarantee with a ready source of cash. To access that cash, all that the beneficiary has to do is to go to the relevant bank and demand the money. There is no need to show that the contractor was actually in default.

The wording of unconditional bank guarantees tends to vary significantly. Here’s a fairly typical example of the type of wording used: “At the request of [the contractor] and in consideration of [the owner] accepting this undertaking in relation to the obligation of [the contractor] to provide to [the owner] security for the purpose of ensuring the due and proper performance of the contractor’s obligations under the [underlying contract], [the bank] unconditionally undertakes to pay on demand any sums which may from time to time be demanded by [the owner] to a maximum aggregate sum of [£X] (the “Sum”). The undertaking is to continue until notification has been received from [the owner] or until this undertaking has been returned to [the bank] or until payment to [the owner] by [the bank] of the whole of the Sum or such part as [the owner] may require. Should [the bank] be notified in writing purporting to be signed by or on behalf of [the owner] that [the owner] desires payment to be made of the whole or any part or parts of the Sum, it is unconditionally agreed that such payment or payments will be made to [the owner] forthwith without reference to [the contractor] and notwithstanding any notice given by [the contractor] to [the bank] not to pay same”.

Even though default does not have to be shown before the security may be called up, the purpose of a contractor providing an unconditional bank guarantee is to secure the owner against the contractor’s default. For example, if a massive defect appears in a building under construction, and the contractor does not fix it, the owner may want to access funds quickly to pay someone else to rectify the problem and get the project completed. An unconditional bank guarantee can provide a ready source of cash for this to occur.

But what if the contractor takes the view “It wasn’t my fault. The defect appeared for reasons that have nothing to do with me”? The contractor may feel aggrieved if the owner goes off to the bank and collects the proceeds of the unconditional bank guarantee. The contractor may feel that it has done nothing wrong, even though the owner takes a different view about where the blame lies. Why should the contractor’s cash flows take a hit when it is not responsible for the damage to the building?

What happens quite commonly is that when an owner tries to call up an unconditional bank guarantee, the contractor who supplied it will race down to court and seek an injunction to restrain the owner from making or pursuing the demand. If, however, the owner has already got the money in its pocket, the contractor may seek an order that the money be frozen, so that the owner cannot use it.

When the matter goes before the Court (on an urgent basis), the judge will usually have a very limited amount of evidence before him or her about the dispute, with the parties at loggerheads as to whether the contractor was in default, and whether the owner was entitled to call upon the bank guarantee. And yet the Court will be required to make a decision very quickly as to what happens to the unconditional bank guarantee and/or its proceeds pending final resolution of the matters in dispute (which may be resolved months or years later). Bank guarantees may also be for very large amounts of money – sometimes millions of pounds.

How do the courts resolve these disputes? What criteria do they apply in deciding whether to grant an injunction against an owner with an unconditional bank guarantee in its hands?

Interlocutory injunctions

The particular type of injunction that contractors usually seek is an “interlocutory” injunction. This type of injunction may be granted before all of the issues in dispute have been fully thrashed out before the Court. It will usually be sought on an urgent basis (to stop the owner immediately from calling upon the bank guarantee, or using its proceeds). The purpose of the injunction, if granted, will be to maintain the status quo between the parties pending the final determination of the issues in dispute. For example, if the owner has made a demand for payment under a bank guarantee, the court may order the owner to withdraw the demand, or not pursue the demand, until the rights and wrongs of the principal making a demand have been argued fully before the Court (with evidence), and the Judge has made a decision. Once all of the evidence and argument has been heard by the Court, the Judge will then be in a position to say either “Yes, the owner was (and is) entitled to call upon the bank guarantee” or “No, the contractor was right – the owner’s demand was unlawful”.

Contractors naturally don’t like having unconditional bank guarantees cashed on them. The impact on cash flows can be quite severe. But interlocutory injunctions aren’t granted cheaply. If a contractor is seeking an injunction, it must establish three things to the Court’s satisfaction:

• First, that there is a “serious or substantial question to be tried”.
• Second, that if an injunction were not granted to the contractor, and the owner proceeded to access the funds of the unconditional bank guarantee, and it turns out at the later trial that the owner was not justified in making the demand: an award of damages to the contractor would not be an adequate remedy.
• Third, that the “balance of convenience” favours the granting of an injunction, rather than its refusal.

First question: is there a serious or substantial question to be tried?

This, in essence, means that the contractor has to show that if the matter goes all the way to trial the contractor will have a fairly arguable case that the principal wasn’t entitled to call upon the unconditional bank guarantee. The contractor doesn’t have to prove its case fully when it seeks an urgent injunction. But it must put up pretty good evidence to give the Court the impression that the owner, in making a demand under the unconditional bank guarantee, was acting unlawfully.

The main grounds on which contractors try to attack owners’ demands are:

• The demand was made fraudulently. For example, if the owner knows full well that the contractor has done nothing wrong, but it runs off to the bank and tries to cash the bank guarantee just to get the pot of gold into its hands: there is a fair chance that a Court would say that the owner has acted fraudulently.
• That a binding construction contract was never created (in law), so the unconditional bank guarantee can serve no lawful purpose in the owner’s hands. This line of attack proceeds on the basis that unconditional bank guarantees are security for a contractor’s performance under a construction contract. If there is no construction contract (for example, because the “contract” is illegal under statute, or the parties never actually reached agreement on essential contractual terms), what right does the owner have to use the bank guarantee?
• That the demand for payment was not made in accordance with the terms of the unconditional bank guarantee. For example, the bank guarantee document may require the owner’s demand to be accompanied by a certificate from a superintendent or architect asserting that the contractor is in breach of the relevant construction contract. If the owner’s demand is not accompanied by such a certificate, the demand may be unlawful.
• The demand was made “unconscionably”. In general terms, “unconscionability” refers to behaviour that shocks the conscience, or something that is harsh or oppressive in that it involves taking advantage of someone’s special disability or disadvantage. It’s very uncommon to find examples of unconscionability in commercial disputes, such as disputes over bank guarantees, so contractors rarely succeed when they cry “unconscionability”.
• The demand was made in breach of a term of the relevant construction contract. Although unconditional bank guarantees are expressed in unqualified terms, i.e. they basically say “The bank will pay the owner if the owner comes to the bank and demands to be paid”; the underlying construction contract may attempt to qualify this right. For example, the construction contract may say “The owner is entitled to call upon the unconditional bank guarantee where the contractor owes money to the owner under the contract, and fails to pay it within X days”. If the owner goes to the bank before X days have elapsed, the contractor may say “Well, even though the bank guarantee is unconditional, the contract makes it clear that it can only be called upon if I owe money, and don’t pay the money within X days. I say that I don’t properly owe any money, but even if I do X days has not elapsed. The owner should be stopped”.

Second question: are damages an adequate remedy?

The starting point that the Court will take is that if the owner makes an unlawful demand, the contractor can be compensated for this by an order that the owner pay the contractor an amount of money. There is no need for the Court to intervene by granting an injunction (to stop the owner from making or pursuing a demand for payment), because a later order that the owner pay compensation to the contractor will do the trick. But there will be some cases where money won’t be adequate. For example, if the owner is just a shell of a company, there may be a risk that the owner will take the proceeds of the bank guarantee, and the contractor will not have a snowball in hell’s chance of getting any money back from the owner later on (if compensation is awarded).

Third question: does the balance of convenience favour the granting of an injunction?

In relation to this issue, the contractor must try to convince the Court that there would be a greater inconvenience suffered by the contractor if an injunction were refused, and the owner were allowed to call upon the bank guarantee (even if unlawfully); compared to the inconvenience suffered by the owner if an injunction were to be granted, and the owner were prevented from accessing the cash immediately (even if the owner is, in fact, actually entitled to make a demand under the bank guarantee). There is a whole range of factors that a Court may take into account in deciding where the balance of convenience lies. One factor is that the contractor may find it more difficult to obtain work in the future, its finance charges will increase, should the owner cash in the unconditional bank guarantee. On the other hand, if the bank guarantee has an expiry date, and an injunction were granted to stop the owner from cashing the bank guarantee; the bank guarantee may be rendered worthless should the owner be injuncted, because the bank guarantee may expire before the real issues in the case get thrashed out and resolved before the Court.

Conclusion

These are the three hurdles that a contractor must clear before it can have an owner’s demand for payment halted. As can be seen, it is usually quite hard for a contractor to satisfy the Court that an injunction ought to be granted. It must also be borne in mind that if a contractor is seeking an injunction, it will be required to give an “undertaking as to damages”. That is, the contractor must undertake to the owner that if the contractor is wrong, and the owner is entitled to make a demand for payment, the contractor will compensate the owner for the loss it suffers in not being able to access the funds behind the bank guarantee when it wanted to.

Unconditional bank guarantees are regarded as being creatures autonomous of the construction contracts pursuant to which they are provided. Their value is in their liquidity. That liquidity would be diminished if contractors could get injunctions cheaply against owners to stop them from making or pursuing demands for payment. This is something of which the Courts are acutely aware.

For further information please contact Julian Bailey at [email protected] or on +44 (0)20 7367 2057