Background

A recent decision of the Federal Court of Australia examines whether a contractor can prevent the principal calling on the bank guarantee when the project goes off the rails.[1]

Redline contracted with MCC to build three 29km pipelines servicing the Sino iron ore project in WA.  The pipes were to transport iron ore concentrate, return water and desalinated water respectively.  MCC was to supply the pipe and Redline was to construct the pipeline, including the welding of each section.  The contract sum was $66 million.  Redline was required by the contract to provide security in the form of unconditional bank guarantees totalling 10% of the contract sum.

The dispute commences

The parties fell into dispute.  Redline said that the pipe supplied by MCC was below specified tolerance and had been supplied late. Redline said it had been induced by the specified tolerance standards, to tender at a much lower price than it would have done if it had known the lower standard pipe that MCC ultimately supplied. Redline claimed that the lower standard pipe had resulted in it having to abandon its proposed method of welding the pipeline to substitute a slower more expensive method. Redline claimed $3.6 million in delay costs.

MCC claimed that Redline’s work was defective and this was the real cause of the problems.  Ultimately, MCC terminated the contract.  Redline responded by saying that MCC had repudiated the contract and then also terminated the contract. The four bank guarantees each of about $1.65 million remained in the hands of MCC.

MCC then engaged another contractor to complete the works and rectify defective work.  Soon after, MCC wrote to Redline saying it intended calling on one of the bank guarantees to recoup its losses.

Redline goes to Court

Redline approached the Federal Court seeking an interim injunction preventing MCC from calling on the guarantees. Clause 5.2 in the contract stated:

“Security [bank guarantees] shall be subject to recourse by a party who remains unpaid after the time for payment where at least 5 days have elapsed since that party notified the other party of intention to have recourse.”

The construction industry has long considered security in the form of bank guarantees to be akin to cash payable on demand and the general rule is that a Court will not interfere when a call is made on such a guarantee.  In Clough Engineering v ONGC[2] the Full Federal Court gave a detailed analysis of the three situations in which a Court will intervene:

  1. Where the party calling on the guarantee has acted fraudulently;
  2. Where the party calling on the guarantee would be acting unconscionably;
  3. Where to call on the guarantee would be a breach of a qualification of an otherwise unconditional guarantee.

Redline did not suggest any fraudulent conduct was involved, but sought to rely on the second and third exceptions to the general rule.

Unconscionability

Redline said that MCC had mislead or deceived Redline when it stated in the specifications the proposed tolerance standards of the pipe which MCC was to supply. Redline contended that the misleading or deceptive conduct was analogous to the unconscionability exception in Clough. Redline said that MCC could not be permitted to take advantage of its own wrongdoing.

Implied contractual restriction

Redline referred to the words “time for payment” in the contract clause quoted above and said those words implied a contractual restriction. Before MCC was entitled to call on the guarantee, it had to be determined under the contract that Redline was liable to pay the amount claimed to MCC.  Redline said that in calculating the amount due, Redline’s claim to delay damages should be taken in to account as an offset.  Once that was done, Redline said, it was not required to pay anything to MCC under the contract and therefore MCC was not entitled to call on the guarantee.

The Court’s findings

The Court reviewed the authorities and emphasised that the construction industry has developed a long standing practice of regarding unconditional guarantees exactly as they are described: unconditional.  The Court said that reading the contract as a whole, there was no doubt that this was intended by the parties to be an unconditional guarantee.  On that basis, the Court examined the three possible exceptions set out in Clough.

There was no fraudulent conduct so the first exception outlined in Clough was not relevant.

As to unconscionability, the Court said

Redline’s contention … does not have sufficient prospects of success at trial to warrant granting the interlocutory injunction claimed. The commercial utility of having the benefit of a performance bond would be rendered virtually nugatory if that proposition was correct.

This approach is consistent with a long line of cases which establish the unconditional nature of this type of undertaking.  The test for unconscionability (the second exception in Clough) is higher than that usually adopted for misleading and deceptive conduct.

In relation to the third exception, the Court said “whether the underlying contract contains a qualification on the right to call upon the security must be determined in light of the contract and the form of the performance guarantee as contained in the contract.”

The Court went on to say “First, the contract is to be construed in its commercial context, namely, that performance guarantees and like instruments, are treated as providing the beneficiary thereof with a security which is only defeasible in such limited circumstances, that it is to be regarded as approximating cash.”

Given these considerations, the Court declined to issue any injunction and MCC was at liberty to call on the guarantees.  In the end result, Redline would of course be permitted to pursue its claim for damages to conclusion, but for the time being at least would have to allow the security to be drawn.

Conclusion

If a contracting party has any concern about the other party unfairly calling on a security, it is essential to include express limitations on the undertaking in the terms of the contract before the contract is agreed.  Otherwise, the usual forms of security widespread in the construction industry amount to providing the other party with a cash deposit that is subject only to the three narrow exceptions set out in Clough.

Contributor:  Tom Grace


[1]Redline Contracting Pty Ltd v MCC Mining (Western Australia) Pty Ltd [2011] FCA 1337

[2] [2008] FCAFC 136