Bank Guarantees are a common feature of international construction contracts. Bank Guarantees are typically used as a security for one party’s (usually the contractor’s) performance of its contractual obligations. Bank Guarantees frequently play a central role in construction disputes as well – either as an important aspect of background facts of the dispute or as a trigger event for one party to commence litigation or arbitration proceedings, for example, to prevent the wrongful call of Bank Guarantees.
Is it possible to prevent the wrongful call of a Bank Guarantee and, if so, what is the correct forum? The answer largely depends on the law applicable to the Bank Guarantee, which is not necessarily the law of the underlying substantive dispute. As most banks require disputes under the Bank Guarantees and other types of security to be resolved by local courts, whereas international construction contracts usually specify international arbitration as a dispute resolution mechanism, legal issues concerning the calls of Bank Guarantees represent one of the most complex and challenging issues in international construction arbitration.
Common Forms of Security in Construction Projects
Bank Guarantees are one of several forms of security commonly used in international construction projects. Frequently-used types of security in construction contracts include but are not limited to:[1]
- Advance Payment Bond/Guarantee – this is used to secure repayment of the advance payment made by way of deduction (clawing back) from the sums earned during the life of the contract;
- Retention Bond/Guarantee – typically used by the employer as a security for valid claims or for unrectified defects. Commonly, the first half of the Retention Bond/Guarantee is released upon the certification of completion, whereas the remaining half is released upon the expiry of the defects liability period;
- Performance Bond/Guarantee – used to secure due performance of obligations by the contractor;
- Parent Company Guarantee – provides the employer with security from the parent company of the party to the original construction contract.
While the terminology used for different forms of security varies in practice, two main types of bonds or guarantees are the so-called: [2]
- “On-Demand Bonds” or “Guarantees” (also known as “First Demand Bonds” or “Guarantees”), most commonly issued by a bank, which create an autonomous types of payment obligation; and
- “On-Default Bonds”,”Conditional Bonds”, or “Guarantees”, which create an accessory obligation of payment.
The main difference between the two is that an On-Demand Bank Guarantee is typically payable against any documents, meaning that the employer can call the Bank Guarantee without providing evidence of the underlying breach of contract or damages suffered. A claim under a Conditional Bank Guarantee, on the other hand, requires proof that there was a breach of the underlying construction contract that must be supplied.
This distinction is important, considering the significant implications that the calling of an On-Demand Bank Guarantee, wrongful or not, can create for the contractor. These consequences include, for example, harm for a contractor, such as damage to its reputation with the bank which provided the security. It can also create significant financial concerns, lead to a revision of credit lines and facilities with banks, and cause significant cash flow problems. The calling of an On-Demand Bank Guarantee can also have a significant impact on a contractor’s ability to participate in future tenders and projects, as the contractor may face problems securing new bonds and facilities from banks.
Resisting the Wrongful Call of a Bank Guarantee
Whether an employer is entitled to simply call an On-Demand Bank Guarantee, at any time and without any grounds, depends on the law in question. Most legal systems provide for mechanisms to prevent the wrongful, fraudulent and/or otherwise unconscionable calling of bank guarantees, even those that are On-Demand Bank Guarantees.
This is typically accomplished by applying for an injunction or restraining order to local courts that have jurisdiction over the Bank Guarantee in question. While most jurisdictions have their own specific rules on how the wrongful calls on On-Demand Bank Guarantees may be prevented, the procedures are similar in most common law jurisdictions.
English Law and Wrongful Calls on On-Demand Bank Guarantees
The traditional approach of English courts to the calling of Bank Guarantees was to limit injunctions to situations where there was clear evidence of “fraud“. “Fraud” under English law can only be proven if it is demonstrated that a false representation has been made (i) knowingly; or (ii) without belief in its truth; or (iii) recklessly without caring as to whether it be true or false, as set out in Derry v Peek [1889] 14 App Cas 337. Fraud in relation to the calling of Performance Bonds has been extensively discussed in cases such as Enka Insaat Ve Sanayi v Banca Popolare Dell’Alto Adige [2009] EWHC 2410, which further confirms the high threshold for proving fraud under English law.
This strict approach to preventing the wrongful call has relaxed, to some extent, over recent years. In a more recent decision, Simon Carves Ltd v Ensus UK Ltd [2011] EWHC 657 (TCC), the court significantly widened the potential grounds for challenging a call, finding that “fraud is not the only ground upon which a call on the bond can be restrained by injunction”. As Mr Justice Akenhead stated:
“(d) In principle, if the underlying contract, in relation to which the bond has been provided by way of security, clearly and expressly prevents the beneficiary party to the contract from making a demand under the bond, it can be restrained by the Court from making a demand under the bond.
(e) The Court when considering the case at a final trial will be able to determine finally what the underlying contract provides by way of restriction on the beneficiary party in calling on the bond. The position is necessarily different at the without notice or interim injunction stage because the Court can only very rarely form a final view as to what the contract means. However, given the importance of bonds and letters of credit in the commercial world, it would be necessary at this early stage for the Court to be satisfied on the arguments and evidence put before it that the party seeking an injunction against the beneficiary had a strong case. It can not be expected that the court at that stage will make in effect what is a final ruling.”
This approach is confirmed by subsequent jurisprudence. In Doosan Babcock Ltd v Comercializadora de Equipos y Materiales Mabe Limitada [2013], the Judge emphasized the departure from the traditional approach, which appears to be a trend, not only in England but also in other common law jurisdictions.
Singapore Law and Wrongful Calls on On-Demand Bank Guarantees
In Singapore, the position of the courts is similar to the position of the courts in England. Calls on On-Demand Bank Guarantees can be restrained, either on the account of “fraud” or “unconscionability“, which are treated as two distinct and independent grounds of restraint.
This position originally derives from the decision of the Singapore Court of Appeal in Bocotra Construction Pte Ltd v Attorney General (No. 2)[1995]. The same approach has been affirmed in number of other decisions, including GHL Pte Ltd v Unitrack Building Construction Pte Ltd [1999], Dauphin Offshore Engineering & Trading Pte Ltd v HRH Sheikh Sultan bin Khalifa bin Zayed Al Nahyan [2000] and Shanghai Electric Group Co Ltd v PT Merak Energi Indonesia [2010].
Singapore courts have defined “unconscionability” as “…unfairness, as distinct from dishonesty or fraud, or conduct of a kind so reprehensible or lacking in good faith that a court of conscience would either restrain the party or refuse to assist the party. Mere breaches of contract by the party in question … would not by themselves be unconscionable”, as held in Ryobi-Kiso (S) Pte Ltd v Lum Chang Building Contractors Pte Ltd [2013] SGHC 86.
As further held in Tactic Engineering Pte Ltd (in liq) v Sato Kogyo (S) Pte Ltd [2017] SGHC 103, a contractor applying for an injunction on the basis of “unconscionability” has to establish a “stong prima facie case of unconscionability”. In the same case, the court further pronounced that the parties’ conduct leading up to a call on a bond and the presence of notice are all relevant considerations.
Malaysian Law and Wrongful Calls on On-Demand Bank Guarantees
The position of Malaysian courts is not very different from the position adopted by Singapore courts. The Federal Court in a landmark case Sumatec Engineering & Construction Sdn Bhd v Malaysian Refining Company Sdn Bhd [2012] 3 CLJ 401, pronounced that an injunction preventing the calling of the bank guarantees required a strong prima faciae case of “fraud” or “unconscionability“. The Federal Court further held that “unconscionability” was a separate and independent ground to issue a retraining order, which stems from the “general underlying notion… of equity’s traditional jurisdiction to grant relief against unconscientious conduct namely, that a person should not be permitted to use or insist upon his legal rights to take advantage of another’s special vulnerability or misadventure for the unjust enrichment of himself…” .
The test set up in the Sumatec case has been frequently applied in a number of other cases in Malaysian courts, with more recent examples including Bella Builders Sdn Bhd v Kerajaan Malaysia & Another [2017] 1 LNS 557; and Dunggon Jaya Sdn Bhd v Aeropod Sdn Bhd & Anor [2017] MLJU 1225.
Therefore, while common law jurisdictions appear to be adopting a less strict approach to issuing restraining orders preventing a wrongful call, the threshold for proving “fraud” or “unconscionability” nevertheless remains high.
It is also important to bear in mind that the underlying question of whether there was a breach of contract, which is frequently the main trigger event or, sometimes, an “excuse” which leads to the call of on On-Demand Bank Guarantee, is typically an issue to be determined by an arbitral tribunal, if the main contract contains an arbitration clause, of course. This leads to an interesting, yet complex interplay between parallel proceedings in local courts and before arbitral tribunals, where local courts may grant injunctions in aid of arbitration, pending the final outcome of the dispute before the arbitral tribunal.
[1] Jane Jenkins, International Construction Contracts, (Second Edition)(Kluwer Law International 2013), pp. 42-44.
[2] Stavros Brekoulakis, David Brynmor Thomas, The Guide to Construction Arbitration, (Second Edition) (Global Arbitration Review, 2017), pp. 18-19.
