Performance bonds (referred to in this article by their common name 'bank guarantees') are a tool commonly used in the construction industry to protect principals against the insolvency of a contractor or non-performance of a contract.

In Simic v New South Wales Land and Housing Corporation¹ (Simic) the High Court has upheld a principal’s right to call on certain bank guarantees, even though the beneficiary named in the bank guarantees was a non-existent entity, rather than the principal.

Key points

1. Lenders are not obliged to enquire into the background or purpose of a bank guarantee to determine the validity of a person’s demand on the guarantee.
2. Where a bank guarantee contains an error, principals may be able have it rectified by a court, but only in certain circumstances and only after considerable time and expense.
3. Bank guarantees are not a principal’s only form of protection from a contractor’s insolvency. Principals should also ensure any relevant 'security interests' are registered on the Personal Properties Securities Register (PPSR).
4. Construction contractors should be aware a misdescription of the beneficiary in a bank guarantee does not necessarily mean it cannot be enforced by your principal (the intended beneficiary).

The High Court decision

The brief background to the High Court’s decision was as follows:

• Nebax Constructions Australia Pty Ltd (Nebax) arranged for ANZ Bank (ANZ) to issue bank guarantees in favour of the non-existent 'New South Wales Land & Housing Department trading as Housing NSW ABN 45754121940'.
• The bank guarantees were issued as security for Nebax’s obligations under a construction contract with the 'New South Wales Land and Housing Corporation (ABN 24 960 729 253)' (Corporation).
• The bank guarantees also misstated the job number and contract number referred to in the construction contract. The bank guarantees did correctly describe the location of the works, but the suburb was misspelt.
• The errors in the bank guarantees were due to incorrect instructions given by Nebax to ANZ, but it was always the intention of the parties that the Corporation was the beneficiary.
• Nebax went into liquidation. The Corporation sought to have recourse to the bank guarantee.
• They refused to pay, because the Corporation was not the named beneficiary.
• The Corporation initially successfully argued in both the New South Wales Supreme Court and Court of Appeal that, notwithstanding the errors in the documents, as a matter of contractual interpretation the Corporation was the intended beneficiary, so ANZ should have paid out. The issue of 'rectification' of the guarantees was raised but it was not necessary for the Courts to consider this in detail in view of their finding on the correct interpretation of the guarantees.
• The High Court found:
  • it was not possible as a matter of contractual interpretation to refer to the underlying facts (i.e the construction contract) to interpret the reference to the non-existent entity as a reference to the Corporation
  • such an approach would require enquiries by the issuing institution, which was inconsistent with the commercial purposes of bank guarantees, i.e. that bank guarantees are the equivalent of cash
  • the Court considered it was the clear common intention of Nebax and the ANZ that the beneficiary would be the Corporation, being the principal in the construction contract. In view of this, the bank guarantees were able to be rectified to identify the Corporation as the beneficiary. Generally, rectification is a far higher bar to reach.

Issues for lenders

Importantly, the Court confirmed a lender is not required to consider the terms of the underlying contract or whether the contractor is in breach of the contract, when a beneficiary seeks to have recourse to a bank guarantee. The lender’s sole concern is to provide security as agreed with the customer and, when the security is called on, to see whether any conditions to payment are met.

Interestingly the Court also stated in the 'ordinary case, saving minor slips and misdescriptions' the name of a beneficiary on a bank guarantee cannot be changed to another entity. Although lenders should insist on strict compliance with the terms of a bank guarantee, the High Court observed this must be applied intelligently, not mechanically and the lender must exercise its own judgment about whether the conditions for payment have been met. The Court did not elaborate on what a 'minor slip' in the name of the beneficiary could be.

Lenders need to be aware they may breach their agreement with the customer if they wrongfully pay out on a bank guarantee. Lenders need to tread very carefully when a bank guarantee is unclear or has 'minor slips', and would be best served leaning towards strict compliance with the written terms of the bank guarantee.

Issues for principals

In Simic, the bank guarantees were rectified as it was intended the beneficiary would be the Corporation. Rectification requires evidence of a 'common intention' or agreement between the parties. As a starting point, it is better not to rely on rectification. In particular, as the relevant intention is that of the issuing bank and the requesting contractor and not that of the principal, obtaining rectification is far from certain.

It may seem obvious, but it is vitally important a bank guarantee accurately describes all relevant details such as the beneficiary, the contract and the works or project. In Simic, the High Court specifically noted the Corporation should have been able to determine whether the bank guarantees were suitable and taken steps, such as rejecting the bank guarantees and serving a breach notice if satisfactory security was not provided. The court also stated a principal should review the security before performance of the contract rather than after and if it fails to do so should bear the costs.

Beyond this, the Simic decision is a timely reminder principals need to consider all relevant factors before accepting a bank guarantee. The relevant considerations will depend on the nature of the project and the risks the principal is trying to address. However, in general terms principals should consider:

• pressing for an unconditional bank guarantee to ensure there are no impediments to immediately calling on the guarantee
• similarly, refusing to accept any notice requirements imposing an obligation on the principal to give notice to the contractor of their intention to call on the bank guarantee
• requiring the right to assign the benefit of the bank guarantee to another beneficiary if there is a prospect of a change in the principal for the project
• whether the amount of the bank guarantee is adequate and will remain adequate throughout the project
• for now, ensuring 'insolvency event' clauses are broadly drafted (see the comments below)
• whenever there is an extension or change in scope of the contract these issues should be revisited to ensure, for example, the bank guarantee does not expire and remains for an adequate amount.

In addition to the right to call on bank guarantees where the contractor suffers an insolvency event or there has been a substantial default, many construction contracts give principals other powers, such as the power to step-in and complete the project, often with rights to use plant, materials and equipment of the contractor. Principals also need to bear in mind the proposal any 'ipso facto' clause, being a provision in a contract that gives a right to terminate or vary the contract on the occurrence of an insolvency event, is void². These reforms may significantly restrict a principal’s rights arising from a contractor’s insolvency and are a reminder to principals to ensure their rights are otherwise protected by ensuring all PPSR registrations are correct and all relevant 'security interests'³ have been registered.

Issues for contractors

A misdescription of the beneficiary in a bank guarantee does not necessarily mean it cannot and will not be enforced by your principal (the intended beneficiary). The High Court has made it clear it is open to Courts to rectify a misdescription in a bank guarantee where that would reflect the (objectively ascertained) common intention of the contractor and the lender.

[1] [2016] HCA 47

[2] See the Federal Government’s Improving Bankruptcy and Insolvency Laws Proposals Paper

[3] It is not possible to list all potential interests that need to be registered, but principals need to consider registering rights such as step-in, equipment hire arrangements and any interests in unfixed goods and materials, particularly where they have paid for the materials in advance.