Bonds – A license to kill your cashflow
Authored by: John Smy, Matthew Page and Anthony Edwards
A phrase often heard these days is “lack of liquidity”, applying to the UAE’s Construction sector. In somewhat blunter terms it equates to recurrence of payment issues which may often simply amount to a failure to pay by one party to the other party under a Main Contract or Subcontract.
When financial problems arise it is not uncommon for the party facing the cash shortfall at the hands of the other party to look to recoup the shortfall, however it can. An employer facing liquidity issues with its funders may look to recoup the shortfall against the Main Contractor, as may a Main Contractor against its Subcontractor. One means of doing so, now again seen increasingly frequently, is recourse to a questionable call by a cash strapped party against the Performance Security provided to it by the other party to the contract.
Some forty years ago a noted UK Judge coined the phrase “Cash Flow is the life-blood of the Industry” and recouping funds under a call on a Performance Security may be considered as one straightforward means of enhancing one party’s life sustaining cash flow, at the expense of causing loss of it to the other party.
Main Contracts and Subcontracts are essentially binding only as between the two parties who enter into them. All the standard FIDIC forms of Main Contract and Subcontract contain provisions whereby the one party has to provide – or, as lawyers would more particularly have it, “procure” – a Bond which guarantees the providing party’s performance to the other party. These Bonds are more specifically referred to in the Guidances issued by The International Chamber of Commerce [ICC] as “Demand Guarantees”. But in Civil Code Law, such as found in the UAE, and in Common Law jurisdictions, a distinction has to be made between what is a Demand Guarantee and what is a Guarantee simple, as important differences apply between these two types of “Security” relating to obligations contracted for under relevant contracts.
In this short article, the important distinction between the Demand Guarantee and the Guarantee simple is found by reference to the name of the former type of Security; namely, a Security that is recoverable On Demand. The Guarantee simple is subject to such defences as may be advanced against the party calling for performance under the Guarantee.
Invariably, the required Security under FIDIC contracts is a Demand Guarantee providing for an immediate cash payment – typically limited to a ceiling of 10% of the Contract value – in favour of the Beneficiary of the Demand Guarantee. In contrast a Guarantee simple is a means of securing performance by the Guarantor of the failed performance of the party that had the contractual obligation to undertake the Work and obliges the Guarantor to pick up the pieces if the procuring party fails to perform and to complete the Works, or is otherwise claimed to be in breach of its obligations.
In the case of the Demand Guarantee all that the injured party has to do is call upon the Guarantor to pay up the value guaranteed. Under a Guarantee simple, the injured Beneficiary may well first have to deal with the Guarantor’s challenge that the procuring party was not in breach of its obligations under the contract before the Beneficiary can obtain the benefit of performance by the Guarantor.
The Demand Guarantee contains this particular characteristic because the Guarantor – invariably a Bank – is simply not interested to know whether the procuring party can be said to be in breach as against the Beneficiary. All the Bank wishes to ascertain is whether the Demand Guarantee it has issued in favour of the injured Beneficiary is payable according to the procedural steps set out in the Demand Guarantee.
In UAE Law (see Articles 411 and 414 of the Federal Law 18 of 1993) the Demand Guarantee is defined as an undertaking by the Bank to pay to the injured Beneficiary a specified amount “unconditionally and without restriction”. Under it the paying Bank does not contest the call made on it by the Beneficiary. In contrast, a Guarantee simple under the UAE Law is an obligation to pay the procuring party’s “debt”. Under most jurisdictions and laws debts have to be proved and can be contested. The Guarantor can therefore rely on such defences as the procuring party has, to prevent the Beneficiary from recovering under the Guarantee simple.
Banks, being essentially Commercial institutions, cover their liability, not by complex litigation with the Beneficiary over whether or not the Beneficiary was entitled to make the call, but by securing themselves by Counter Indemnities from the procuring party (their Customer). They invariably have either the cash available in the Customer’s account before paying the Beneficiary or the benefit of a counter indemnity from another Bank of good standing. The Customer automatically has its line of credit with the paying Bank reduced by the amount of the payment to the Beneficiary, a serious consequence for the Customer.
The only step open to the procuring party to prevent the Guarantor Bank making payment to the Beneficiary under a Demand Guarantee is to institute legal process against its own bank to prevent it from making the payment; a somewhat counter-intuitive step by any business entity – to sue its funder. Such a step requires not only immediate additional cost expenditure by the procuring party, and a fair amount of good luck in the choice of Judge applied to, but also considerable experience in these matters by its lawyers, as the action required must take place quickly before the paying Bank has completed its relatively straightforward verification process prior to deciding it must meet its commitment under the Law, to “pay unconditionally and without restrictions”; only a day or so may be available to the procuring party to obtain legal help and to make the appropriate Court application to seek an order levying seizure against its own Bank of the amount under the Demand Guarantee.
The material provision of the applicable Law (see Article 417(2) of Law 18 of 1993) requires the procuring party to have “serious and sure grounds” to succeed in obtaining the seizure order. The application is made by the equivalent of ex parte submissions to one of the Emergency Judges who sit daily in the UAE Courts. A limited amount of time is perforce therefore allocated to the review of the application and so a carefully prepared submission and selected attachments are vital components for success.
If the application succeeds, the Court notifies the Bank not to pay. The procuring party must then commence proceedings in Court and in arbitration (if the contract provides for arbitration) almost immediately, to substantiate the serious and sure grounds relied upon before the Emergency Judge. The Beneficiary may then defend those proceedings.
Demand Guarantees are required in most, if not all, significant UAE projects. The Guarantee simple is not; its use could, though, prevent what may often amount to abuse in making questionable calls under Demand Guarantees. It would require parties to accept the Guarantee simple when negotiating their contracts and of course require a Guarantor capable of completing the Works if left uncompleted by the procuring party. In times of lack of liquidity keeping the cash flowing is vital and parties should therefore use what means they properly can to avoid unwarranted bond calls.
(Previously published by Emirates Law)
This article, together with any commentary, does not constitute legal advice. It is provided solely for information purposes on a complimentary basis, without consideration of any specific objectives, circumstances or facts. It reflects then current views of the writer which may modify in time and based on differing objectives, circumstances or facts. A writer's view may differ from views of colleagues and/or the firm. You should seek legal advice on each specific matter. Access to this article does not form an attorney-client relationship.