Relying on performance guarantees – never simple when insolvency arises

21/12/2011 in Commercial, Construction Disputes, Dispute Resolution, Real Estate, Housing & Regeneration, Real Estate Litigation

Parties relying on guarantees when the other contracting party becomes insolvent, more often than not, consider they will be paid almost immediately by the guarantor. A recent case has highlighted the difficulties with performance guarantees, in the form of a default bond, and provides a possible solution.

Background

In today’s uncertain economic climate, many companies are rightly concerned about the continuing solvency of their suppliers. In particular, they’ll want to ensure that they can continue to trade themselves in the event of the insolvency of a major supplier on whom they depend. Many therefore ask their suppliers for either a parent company guarantee or a bond from a bank or other worthy credit institution. Most bonds are “performance bonds”, otherwise known as “default bonds”, as opposed to “on demand bonds”.

In order to be able to claim under this type of guarantee or default bond, the company that is the beneficiary of the guarantee / bond will need to show breach of contract on the part of the supplier whose performance is being guaranteed.

Typical contractual clauses

Many commercial parties, when obtaining a guarantee or performance bond, also include in their contract with the supplier a clause which states that the supplier’s employment under the contract will terminate automatically on the supplier’s insolvency. The same contract may also provide that in the event of early termination there will be a balancing of the parties’ accounts, at the time when the supplier’s employment would have otherwise ended had it not been for the early termination. This is typical in most construction contracts, the JCT suite of contracts being an example.

What’s the problem?

While this all sounds sensible enough from a commercial point of view, unfortunately the law is never so simple. The problem is that insolvency is not in itself considered a breach of contract. As a result, unless expressly provided for in the guarantee or default bond, a claim cannot be made on the guarantee / default bond immediately on, and solely by reason of, the supplier’s insolvency. Instead, the customer has to wait until the supplier has failed to pay (and thus be in breach) after the balancing of the parties’ accounts at the end of the contract. Only then will the customer be able to claim for its loss under the guarantee / default bond.

In this difficult economic market, this delay in being able to claim under the guarantee / default bond may have serious implications for the customer’s cash flow and financially be very damaging to it.

A pragmatic solution

The case of Hackney Empire Limited v Aviva Insurance UK Limited (formerly trading as Norwich Union Insurance Limited) appears to have provided a pragmatic solution to this conundrum.

The answer lies in making a slight change to the contract which makes the supplier’s insolvency an event which entitles the customer to terminate the supplier’s employment under the contract on notice, rather than an event which automatically terminates the supplier’s employment. The termination clause should also state that it is without prejudice to any other rights and remedies which the customer may have.

How it works

It is normally the case that immediately prior to a supplier’s insolvency, the customer will notice a severe deterioration in service from the supplier. For example, the customer’s regular point of contact is made redundant; deliveries are late; and performance is poor. This is likely to result in the supplier becoming in breach of contract. As soon as the supplier is in breach, the customer will have a valid claim for damages and hence be able to make an immediate claim under the guarantee / default bond. Once the customer has “bagged” the supplier’s breach, entitling it to make a claim under the guarantee/default bond, the customer will then choose to terminate the supplier’s employment under the contract.

The risk with automatic termination on insolvency is that the termination may occur without the supplier committing a prior breach of the contract and thus preventing the customer from being able to claim under the guarantee / default bond at that point.

The answer is usually fairly easy. The trick is knowing where the trap lies…

You can read the judgment of Hackney Empire Limited v Aviva Insurance UK Limited (formerly trading as Norwich Union Insurance Limited) [2011] EWHC 2378 here

For more information on these issues please contact James Levy or your usual Lewis Silkin contact.