PERFORMANCE Often in commercial transactions, a In this article, we look at the

GUARANTEES--TRAPS party will require one of their different varieties and types
counterparties to back up its
AN DPITFALLS obligations with additional
of performance
guarantees-and what you
David Lester support. This support might be in
Senior Associate the form of security-for example, a need to do to get the most
mortgage over real property or a out of them.
CLayton Utz charge over all or part of the assets
Brisbane of the corporate counterparty.
Alternatively, it may be considered
that a performance guarantee from
a third party is sufficient. This article
discusses some traps and pitfalls
that should be kept in mind when
asking for a performance
guarantee.

WHAT ARE YOU SEEKING?

The first issue to resolve is exactly
what form of support isrequired.
There are many forms of support
that can be provided and even more
confusing jargon and terminology.
The jargon includes terms such as
performance bonds, bank
guarantees, insurance bonds,
performance guarantees, parent
company guarantees, letters of
credit and letters of comfort. Each
of these may provide varying levels
of comfort and support to a
transaction and the legal and
commercial consequences of each
ranges widely. They are described
below.

PERFORMANCE BONDS
'Performance bond' is a generic
term that has a range of possible
meanings. It is generally accepted
that a performance bond is an
undertaking, under seal, from an
entity guaranteeing the
performance of a third party's
obligations. However, such bonds
may be conditional or
unconditional.
If a bond is conditional then it is a
form of guarantee and, accordingly,
a secondary obligation accessible
only upon proof of breach of the
guaranteed or principal obligation.
It also means the issuer is entitled
to a range of common law and
equitable defences available to a
guarantor: For example, if the

AUSTRALIAN CONSTRUCTION LAW NEWSLETTER #93 NOVEMBER/DECEMBER 2003 49

However, before simply underlying contract is varied or the the beneficiary, or authorises
asking for a performance counterparty is granted an another bank to effect such
extension of time then, without payment, or to accept and pay such
guarantee, careful
clear agreement to the contrary, drafts, against stipulated
consideration needs to be the liability of the guarantor may be documents, provided that the
given to the particular discharged. specified terms and conditions are
circumstances, the level of complied with. The bank need only
While it is not free from doubt, it is
support that is required, the generally accepted that an
be concerned with the terms of the
terms upon which that credit itself and not the underlying
unconditional performance bond is
transaction. There is a whole range
support is to be provided and not a secondary obligation in the
of different types of credits
which entity is most nature of a guarantee and is not
including confirmed credits, sight
appropriate to give that dependent upon proof of breach of
credits, revolving credits and
the guaranteed or principal
support. standby credits. Letters of credit are
obligation. The issuer is
traditionally used to secure
undertaking to simply pay an
payments under international trade
agreed amount on demand.
contracts, although a simple bank
BANK GUARANTEE/ guarantee is likely to be a form of
UNDERTAKING standby letter of credit.
Generally speaking, 'bank LETTERS OF COMFORT
guarantee' or 'bank undertaking' or
Letters of comfort are generally
'first demand guarantee' referto an
considered to be a softer
unconditional performance bond
alternative to a guarantee or
from a bank, i.e. an undertaking
performance bond. The terms of a
from a bank to make a payment
letter of comfort will vary from
upon presentation of a
transaction to transaction, but
demand. However, the terms and
usually encompass representations
conditions of these documents may
that the issuerwill ensure the entity
differ from bank to bank and from
the subject of the letter will meet its
transaction to transaction, so the
obligations and will remain solvent
terms of the document must be
and/or that the issuerwill not
closely examined. In particular,
reduce its shareholding in the
care should be taken to ensure that
counterparty. The question of
the conditions needed to be
whether a letter of comfort is
satisfied before the bank will make
legally binding on the issuerwill
payment are easily achievable. In
generally depend on whether:
accepting documents of this nature,
the beneficiary is accepting the • the representations in the letter
credit risk of the issuing bank. are sufficiently promissory in nature
to be contractual; and
INSURANCE BONDS
• there is an intention to create
These are usually unconditional
performance bonds issued by legal obligations between the
insurance companies. The same parties.
issues that arise with bank WHAT IS A PERFORMANCE
guarantees arise with these GUARANTEE?
documents, however, the credit risk
Performance guarantees are a
lies with an insurer, ratherthan a
form of conditional performance
bank.
bond, i.e. a secondary obligation in
LETTERS OF CREDIT the nature of a guarantee used to
A 'letter of credit', 'documentary secure performance of contractual
credit' or 'credit' referto an obligations. Usually these are taken
arrangement where a bank agrees from a parent or related company
to make a payment to, or to the of the counterparty.
order of, a beneficia ry, or to accept
and pay bills of exchange drawn by

50 AUSTRALIAN CONSTRUCTION LAW NEWSLETTER #93 NOVEMBER/DECEMBER 2003

WHAT IS THE NATURE OF enhanced by the worth of the breach of the Corporations Act,
THE OBLIGATIONS TO BE co unterp arty. unless certain requirements are
met, for a public company (or an
SECURED? Performance risk-Consideration
entity that the public company
Is it simply the payment of money needs to be given to whether the
controls) to give a financial benefit
or the performance of an obligation guarantor can actually perform the
(which would include providing a
to do something that is being obligation it is guaranteeing. For
guarantee) to a related party. This
secured? For example, contrast a example, in Queensland, if the
means careful consideration needs
guarantee of the payment of the principal under a building contract
to be given before a public company
purchase price by the purchaser insisted that the holding company of
gives a performance guarantee to
under a gas supply agreement with the contractor complete
support the obligations of its own
a guarantee of the supply of gas by construction, it may find the parent
directors (or their spouses), its
the vendor under that same does not have the requisite license
parent entity, any sibling entities,
agreement. to do so and performance by that
the parent of its public company
company (or even agreeing to
Guaranteeing the performance of parent orthe directors (ortheir
perform that work) may be illegal.
an obligation to do something can spouses) of those entities.
create a conditional debt obligation Guarantee risks-As previously
on the part of the guarantor. Under mentioned, a performance CONCLUSION
a performance guarantee for the guarantee is only a secondary Performance guarantees are a
completion of construction, the obligation and is dependent upon common form of support used in
guarantor is guaranteeing that the proof of breach of the primary commercial transactions. However,
completion of a project occurs by a obligation by the counterparty. The before simply asking for a
specified date, but if the contractor guarantor may be entitled to all of performance guarantee, careful
fails to achieve this date then the the rig hts given to a gua ra ntor by consideration needs to be given to
guarantor may simply be liable in common law and equity. the particular circumstances, the
damages. level of support that is required, the
Enforcement risk-Apart from the terms upon which that support is to
However, if the purpose of the risk of insolvency of the guarantor, be provided and which entity is most
performance guarantee is forthe it may be that the parent company appropriate to give that support.
guarantorto cure a default or invest of the counterparty is a foreign
equity into a project if certain company. If this is the case, then
performance targets are not there is a new set of risks relating David Lester's article was
satisfied, then the terms of the to the beneficiary's ability to enforce previously published in Clayton
guarantee need to be drafted in a the obligations of the guarantor, not Utz's Insights Banking and
waywhich requires this to be done. the least of which is the risk that the Financial Services (October-2003).
guarantee document is not legally Reprinted with permission.
WHAT ARE THE RISKS OF A recognised and enforceable under
PERFORMANCE the laws of the other jurisdiction.
GUARANTEE?
Corporate benefit-How does the
Not security-Performance
giving of the performance
guarantees do not give the
guarantee benefit the guarantor? A
beneficiary an interest in any
guarantee that does not benefit the
property. They are simply a
company, and therefore breaches a
contractual undertaking by one
director's fiduciary duty, may be
party to another.
voidable by the company. This is
Insolvency risk-Upon enforcement less of an issue where a parent
the beneficiary is just another guarantees the obligations of a
unsecured creditor. Should the subsidiary, however, it may be
guarantor become insolvent the harderto show corporate benefit if
beneficiary under that guarantee a subsidiary is guaranteeing the
will have to stand in line with the obligations of its parent (although
other unsecured creditors. section 187 of the Corporations Act
may provide some assistance for
Credit risk-By taking a
100 % owned subsidiaries).
performance guarantee the credit
risk of the guarantor is not removed Related party transactions-While it
from a transaction, but simply does not void the transaction, it is a

AUSTRALIAN CONSTRUCTION LAW NEWSLETTER #93 NOVEMBER/DECEMBER 2003 51