On-demand guarantees: At the mercy of the client

The advantages of an on-demand guarantee are, without doubt, among the most attractive available. Since the early sixties employers, especially those with international contracts, have sought to persuade contractors to provide such bonds as security for their performance. The form of guarantee is usually a promise by a bank or financial institution to pay to the client anything up to a pre-agreed amount if the client demands it. Although this is essentially a guarantee against the effects of non performance, the English courts have since 1978 equated them with letters of credit and enforced them – unless fraud on the part of the client could be established.

Effectively, the on-demand guarantee has been used to provide a cash-flow advantage to clients in the event of a dispute. As the contractor will almost certainly have given a counter-indemnity to the guarantor for the amount of the guarantee, the onus is on it to take action in order to obtain reimbursement.

In October, the issue came before the English courts for the first time in a considerable while. The case was Enka Insaat vs Sanayi AS vs Banca Popolare dell’Alto Adige SPA. The facts were that Enka had entered into a contract to build a substantial development in Moscow. It appointed Frener & Reifer as cladding subcontractors. The contract provided for Frener & Reifer to receive an advanced payment from Enka of 30% of the contract price, against which it provided an on-demand advance payment guarantee from its Italian bankers. It also provided a 10% performance guarantee from another bank.

For reasons that were not before the court, Enka’s main contract was terminated before Frener & Reifer had been able to start any of its installation works. Enka vacated the site and, on the same day, made demands on both the advanced payment and performance guarantees. Enka commenced proceedings in England on both guarantees and made applications for summary judgment.

The banks argued there had to be a causal connection between the allegation of a failure to fulfil obligations and the amount claimed. It was submitted for the banks that as the contractor had not established any loss as a result of the alleged breaches by the subcontractor it should not be able to enforce the guarantees. This would involve consideration of the underlying dispute between the Enka and its subcontractor, which would be determined elsewhere.

The banks’ arguments were rejected. The court was keen to emphasise that such guarantees “have more of the characteristics of a promissory note than of a guarantee. Their economic function is more in the nature of a secure payment to [the client] by the banks than of a guarantee of [the subcontractor’s] obligations.”

Those asked to provide such guarantees are at risk of a call on the bond that is unscrupulous even if it is not fraudulent

The view that such a guarantee was “not intended to represent an estimate of the amount of damages to which the client may be entitled for the breach alleged to give rise to the right to call” was accepted.

Essentially, the court decided that the point of the guarantee was to give the contractor the advantage of having the cash in its bank account while the dispute was resolved some time in the future.

The case emphasises the strength of the position that the client has, not only against the guarantors but, by implication, against the contractor. The slightest dispute can lead to a call on such a guarantee and then the guarantor will, naturally, call upon its cross-guarantee from the provider.

Those asked to provide such guarantees are at risk of a call on the bond that is unscrupulous even if it is not fraudulent.

At a time when cash flow is all important, the advantage to the client is great. A call on the bond will put money in its hands and remove it from the contractor’s. Thus, whatever dispute procedure is adopted by the contractor (assuming that it can maintain its solvency in the meantime), the balance of cash, and hence of power, will have swung heavily against it.