Performance security: Practical tips for principals and contractors

What you need to know

• Performance securities are important tools to secure a contractor's performance of its obligations under a construction contract.
• Ideally, the terms of the underlying contract and the security instrument will clearly identify the circumstances in which a principal may call on and use the performance security.
• Injunctive relief is often sought by contractors where these provisions are unclear and/or where the requirements for making a call have arguably not been followed.
• In this context, it must be remembered that the commercial purpose of performance security is not only to secure a contractor's performance, but also to allocate financial risk between the parties pending resolution of a dispute. This, coupled with the fact that a performance security is typically an unconditional instrument, means courts are reluctant to restrain a party from having recourse to a performance security, unless there are clear words or special circumstances that suggest they should.

What you need to do

• To minimise the risk of disputes relating to performance security, you should ensure the terms of the relevant contract and security instrument clearly identify when a principal will be entitled to call on the performance security and use or apply the funds, as well as any formal requirements for making a call.
• You should also check for any legislative requirements that may govern a principal's right to call on and/or use a performance security. For example, in Queensland, section 67J of the Queensland Building and Construction Commission Act 1991 imposes notice requirements on a principal before it will be entitled to use a security.
• Where a dispute arises and a call on security is a likely prospect, both parties should immediately consider whether the contract permits a call on the security in the circumstances, and whether any formal and/or legislative requirements have been met. Careful consideration of the parties' respective positions and communication of those positions may help to avoid escalating a dispute and wasted costs.

Where a principal considers it is owed money or has otherwise suffered a loss as a result of a contractor's breach of contract, it is common for the principal to look to recover that loss by having recourse to performance security. A call on performance security can however negatively impact a contractor's cash flow and reputation in the market as well as its ability to secure performance security on reasonable terms in the future. It is therefore not surprising that contractors seek to prevent this from happening, including by seeking injunctive relief.

Understanding the purpose of performance security in construction contracts, when a principal will be entitled to call on it, and where it might be prevented from doing so, is therefore critical to both parties.

This publication addresses those questions and offers practical tips for parties to keep in mind when it comes to performance security.

Q: What is performance security and why might it be called on?

Performance security is designed to financially protect a principal in the event the contractor defaults on its contractual obligations.

It can take many forms – such as a performance bond, parent company guarantee, financial institution guarantee, or letter of credit. Each of these is used to achieve the same goal; namely, to increase confidence and manage risk between the parties to facilitate the underlying transaction or project.

In the construction industry, performance securities expressed to be irrevocable and unconditional, such as most bank guarantees, are popular, given that they are payable on demand. In that sense, they can be considered "as good as cash".

A principal may call on performance security to recover amounts owing by the contractor (e.g. liquidated damages) or to compensate it for loss suffered as a result of the contractor's breach of contract (e.g. defective works). Depending on how the relevant clause is worded, it may not even be necessary for the principal to first prove that it is in fact entitled to compensation before calling on security. A bona fide claim alone could be sufficient.

When a performance security is called on, it is the issuer of the performance security – as opposed to the contractor – that will be required to pay the principal a monetary sum up to the secured amount on demand, or otherwise in accordance with the terms of the performance security.

Q: When is a principal entitled to call on and use security?

As indicated above, the right to call on and use performance security is dictated by the terms of the underlying contract and any applicable legislative requirements.

Construction contracts generally include a clause conferring an express right on the principal to call on performance security in certain circumstances. However, these clauses are typically interpreted as imposing a "negative stipulation", preventing the principal from calling on the security unless certain conditions are satisfied.

For example, if the relevant clause simply provides that a principal may have recourse to the performance security for an amount due and payable by the contractor, the principal will not be entitled to have recourse to the performance security if the relevant amount is not in fact due and payable. This may be the case where an amount needs to be certified as owing, and mere assertion by the principal that it is owing is not enough. Accordingly, the right to call on a performance security may be subject to conditions, even though the security to which the clause relates is unconditional.

Importantly, while such clauses generally set out the circumstances under which a principal is entitled to call on the performance security, in some cases they do not specify whether the principal is entitled to use and/or apply the funds once paid. This ambiguity can lead the parties into dispute. It is therefore advisable to ensure that provisions that govern recourse to performance security in contracts are also clear in this regard.

Whether notice needs to be given before a call on security will depend on the terms of the contract and any applicable legislation. Principals and contractors should ensure they are aware of any notice requirements and that those requirements are adhered to. Non-compliance could restrict a principal's right to call on an "unconditional" security.

Q: Are there any requirements to use a particular form or procedure when calling on security?

In addition to the underlying contract, the terms of the security instrument itself may affect when and how a principal can have recourse to it.

To illustrate, a performance security instrument may impose conditions requiring a particular form or procedure, not otherwise stated in the contract, to restrict the circumstances in which payment of the secured amount has to be made. Where the terms of the instrument have not been satisfied, its issuer (commonly a bank) can refuse payment.

Even a minor discrepancy in form or procedure, such as a person signing the demand without clearly identifying that he or she is an authorised representative of the principal or the principal serving the demand by post instead of hand-delivery where required, can cause a bank to refuse to pay a demand. A bank may also refuse to pay a demand where the name of the bank account into which the proceeds are to be paid is not the same as the beneficiary of the performance security. An example of this would be where the bank guarantee is in favour of one joint venture partner but the bank account into which proceeds are requested to be paid is in the name of both joint venture partners. This can be particularly problematic where the security is about to expire and the requirement to call on it is therefore urgent.

On the other hand, if the demand is made in accordance with the terms of the performance security, the issuer must pay the amount demanded even if the contractor tells it not to.

Accordingly, when considering making or contesting a call on performance security, it is important to check whether the formal requirements for making the call and enabling payment are strictly followed.

Q: Under what circumstances will a court restrain a call on the security?

When faced with a call on performance security, it is common for a contractor to either pay the sum demanded by the principal to avoid a call or apply to the court for an injunction to restrain that call. This is typically done in order to safeguard the contractor's reputation in the market and cash flow in particular.

In order to obtain a temporary injunction, a contractor will be required to establish that:

• there is a serious question to be tried as to whether the principal has a right to call on the security; and
• the balance of convenience favours leaving the security intact until the dispute is resolved. This will often the case where a contractor can demonstrate that the payment of damages in lieu of an injunction would be an inadequate remedy.

While it might appear that these requirements could be readily satisfied where there is a bona fide dispute, particularly where the contractor stands to suffer significant reputational damage if a call were to be made, in the context of performance security, courts will typically refuse an injunction unless there are clear words or special circumstances that suggest they should do otherwise.

The rationale behind this is that, by agreeing that the contractor will provide the performance security on the terms set out in the contract, the parties have also agreed to allocate the financial risk of any dispute to the contractor until it is finally resolved.

There are however at least three instances where courts will deviate from this position:

• where there is compelling evidence of fraud on the part of the principal;
• where there is compelling evidence of unconscionable conduct on the part of the principal; or
• to ensure the principal adheres to any contractual promise not to call on the performance security (i.e. a negative stipulation).

Unless the above circumstances are present, a court is likely to refuse an injunction for the reasons set out above.

Q: What happens if the clause says the contractor cannot seek an injunction restraining the principal from calling on the performance security?

It is common for clauses relating to performance security to include a provision that the contractor will not to take steps to injunct a principal from having recourse to the performance security.

Recently, in NSW, a provision to that effect was found to be unenforceable on the basis that it was an ouster of the court's jurisdiction: G&S Engineering Services v MACH Energy Australia Pty Ltd [2019] NSWSC 407. However, that alone was not sufficient to refuse an injunction. On the contrary, an injunction was granted in this case as the court was satisfied there was a serious question to be tried, and the balance of convenience favoured it.

It is relevant to note that even though such provisions may be unenforceable, a court may still have regard to them for the purpose of construing the parties' bargain, including, in particular, whether the parties intended to allocate financial risk to the contractor pending resolution of a dispute.

Q: Are there any relevant statutory provisions?

The mere fact that a contractor has a claim on foot under security of payment legislation does not necessarily mean that the principal is unable to have recourse to performance security. However, in some Australian jurisdictions, security of payment legislation expressly requires principals to provide notice before calling on performance security.

For building contracts in Queensland, a principal is required to give notice of its intention to use a security or retention amount within 28 days after it becomes aware, or ought reasonably to have become aware, of its right to obtain the amount owed (see s 67J, Queensland Building and Construction Commission Act 1991 (Qld)). Under that section "use a security or retention amount" includes the act of converting securities into cash where the securities are held as negotiable instruments.

In Western Australia, proposed amendments to the security of payment regime will similarly require that a party seeking recourse to performance security must provide five business days' notice to the party that provided the security.

Q: What should be considered after the security has been called upon?

Principals should consider whether the contract entitles them to request further performance security to replace or "top-up" the performance security.

For contractors:

• it is possible (but much more difficult) to obtain an injunction if the performance security has already been called on. Where this has occurred, an injunction will be directed at preventing the principal from dealing with the funds or requiring the principal to place the funds into a separate bank account.
• if no injunction is sought and the principal has called on the performance security without a proper basis or in contravention of any statutory notice requirements, the contractor may be entitled to damages.

Q: Are there any other key considerations when it comes to performance security?

Aside from the matters discussed above, there are some key practical issues parties should bear in mind when it comes to performance security.

First, performance security issues can arise quickly and without warning. For this reason, parties should ensure they are across the details of their performance security at all times by keeping a register. That register should specify the amount secured, any contractual replacement dates or step downs, and the expiry dates. By keeping a register, parties should be in a better position to avoid last minute issues that can arise when these details are overlooked.

Secondly, courts have found that a principal may, in effect, claw back money paid pursuant to an adjudication decision under the relevant security of payment legislation, by exercising its contractual right to call on a performance security. Parties should bear this in mind when embarking upon the security of payment route.

Finally, it is important to remember that calling on performance security is a significant step. While it may serve to break a deadlock between parties and shift the financial risk until a dispute is finally resolved, this should be weighed against the inevitable damage to the principal/contractor relationship and how that might affect the project going forward. If a project is a long way off completion, parties may prefer to try to work collaboratively to achieve a commercially sensible outcome in the interests of the project.

Authors: James Clarke, Partner; Jeremy Chenoweth, Partner; Melissa Yeo, Senior Associate; Amelia Barrow, Lawyer; and Alicia Crossley, Lawyer.