PERFORMANCE SECURITY: BONDS, GUARANTEES AND …

1 Asia Pacific Projects UpdatePERFORMANCE security : BONDS, GUARANTEES AND LETTERS OFCREDITKEY CONTACTSAlex GuyPartner, Finance & ProjectsT+61 7 3246 PapailiouSenior Associate, Finance & ProjectsT+61 7 3246 considering PERFORMANCE security requirements tosupport project contracts, parties often wonder what formof PERFORMANCE security is appropriate - a performancebond, parent company guarantee , financial institutionguarantee or letter of credit. Each of these instruments isused to achieve the same goal, namely to increaseconfidence and manage risk between the parties in orderto facilitate the underlying transaction. However, eachinstrument carries nuances that may impact upon itsoperation and utility, and therefore its appropriateness indifferent commercial issues were brought into sharper focus followingthe UK Court of Appeal's decision inWuhan GuoyuLogistics Group Co Ltd, Yangzhou Guoyu ShipbuildingCo Ltd v Emporiki Bank of Greece1(Wuhan Case).

2 In theWuhan Case, a decision was made as to whether apayment guarantee in relation to a shipbuilding contractprovided by a bank was properly classified as a guaranteeor an 'on demand bond '. As will be discussed, thedistinction between a guarantee and an 'on demand' bondis an important one, with significant consequences forboth those seeking to rely on the security2and thoseproviding paper sets out the key differences between thevarious forms of security commonly used in the Asia-Pacific market to help you determine which instrument ismost appropriate for your ISSUED BY FINANCIALINSTITUTIONSB anks and other financial institutions can be called uponto secure the PERFORMANCE of a party's obligations under aproject major benefit of using such securities is that the partiescan normally be assured that the institution has the credit-worthiness to satisfy the security in the event of [2012]

3 EWCA Civ ' PERFORMANCE security ' and ' security ' are usedinterchangeably in this article, it is important to note thatthese are not ' security ' in the sense that no security interestis PERFORMANCE security : Bonds, GUARANTEES and Letters of CreditHowever, such securities normally carry fees and charges,which may add to the overall cost of the transaction. Suchsecurities can also be difficult to obtain if the contractparty has poor credit or if the secured amount is too great,and will typically specify a maximum securities can be issued by insurers as well as securities can free up working capital thatis ordinarily tied up under a bank security . In addition,such securities are treated as 'off balance sheet' meaningthat they do not impact upon the company's three main financial institution-issued instruments areletters of credit, GUARANTEES and PERFORMANCE of CreditA Letter of Credit (LOC) creates an obligation on thebank to pay a beneficiary a specified sum of money oncethe beneficiary satisfies the bank of certain are commonly used in international tradetransactions, where the LOC operates as both a means ofpayment and security for the transaction.

4 A purchaser willnormally procure an LOC from a bank in the vendor'sjurisdiction. The vendor will then cash the LOC after itships or delivers the goods. The LOC ensures that thevendor is paid promptly and in the correct currency. Theconditions stipulated in the LOC can also be used toprotect the purchaser against conditions in an LOC can be as simple as requiringthe beneficiary to issue a demand on the bank. Howeverthe contract party will normally push for more stringentobligations. For example, in a standard shippingarrangement, the LOC will usually require the vendor topresent a certificate of receipt to the bank in order toprotect the purchaser from non-delivery. Beneficiaries ofan LOC should pay particular attention to the proposedconditions. If the beneficiary cannot comply with theconditions then the LOC is essentially key point to note with LOCs is that the terms of theprimary agreement are of no concern to the bank grantingthe LOC.

5 It is the LOC alone that governs the relationshipbetween the bank and the beneficiary. The bank is legallyobliged to pay the beneficiary once the conditions in theLOC are satisfied irrespective of any instructions orobjections from the contract form of a general LOC is standardised by theUniformCustoms & Practice or Documentary Credits 2007(UCPs) published by the International Chamber ofCommerce. The UCPs are usually expressly incorporatedinto the terms of an LOC. In some instances it may bemore appropriate to adopt other rules such as the ICC'sUniform Rules for Demand , if theLOC in question is a standby LOC, these tend to bestandardised by theInternational Standby Practices financial institution guarantee requires a financialinstitution to assume liability in the event that the contractparty breaches an obligation under the project contract andis unable to rectify the default itself.

6 As guarantor, thefinancial institution is technically required to subsume theperformance of the contractor's primary obligation(usually to make a payment). However, in practice, it ismore common for the guarantee to be worded so that thebeneficiary can rectify the default itself and claim the facevalue of the guarantee as damages from the financialinstitution in specific drafting to achieve the contrary, afinancial institution guarantee imposes a secondaryobligation on the financial institution and the beneficiaryhas no right of action against the financial institutionunless the contract party has breached an obligation underthe project , the beneficiary can beprevented from cashing the guarantee if there is a questionover whether there has been a breach or a question overthe amount of damages claimed. InWalton Construction(Qld) Pty Ltd & Anor v Venture Management ResourcesInternational Pty Ltd & Anor4the Queensland SupremeCourt granted an injunction preventing a financialinstitution from paying out a bank guarantee because therewas a serious issue to be tried in relation to the amountclaimed by the , if carefully worded, a financial institutionguarantee can be drafted as a primary obligation in termsthat require the financial institution to make paymentunconditionally and upon demand.

7 This indemnitystructure allows the beneficiary to claim directly againstthe financial institution without first having to pursue thecontractor or prove the contract's breach. This form offinancial institution guarantee is most commonly used inthe Asia Pacific financial institution guarantee is normally governed bythe law of the country in which the guarantee is issued,normally the domicile of the institution. Parties should bemindful that certain jurisdictions may impose specificrequirements for the form of guarantee . For example, aguarantee must be in writing signed by the guarantorwhere theStatute of Frauds 1677(Imp) or some localequivalent applies. In jurisdictions with roots in Englishlaw it is also recommended that GUARANTEES are drafted inthe form of a deed to overcome any issues of for exampleTurner Manufacturing MCO Pty Ltd v Senes [1964]NSW R6924[2010] QSC PERFORMANCE security : Bonds, GUARANTEES and Letters of CreditPerformance BondPerformance bonds are provided by a third party for up toa stated amount, payable in the event that the beneficiaryincurs loss as a result of the contract party's are two main forms of PERFORMANCE bonds: a'default' bond and an 'on demand' bond .

8 A 'default' bondimposes a secondary obligation on the grantor. Similar toa guarantee , the beneficiary must prove that the contractparty has breached the contract and caused damage inorder to cash the bond . The issuer of the bond can objectto payment if there is doubt over the primary breach or theamount of damages contrast, an 'on demand' bond creates a primaryobligation on the issuer to pay the stated amount ondemand, irrespective of any objections raised by thecontract party. The bond is not conditional on the creditorproving the contract party's default and the beneficiary hasa primary right of action against the issuer in the event speaking, PERFORMANCE bonds are limited for aspecific duration and up to a maximum cap. Performancebonds will usually expire after a specified time, such aspractical completion or after the defects liability addition, a PERFORMANCE bond will rarely guarantee theperformance of all of the contract party's obligations;rather it provides the recovery of financial loss up to thestated amount, often framed as a percentage of thecontract price.

9 This can be problematic where multipleissues or insolvency quickly exhaust the level of cost of obtaining an 'on demand' bond is generallymuch higher than the cost of obtaining a 'default' bond . Insome markets 'default' bonds have become more commonfor this reason, but in the Asia Pacific region, 'on demand'bonds and letters of credit remain the COMPANY GUARANTEESIt is sometimes more appropriate to obtain security from athird-party that is not a financial institution, for instance, aparent company of the contracting securities are often easier and less costly toobtain than financial institution securities, particularlywhen the security comes from another entity in thecontracting party's corporate group. Furthermore, incomparison to banks and unrelated third-parties, relatedentities are often more willing to provide morecomprehensive security should be conscious of a number of risks whenusing third-party securities.

10 Firstly, in comparison to afinancial institution, there is greater risk that the providerof the security may not have the credit to meet itsobligations under the security . This risk is particularlypresent when dealing with complex company groupstructures, where it can be unclear where the group'sassets are , a company providing security might need tocomply with certain internal processes before granting thesecurity, such as board or shareholder approval. Theseadditional hurdles can pose additional risk to the validityof a third-party security and can also affect projecttimeframes. Provision of a legal opinion to cover dueauthorisation and enforceability may give further comfortto a recipient of a third-party parent company guarantee (PCG) is similar to afinancial institution guarantee except it that it is issued bya parent of the contract party or another related PCG has the same basic effect as a bank a bank guarantee , a PCG can be drafted in terms of aprimary or a secondary obligation.