Confirmation of an adjudication antidote and good news for principals for recourse to security

Our Bartier Bulletin in May 2014 highlighted the decision of Patterson Building Group Pty Ltd v Holroyd City Council (A Principal’s Antidote to Adjudication?).  In Patterson, it was held that where there is an arguable question regarding the merits of an adjudicator’s determination, a principal can be repaid amounts paid to the builder pursuant to an adverse adjudication if the contractual trigger for recourse to security provided by the builder is a mere claim to be owed money.

Recently, in Sugar Australia Pty Ltd v Lend Lease Services Pty Ltd, the Victorian Court of Appeal confirmed a principal’s right to recourse, explaining that the purpose of such a provision is to shift the risk of being out of pocket pending final resolution of a dispute.

Facts

The appeal was from an interlocutory decision to grant an injunction restraining the principal from recourse to two bank guarantees totalling $4.2 million provided by the builder under a building contract to design and construct a refined sugar plant.

The recourse provision provided that the security would be “available to the Principal whenever the Principal may claim (acting reasonably) to be entitled” (emphasis added) to payment by the builder.

The building contract had been terminated, purportedly by both parties, following a dispute, and both parties had commenced proceedings in the Supreme Court of Victoria claiming damages for breach of contract from the other.  On the day it commenced proceedings, the principal had given notice to the builder that it intended to have recourse to the bank guarantees.

The threshold issue before the trial judge on the builder’s application for an injunction was the construction of the recourse provision.  That is, was the provision merely for the purpose of giving security or was it a risk allocation device, and, if the latter, what did “acting reasonably” mean?

The trial judge, however, declined to construe the recourse provision, and the meaning of “acting reasonably”.  Instead, the trial judge held that the construction of the provision itself raised a serious question to be tried and, given the amount involved, the hardship to the builder if the bank guarantees were called outweighed the hardship to the principal if they were not.

The Appeal Decision

There are usually two commercial purposes for this kind of contractual provision.  One is to provide security so that if the principal has a valid claim and there are difficulties about recovering from the party in default, it has recourse against the bank.  The second purpose, which is additional to the first, is to allocate the risk as to who should be out of pocket pending resolution of a dispute.  The beneficiary is then able to call upon the guarantee, even if it turns out in the end that the other party was not in default.  It is a question of construction of the underlying contract whether the guarantee is provided solely by way of security or also as a risk allocation device.

The Court of Appeal held that if the commercial purpose of the recourse provision is to allocate risk pending final determination, then the context in which the Court exercises its discretion whether to construe the recourse provision is altered, as is application of the usual principles that govern an interlocutory application.

The practice adopted by the courts relating to such provisions is that it is ordinarily appropriate for the court to consider whether the recourse provision is intended to effect an allocation of risk pending resolution of the dispute between the parties and, if it does, what is the nature of any qualification imposed on using it.

If that question is not answered at the interlocutory stage, then the risk allocation purpose of the clause is potentially defeated.

Here the parties made a commercial agreement as to when and how recourse might be had to the security.  In doing so, they effectively determined which of them would bear the financial risk without the need for the principal to prove an entitlement to be paid.  The safeguard negotiated and agreed by the parties was that the principal must act reasonably when claiming an entitlement to payment and calling on the bank guarantees.  One important commercial effect of this was that the principal did not have to wait until trial for payment of some amount by the builder.

Accordingly, the Court of Appeal held that the trial judge had erred to the extent that it found that the arguments in favour of not construing the recourse provision did not outweigh the factors in favour of construction, particularly with reference to the commercial purpose of the recourse provision. The Court of Appeal took the view that until the recourse provision had been construed, it was not possible to determine whether there was a serious question to be tried and that the concept of reasonableness in the recourse provision was to be determined objectively.

On the facts, the Court of Appeal found that there was no serious issue to be tried in respect of the reasonableness of the principal’s claim to recourse for at least $2 million, and that the balance of convenience did not favour the grant of an injunction in respect of the balance of the security amount ($2.2 million).  In particular, the Court of Appeal held that by agreeing to the recourse clause, the builder assumed the risk that a call might be made on the security, and that the principal would otherwise be deprived of the right provided to it under the recourse provision that the builder, and not the principal, would carry the risk as to which party was out of pocket pending resolution of the disputes between them.

Conclusion

The Victorian Court of Appeal has confirmed that an appropriately worded security provision in a building contract can be powerful tool in the hands of the principal – a real antidote to the sting of an adverse adjudication determination.

Conversely, contractors need to be careful to make sure the principal is required to prove its entitlement before calling on security

This becomes of even greater importance as more principals are likely to insist on bank guarantees rather than retention sums as security following the amendments to the Building and Construction Industry Security of Payment Act 1999 (NSW) earlier this year which impose onerous obligations on the establishment and maintenance of retention trust accounts. For more information on those amendments, please see our bulletin from last month: Retention sum headaches – The joys of trust accounting for head contractors.

Authors: David Creais & Ben Hardy