Legal blog: On demand or on default?

Parties to construction contracts are often required to provide some sort of security for performance of their obligations. This is so commonplace that most major suites of standard form contracts now contain requirements concerning the provision of bonds or guarantees. However, there are very few - if any – standard forms of guarantee or bond that are widely accepted and the use of bespoke forms therefore abounds.

The question of whether a particular form of security or payment guarantee can be invoked “on default” or “on demand” is one of those perennial issues that trouble not only those negotiating the security but also those involved in enforcing it once it is in place. It is particularly difficult when the security contains a mixed bag of clauses that point in both directions. The answer does, however, have a significant impact on risk. If the security is on demand, then the giver is required to pay out on demand, irrespective of whether there has been a breach of the underlying contract for which the security was provided. If the security is on default, then it is a secondary obligation that comes into play only if a breach of the underlying contract has been established. Given the importance of the answer, parties often fail to agree which category the security falls into and end up in court arguing the point.

Sure enough, the point was recently before the courts again – this time in the context of the long-running saga about the Panama Canal expansion (Autoridad del Canal de Panama v Sacyr SA & Others [2017] EWHC 2228).  

Simplifying the facts: the claimant (the Panamanian canal authority) had entered into a construction contract with a Panamanian company for the carrying out of the Third Set of Locks project for the canal expansion. A couple of years into the project, the Panamanian company started to suffer cash flow problems and asked the claimant to make advance payments to enable the works to continue. 

Over the next few years the claimant agreed to make various advance payments and to extend the repayment dates on existing advance payments. Each of these advance payments was secured by a specific advance payment guarantee given by a consortium of the defendants. The earlier ones were subject to Panamanian law and International Chamber of Commerce arbitration in Miami (as was the construction contract). The later ones, however, were subject to English law and the jurisdiction of the English courts.  

If the security is on demand, then the giver is required to pay out on demand, irrespective of whether there’s a breach of the underlying contract for which the security has been provided

Repayment of the advance payments fell due and did not occur. A flurry of proceedings and applications ensued. These included the commencement by the claimant of proceedings in the English courts asking for declarations as to its entitlement to demand repayment under the English law advance payment guarantees and summary judgment on its claims for payment under those guarantees.

The outcome of the claimant’s summary judgment application depended on how the relevant advance payment guarantees should be interpreted. Were they “true” guarantees under which the guarantors were only obliged to make good any defaults by the contractor under the underlying contracts?  Or were they “on demand” instruments, imposing primary obligations, and payable simply on presentation of a demand in the correct form? 

In deciding the answer to the question, the court reminded us that the title of the document is not conclusive, and that you cannot pick on just one clause within the security to determine its form.

The only presumptions that can be made are the presumptions that security given by a party other than a bank or financial institution will usually not be on demand, and that (conversely) a security given by a bank or other financial institution usually will be. Otherwise you must look at the instrument as a whole to decide what it is the case, without any preconceptions as to what it might be.   

In this case there were some provisions in the guarantees which pointed in the direction of them being “on demand”. For example, one particular paragraph confirmed that the defendants entered into the guarantees “as primary obligor and not as surety”.  Also in the interest clause there was wording stating that the claimant would decide the amounts payable, and that its decision would be conclusive save for manifest error. 

However, this was not enough. The court decided that the guarantees were not “on demand”, and in order to be triggered required proof that the relevant advance payments were overdue.  

The key clause it referred to in reaching this decision was the paragraph providing that: “if [the Panamanian company] is in breach of any of its obligations … [the defendants] shall upon demand by [the claimant] … forthwith perform the obligations … in the same manner that [the Panamanian company] is required to perform such obligations according to the terms of the contract”.  

While the court recognised the reference to “upon demand” in this paragraph, it found that this was a relatively neutral factor. Instead it decided that the part of the paragraph requiring the defendants to perform the contractor’s obligations “according to the terms” of the underlying contract was key. This required demonstration of what those obligations were and made it clear that the guarantees were  “on default”. The court was also supported in drawing this conclusion by the presumption against instruments issued by parties other than banks and other financial institutions being “on demand”.