Performance Securities – You got to know why to hold ‘em

The ‘purpose’ of performance security

In construction contracts, performance security is not only common, but it is a critical part of the commercial deal. This article looks at the relevance or importance of the link between the documented purpose of performance security and a beneficiary’s ability to have recourse to it.

At a basic level, the purpose often stated for providing performance security in the context of a construction contract is to ‘ensure the due and proper performance of the contractor’s obligations under the contract’ (or wording to that effect).

To use Australian Standard contracts as an example:

  1. AS2124 provides a stated purpose for security in clause 5.1:  “Security, retention moneys and performance undertakings are for the purpose of ensuring the due and proper performance of the Contract.
  1. However, both AS4000 and the draft AS11000 do not contain any similar provision (i.e. no purpose for security is expressed).

Including a statement as to the purpose of the performance security (as above) is often seen as limiting when read in conjunction with a broadly drafted clause setting out entitlements to have recourse to the performance security.  For example, a lawyer drafting a contract for a principal may include a provision entitling recourse to performance security as follows:

“The Principal may have recourse to the Security without notice to the Contractor at any time it claims that the Contractor is indebted to the Principal, in relation to the Contract or otherwise.

If the contract was also to include a statement as to the purpose of the security such as the generally accepted ‘to ensure the due and proper performance of the contractor’s obligations under the contract’, this would be inconsistent with the recourse provision, which would (in isolation) allow the principal to have recourse to the performance security even though the contractor may be properly performing its obligations under the contract.  This would be a problem if and when the beneficiary seeks to have recourse to that security, and the inevitable injunction is sought by its provider.  This is because, when determining whether to restrain a principal from calling on a contractor’s security, courts will not only look at the express recourse provisions under the contract, but also consider the purpose of the security.

Based on this reasoning, a lawyer acting on behalf of a contractor will often insist on a statement as to the purpose of the performance security (as above) being inserted into the contract, while the lawyer acting for a principal will often push for its deletion (as well as including a broadly drafted recourse provision).

So is the purpose of performance security, in today’s climate, really about ensuring the contractor’s due and proper performance of its obligations under the contract?  Do principals only require recourse to security where there has been a demonstrated failure by the contractor to perform (i.e. a breach of contract)?  When the contractor fronts up to court and seeks to injunct the principal from cashing a bank guarantee, and the court requires the principal to prove the contractor’s failure to perform, will the principal be able to do this, given the urgency and immediacy surrounding these claims in practice?

In practice, holding performance security is really more about reducing the beneficiary’s risk of immediate financial exposure in the event that the parties fall into dispute.  Fundamentally, performance securities are instruments of risk allocation.  So can beneficiaries ensure that their contracts align with this purpose?

What the courts say

Throughout Australia, there is a substantial amount of case law considering whether or not a party is entitled to have recourse to performance security.  The reasoning and relevant contractual provisions in some of the key cases are considered in more detail below.

Clough Engineering

In Clough Engineering Ltd v Oil and Natural Gas Corporation Ltd [2008] FCAFC 136, Clough sought an injunction to prevent Oil and Natural Gas Corporation (ONGC) from calling on an unconditional and irrevocable performance guarantee relating to oil and gas field development works in India. The security clause was drafted as follows:

3.3.1. This irrevocable Performance Bank Guarantee shall be drawn in favour of the Company

3.3.3: The Company shall have the right under this guarantee to invoke the Banker’s guarantee and claim the amount there under [sic] in the event of the Contractor failing to honour any of the commitments entered into under this Contract.

The performance guarantee itself contained the express reservation “…notwithstanding any dispute(s) pending”, without reference to the contractor and “without any demur, reservation, contest or protest”.

Disputes arose between Clough and ONGC. ONGC subsequently called upon the performance bonds.  Clough argued that the call on the performance bonds was unconscionable under s 51AA of the TPA as the alleged defaults in question were caused by ONGC and/or alternatively involved a call on the performance bonds in circumstances whether other mechanisms protected ONGC for the specific defaults.

Clough set out the principles to be followed when construing the purpose of a security clause:

  1. subject to the exceptions of fraud and unconscionability, the beneficiary of a performance guarantee granted in its favour as a risk allocation device, will be entitled to call upon the guarantee even if it turns out, ultimately, that the other party was not in default (at [80]);
  2. the contract should be considered against the national and international commercial background (at [81]);
  3. a court should not too readily favour a construction which is inconsistent with an agreed allocation of risk as to who is to be out of pocket pending resolution of a dispute (at [82]);
  4. clear words will be required to support a construction which inhibits a beneficiary from calling on a performance guarantee where a breach is alleged in good faith (at [83]); and
  5. the proper construction of the beneficiary’s right to call on the guarantee must be informed by a consideration of the prescribed form of the guarantees (at [90]).

The court concluded that upon the proper construction of clause 3.3.3, when read together with the performance guarantee, show that the commercial purpose of the contract was to allocate the risk of who should be out of pocket notwithstanding that there may be a genuine dispute as to whether Clough had failed to honour commitments under the Contract. The risk was allocated to Clough, there being no clear words to inhibit ONGC as the beneficiary of the guarantee from invoking it. The court therefore refused the injunction sought by Clough.

Redline Contracting

Redline Contracting Pty Ltd v MCC Mining (Western Australia) Pty Ltd (No 2) [2012] FCA 1 concerned the construction of pipelines for the Sino Iron Project in WA. Redline provided four unconditional undertakings to MCC Mining for $1.66m each (being an aggregate of 10% of the contract price). MCC Mining terminated the contract and claimed Redline owed it $1.29m for an outstanding balance of an advance payment by MCC and unpaid fuel invoices. MCC Mining gave notice of intention to have recourse under clause 5 of the contract, and Redline sought an injunction from calling upon any or all of four unconditional undertakings given to MCC Mining.

Clause 5.2 of the contract stated:

Security shall be subject to recourse by a party who remains unpaid after the time for payment where at least 5 days have elapsed since the party notified the other party of intention to have recourse.

Redline argued that the words “unpaid after the time for payment” as referring to the payment of a sum which is ‘due and payable’ and, therefore, did not contemplate the circumstance of MCC Mining calling upon the unconditional undertakings in support of a disputed claim for unliquidated damages. The time for any damages had not yet arisen until there was judgment in favour of MCC Mining or an agreement with Redline.

MCC Mining argued the commercial purpose behind clause 5 was to allocate risk and it was entitled to call upon the unconditional undertakings in respect of its unliquidated damages claim, notwithstanding that the parties were in dispute as to the existence and the amount of the claim.

The court agreed that the proper characterisation of clause 5 is a risk allocation clause stating at [48]:

…resort to the security by MCC Mining is not conditioned upon there being an undisputed amount due and payable by Redline. It is sufficient, in my view, that MCC Mining bona fide believed that it had such a claim… the resort by MCC Mining to the unconditional undertakings will not be precluded, by reason only, that the disputed claim is in respect of an unliquidated amount as damages.

The court held that Redline failed to demonstrate it as entitled to restrain MCC Mining from resorting to the unconditional undertakings for the full amount of the security, either on the grounds of an implied negative stipulation in the contract or on unconscionability grounds.

Walton Construction

The court in Walton Construction Pty Ltd v Pines Living Pty Ltd [2013] ACTSC 237seemed to shift the law from requiring a need for no prohibition to call on the security, to needing a positive right to call on the security. The decision concerned a contract in the form of PC-1. The security clause was silent about when Pines Living might call upon any security. In accordance with the contract, Walton provided two bank guarantees of $190,000 each.

Walton argued in the absence of an express term dealing with the circumstances in which recourse could be had to security, the parties could not have intended that the right to call upon the bank guarantees be unconditional and unqualified. This term would not satisfy the criteria ordinarily considered when implying contractual terms.

Pines Living argued that it is evident from both the bank guarantees and the construction contract that the parties intended to make demand on the bank guarantees unconditional and unqualified. Further, authorities had established that in the absence of a clear negative stipulation in the contract, it was entitled to call upon the bank guarantees.

The court held that as the contract did not include an express right to call on the bank guarantee, it did not serve the “allocation of risk” purpose stating:

…in the absence of any express provision in the contract itself relating to the circumstances in which recourse might be had to the guarantee, in my view the fact that the guarantee is an unconditional one would not, even if, as in Clough, incorporated into the contract, be a circumstance which would permit it to serve the allocation of risk purpose… I do not accept the submission made by Pines that in the absence of a clear negative stipulation a party may not be enjoined from calling on an unconditional guarantee except where there is fraud or unconscionability.

His Honour held that a term would have to be implied in order to be able to have recourse to the security in the absence of an express right to do so, and the facts of the case did not give rise to such an implied term.  The court granted an injunction to restrain Pines Living from calling on the guarantees.

Sugar Australia

In Sugar Australia Pty Ltd v Lend Lease Services Pty Ltd [2015] VSCA 98, Lend Lease agreed to design, construct, supply and install a new refined sugar plant for Sugar Australia. The contract required Lend Lease to provide security in the form of two unconditional bank guarantees for an amount representing five per cent of the original contract sum, being $4,190,000 in aggregate. A dispute arose between the parties during the performance of the contract works, and both parties purported to terminate the agreement. Sugar Australia issued a notice that it intended to have recourse to the bank guarantees.

The recourse to security clause was as follows:

5.2 Any security provided by the Contractor in accordance with the Contract shall be available to the Principal whenever the Principal may claim (acting reasonably) to be entitled to:

(i)    the payment of monies or an indemnity by the Contractor under or in consequence of or in connection with the Contract;

(ii)    reimbursement of any monies paid to others under or in connection with the Contract; or

(iii)   other monies payable by the Contractor to the Principal (whether by way of set off or otherwise).

Recourse to security shall only be subject to the Principal having given the Contractor five days’ notice of its intention to have recourse to the security for the purpose of allowing the Contractor to replace the security with cash where it has been issued in a form other than cash.  Where the Principal has recourse to security in accordance with clause 37.3, the Contractor shall provide replacement security in accordance with clause 37.3.

Lend Lease submitted Sugar Australia was not entitled to seek recourse to the bank guarantees because:

  1. Sugar Australia was not acting reasonably as required by clause 5.2;
  2. the recourse notice provided was invalid; and
  3. should Sugar Australia have recourse to the bank guarantees, Lend Lease would suffer significant commercial and reputational damage in the building industry.

Sugar Australia submitted that it was acting reasonably in having recourse to the bank guarantees.

The court considered one of the issue for determination was whether clause 5.2 only permits Sugar Australia to have recourse to the performance bonds for reimbursement of moneys presently due or expended by Sugar Australia or whether, on the other hand, recourse might be had in respect of moneys payable in the future.

Agreeing with Kaye JA, Osborn and Ferguson JJA relevantly stated:

[21] If a provision in a building contract requiring a performance bond is intended to operate as a risk allocation device pending the final determination of the dispute between the parties then that intention must be fundamental to a consideration of the justice of an application made to restrain recourse to such a bond pending final determination of the dispute.

[25] The fact that a performance bond is intended to operate as a risk allocation device is not, of course, necessarily determinative of the right of a party to have recourse to it.  It may be subject to a contractual qualification or limitation upon the circumstances in which recourse may be had.  Nevertheless, the fundamental characteristic of a risk allocation device informs the task which the Court must undertake in resolving whether or not to grant an injunction.

Osborn and Ferguson JJA concluded that the parties had entered into a commercial agreement as to when and how the performance bonds might be called upon.  In doing so, they effectively determined which of them would bear the financial risk without the need for Sugar Australia to prove an entitlement to be paid. The safeguard negotiated and agreed by the parties was that Sugar Australia must act reasonably when claiming an entitlement to payment and calling on the bonds.  One important commercial effect of this was that Sugar Australia did not have to wait until trial for payment of some amount by Lend Lease.

In agreeing with the majority, Kaye JA relevantly stated:

[139] In the present case, clause 5.2 contains three preconditions to the exercise by the appellant of its right to access a security specified in clause 5.1.  First, the appellant must be ‘acting reasonably’ in making the claim to the entitlement to payment or reimbursement.  Secondly, the claim by the appellant must be in relation to an entitlement to one of the three categories of payment, reimbursement or indemnity, specified in sub-clauses (i), (ii) and (iii) of clause 5.2.  Thirdly, the appellant must first give the respondent five days’ notice of its intention to have recourse to the security.

[141] … it is important to bear in mind, first, that that provision does not require the appellant to establish or demonstrate an entitlement to the payment, indemnity or reimbursement referred to in the clause.  Rather, it is sufficient that the appellant has a ‘claim’ to such an entitlement… the security, provided under clause 5.2, was intended to serve both purposes described by Callaway JA in Fletcher Construction, namely, to provide security to the appellant, and also to allocate the risk to the respondent as the party which should be out of pocket pending resolution of any dispute between the parties.

Rather, the qualification is expressed to require that the appellant be ‘acting reasonably’ in making the claim. This does not require the claim itself to be reasonable.  The court held that the balance of convenience did not support the grant to Lend Lease of an injunction restraining Sugar Australia from accessing the bank guarantees.

Conclusion

In practice, holding performance security is often about reducing the beneficiary’s risk of immediate financial exposure in the event that the parties fall into dispute.  Fundamentally, in such circumstances, performance securities are instruments of risk allocation.

In Clough, the court held that if the purpose of the security clause is a risk allocation device, then subject to the exceptions of fraud and unconscionability, the beneficiary of a performance guarantee granted in its favour will be entitled to call upon the guarantee even if it turns out that the other party was not in default.

Recent judicial authority on the consideration of a security’s purpose have demonstrated the purpose of a security clause will depend upon the wording of the clause, the wording of the security provided (if any) and those clauses which impact upon the potential to have recourse to security (such as dispute resolution or termination clauses).

For the avoidance of ambiguity, parties should draft security clauses which clearly identify the intention of the clause as a risk allocation mechanism (if appropriate) and the circumstances of when a party may have recourse to the security. If acting for a principal, it is preferable to draft the clause with this stated purpose so as benefit from a wide and essentially unfettered ability to access security. This clause should be drafted as widely as possible, and without reference to damages or amounts agreed or otherwise.

Broad Indemnities and Narrow Insurances – A Match Made in Hell

When drafting indemnities into contracts, it is important to consider the relevant insurances that sit behind the parties and the interplay between them.

Too often, contracting parties insert indemnity clauses into contracts without giving adequate consideration to the effect and operation of those indemnities.  It is usually the contracting party with the most bargaining power that will insist on broad indemnities.  This article touches on some of the issues, particularly those relating to insurance, that need to be considered (by both contracting parties) before entering into a contract that contains indemnities.

An indemnity, put simply, provides that one party is to be held harmless for the actions or omissions of another. This effectively transfers risk from one party to a contract to the other party in relation to a specific event.

As we know, each project is different, and each contracting relationship has its own distinct nuances.  It follows that ‘boiler-plate’ indemnity clauses obtained from a previous contract or a lawyer’s precedent files are unlikely to allocate risk between the parties in a manner that reflects the inherent or underlying risk of the project or the contracting parties’ relationship.

These broad indemnities may also be inconsistent with the parties’ respective common law rights and obligations.  This is where the parties’ insurances become relevant.  A party who offers a broad indemnity may not be able to obtain insurance for the full extent of the liability imposed by the indemnity.

The issues that arise for insurers (who may ultimately be responsible for defending liability claims) are many.  Below are three of the more significant considerations.

  1. From a legal perspective, indemnities often alter the tests for causation and remoteness. It is the wording of the indemnity provision itself that determines causation (as opposed to actual cause), meaning that it is not necessary for the indemnified party to prove that the wrongdoer actually caused the loss claimed.  Similarly, indemnity provisions may be drafted in a manner that removes the common law test of remoteness (reasonable foreseeability).  This extends the indemnifier’s liability to types of loss and damage that is not reasonably foreseeable (and would not otherwise be recoverable).
  2. Another issue to consider is that indemnities may remove the common law duty of the innocent party to mitigate its loss. Again, this extends the indemnifier’s liability to losses that may not have been incurred if the indemnified party had taken steps to reduce its loss (as it would be required to do in relation to a common law damages claim).
  3. Thirdly, an indemnity can have the effect of extending the relevant statutory limitation period. For example, in NSW, the time period within which a claim may be brought for breach of contract is 6 years (commencing from the date of the breach).  With respect to indemnities however, the relevant breach (and therefore the limitation period) commences from the date on which the indemnifier refuses to honour the indemnity. This may be some time after the act or omission that triggered the indemnity.

Not only are the above considerations important for parties to understand the extent of their liability, but they also may have an effect on a party’s ability to obtain adequate insurance, or be determinative on whether an existing policy will respond.

The obvious example, in a construction context, is where a principal requires its contractor to indemnify it against loss and damage caused not only by that contractor but also the contractor’s sub-contractors and consultants.  In practice, the average contractor will have an existing public liability insurance policy in place.  Such policy will usually exclude liability assumed by way of contract, unless that liability would have existed in the absence of the contract.  The effect of this exclusion is that the insurance policy will cover liability only where the contractor or sub-contractor has been negligent.

Public liability insurance policies are also typically narrower than indemnities in that those policies:

  1. will not cover the proportionate liability of a concurrent wrongdoer who is not covered by the insurance;
  2. may only cover liability in respect of personal injury (or death) and property damage (and not liability where it does not arise or flow from property damage); and
  3. will exclude professional services such as design, specification and advice.

Consequently, it is likely that any broad contractual indemnity will be broader than the average public liability policy that is maintained by contractors.  This has obvious effects for the contractor who has assumed uninsured risk and must bear the loss itself.  This dominos to affect the project, as the principal may be faced with a contractor who is not financially capable of satisfying the principal’s claim.

To cover its ‘contractually assumed’ liability, the contractor may effect and maintain additional liability insurance (covering itself and its sub-contractors and consultants), and it may name the principal as an insured. It is therefore important that a contract specifies the scope of insurance cover required by each party.  Indeed, a prudent principal may insist that a contractor effect and maintain insurance that will respond to a claim under each indemnity (and to provide a copy of all such policies in order to confirm that is the case).

In the absence of such additional insurance, a party giving an indemnity under a contract is best advised to ensure that indemnity provisions are covered by the insurances in place, and do not invalidate those policies. This can be achieved by:

  1. limiting the indemnity to losses foreseeable at the time of contract;
  2. amending the indemnity to require the indemnifier to mitigate its loss;
  3. amending the indemnity to apply only to loss or damage caused by the indemnifier;
  4. amending the indemnity to reduce proportionately to the extent the loss, claim or damage is caused or contributed to by the indemnified party or its agents;
  5. amending the indemnity to exclude ‘consequential loss’ (and defining that term sufficiently);
  6. seeking an overall liability limit on the indemnity (to the proceeds of available insurance policies); and
  7. amending the indemnity to limit the time period within which claims can be brought under the indemnity (e.g. 6 years from the date of completion of the relevant work).

If you or your business needs advice in relation to this subject matter, please do not hesitate to contact us.

The Vienna Convention: all about opting out

According to the Australian Department of Foreign Affairs and Trade, in the 2014-2015 financial year Australia exported and imported approximately AU$256bn and AU$270bn worth of goods respectively. It is clear that trade on this scale requires some form of international regulation. The United Nations Convention on Contracts for the International Sale of Goods 1980 (Vienna Convention), to which Australia is a Contracting State, attempts to provide uniform regulation while also taking into account different social, economic and legal systems. It is hoped this form of uniform regulation will remove legal barriers in and promote the development of international trade.

Application of the Vienna Convention and the ‘opt out’ culture

The Vienna Convention has a broad application. It applies to contracts for the international sale of goods if:

  1. the parties have places of business in different Contracting States (article 1(1)(a));
  2. the parties have places of business in different States, and the rules of private international law leads to the law of a Contracting State (article 1(1)(b));
  3. the parties agree that the Vienna Convention applies, even if neither party is from a Contracting State; or
  4. the relevant contract does not contain a choice of law clause, and an arbitral tribunal determines the Vienna Convention applies as the appropriate law (for example, article 21(1) of the ICC Rules of Arbitration 2012).

At present, the Vienna Convention has 84 Contracting States which includes some of Australia’s largest trading partners such as China, the United States, Japan and the Republic of Korea. However, there are some notable exclusions to the list of Contracting States including Indonesia, India and the United Kingdom. In Australia, the Vienna Convention has been implemented into domestic legislation through sales of goods legislation in each state and territory, as well as section 68 of the Australian Consumer Law in Schedule 2 of the Competition and Consumer Act 2010 (Cth).

Article 6 of the Vienna Convention allows parties to exclude its operation or vary its provisions. A discussion paper released by the Attorney General’s Department, Improving Australia’s law and justice framework – A discussion paper exploring the scope for reforming Australian contract law (2012), found that although empirical data is limited, Australian businesses have made relatively little use of international principles (including the Vienna Convention) when entering into international contracts. Similar ‘opt out’ cultures exist outside Australia with 55% of lawyers in the United States and 42% of German lawyers generally opting out of the Vienna Convention.[1]

Notwithstanding these statistics, the Vienna Convention has continued to be used in other countries such as China and Switzerland. This has resulted in the Vienna Convention becoming a well-tested body of law. It may now be time to reconsider whether Australian lawyers and commercial parties entering into international sale of goods contracts should continue to subscribe to the ‘opt out’ culture.

Should parties continue to opt out of the Vienna Convention?

There is no correct answer as to whether parties should continue to opt out of the Vienna Convention. The decision of a party to opt out will be dependent upon all of the circumstances relevant to the contract, the goods sold and its contracting party(s).

The Vienna Convention certainly has some benefits for international contracting parties:

  1. it has been customised and standardised to meet the requirements of international transactions due to longer transport distances and cultural differences, in contrast to often anachronistic and localised domestic sales law;
  2. it provides a neutral legal mechanism accessible in several languages, rather than the party with the least bargaining power most likely required to agree to and research the law of an unfamiliar jurisdiction;
  3. its use for over 35 years has resulted in a well-known and well-tested area of law in both arbitral and court proceedings; and
  4. the obligations imposed by the Vienna Convention do not impede upon the parties’ freedom of contract, allowing parties the ability to agree the rights, obligations and risks of the transaction.

Notwithstanding these benefits, there remain fundamental issues which parties should consider before deciding whether to opt out.

The Vienna Convention is the result of compromise rather than a search for international best practice. As a heavily negotiated legal instrument, compromises were made to ensure its passing, leaving some provisions unclear and/or incomplete. For example, article 78 provides interest is payable on sums in arrears, but does not specify the rate of interest or how this is to be determined. Another example is article 25 which introduces the concept of ‘fundamental breach’ couched in vague terminology, allowing a party to ‘avoid’ a contract should the defaulting-party fail to perform its obligations amounting to a ‘fundamental breach of contract’.

This ambiguity and/or incompleteness results in greater unpredictability and uncertainty. Through inadvertently encouraging reliance on more familiar domestic legal concepts to give meaning to its terms or to fill-in the gaps, the wording of the Vienna Convention increases the possibility of inconsistent interpretations by judges and arbitrators from different jurisdictions. This is exacerbated by difficulties in translating terms from one language to another. For example, the translation of the terms ‘fundamental breach’ or ‘specific performance’ into six different languages is not merely a case of pure translation, but rather the more difficult translation of legal issues.

A further issue is the Vienna Convention’s interaction with Australian contract law. Similar to Australian contract law, the Vienna Convention requires an offer and acceptance prior to the formation of a contract. However, article 14(1) provides an offer will be made if it is “sufficiently definite” and indicates an intention to be bound. An offer is ‘sufficiently definite’ if it indicates the goods and fixes or makes provision for the determination of quantity or price, but does not need to include the place or time for delivery, insurance or security requirements.

The ability to have insufficiently definite offers causes complications in situations where purchase orders and invoices with limited detail flow between the parties. This was the case in Castel Electronics Pty Ltd v TCL Airconditioner (Zhongshan) Co Ltd [2013] VSC 92 where the court was required to determine whether purchase orders or signed and returned invoices constituted an offer and acceptance, or an offer and a counter-offer. It was argued that the purchase orders were not ‘sufficiently definite’ regarding key aspect of the orders such as shipment of the goods. However, the court found the documents amounted to an offer and acceptance, as the purchase orders listed the products by model, quantity required and the unit cost.

A further contractual issue with the Vienna Convention is found in article 8 which requires primarily a subjective, rather than objective, approach to contract interpretation whereby conduct is to be interpreted according to the party’s intent. If the other party was not and could not have been aware of the first party’s intention, then the relevant conduct is to be interpreted according to the understanding that a reasonable person would have had in the same circumstances. In determining the intent of a party on the understanding that a reasonable person would have had, all relevant circumstances of the case are taken into account including negotiations and established practices between the parties.

The difficulty in utilising different methods of contractual interpretation, applicable to any situation where the courts are utilising rules from different jurisdictions, was best described by Lord Hoffman in Chartbrook Ltd v Persimmon Homes Ltd [2009] 1 AC 1101: “One cannot in my opinion simply transpose rules based on one philosophy of contractual interpretation to another, or assume that the practical effect of admitting such evidence under the English system of civil procedure will be the same as that under a continental system.”

This is particularly relevant in Australia where there is currently judicial uncertainty regarding the ability to consider pre-contract communications in contractual interpretation. Despite the ‘true rule’ in Codelfa Construction Pty Ltd v State Rail Authority of NSW (1982) 149 CLR 337 that evidence of surrounding circumstances is only admissible in instances of ambiguity, there have been recent decisions in Electricity Generation Corporation v Woodside Energy Ltd (2014) 251 CLR 640 and Mainteck Services Pty Ltd v Stein Heurtey SA (2014) 310 ALR 113, as well as the special leave application in Western Export Services Inc v Jireh International Pty Ltd (2011) 282 ALR 604, that contractual interpretation is determined by reference to a reasonable person with a knowledge of the surrounding circumstances known to the parties at the time the contract was entered into (amongst other things) i.e. without the need for ambiguity in the contractual terms. However, this issue has not been settled by the High Court.

Although the risk of a dispute is ultimately a function of the relationship between the parties and their risk allocation, and notwithstanding the benefits to the Vienna Convention, parties need to be aware that its application can lead to uncertain and unpredictable complexities in the event of a dispute.

Opting out of the Vienna Convention

Depending upon the other terms of the contract, an opt out of the Vienna Convention can be as simple as expressly stating the Vienna Convention does not apply. The courts will take a broad approach to an exclusion if the parties intended to opt-out of the convention’s operation. In Olivaylle Pty Ltd v Flottweg GMBH & Co KGAA (No 4) [2009] FCA 522, the contract stated the contract was governed by “Australian law applicable under exclusion of UNCITRAL law”. The court held that notwithstanding the Australian sale of goods legislation which incorporates the Vienna Convention, the contract evidenced an intention to exclude the Vienna Convention from application through the phrase ‘exclusion of UNCITRAL law’.

However, opting out does not mean civil law concepts cannot be considered. In the same case, the court found that contractual terms referring to a “reasonable period of grace” and a “reduction in price” are civil law rather than common law concepts. The fact that the Vienna Convention had been excluded did not prevent the court from taking guidance from the civil law to understand these contract terms.

Conclusion

Prior to opting out of the Vienna Convention, parties must consider whether it is the right decision in light of the other party(s) places of business and whether this is a Contracting State, all the circumstances relevant to the agreement and the risk allocation under the contract. Any party that continuingly and blindingly opts out of the Vienna Convention may be missing an opportunity to provide regulation that is best suited to a particular transaction. In many transactions the Vienna Convention may be the better choice, but no law is perfect in every circumstance.

[1]Lisa Spagnolo, ‘The last outpost: Automatic CISG opt-outs, misapplications and the costs of ignoring the Vienna Sales Convention for Australian lawyers’ (2009) 10(1) Melbourne Journal of International Law 141, 160.

Are you contracting out of more than just proportionate liability legislation?

Since the introduction of proportionate liability legislation, most design and construct contracts expressly provide that the contractor agrees to be responsible for the acts and omissions of its subcontractors.  The intent, of course, is to allow the principal to seek contractual recourse against the contractor, and not have to establish negligence claims against subcontractors (whom the principal has no contract with).

But how does this type of provision interact with insurance policies required under the contract?

What is proportionate liability?

Proportionate liability is the concept of allocating liability between defendants in proportion to their contribution to the loss of the aggrieved party.

Proportionate liability legislation has been enacted in various formats in each State.  However, in essence, the Courts are able to apportion liability between ‘concurrent wrongdoers’ in claims for economic loss or property damage.

What happened prior to proportionate liability legislation?

Prior to the enactment of proportionate liability legislation in Australia, where two or more defendants were found liable to have caused the same type of loss, each defendant would typically be found to be jointly and severally liable to the plaintiff for the whole amount.  Accordingly, the preferred approach was for a plaintiff to seek recourse against the defendant with the ‘deepest pockets’ (such as professional service providers who typically carry professional indemnity insurance).  Often, one defendant may be insolvent and so the other would be left to pay for the loss.

Contracting out of proportionate liability legislation

In New South Wales, Western Australia and Tasmania there is an express ability to ‘contract out’ of proportionate liability legislation.  Consequently, parties may include a clause in their contract which stipulates that the operation of the relevant proportionate liability legislation is excluded from, and does not apply to, the contract.  Principal-drafted contracts often include such a clause, with the intent of allowing the principal to treat the contractor as a ‘one-stop-shop’ for all of its claims, regardless of the extent to which the contractor’s subcontractors or consultants may have contributed to the loss.  This relieves the principal of the burden of establishing negligence claims against such non-contracted parties.

Interestingly, the contract does not need to expressly refer to the proportionate liability legislation for the parties to be deemed to have contracted out of the proportionate liability legislation.  A judgment in Tasmania (and referred to in relation to a New South Wales case) has held that if the contract contains a provision which is inconsistent with the principles of proportionate liability, this will be sufficient (at least in Tasmania and New South Wales).   For example, if a party agrees to be responsible for the acts and omissions of its subcontractors (a very typical term contained in most design and construct contracts), the parties may have impliedly agreed to “contract out’ of the proportionate liability legislation.  The fact that the parties did not intend to ‘contract out’ of the proportionate liability legislation may be irrelevant.  This implication would not apply in Western Australia where the relevant legislation requires express reference in the contract for the contracting out to be effective.

In Queensland, the proportionate liability legislation provides that it cannot be contracted out of.  All other states are silent concerning whether parties may contract out of the relevant proportional liability legislation (however there are views on each of these – a discussion for another article).

Effect on insurance

Where parties elect to ‘contract out’ of proportionate liability, parties are exposing themselves to greater liability than they otherwise would have been exposed to at law (they are assuming liability that would have been apportioned to another wrongdoer).  Insurance policies refer to this as ‘contractually assumed liability’, and more often than not, expressly exclude such liability (meaning that the policy may not respond as intended).

Insurance policies that contain the usual contractual liability exclusion will only cover an insured for the portion of the loss that a court, under the relevant proportionate liability legislation, attributes to the insured (because that would be the liability that would have attached ‘but for’ the contract).  The additional liability a party voluntarily assumes by ‘contracting out’ of proportionate liability legislation will be excluded from the insurance policy coverage.  The insured will therefore have a ‘gap’ in its insurance coverage.  This will obviously not assist either party to the contract and would be an unintended effect of the decision to include the provision excluding the operation of proportionate liability legislation in the first place.

Accordingly, before executing the next construction contract which excludes the application of proportionate liability legislation, parties (this applies equally for principals and contractors) should confirm the effect of such provisions on the insurance policies relied on by the project.  Whilst the outcome depends very much on the wording of the policy and the drafting of the contractual provisions, there is a real risk that the insurer will not pay a claim if the insured has agreed to contract out and this has extended their legal liability beyond what it would have been at law.

The float. Own it.

While the vast majority of parties to construction projects understand the practical importance of a program float, the contract provisions that control this issue are increasingly being overlooked. Indeed, in today’s growing construction climate, some of its participants do not seem to understand the effect that contract drafting can have on program contingency and which party actually receives its benefit.

It is now common for projects to be controlled by a ‘critical path’ method of programming. This means that all construction activities are identified, broken down and then plotted onto a matrix which establishes which activities are on the critical path to enable practical completion to be reached by the date for practical completion. Each critical path activity must be started and finished on fixed dates or the completion of the project will be delayed.

However, construction activities which are not on the critical path are assigned completion periods longer than actually required for the activity, during which the construction activity may be completed without delaying the entire project. The ‘float’ is the period between the earliest possible start and the latest possible finish, less the actual time taken to complete the activity itself. If completion of an activity is delayed beyond its available ‘float’, it becomes a critical path activity in relation to which further delay will result in practical completion not being achieved by the date for practical completion, and consequently the contractor may be liable to the principal for liquidated damages.

So the ‘float’ is the period of time that a contractor includes in its program to enable it to accommodate various risks (such as industrial action or wet weather). Traditionally, it has been accepted that the float is a ‘buffer’ and risk management tool for the benefit of the contractor (meaning that the contractor ‘owns the float’). However, after many years of contracts being amended to be more ‘principal-friendly’, many projects are currently moving forward in circumstances where the principal owns the float. While this, of itself, is not an issue (indeed, many contracting parties negotiate a position under which the principal owns the float for good reason), contractors and principals alike need to ensure that they understand the effect of drafting amendments included in many of today’s contracts.

Ownership of the float is dependent on interpretation of contractual provisions, and in the absence of such clear provisions, the principles of common law. The three possibilities are:

  1. the contractor owns the float; or
  2. the principal owns the float; or
  3. neither party owns the float.

So who should own the float?

Proponents for ‘the contractor owns the float’ position argue that the contractor is entitled to use the float for his own risk events and program rescheduling. The argument is based on the fact that the contractor is the party who develops and owns the program, and if work is planned and carried out in a way that allows for a float, then the contractor should be entitled to the benefit of that float.

Proponents for ‘the principal owns the float’ position argue that because the value of the float forms part of the contract price, and the program is one of the tools to manage the project, the principal should be able to control the float to reduce its costs and control progress. Further, the theory is that the only effect in using the float, is the reduction of the float, which does not affect project completion. On this reasoning, it is viewed as unfair (and unnecessary) to grant the contractor an extension of time while the contractor did not, in fact, suffer any delays to project completion (and will not therefore be liable for liquidated damages).

Each of these possibilities has its own merits. However, at common law, where no express agreement to the contrary exists, the float is not owned by either party. In theory, this should be for the benefit of both parties (as needed throughout the project) for the benefit of the project, however more often than not, this leads to uncertainty and dispute.

The parties’ intentions as to who ‘owns the float’ should be addressed expressly when drafting construction contracts. Properly drafted clauses can avoid disputes arising during the course of the project and they can minimise the incentive to claim extensions of time prematurely (for the purpose of using up the float).

Where a contract provides that an EOT may be granted whenever the contractor is delayed in reaching practical completion, the float remains ‘intact’ and can be carried forward by the contractor to use for its benefit where ‘non-qualifying’ causes of delay arise. For example, Australian Standard contract AS4902 provides:

The Contractor shall be entitled to such extension of time for carrying out WUC (including reaching practical completion) as the Superintendent assesses (‘EOT ’), if:

(a) the Contractor is or will be delayed in reaching practical completion by a qualifying cause of delay; and

Such drafting results in the contractor ‘owning the float’.

Alternatively, where a contract provides that an EOT will be granted only in circumstances where the delay will prevent practical completion being achieved by the date for practical completion, this means that the float needs to be used up before an EOT will be granted.

For example:

The Contractor shall be entitled to such extension of time for carrying out WUC (including reaching practical completion) as the Superintendent assesses (‘EOT ’), if:

(a) the Contractor is or will be delayed in reaching practical completion by the date for practical completion by a qualifying cause of delay; and

The inclusion of the words ‘by the date for practical completion’ results in the principal ‘owning the float’.

Courts are traditionally reluctant to imply obligations on parties to take action to preserve program floats and/or achieve completion dates, so it is important that parties ensure that the contract they are signing gives effect to the parties’ practical understanding of the float, and for whose benefit it is included.

Delay damages vs delay costs – same same but different

I’ve lost count of the meetings, teleconferences and email exchanges that I’ve had with contractors (and their solicitors) in which this topic has been debated healthily, albeit resulting in an agreement to disagree.

Put simply, many contractors seek to amend standard contracts to provide broad circumstances in which they may claim delay damages or delay costs and, more often than not, these two terms are used (or at least understood by some to be used) interchangeably.

At common law, there is no automatic right to delay damages.  As with all damages claims, delay damages can only be recovered if they can be proven to be damages resulting from a breach of contract.  As regards a construction project, the contractor must show that the loss it suffered arose naturally from the principal’s breach, or may ‘reasonably be supposed to have been in the contemplation of both parties’ at the time the contract was entered into.  Delay damages can only be recovered automatically when a contract specifically allows.

On the other hand, delay ‘costs’ are, if given the ordinary meaning of that word, the expenditure of time or labour necessary for the attainment of something.  The important distinction is that most construction contracts provide for the recovery of costs expended by a contractor (including those related to time), in the absence of an act of breach by the principal or head contractor (as applicable).

The current Australian Standard suite of contracts has perhaps contributed to some of the confusion and consequent misconceptions within the industry on this subject.

Clause 34.9 of AS 4000-1997 and AS 4902-2000 provide that, where an extension of time has been granted, the contractor is entitled to ‘delay damages’ for every day falling within an extension of time for a ‘compensable cause’.  A compensable cause means an act, default or omission of the superintendent, the principal or its consultants, agents or other contractors (not being employed by the contractor).  It also includes any causes listed in Item 31 of Part A of the annexure to the contract.  In other words, the contractor may claim damages, even when there is a neutral cause of delay (ie no breach by the principal), if the contract so allows.  It is because of this drafting and, in particular, the use of the word ‘damages’ other than in the context of a breach of contract that has led many contractors to believe that they should be entitled to delay ‘damages’ for every time-related cost under the contract (such as variations, suspension and latent conditions to name a few).

This issue is further complicated by the drafting in clause 36 (variations).  Clause 36.2 (proposed variation) provides that the superintendent may direct the contractor to provide details of any time related costs in respect of a proposed variation.  Because the superintendent has a discretion as to whether or not it will direct the contractor to provide such information, such information may not have been provided when a variation is valued under clause 36.4.  Consequently, it is unclear if the superintendent is to consider time related costs when valuing a variation under clause 36.4.

When you consider that the drafting in clause 34.9 provides that every day the subject of a ‘compensable cause’ (which includes any act of the superintendent, including directing the contractor to perform a variation), this means that it is possible, in some circumstances, for the contractor to be entitled to ‘double dip’ by claiming delay ‘damages’ pursuant to clause 41.1, in addition to its time related costs under clauses 36.2 and 36.4.

In light of the above, there is some merit in contractors arguing for variations to be included as ‘compensable causes’, however in practice, this simply substitutes one problem with another.  In my experience, the problem is best addressed by amending (for example) clause 36.4 to expressly include time related costs, and clause 34.9 to operate only where 36 does not.  Ideally, the definition of ‘compensable cause’ should be amended to relate only to breaches by the principal.  As long as the contract uses the word ‘damages’, it is only natural that they arise in relation to a breach of contract.  This, of course, raises red flags to contractors and protracted negotiations often ensue.  Such amendments however are not aimed to allocate risk, but to simply enable the contract to operate as intended.

Thankfully, the draft AS 11000 (issued for public comment in January this year) goes some way to clarifying this issue.  For the first time, the contract includes a clause dealing with delay damages (clause 37.22) and a clause dealing with delay costs (clause 37.23).  Relevantly, the contractor’s entitlement to delay damages is limited to ‘acts of prevention’ by the principal (which is not limited to breach, but does expressly exclude variations).  Accordingly, the contractor is entitled to claim ‘delay costs’ as part of its variation claim.

While the draft AS 11000 still applies delay ‘damages’ quite broadly, the new drafting should enable amendments narrowing that application to acts of breach to be less controversial to contractors.  This is because contractors have traditionally (and understandably) only taken issue with these type of amendments to seek to preserve their entitlement to claim time related costs for variations, latent conditions and principal suspension, not to actually claim ‘damages’ for breach of contract.

Liquidated damages: not negotiable

Liquidated damages (“LDs”) clauses are par for the course in standard construction contracts. These clauses provide that a contractor is required to pay a pre-determined sum of money, as damages for breaching a particular term of a contract (eg failing to complete the works on time). LDs can benefit both parties to a contract by:

  • providing contractual certainty;
  • not requiring proof of loss;
  • simplifying disputes;
  • inducing performance; and
  • providing a cap on liability.

The topic of LDs is often a red flag to contractors, and so it should be. No contractor wants to be liable for LDs, regardless of the quantum. No amount of planning or program contingency can guarantee that a contractor will not fall behind schedule or miss critical milestones (such as practical completion). Some contractors seek to deal with this issue by simply ignoring it during contract negotiation. The contract is signed and put in the drawer until the project is delayed, and only then do they realise the extent of their exposure.

However, too often, the temptation for parties is to negotiate the sum of LDs at the time of entering into a building contract just as they would any other commercial term. Whilst it seems commercially ideal for the parties to ‘agree’ to the sum of liquidated damages, this is problematic for three reasons.

The first (and perhaps the basis for the second and third reasons) is that, in practice, any agreement reached will depend on the extent of the parties’ bargaining power. Ironically, large contractors with more commercial sway can often negotiate lower LD rates than small builders with no bargaining power (and no way of satisfying such large LD liabilities). This of course has its own inherent risks to the success of a project.

Secondly, at common law, liquidated damages must be a “genuine pre-estimate” of the loss that will be suffered by the non-breaching party in the event that the works are not completed in time. If the amount of LDs cannot be proven to be a genuine pre-estimate of loss as at the time of entering into the contract, it may be held to be a penalty at law and the LDs clause will be unenforceable.  So, if the negotiated LDs rate is too high, there is a real risk that it will be classified by a court as a penalty. But, to prove that a LDs provision is penal would require the aggrieved contractor to commence legal proceedings, which are expensive, stressful and time-consuming. Even then, the contractor may still be liable to the principal to pay such amounts of damages as the principal can satisfactorily evidence. For these reasons, in practice, the fine line between what is a ‘genuine pre- estimate’ and what is a ‘penalty’ is rarely tested.

Thirdly, if the negotiated LDs rate is too low, it may mean that the principal effectively ‘caps’ its ability to recover loss in relation to the particular breach of contract. LDs are usually the sole remedy in relation to a particular breach, so, once the breach occurs (eg failure to bring the works to completion by the date for completion), the principal’s entitlement to recover actual loss is limited to the agreed amount of LDs. A failure by the principal, at the time of entering into a contract, to properly assess the potential heads of loss that it will be exposed to for a later breach of contract can place a wronged principal in a very frustrating and costly position.

Further to the above, there are real dangers in agreeing LDs clauses which only provide for nominal or “nil” damages, or which state that the LDs clause is “not applicable”. As LDs are usually the sole remedy, such clauses may have the completely unintended effect that the contractor is absolved from any liability for damages for late completion or non-performance. In those circumstances, the principal should delete the LDs clause in its entirety and preserve its rights to rely on general damages.

LDs are a useful tool for risk allocation between parties but developers and contractors should ensure that LDs clauses are used properly and avoid the pitfalls set out above.

Time is money – the importance of drafting and contract administration

The recent Supreme Court decision in Champion Homes Sales Pty Limited v DCT Projects Pty Limited [2015] NSWSC 616 provides a timely reminder of the importance of contract drafting and administration, particularly in respect of extension of time claims and liquidated damages.

Extensions of time

Ordinarily, a construction contract will set out a clear regime for a builder to claim extensions of time (EOTs). Often, builders are contractually time barred from making any claim for an EOT if they do not comply with the contractual regime.
In this case, the contract had the following EOT regime:

  1. The builder was required to give a written notice of a claim for an EOT, which detailed both the cause of the delay and the time claimed. The claim had to be made within 10 workingdays after the builder became aware of “both the cause and extent of the delay”.
  2. Assuming the builder complied with its notice requirements, the builder was entitled to the EOT claimed unless notice disputing the EOT was given by the principal to the builder within 5 working days of the builder’s notice, which detailed the reasons why the EOT was disputed.

The project was delayed. The builder submitted a number of EOT claims for different causes of delay, including variations and adverse weather.

In assessing whether the builder was entitled to an EOT, essentially, the Court assessed whether the builder had complied with the EOT regime under the contract. The Court found that the builder was entitled to give notice of its claim for EOTs in respect of variations when the variation work was completed because that was when the builder would become aware of both the cause and extent of its delay. Further, the Court found that the principal had failed to issue notices disputing the
entitlement to EOTs, in accordance with the contract.

Separately, the Court found that the builder was not entitled to EOTs claimed for adverse weather because the builder had not given notice of those delays in accordance with the EOT regime under the contract.

Ultimately, the Court found that the builder was entitled to a number of EOTs, which significantly reduced the principal’s entitlement to liquidated damages for the builder’s delay in achieving practical completion.

Liquidated damages

The builder attempted to defeat the principal’s claim for liquidated damages by relying on the ‘prevention principle’ to assert that the builder was prevented from completing the work by the time stated in the contract due to the conduct of the principal.

The Court did not accept the builder’s reliance on the prevention principle in circumstances where the contract set out a clear regime to claim EOTs and the contract provided for liquidated damages.

The Court relied on the decision of Cole J in Turner Corporation Ltd (rec and mgr apptd) v Austotel Pty Ltd (1994) 13 BCL 378, in which his Honour said:

If the Builder, having a right to claim an extension of time fails to do so, it cannot claim that the act of prevention which would have entitled it to an extension of the time for Practical Completion resulted in its inability to complete by that time. A party to a contract cannot rely upon preventing conduct of the other party where it failed to exercise a contractual right which would have negated the affect [sic] of that preventing conduct.

As noted above, the builder had failed to comply with the EOT regime for some claims. The Court found that the principal was entitled to liquidated damages, albeit for a much reduced amount, once EOTs (that had been properly claimed under the contract) were taken into account.

Issues to note for principals and builders

Contract drafting

In this case, to claim an EOT, the builder was only required to first notify the principal when it became aware of “both” the cause and extent of the delay. The Court accepted that the builder may only become aware of the extent of the delay for variations when the variation works have been completed. Thus, the principal only became aware of the extent of the delay to the date for practical completion once the variation works had been completed.

Principals should protect themselves by requiring builders to notify when they become aware of something that may cause delay (within 5 or 10 days), as a prerequisite to claiming an EOT. With respect to variations, any claim for a variation should include an EOT claim, including the extent of the delay claimed. Thus, the principal should be fully aware of the effect of a cause of delay/variation on the date for practical completion before variation works are carried out rather than getting a nasty surprise once variation works are completed.

Contract administration

Notwithstanding the above, the principal could have preserved its position in relation to the EOT claims by issuing a complying notice disputing the EOT claims within 5 business days. In response to a number of EOT claims, the principal did not do so, which was fatal to its defence to the EOTs claimed.

Further, the builder failed to submit timely EOT claims for adverse weather and the Christmas shutdown period, which disentitled the builder from claiming those EOTs.

Poor administration of a contract is often fatal, particularly contracts that include time bars. At the start of any project, principals and builders should inform themselves of the administrative requirements of the contract to ensure they protect their rights and entitlements.

Liquidated damages

Principals should note the restatement of the law in relation to the prevention principle. That is, the builder cannot rely on the prevention principle in circumstances where it has waived or failed to properly exercise its rights and entitlements under the contract.