Article


by Roger Fayers

In Enka Insaat Ve Sanayi v Banca Popolare Dell'alto Adige SPA1 the UK commercial court was concerned with claims under performance and advance payment guarantees. The decision provides an oppor tunity to explain two aspects of English law in relation to these instru ments that may be of interest to bankers, contractors and lawyers in other jurisdictions. The first concerns court practice and the second the approach to construing their wording.

The parties, the contracts and the guarantees

ENKA, a Turkish company, was employed by OAO to design and build a retail office in Moscow. By a subcontract (governed by English law and subject to English jurisdiction) ENKA subcontracted the installation of the external façade to F&R for a fixed price of US$36.3m. The price was to be paid by ENKA to F&R by an advance payment of 30 per cent, a second payment of 10 per cent and thereafter by a series of current or monthly payments.

The advances were made. They were to be repaid by F&R by way of ENKA deducting a certain percentage from each of its current or monthly payments. In the event, no current or monthly payments were made so the advances were retained by F&R. The subcontract obliged F&R to put in place certain guarantees by an international bank, a performance guarantee for US$1.8m and two guarantees of the advance payments for US$13.8m. ENKA had power to terminate the subcontract unilaterally in the event of non-performance and other failures by F&R.

Both the PG provided by Cassa Di Risparmio Di Bolzano SPA (CRB) and the APGs provided by Banca Popolare Dell'Alto Adige (BP) were governed by English law and subject to exclusive English jurisdiction and were in familiar form. The demands were to state that "(1) [F&R] has failed to fulfil its obligations to the Contractor under the subcontract, accordingly (2) [ENKA] is entitled to receive payment" (in the case of the PG) "under this guarantee" and (in the case of the APGs) "of the advance payment". Both guarantees contained the usual pro visions, e.g., that "payment ... shall be without the need for proof or conditions" and the "demand shall be conclusive evidence of our liability ... ".

What happened?

As often occurs in construction projects, a series of alleged contractual defaults and guarantee demands ensued. On 26 November 2008, OAO gave ENKA notice of termination under the main contract and made demands under guarantees put in place by ENKA under that contract. On 2 December 2008, ENKA demanded payment from CRB for US$1.8m under the PG and from BP under the APGs for US$10.8m2. On 22 December 2008, ENKA gave notice to F&R terminating the subcontract.

English pre-trial procedure

Under Part 24 of the Civil Procedure Rules of Court, the court, on application made by a claimant, may grant summary judgment against the defendant "if it considers that the defendant has no real prospect of successfully defending the claim and there is no other compelling reason why the case should be disposed of at trial" (i.e., after a full trial). ENKA adopted this process and sought summary judgment against CRB under the PG and against BP under the APGs. In support it submitted the witness statement of its general manager who had made the demands in which he testified that the demands were in the form required by both guarantees, that he believed F&R to be in breach of the subcontract and that ENKA was entitled to receive payment under the PG and of the amount of the advance payments that F&R had not repaid. In their defence, the banks raised the fraud exception.

The test for summary judgment

The manner in which the rule should be applied where summary judgment is sought against a bank under a letter of credit or a performance guarantee, although discussed by the appeal courts over the years3 was, the judge thought, not entirely clear. After considering these authorities, he concluded that the test he had to apply to ENKA's claims was the "real prospect" test, viz: "whether there is a real prospect that the banks will establish at trial that the only realistic inference is that the fraud exception applies, that is, that ENKA could not honestly have believed in the validity of its demands". Having stated the test, the judge added that in applying it he had to be mindful of the principle that banks, when sued on a letter of credit or performance bond or guarantee, need particularly cogent evidence to establish fraud.

The suggested fraud

The fraud the banks alleged was that in making its demands ENKA did not honestly believe them to be correct. This is a tricky area. Whilst a demand that the maker does not honestly believe to be correct as to its amount is fraudulent, the difficulty lies in establishing it in the context of the guarantee. This is because precisely how and in what amount the contractor is entitled to demand will depend upon the particular terms of that guarantee. The banks advanced several reasons why they thought ENKA's demands were dishonest. It is instructive to look at these, because they spell out what are likely to be just the sort of reasons those resisting payment will raise from time to time:

(1) ENKA made its demands as a precipitate reaction to the termination of the main contract with no thought being given to whether ENKA had an entitlement to the sums claimed;

(2) Merely stating that "F&R had failed to fulfil its obligations" was not enough, since no attempt had been made to access whether and if so how much damage had been caused to ENKA by the alleged breaches of the subcontract;

(3) In any event, the alleged breaches were a "series of technical or adminis trative complaints" which did not, in a real sense, matter;

(4) The assertion that such breaches caused a loss ofUS$1.8m (the maximum under the PG) would be unreasonable and incredible such that it cannot have been entertained by ENKA;

(5) Indeed, ENKA did not make such an assertion. Since its managing director had merely stated that he did not understand the guarantees to require that the alleged breaches by F&R had caused any particular loss, it was clear that he did not apply his mind at all to the question of what sum (if any) ENKA was entitled to claim under the PG;

(6) The managing director's belief that the PG did not require ENKA to assert that F&R's breaches caused any particular loss was so astonishing and uncommercial as itself to evidence that the alleged belief was not honestly held;

(7) No credible explanation had been given for the managing director's belief that, as of 2 December 2008, ENKA was entitled to the full amount of the APGs.

(8) ENKA had acknowledged in January 2009 that it could only make a demand under the APGs once the subcontract had been terminated, and F&R was obliged to repay the amounts advanced. So, when making that demand before termination, the managing director had not properly applied his mind to what sum (if any) ENKA was entitled to claim under the APGs.

The rival contentions

At the forefront of the banks' argument was that since the economic function of these types of guarantee was to guarantee the liability of F&R to ENKA, the honesty of the belief of the demand asserted was to be assessed by reference to its commerciality or reasonableness. If in the context that demand was so un com mercial or unreasonable, then (surely) it defied credibility that such belief was honestly held. The link between the demand and its commerciality was formed by the word "accordingly" introducing paragraph 2. That implied a requirement for there to be some causal connection between the alleged breach (stated in paragraph 1) and the amount that was then claimed. Here, such connection required that the sums claimed from the banks were payable by F&R to ENKA, or at least that ENKA said were payable or had reason to believe were payable.

As a matter of construction, the banks argued that if "accordingly" did not imply such a connection and simply required ENKA to state that it was entitled to receive payment, then the statement that F&R had "failed to fulfil its obligations" to ENKA in paragraph 2 added nothing to the statement of F&R's breach in paragraph 1. This approach was said to be supported by the fact that the PG and the APGs contained provisions that expressly contemplated demands up to an amount not exceeding the "guaranteed amount", and because they expressly contemplated there was more than one demand.

ENK's response was a simple one. It was not a question of simply determining the commerciality or reasonableness of the demand. The precise wording of the guarantee had to be looked at. In these guarantees all that the word "accordingly" required was that ENKA state its entitlement to receive payment from the banks because F&R had breached its obligations. This was the general manager's belief and this is what he had stated. The word did not impose on ENKA an obligation either to state (expressly or by implication), or to have reason to believe (in the case of the PG), that it had suffered damage in the amount claimed, nor an obligation (in the case of the APGs) that it was entitled to repayment by F&R of the price paid in advance.

The judge's conclusion

The approach the judge adopted was first to bear in mind the nature of PGs and APGs and their commercial purpose since both were part of the background reason ably available to the parties - ENKA, CRB and BP. A review of the earlier court judgments4 suggested that ENKA's submission as to the meaning of the word "accordingly" was at least consistent with the manner in which such guarantees have been understood to operate. The judge answered the banks' submissions as follows:

(1) The true economic function of the PG and the APGs was more in the nature of a secure payment to ENKA from the banks rather than a guarantee of F&R's obligations. This was so even though as between ENKA and F&R the guarantees were intended to secure the performance of F&R's obligations;

(2) Whilst "accordingly" did imply a connection between breach by F&R and the liability of the banks, there was such a connection on ENKA's approach in that the liability of the banks to pay arose on the demand following what ENKA had stated to be a breach by F&R; and

(3) The "amount guaranteed" provisions did not clearly point to a requirement that ENKA must state or have reason to believe that the amount it demanded was its estimate of the damage suffered by it or that it was entitled to repayment of the price;.and

(4) Neither did the provision allowing more than one demand clearly point to such a requirement, since there may be many reasons for there being more than one demand.

In the result, the judge agreed that the managing director's stated belief reflected the true construction of the guarantees.

Roger Fayers' e-mail is r.fayers@ntlworld.com

1 [2009]eWhc 241.

2 a formal requirement not complied with was subsequently rectified.

3 in Safa Ltd v Banque du Caire [2000] 2 Lloyds Rep 600, Solo Industries UK Ltd v Canara Bank [2001] 1 WLR 1800 and Banque Saudi Fransi v Lear Siegler Services Inc [2007] 2 Lloyds rep 47.

4 Edward Owen Engineering Ltd v Barclays Bank International Ltd [1978] 1 QB 159 and Cargill International v Bangladesh Sugar and Food Industries Corporation [1996] 2 Lloyds rep 524.