Article

Factual Summary: To assure proper performance of a RM56,586,000 contract to design a mild steel pipeline to carry water, Contractor (Principal) provided a bank guarantee (called a "design guarantee") issued by Guarantor for RM4,895,160 in favor of the government agency (Beneficiary) for whom the pipeline was to be built. The Guarantee provided that it was payable on first demand notwithstanding any contestation or protest and without proof or conditions and that it was irrevocable. The text of the relevant contractual clauses and of the Guarantee are reprinted subsequently.

After being in force for more than four years and a year prior to its expiry, Beneficiary drew on the Guarantee without any notice to Contractor/ Principal or recital of the reasons for the drawing. After receiving notice of the drawing, Principal sought an ex-parte injunction to restrain Beneficiary from drawing which was granted. In the interim, the guarantee expired. At a hearing, the Judge ruled that the demand was improper.

By its terms, the contract provided that the guarantee was to protect "against any defects or damages which may arise due to any defect, fault or insufficiency in design, materials or workmanship or against any other failure which an experienced contractor may reasonably contemplate but shall not include normal replacement and maintenance." [Emphasis in opinion]

The Guarantee recited its purpose, tracking the language of the contract, and undertook to "pay to the Government the amount specified in such demands notwithstanding any contestation or protest by the Contractor or any other third party and without proof or conditions." [Emphasis in opinion]

Legal Analysis:

1. Expiration. As indicated, the Guarantee expired in the interim between the ex parte injunction and the court's decision following a hearing. The Judge noted that "the [Beneficiary] did not take any steps to preserve the Bank Guarantee, i.e. the subject matter of the suit and appeal by filing, for example, an application or the interim preservation of property under" applicable rules of procedure.

2. Interpretation; Intention; Guarantee, recital of reason for drawing: The Judge concluded that whether there must be a statement of default or an explanation of the reason for the drawing depended on the terms of the performance bond under Malaysian law. He stated that the "Malaysian Courts have generally come to three different constructions based on the varying words used in performance bonds." Citing South East Asia Insurance [2000 3 CLJ 705 at 711], he noted that the three constructions are "First, no more than a mere written demand is required. Secondly, the demand must assert a failure to perform the contract. Thirdly, because of the word 'damages', proof thereof and not mere assertion is required before liability under the bond arises." [Emphasis in opinion]

Noting that some performance bonds require proof by means of a third party certificate or an inquiry into the breach, the Judge concluded that "the words of the said Bank Guarantee do not make it conditional upon proof or inquiry of a breach of the Contract by the [Principal]."

Beneficiary argued that the bond was a "mere demand guarantee" requiring nothing more than "a 'demand in writing'". Principal responded that "the words of the said Bank Guarantee make it clear that the [Beneficiary] must in its written demand state the basis upon which the demand is made i.e. the demand must assert the failure on part of this contractor." Citing the first paragraph of the Guarantee, which began with the clause "If any defect or damage shall occur to the Works/portion of the Works or any part thereof as a result of any defect, fault or insufficiency in the design, workmanship, materials or otherwise, on the Government first written demand" the Judge agreed with Principal "that the words of the Bank Guarantee requires the [Beneficiary] in its written demand to inform the Bank that its demand is on the basis provided for in the Bank Guarantee itself. This straightforward interpretation gives meaning and effect to the words 'if any defect or damage shall occur to the Works ...' which would otherwise be mere surplusage. In addition, this interpretation in no way imposes any extravagant demand upon the Bank, which is not required to inquire or make any evaluation on the merits of the demand. It is also not an unreasonable condition to impose on the [Beneficiary], as all that is required is the [Beneficiary]'s bare statement without proof of the basis for its demand on the Bank Guarantee." [Emphasis in opinion] The Judge also noted that the reference in the preamble to protecting against "any defect or damage" and the contract provision about the guarantee being "against any defects of damages" reinforced its interpretation. The Judge also noted that his interpretation was "consistent with the actions of the Bank in informing the [Principal] of the [Beneficiary]'s claim on the Bank Guarantee and requesting for the [Principal]'s objection within 3 days."

The Judge stated that "the Bank's intention and understanding of the Bank Guarantee is very relevant to its proper interpretation. The Bank, as the guarantor and party to the Bank Guarantee, clearly understood the conditions of the Bank Guarantee as requiring the demand to assert the defect or damages alleged. In the absence of such an assertion by the [Beneficiary], the Bank found it necessary to inquire with the [Principal] on whether it had any objections to the [Beneficiary]'s demand."

On reviewing English authorities which the Judge found persuasive, the Judge stated "it is similarly salutary and desirable for the [Beneficiary] to commit itself to claiming some "defect or damage" in the Works to prevent any possible abuse of the Bank Guarantee. The [Principal] is also entitled as a matter of natural justice to know the reason why the [Beneficiary] is calling on the Bank Guarantee."

3. Guarantee, "without proof or conditions". Having concluded that the Beneficiary must give the reasons for its drawing, the Judge interpreted several terms in the performance bond that might have suggested otherwise. He stated that "the words 'without proof or conditions' in the Bank Guarantee do not mean 'without having to assign any reason whatsoever.' He indicated that this phrase means that Beneficiary "is not required to prove an actual default by the [Principal] in the performance of the Contract... Even if the proof of an actual default is not required, the Court maintains that the [Beneficiary] must state in its written demand the basis upon which the demand is made." The Judge also understood the reference to not imposing any conditions to operate only on the presentation of a valid demand which Beneficiary had failed to do.

4. Guarantee, notwithstanding any contestation or protest. The Judge concluded that the phrase "without any contestation or protest" in the Guarantee were consistent with his interpretation. Citing Malaysian cases, he noted that Beneficiary "in making a claim on the bond merely has to state in the notice to the bank that the [Principal] has breached the contract and the claim has to be made good or honoured."

5. Good Faith: The Judge ruled that Beneficiary had showed "a lack of good faith because the [Beneficiary] had applied to call for the Bank Guarantee and to receive the RM4,895,160.00 without any notice to the [Principal]; and without giving any reason or complaining of any defect of damage to the Works or any breach of the Contract." He observed that he was "of the view that it is a matter of natural justice that the [Principal] be informed by the [Beneficiary] of its demand on the RM4,895,160.00 and what exactly the [Principal] is allegedly in breach of. This is especially so when the conditions of the Bank Guarantee... expressly require the [Beneficiary] to do so.

Comments:

1. Injunction, Expiration while pending. In some systems, the person seeking an injunction must provide for the continuation of the independent undertaking or post a bond. Wherever the burden lies, however, the beneficiary who is faced with such an action should protect its interests and request either an extension or cash collateral or some equivalent in the event of expiration of the undertaking.

2. Interpretation. The recitals of the court should send a chill into the heart of every beneficiary of a performance bond. The various categories indicate a fluidity between dependent and independent undertakings. They navigate between meaningless phrases such as "without proof" and seek to ascertain the subjective meaning behind them. The question, of course, is whose meaning and why it should matter. What matters is how the words are understood in standard international banking practice.

3. Guarantees. This decision is a striking advertisement for the use of standby letters of credit. There is no doubt as to their independent character and no groping for what the demand must recite. It is well established that a letter of credit (including a standby) only requires the recitals expressly stated in its terms. There is no room in letter of credit practice for implying requirements that are not express. On the contrary, in the vague world of guarantees, performance bonds, and whatever, it is unclear whether the distinction between independent and dependent undertakings is appreciated and what it signifies. This very thoughtful and scholarly opinion renders uncertain ever drawing by a beneficiary of a demand guarantee that does not recite the reason for the drawing.

4. Good Faith. The best illustration of what is wrong with the jurisprudence surrounding guarantees is the court's reference to the lack of good faith in the failure to notify the principal or recite the reasons for the drawing. This approach is justified on the grounds of precedent and natural justice. Whatever the appeal of natural justice, it is not something on which most beneficiaries wish to have the compliance of their claims under independent undertakings measured.

The opinion contained the following terms of the bank guarantee:

"BANK GUARANTEE FOR DESIGN GUARANTEE BG(P)99/33

In accordance with the terms and conditions of Contract No. (JBA/SEU213/97) for the Design, Construction and Commissioning of A 1500MM Diameter MILD Steel Pipeline From The Existing Bukit Jelutong Reservoir To The Existing HICOM Reservoir At Shah Alam Mukim of Shah Alam, Selangor Darul Ehsan (herein referred to as "the Works") , WE, Maybank Berhad, of Nos 28-30, Jalan Tukang, 43000 Kajang, Selangor Darul Ehsan at the request of the Contractor i.e. Konajaya Sdn Bhd irrevocably undertake and guarantee to the Government against any defect or damage which may arise due to any defect, fault or insufficiency in the design, material or otherwise of the said Works/portion of the Works which the Contractor is responsible for the design, in the manner hereinafter appearing.

Now the Guarantor hereby agrees with the Government as follow:

1) If any defect or damage shall occur to the Works/portion of the Works or any part thereof as a result of any defect, fault or insufficiency in the design, workmanship, materials or otherwise, on the Government first written demand, we shall pay to the Government the amount specified in such demands notwithstanding any contestation or protest by the Contractor or any other third party and without proof or conditions. Provided always that the total of all demands so made shall not exceed the sum of Ringgit Malaysia Four Million Eight Hundred Ninety Five Thousand One Hundred Sixty Only (RM4,895,160.00) and the total amount recoverable against us under this guarantee shall not exceed the said sum...

4) The Guarantee shall be irrevocable and shall remain in force until 22.8.2004 being the end of a period of five (5) years Six (6) months after the practical completion of the works (i.e. 22.2. 1999). Claims if any, must be received by us within the period of Guarantee."

[JEB/naa]

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