The well-known Ivy complex in Sydney has recently caught the attention of those in the construction industry in the context of a Contractor’s attempt to restrain a Principal from converting an unconditional insurance bond. It has raised concerns in the market as to whether certain forms of performance security are more bankable than others. Although the matter was heard by both the Supreme Court (Lucas Stuart Pty Limited v Hemmes Hermitage Pty Limited [2010] NSWSC 1101) and the Court of Appeal, neither Court expressed any concern as to the integrity of insurance bonds. Any misgivings about types of security are misplaced in the result of this case, as the case has greater implications for the drafting of contractual regimes for recourse to security to rectify defects. The case shows that any precondition to recourse to security, particularly material non-compliance with the contract, can create a high bar on calls to security. Despite the significance of this case to the way recourse to security provisions are drafted, it also shows that the reputation of the contractor can be a consideration in determining whether an injunction to prevent a principal in having access to security will be successful.

Facts

By way of background, in November 2006 Lucas Stuart Pty Limited (Contractor) entered into a contract with Hemmes Hermitage Pty Limited (Principal) for the construction of a multi storey retail, bar, restaurant and function centre, known as the Ivy, for the sum of $65,446,520.00 (Contract). Under the Contract, the Contractor was required to provide security for the sum of 2.5 per cent of the unadjusted contract sum. The security was provided by way of six unconditional undertakings for each of the three separate parts of the works. The six unconditional undertakings were issued by QBE Insurance (Australia) Limited on behalf of the Contractor. Following certification of Practical Completion in June and July 2010 the Principal retained three of these unconditional undertakings for the defects liability period of each separate part of the works, the total amount being $1,636,163.00.

There was an interim application made by the Contractor in April 2009 at which, based on limited material provided, interim relief was granted for a period of two days restraining the Principal from converting the unconditional performance bonds to cash. However, at a subsequent Supreme Court hearing in September 2010, the Honourable Associate Justice Macready held that the Principal should not be restrained from having recourse to the security as there was no serious question to be tried with respect to the interpretation of the Contract, as the Principal had made a bona fide claim that the Contractor had not materially complied with its obligations under the Contract.

The Contractor appealed this decision to the Court of Appeal.

Application

The Contractor submitted that the Supreme Court had erred in its construction of the Contract, particularly with respect to provisions concerning the entitlement of the Principal to have recourse to security. Clause 16.3 of the Contract provided that the Principal may call upon the security where the Contractor had not complied with a notice given under clause 16.2. A notice could only be given under clause 16.2 if the Contractor had not materially complied with its obligations and was required to state the Contractor’s breach and required remedy.

On 19 July 2010 the Principal issued a notice to the Contractor (Notice) pursuant to clause 16.2 which alleged the existence of defects and the failure of the Contractor to rectify those defects and further provided a period in which the rectification works were to be commenced and completed by the Contractor.

In seeking to restrain the Principal from converting the insurance bonds the Contractor alleged that the Notice was invalid, primarily because the condition precedent to the issue of the Notice, namely that “the Contractor has not materially complied with its obligations”, had not been satisfied. It is important to note that at the time of the Court of Appeal hearing, the Principal had already called on two of the insurance bonds and had received $762,699.50.

Determination

The Court of Appeal held that the Principal should be restrained from converting into cash any unconditional undertaking provided by the Contractor.

Their Honours held that there was a serious question to be tried as to the validity of the Notice which alleged that there were a large number of defects which the Contractor had not yet rectified. As already mentioned, the Notice could only be issued where the Contractor had “not materially complied with its obligations” under the Contract. The Court of Appeal took the view that the issue was whether the Contractor had failed materially to comply with its obligations under the Contract, as opposed to failing to comply with a material obligation, and this required a holistic approach to those obligations rather than a question as to whether the Contractor had breached one of its main obligations.

The view of the Court was particularly influenced by the fact that the Certificates of Practical Completion had already been issued by the Project Director, as agent for the Principal. His Honour Justice Macfarlan felt that this warranted further examination and gave rise to a serious question to be tried as to whether the defects identified in the Notice “were of sufficient seriousness to require a conclusion that the applicant has ‘materially’ failed to comply with its obligations under the Contract”.

While the bonds were held by the Principal to secure the Contractor’s performance during the defects liability period the Principal was restrained from having recourse to the security in part as a result of the Certificates of Practical Completion having already been issued. This significantly narrowed the practical purpose for which security would have been available to the Principal during the defects liability period. The result of the case will not sit well with principals and developers who may question what regard the Court had to the commercial purpose of security in construction contracts. The earlier case of Clough Engineering Ltd v Oil & Natural Gas Corporation Ltd [No 3] [2007] FCA 2082 (Clough) gave great weight to the commercial nature of performance bonds and supported the unconditional nature of the security by establishing that recourse to security may be had where there is a bona fide claim. His Honour Justice Macfarlan however distinguished this decision on the basis of the difference between how the contracts in each of Clough and Lucas Stuart were drafted. Although disapproving of the outcome in Clough, His Honour noted that the outcome in this case may have been different if the Principal’s entitlement to have recourse to security had been drafted to be conditional upon the Principal being satisfied of the existence of material non-compliance by the Contractor or, even more simply, upon the Principal’s assertion that the Contractor was in breach of the Contract.

Secondary to the issues of contractual interpretation were the parties’ arguments with respect to damage suffered as a consequence of calling upon the insurance bonds, particularly damage to reputation. The Principal submitted that as it had already called on some of the security it should be inferred that any damage to the Contractor’s reputation and financial standing had already been suffered. However, both the Honourable Justice Campbell and Justice Macfarlan agreed that further calls upon the security may increase the damage suffered by the Contractor and that in circumstances where the only relevant legal remedy, namely damages, was not adequate it would be justified to require the Principal not to call upon the insurance bonds.

Conclusion

This case is a clear reminder that any contractual requirements for recourse to security must be complied with. Principals should carefully draft their entitlement when preparing contracts and Contractors should carefully check that preconditions to recourse to security have been satisfied. The case does not however diminish the value of insurance bonds when compared to bank guarantees. The same application might have been made by a disgruntled Contractor and the same outcome would have been reached if the form of security provided had been bank guarantees. In our view this case does not suggest that insurance bonds are a less appropriate or reliable form of security than bank guarantees. The consequences are broader than this and call for greater attention to be paid to the way contractual regimes for recourse to security are drafted, especially security provided for a period after practical completion has been certified.