The importance of a well-drafted security clause in procurement contracts to a principal

Most procurement contracts of any importance contain a clause that requires the supplier to provide security for performance of its obligations. Security usually takes the form of either a bank guarantee or a retention sum. The clause will also give the Council, as principal, rights to call on the security (have “recourse” to the security) if the supplier defaults.

The main commercial purpose of such a clause is obvious – if the Council has a valid claim and there are difficulties about recovering from the supplier (eg because it is insolvent), the Council has recourse against the bank that gave the guarantee or the retention sum.

However a well drafted security clause will have a second, additional and extremely useful purpose – to allocate the risk as to who should be out of pocket pending resolution of a dispute.

In practice this means that if the supplier disputes that it is in default, instead of the Council having to prove its case by arbitration or litigation before it can call on the security, the Council can exercise its right to have recourse to the security immediately, even if it turns out in the end that the supplier was not in default.

This means the Council has funding to pay for an alternate supplier, and will not be out of pocket while the litigation takes its course.

Here are two examples.

In Sugar Australia Pty Ltd v Lend Lease Services Pty Ltd, a builder wanted an order restraining the principal from recourse to two bank guarantees totalling $4.2 million provided by the builder under a building contract to design and construct a refined sugar plant.

The recourse provision provided that the security would be “available to the Principal whenever the Principal may claim (acting reasonably) to be entitled” (emphasis added) to payment by the builder.

The building contract had been terminated, purportedly by both parties, following a dispute, and both parties had commenced proceedings in the Supreme Court of Victoria claiming damages for breach of contract from the other. On the day it commenced proceedings, the principal had given notice to the builder that it intended to have recourse to the bank guarantees.

The builder applied for an injunction, and was ultimately unsuccessful. The Court held that the parties made a commercial agreement as to when and how recourse might be had to the security. In doing so, they effectively determined which of them would bear the financial risk without the need for the principal to prove an entitlement to be paid. It only had to claim that entitlement. The important commercial effect of this was that the principal did not have to wait until trial for payment of an amount by the builder.

A second example is provided by Patterson Building Group Pty Ltd v Holroyd City Council. In Patterson, it was held that where there is an arguable question regarding the merits of an adjudicator’s determination, a principal can repay itself amounts paid to a builder pursuant to an adverse adjudication from security provided by the builder, if the contractual trigger for recourse to the security is a mere claim to be owed money.

In any given case it is a question of construction of the underlying contract whether the guarantee or retention sum is provided solely by way of security, or also as a risk allocation device. If it is the latter, it can be a powerful tool in the hands of a Council as principal.

Author: David Creais