In the current economic climate, the risk of contractor insolvency remains an issue for employer clients. For this reason, many employer clients will insist on contractors taking out Performance Guarantee.
Such guarantee typically provide that in the event of default by the contractor, the surety (usually a bank or insurance company) will guarantee to pay the employer’s damages ascertained under the building contract to a maximum of 10% of the Contract Sum.
It is recognised that building contracts are sometime varied, and for this reason most Performance Guarantees provide that the surety’s liability will not be discharged by any alteration, variation, or waiver of the underlying building contract (sometimes called an “indulgence clause”).
But what is the position if the parties to the building contract enter into a side agreement which relates to the building contract?
In Hackney Empire Ltd v Aviva Insurance the Court had to decide this very point.
In brief, in 2001 Hackney Empire Limited (“HEL”) appointed a contractor to undertake extensive refurbishment works. The contractor was in significant delay, but made various claims in respect of extensions of time and additional payment.
In an attempt to ensure the works were completed as soon as possible, (and after Sir Alan Sugar, as he then was, mediated the parties’ disputes!) HEL agreed to advance £1million to the contractor. £500,000 was paid in December 2002 and £250,000 was paid in February 2003. The final payment of £250,000 was never paid because in July 2003 the contractor went into Administration.
HEL had also paid for off-site materials – which it was not obliged to do under the building contract.
The advance payments were made under a “side agreement” which referred back to the building contract.
The contractor had procured a Performance Guarantee in favour of HEL which included an “indulgence clause”. When HEL sought payment under the Guarantee the surety Aviva claimed that its liability was discharged because the advance payments were prejudicial to its position as surety. In the alternative, it argued that the advance payments did not fall within the ambit of the Guarantee.
The Court found that the “side agreement” formed a separate set of obligations between HEL and the contractor rather than varying the terms of the underlying building contract itself. The advance payments were not sums which were recoverable under the building contract and therefore did not fall within the scope of the Guarantee.
However, HEL was entitled to recover other heads of claim under the Guarantee including Liquidated Damages which would have been due from the contractor together with other damages resulting from the contractor’s breach of contract.
COMMENT: The side agreement did not discharge the Guarantee, but the Guarantee did not extend to the new obligations created under the side agreement.
The general position is that any amendments to the underlying building contract will discharge a Performance Guarantee, though as constantly asking a surety’s permission every time an amendment is made is not commercially or practically viable. For this reason, Guarantees often include “indulgence clauses”. However, this does not give a carte blanche, and if the amendments create new or more onerous obligations rather than varying existing obligations, the surety’s liability may be discharged.
If it is proposed to make more than only minor amendments to the building contract, the surety’s permission should always be sought.
Author: James Coppinger, Head of Construction and Engineering.
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