What’s the (parent company) guarantee?

Parent company guarantees (PCGs) are often used in relation to construction project to bolster the financial reliability of a building contractor. With contractor insolvencies continuing to make the headlines and reports from KPMG that construction industry insolvencies are rising at a quicker rate than other UK industries, it seems a good time to question the value that PCGs can bring to projects, and look more closely at the protections they can offer. 

Guarantee vs indemnity

Understood in its purest sense, a PCG is a contractual promise to ensure the guaranteed party performs their obligations under a contract. A guarantee is a contractual arrangement that creates a secondary obligation to ensure fulfilment of a primary obligation. The guarantor’s obligations are contingent and dependant on the underlying contract. So returning to a construction scenario where a guarantee is given in respect of building contractor, the guarantor will have no greater liabilities than those of the building contractor in the building contract. Furthermore, the guarantee will end if the underlying building contract is terminated, becomes invalid or ends. 

A guarantee is different to an indemnity. An indemnity creates a primary obligation to ensure the fulfilment of an obligation given by one party to another. An indemnity is independent of the underlying contract and, therefore, generally survives the termination, invalidity or ending of the underlying contract. 

Developers often seek to ensure PCGs are on terms that offer something more than a pure guarantee and seek to create both a guarantee and indemnity from the guarantor. Contractors, on the other hand, will look to ensure the drafting confines the obligations of the parent company to those of a pure guarantor. Recent experience reveals some nervousness in the market from contractors, which has resulted in a shift away from the availability of parent company indemnities for a large number of projects.

Against this background, it is important to be aware of the issues that can arise in enforcement of pure guarantees and ensure that care is taken to ensure PCGs offer the protection and value intended by the parties. With this in mind, here are our top five issues to consider.
 

1. Cover off the formalities

Guarantees are contracts and, therefore, must contain all the necessary components of a contract – namely offer, acceptance, consideration and intent to create legal relations. In a construction scenario, the parent company guarantor will rarely be entitled to any payment or direct benefit under the building contract, such that there is a valid argument that a parent company cannot give good consideration in respect of any guarantee it may offer. To overcome this difficulty, ensure a PCGs is executed as a deed, since deeds, unlike simple contracts, do not require the exchange of consideration to be enforceable. 

Section 4 of the Statue of Frauds 1677 requires guarantees to be in writing and signed by the guarantor or a person authorised by the guarantor. It is interesting to note that the courts have taken a progressive view as to what constitutes in writing and signature by the guarantor, such that an exchange of emails may well suffice (Golden Ocean Group Ltd -v- Salgaocar Mining Industries PVT Ltd and another [2012] EWCA Civ 265). However, to be on the safe side, and to avoid costly and unnecessary disagreement, it is recommended that all the terms of a guarantee should be set out in a printed signed document. 

2. Check the capacity of the parent company

The company/organisation giving the PCG needs to have the requisite capacity to offer the guarantee or else the provisions of the contract will not come into effect and the guarantee will be void and unenforceable. Whether an organisation has capacity to give a guarantee depends on the terms of its constitution. For most limited trading companies, the giving of guarantees will be sufficiently ancillary to their core purpose, such that the issue of capacity will not arise. However, it is always worth double-checking an organisation’s constitution, especially if you believe provision of a guarantee is not ancillary to the core purposes of that organisation. This scenario may arise where the organisation giving the guarantee is not a limited company, is based outside of the jurisdiction, or is a not for profit/charitable organisation. 

3. Get the scope right

As with all contracts, there is considerable flexibility in the scope and application of any guarantee. In the construction industry, guarantees are commonly understood to cover losses in the event of a default or breach by the contractor. But that begs the question, what failures will amount to a contractor default, and will that always trigger an entitlement to call on the PCG? For example under clause 8.4 JCT Design and Build 2016, the employer can give the contractor a notice of default and if the contractor continues the default for 14 days from receipt of the notice, the employer may give a further notice to terminate the contract on or within 21 days of the expiry of the 14-day period. At what point, therefore, does the guarantor become liable for the default of the contractor? Is it at the point the default occurs, following receipt of the employer’s notice, at expiry of the 14-day period, or following receipt of a termination notice by the employer? The answer to this will not be clear unless the position is agreed and set out in the provisions of the PCG. 

As previously indicated, the rule of thumb is that the guarantor’s liability is the same and no greater than the liability of the guaranteed party under the underlying contract. Consequently, the guarantor will generally be able to rely on any defences, including any counter claims available to the building contractor in the underlying contract. While this is arguably fair and reasonable, it can create some difficulties in enforcement of the guarantee, especially if the employer or guarantor disagreed over the validity of the defences or counterclaims raised. Therefore, depending on your perspective, it may be prudent to contractually exclude or limit the ability of the guarantor to raise defences or counterclaims and/or to postpone the guarantor’s rights to raise such claims until after the guarantor has discharged its obligations under the PCG. But take care and, if necessary, obtain legal advice to ensure the provisions do not fall foul of the Unfair Contract Terms Act 1977.

4. Insolvency is not a breach of contract

The JCT Design and Build 2016 entitles the employer to terminate the building contract and recover for certain losses in the event the contractor goes insolvent. Insolvency is not, therefore, a breach of contract and as such express provisions needs to be included in the PCG to ensure the guarantor is obligated to guarantee the losses which an employer may sustain in these circumstances 

5. Understand how the PCG can be enforced

Given a guarantor’s liability under a guarantee is contingent on the underlying contract, any changes to that underlying contact can have the effect of releasing the guarantor from their obligations. This is particularly important in construction contracts, in which variations and instructions under the building contract are commonplace. Make the intent of the parties clear in the PCG, by ensuring it expressly allows for amendments, variations and instructions under the building contract without affecting the enforceability of the guarantee. 

Perhaps surprisingly, a guarantor is not necessarily liable to pay an amount awarded against a contractor by any judge or arbitrator (Re Kitchin [1881] 17 ChD 668) and The Vasso [1979] 2Lloyd’s Rep 412) unless the guarantor is a party to those proceedings. The concern of the courts is that in circumstances where the guarantor is not party to proceedings, the contractor might neglect to defend or represent the guarantor’s interests properly or make admissions to which the guarantor does not agree to be bound. In Beck Interiors Limited -v- Dr Mario Luca Russo [2009] EWHC B32, the court confirmed the principle extended to adjudication decisions. 

This raises certain legal, practical and financial considerations for any person looking to enforce a PCG, since making a guarantor party to any proceedings before a PCG can be enforced is likely to increase the cost and complexity of those proceedings and, in the case of adjudication, may well not be possible in any event. These practical and procedural difficulties can be overcome by ensuring the PCG contains an express provision whereby the guarantor agrees to be bound, by any adjudication, arbitration or court decision, notwithstanding that it may not have been a party to the proceedings. Alternatively, the PCG could provide a conclusive evidence or ‘pay now, argue later’ clause which would require the guarantor to pay over sums in certain specified circumstances, subject to a right to disprove those sums are in fact owed. However, be aware the inclusion of these provisions is likely to be controversial, and care must be taken to ensure the enforceability of these clauses. As ever, if in doubt take legal advice.  

While the overall value of PCGs is perhaps more complex and limited than their name might suggest, their value should not be discounted. Guarantees are flexible tools that can accommodate the relative bargaining power and risks of the parties in any building transaction. As such, their value lies within the detail of the drafting and a good understanding of the circumstances and methods by which they can be called on.