Parent company guarantees can’t circumvent arbitration because they aren't 'as good as cash'

In a recent decision – JKC Australia LNG Pty Ltd v CH2M Hill Companies Ltd [2019] WASC 177 – the Chief Justice of the Supreme Court of Western Australia refused to declare that a parent company guarantee was ‘as good as cash’. In doing so, he in effect invalidated calls on parent company guarantees while the underlying dispute was subject to arbitration, and clarified the circumstances in which instruments will be treated in that way. 

Background

INPEX Operations Australia Pty Ltd engaged JKC Australia LNG Pty Ltd (JKC) to engineer, procure, construct and commission the Ichthys Onshore LNG Production Facility, which forms part of the Ichthys LNG Project.

The onshore facilities are powered by a Combined Cycle Power Plant (Power Plant). JKC subcontracted the engineering, procurement, construction and commissioning of the Power Plant to a consortium of CH2M Australia Pty Ltd, UGL Infrastructure Pty Ltd, General Electric Company and General Electric International Inc (Consortium).

The performance of the Consortium’s obligations under the subcontract was guaranteed by parent company guarantees (Parent Company Guarantees) given by CH2M Hill Companies Ltd, UGL Pty Ltd, and General Electric Company (the Parents).

The subcontract was terminated no later than 2 February 2017 and disputes arose between JKC and the Consortium relating to the subcontract and the termination. These disputes are presently the subject of an arbitration. JKC is claiming the costs of engaging replacement subcontractors to complete the Power Plant, and the Consortium is claiming for the value of the work it performed.

On 24 July 2018 and 2 November 2018, with the arbitration still unresolved, JKC issued demands to the Parents under the Parent Company Guarantees. The Parents denied they had any liability under the Parent Company Guarantees for the amounts claimed, on the basis that the Consortium’s liability was still in dispute, and that they were entitled to rely on any defence, set-off or counterclaim available to the Consortium.

The court proceedings – what were the issues?

JKC brought proceedings in the Supreme Court of Western Australia seeking a number of declarations as to the proper construction of the Parent Company Guarantees. JKC argued that the Parent Company Guarantees should be treated as 'pay now, argue later' instruments, similar to bank guarantees.

The Parents argued that any obligation under the Parent Company Guarantees depended on establishing actual liability under the subcontract. If so, they could rely on any defence, set-off or counterclaim that the Consortium could assert to resist payment under the Parent Company Guarantees. In that context, the Parents also challenged JKC’s ability to form a reasonable opinion as to the Parents’ liability without reference to the Consortium’s defences.

A question of construction

The dispute turned partly on the construction of clauses 2, 3 and 9.2 of the Parent Company Guarantees.

• Clause 2 provided that the Parents 'unconditionally and irrevocably guaranteed' the performance of the Consortium’s obligations under the subcontract, including 'the payment of any amounts due and unpaid under the subcontract'.
• Clause 3 provided that, if in JKC’s 'reasonable opinion', the Consortium had failed to perform any obligations under the subcontract, the Parents were required to perform those obligations on receiving written notice from JKC 'until the termination of the Subcontract by the effluxion of time or otherwise'.
• Clause 9.2 related to the limitation of the guarantors’ liability under the subcontract, and stated that in the event of 'any claim under this guarantee', the guarantor was entitled to assert any defence, set-off or counterclaim.

Parent Company Guarantees not ‘as good as cash’

Chief Justice Quinlan found that the Parent Company Guarantees were not in the nature of performance bonds, and did require actual liability on the part of the Consortium. Accordingly, the Parents were entitled to assert any defence, set-off or counterclaim to a claim under the guarantees. The effective use was that any call would need to wait until actual liability had been determined in the arbitration.

In coming to that conclusion, Quinlan CJ started from a conventional position of giving the Parent Company Guarantees the meaning that reasonable commercial businesspeople would have understood them to have. Again, conventionally, His Honour considered the text, context (including the Subcontract and other bank guarantees provided under it) and their purpose.

He then turned to guarantee type provisions, and recognised that the decided authorities direct attention to two common commercial purposes for these documents:

• first, as a mechanism to provide security; and
• second, as a contractual allocation of risk.

His Honour emphasised that these purposes must be discerned as a matter of construction.

The Parents argued that a presumption against the second purpose arises where guarantees are not provided by banks, relying on the decision of the Court of Appeal of England and Wales in Marubeni Hong Kong and South China Ltd v Mongolian Government.[1] His Honour found that this presumption did not form part of the law of Australia, which eschews reliance on presumptions in favour of construing the relevant contract itself using its text, context and purpose.

Applying the Australian principles to the Parent Company Guarantees, Quinlan CJ determined that the words of the subcontract did not suggest that the Parent Company Guarantees served a 'risk allocation' purpose as contended by JKC, and so, was not intended to be akin to performance security.

In coming to that conclusion, His Honour gave weight to the following factors:

• the words 'to guarantee the due performance of Subcontractor’s obligations', which preceded the Parent Company Guarantees in the subcontract, suggested that their true purpose was to serve as a mechanism for the Parents to provide security for the subsidiaries’ performance;
• the words 'payable on first demand of Contractor' in the subcontract supported a risk allocation purpose and, in context, could only apply to the bank guarantees contemplated by the subcontract and not the Parent Company Guarantees;
• the context in which guarantees by parent companies are often given. In such cases, parent companies have a real interest in the rights of the parties under the underlying contract, and are the very kind of entities that a reasonable businessperson would expect to be providing security for their subsidiaries’ performance. This is a different scenario to that of a bank providing a bond or a letter of credit; and
• the terms of the Parent Company Guarantees did not contain any express provision which could be said to denote the 'cash equivalent' and 'pay on demand' quality of performance bonds. Rather, they manifested an intention and a purpose that the Parents had a real and substantial interest in the actual liability of the subcontractor, and that actual liability is what would determine the extent of the Parents’ liability.

Comment

This decision is a good example of the Australian approach to the construction of contracts, whatever their nature. Australian Courts will focus on the objective meaning of a contract, and will as a rule be reluctant to use any presumptions to fetter that focus.

It also emphasises that when drafting security that is to be as good as cash, drafters must be careful to ensure that purpose and intent are clear on the face of the agreement. To achieve this they can:

• use clear, express words in the underlying contract, such as 'payable on first demand' when referring to the security in question; and
• include a clause in the security instrument which notes that the guarantor’s obligation to make payment arises on demand, notwithstanding any contest or dispute by the relevant party to the underlying contract.

^{[1] [2005] 1 WLR 2497. See also IIG Capital LLC v Van De Merwe [2008] EWCA Civ 542; Vossloh Aktiengesellschaft v Alpha Trains (UK) Ltd [2011] 2 All ER (Comm) 307;}