Claim for a guarantee of payment for construction works: Practical problems | In Principle

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Claim for a guarantee of payment for construction works: Practical problems

A request for a payment guarantee may appear on an investor’s desk suddenly, causing numerous complications. Sometimes, contractors make such a demand to have an excuse to withdraw from the contract. Then a race against the clock begins, not to give them that excuse. But in advance, the investor can also arrange a commercial solution to the problem, i.e. a bank guarantee facility in the loan agreement.

In a construction project in Poland, a payment guarantee strengthens the contractor’s position against the investor. It is an additional mechanism to ensure payment of the contractor’s fee. The statutory purpose of this institution is to prevent investors from failing to pay for completed work.

However, the commercial practice shows that contractors often use a demand for a payment guarantee to obtain a basis for submitting a declaration of withdrawal from the contract—particularly when further performance of the contract would no longer be profitable for the contractor and it is looking for an excuse to abandon the construction site. The current difficult market situation (with a significant increase in the prices of construction materials and labour) has intensified this phenomenon. We wrote about this in the article “Guarantee of payment or guarantee of withdrawal from the contract?

If the investor fails to provide a guarantee within 45 days, the contractor may withdraw from the contract with effect from the date of making such declaration (Civil Code Art. 6494 §1). The lack of a requested payment guarantee constitutes an obstacle to execution of construction works for reasons attributable to the investor (Art. 6494 §2).

Under Art. 6494 §1 of the Civil Code, the guarantee shall cover the fee foreseen in the contract for construction works, as well as the fee for additional work or work necessary for performance of the contract accepted in writing by the investor. The maturity of the contractor’s claim, any circumstances related to the general market situation, the investor’s individual financial situation, or default on its side in payment already due, are not conditions for granting a payment guarantee. The contractor has the right to demand a payment guarantee, and this is not subject to any additional conditions not expressed stated in Art. 6491.

Guarantee claim: Practical problems for the investor

The contractor may draw on the guarantee at any time and without giving any reason. The investor may refuse to establish a payment guarantee on the grounds that the investor’s own assets or stable financial position excludes the risk of non-payment of the fee to the contractor. However, the investor cannot withdraw from the contract on the grounds that the contractor has requested a payment guarantee (Art. 6492 §2).

In principle, a demand for a payment guarantee cannot be considered an abuse of right, nor contrary to the socio-economic purpose of the contract, or inconsistent with public policy. The payment guarantee is an instrument designed to protect contractors, and is framed quite favourably to them. The parliament assumed that the contractor is the weaker party to a construction contract and requires special legal protection. Sometimes this solution has been criticised in the legal literature on the grounds that it is not always legitimate to favour contractors, which are often large companies. Thus, according to a minority view among commentators and in the case law, a demand for a payment guarantee may be considered an abuse of right.

Security should be provided in one of the following forms: a bank guarantee, an insurance guarantee, a bank letter of credit, or a bank surety bond issued at the instruction of the investor. The law does not specify who chooses the method of security, but in the literature and the case law it is most often assumed that the decision is up to the investor. Unless otherwise provided in the construction contract, the contractor cannot demand security in a strictly defined manner, as the obligation to provide a payment guarantee is an alternative obligation.

Civil Code Art. 6491 §3 provides that the investor and the contractor shall bear the documented costs of the payment guarantee in equal parts, while pursuant to Art. 6492 §1, “The contractor’s (or general contractor’s) right to demand a payment guarantee from the investor cannot be excluded or limited by a legal act.” Thus, the parties’ contract cannot burden the contractor with the cost of providing the guarantee beyond the extent provided for in the Civil Code.

The act does not specify the wording of the payment guarantee. In particular, it does not specify the conditions for contractors to draw on the payment guarantee established in their favour. Sometimes, investors take advantage of this legal loophole to issue payment guarantees with conditions for drawing on the guarantee framed to effectively make it difficult or even impossible for contractors to take advantage of the security.

But the investor does not have complete discretion in this regard. The wording of the payment guarantee should take into account the purpose of this institution relating to the specific legal relationship existing between the investor and the contractor, also reflecting the mandatory applicability of Civil Code Art. 6491–6495.

There are various views in the legal literature and the case law on the wording of payment guarantees. Under one view, the provisions of the Civil Code on payment guarantees do not give the contractor the right to demand security under which payment must be made unconditionally, on first demand, based only on the contractor’s statement that the fee for executed construction works has not been paid on time. The supporters of this view hold that investors can frame the security in such a way that, for example, a condition for payment will be submission by the contractor to the guarantor of handover protocols signed by the investor, a VAT invoice accepted by the investor, or other documents confirming proper execution of a certain stage of works (e.g. payment terms analogous to those in the construction contract).

This approach allows investors to reduce the risk associated with the security provided by making the disbursement of funds under the guarantee conditional on the investor’s confirmation of proper performance of works by the contractor. But an effect of this is that in the event of a dispute over the correctness of the performance of works, the contractor cannot draw on the payment guarantee. This significantly reduces the scope of the contractor’s protection.

Guarantees in which the conditions for payment extend beyond the conditions for maturity of the claim for the fee provided for in the contract with the investor, or the conditions are designed to frustrate satisfaction of the claim (e.g. by requiring the contractor to obtain a final judgment against the investor), should be considered contrary to the purpose of the payment guarantee.

Therefore, while the investor is not bound by the wording of the contractor’s request as to the terms of payment from the guarantee, the security provided must not contradict the purpose for establishing the security, i.e. to guarantee the payment of a certain amount by a certain date. At the same time, the terms for payment from the guarantee can be framed, for example, analogously to the provisions of the contract on payment of the contractor’s fee.

Another view is that any conditions introduced into the wording of the guarantee for drawing on the guarantee are contrary to the limitations of the Civil Code on the contractor’s right to obtain a payment guarantee (even those that are framed analogously to the parties’ contract). According to this position, a guarantee with such wording does not fulfil the investor’s guarantee obligation and provides grounds for withdrawal from the contract, because even though a payment guarantee has been provided, it is still up to the investor to decide whether the contractor can draw on the guarantee. The contractor’s situation is similar whether it holds a guarantee or not (the investor controls the payment and effectively decides whether to allow it). In the event of a dispute, this does not give the contractor adequate protection and may defeat the purpose of the guarantee.

Given the divergence in the legal literature and the case law, the safest solution is to provide a guarantee in accordance with the contractor’s demand (usually unconditional, payable on first demand, etc). The criterion of unconditionality of the guarantee is met when drawdown of the guarantee is based on a declaration by the contractor that the fee covered by the guarantee is due but has not been paid by the investor. This is the safest way to provide security while protecting against the risk of withdrawal by the contractor.

Guarantee facility in the loan agreement as a commercial solution to the problem

This raises the question of how investors can commercially secure themselves in advance in the event that a bank guarantee is requested by the general contractor for a project.

Currently, most development projects in Poland are implemented with the support of external financing, in the vast majority of cases bank financing. Major loans for construction projects are structured and based on standard LMA documentation. As a rule, especially in the field of construction projects, a standard loan agreement for project finance does not include provisions for drawing on a loan facility in the form of instructing the lenders to issue a bank guarantee.

Nevertheless, from a legal point of view, apart from the complexity of the legal documentation, there is no barrier to offering this type of product as an option. In the case of investors that already have bank financing in place, they find themselves in a completely different situation when a dispute with the general contractor arises. Then the investor is forced to apply to the financing bank to amend the loan documentation. Due to the conditions precedent required by the bank and the need to amend the security documents, legally and operationally the process is not simple and can take some time. Therefore, a serious risk exists that it will not be possible to work through such changes with the bank soon enough to meet the statutory deadline for providing the bank guarantee requested by the contractor. The situation becomes even more complicated if there is syndicated financing and work needs to be coordinated among several lenders.

Therefore, from the investor’s point of view, it may be desirable to secure the option of instructing the lender to issue a bank guarantee for the contractor at the stage of negotiating the construction loan documentation, even before any potential problem or dispute may arise.

In this regard, the following constructions may be applied in the loan agreement:

  • In addition to construction and VAT loans, the loan agreement may include an additional product in the form of a guarantee facility, under which the lender will issue a bank guarantee up to a certain amount in favour of a given beneficiary at the investor’s request. The guarantee facility is an additional product, and thus the financing limit must be high enough to cover the three types of bank products. If sufficient collateral is not available, e.g. a parent-company guarantee from the project sponsor, it can be a problem to obtain such high financing for a special-purpose vehicle.
  • In addition to construction and VAT loans, the loan agreement may include an additional product in the form of a guarantee facility, but a mechanism is set in place to ensure that the limits on the construction loan and the guarantee facility reduce each other: the use of one of these products automatically reduces the maximum available exposure for the other product. Similarly, repayment under one product automatically renews the limit in the other product.

It is worth noting that in the second solution, where there is no increase in the overall financing limit, the investor should have in place a large contribution of its own, or the backing of the project sponsor (and in the case of housing projects, large ongoing sales of apartments), so that if the guarantee facility needs to be used, the construction can be financed from sources other than the loan.

In summary, the current regulations give contractors a wide range of options for requesting payment guarantees. In such case, an effective solution, protecting the interests of the investor, may be to include a product in the form of a bank guarantee facility as part of the financing for the project. While this complicates the structure of the documentation and the work required by the investor, the lenders and their advisers, it can provide great advantages in the event that problems arise with the contractor.

Mateusz Tusznio, adwokat, Banking & Project Finance practice, Wardyński & Partners

Agata Jóźwiak, attorney-at-law, Dispute Resolution & Arbitration practice, Wardyński & Partners