Bonds and other forms of guarantees and indemnities are commonly used on construction projects. If a contractor applies for a performance bond, the bonding company will require the contractor to indemnify the bonding company. The bonding company may also require the principal shareholder of the contractor to guarantee the contractor’s obligation and to directly indemnify the bonding company. The bonding company may also take security over the contractor’s assets as a further condition of providing the bond. If the principal shareholder of the contractor is required to indemnify the bonding company, is that shareholder entitled to the security obtained by the bonding company over the contractor’s assets?

Normally speaking, one would think so. By indemnifying the bonding company, the indemnifying party should be subrogated to all the rights of the bonding company, including the security held by the bonding company.

But the English Court of Appeal held to the contrary recently in Ibrahim v. Barclays Bank Plc. There were two significant features of the indemnity and guarantee documents in that case, and they resulted in Mr. Ibrahim not being entitled to exercise rights under the securities which were originally available to the guarantor.

Those features of the Ibrahim decision must be carefully scrutinized by any persons about to give or to guarantee a bond. A bonding company, or a person holding competing security to the bonding company, may want to duplicate the features found in the documents in the Ibrahim case in order to avoid those securities passing to the third party which agreed to indemnify the bonding company. On the other hand, a third party who is indemnifying the bonding company may want to avoid those features in order to obtain the securities held by the bonding company.

Factual Background

LDV was an English van manufacturer. In 2008, it was in severe financial condition. Weststar was interested in purchasing the shares of LDV, but it needed a due diligence period to examine LDV’s affairs. Barclays was LDV’s banker. It was agreeable to advance further moneys to LDV during the due diligence period provided that the repayment of its further loan to LDV was guaranteed by a department of the British government, BERR. As a condition of providing its guarantee of LDV’s obligation, BERR demanded a letter of credit from a bank, UBS. UBS in turn demanded a guarantee from the principal shareholder of Weststar, Mr. Ibrahim. These arrangements were put in place.

The agreement between Barclays and BERR provided that “unless and until the Guarantor Liabilities have been paid and discharged in full and [BERR] has no further actual or contingent liability under or in respect of the Guarantee”, Barclays and BERR were to share in the recovery from the assets of LDV under the security which Barclays held over LDV’s assets. USB and Mr Ibrahim were not parties to those arrangements.

As a result of the due diligence conducted by Weststar, it decided not to proceed with the purchase of the shares of LDV and LDV went into insolvency. Barclays called on BERR ‘s guarantee of LDV’s obligation to repay the monies it had advanced to LDV. BERR in turn called upon UBS to pay under its letter of credit, and UBS demanded the Mr. Ibrahim pay under his guarantee. Having paid UBS, Mr Ibrahim asserted the right to exercise the rights accorded to BERR under its agreement with Barclays and to share in the recovery which Barclays had made under the security it held over LDV’s assets.

At trial, Mr. Ibrahim asserted his claim by way of subrogation to BERR’s rights. By the time the appeal was heard, Mr. Ibrahim had obtained an assignment of BERR’s rights under its arrangement with Barclays and asserted that BERR had a right, and that he had the same right by way of assignment, to share in the recovery from LDV’s assets.

The Decision

The English trial division and Court of Appeal held that Mr. Ibrahim had no right to share in the recovery made by Barclays from the assets of LDV, for two reasons.

First, they held the effect of the payment by UBS to BERR was that BERR was paid in full in respect of the obligation of LDV. Under the wording of the Barclays-BERR agreement, that payment discharged the obligation of LDV even though the proceeds came from UBS, and not LDV. Therefore, under the Barclays-BERR agreement, BERR’s rights to share in LDV’s assets had come to an end.

Second, the Court of Appeal held that the letter of credit given by UBS to BERR was an “autonomous instrument” which stated that the obligation to pay accrued when the Secretary of State certified that amounts were due in respect of the LDV debt and that it would discharge the LDV debt. Therefore, the payment by UBS to BERR under that letter of credit did discharge the LDV debt to BERR, and under the Barclays-BERR arrangement BERR had no further right to share in Barclays’ recovery from LDV’s assets.

Mr. Ibrahim argued that the payment by UBS did not discharge LDV’s obligation to BERR. He argued that a payment by a third party of a debtor’s obligation to the creditor does not discharge the debt, that the debt remains alive and that the third party can assert the creditor’s rights against the debtor by way of subrogation or assignment.

A considerable amount of old English legal authority was reviewed by the court. The point of the review was to determine the circumstance in which a debt is considered to be discharged by a payment made by a third party. Having reviewed those cases, the Court of Appeal concluded that when the third party has an obligation to pay the debtor’s obligation by reason of some outstanding obligation to do so, then the debtor’s obligation to the creditor is discharged but the third party has a direct right to recover from the debtor.

In the second situation, when the third party has no such obligation and makes the payment voluntarily, the debt is not discharged unless the payment is made as agent for the debtor, and the third party can bring a subrogated claim against the debtor based on the continued existence of the debt.

Since UBS’s payment was made under an obligation to do so contained in the letter of credit, and in any event UBS’s payment was not made as an agent for LDV, the English Court of Appeal held LDV’s obligation to BERR had been satisfied. Therefore, under the particular wording of the Barclays-BERR agreement, BERR had no further right to share in Barclays’ recovery from LDV’s assets.

Discussion

This decision has a number of lessons for those using bonds, guarantees and indemnities.

First, a third party who is providing a guarantee to the bonding company should examine the securities which the bonding company is taking. If those securities provide that upon payment to the bonding company the loan is effectively discharged, then that is not a good provision so far as the third party is concerned. Or if upon payment by the third party to the bonding company, the bonding company loses its security or its security is in any way impaired, the guaranteeing party will want to change that wording to ensure that its payment does not discharge the debt or impair the security which the bonding company is holding. Indeed, the third party may want to require the bonding company not to impair any securities obtained by it and to ensure that any securities held by it shall remain in effect and be transferred to the third party guarantor.

The time to do so is, of course, at the time of the initial guarantee. Mr Ibrahim may have been in a position at the outset to insist that Barclays agree that he would share in the LDV asset recovery if, through UBS, he effectively paid LDV’s obligation to BERR. If Barclays was willing to make that arrangement with BERR, it may have made that arrangement with Mr. Ibrahim who was the principal in Weststar and was providing the guarantee which supported the loan arrangement.

Similarly, when a shareholder of a contractor is asked to give a guarantee for the contractor’s performance bond, and the bonding company also asks for security over the contractor’s assets, the time when the application for the bond is made is the time for the shareholder to examine that security The guaranteeing shareholder will want to ensure that, if the guarantee is called upon and paid by the shareholder and not the contractor, the contractor’s debt will not be considered to have been paid or the security impaired, and that the security will be available to the shareholder who pays the bonding company. On the other hand, the contracting company itself, or those with a financial interest in that company including its other secured creditors, may have an opposite interest and may wish the security to terminate if the bond is paid by the guaranteeing shareholder.

Second, the Ibrahim decision may suggest that a letter or credit or negotiable instrument has an independent role which can nullify or impair the rights of the ultimate third party guarantor.

This suggestion could be supported from the absolute nature of these instruments. A guarantor such as BERR may wish to have the certainty of an unconditional promise to pay without any requirement to account for securities to which it is entitled. BERR may not have wanted any obligation on its part to bargain with Barclays to retain rights to a continued share in LDV’s asset after it was paid. If this is so, then bonding companies may wish to use these sorts of instruments and third party guarantors will want to avoid them.

However, others may argue that this suggestion is based on an incorrect reading of the Ibrahim decision. It can be argued that the wording of the particular letter of credit, when combined with the particular wording of the Barclays-BERR agreement, simply led to the conclusion that, once BERR was paid by UBS, BERR had no further rights under that agreement and therefore neither did Mr. Ibrahim either by way of subrogation or assignment. If so, then a third party guarantor will want to avoid the particular wording of the documents in the Ibrahim case, while a bonding company may want to use that wording as a useful precedent.

Whichever way one reads the Ibrahim decision, it serves as a warning to all those involved in bonds and other sorts of indemnities and guarantees. If the bonding company holds securities for the bonded obligation, then the parties should clearly understand the rights of a third party in that security if the third party has the ultimate obligation to indemnify the bonding company.

See Heintzman and Goldsmith on Canadian Building Contracts, 4th ed., chapter 9

Ibrahim v. Barclays Bank Plc., [2012} EWCA Civ 640

Building Contracts – Bonds – Remedies

Thomas G. Heintzman O.C., Q.C., FCIArb                                                                                                         November 11, 2012

www.heintzmanadr.com
www.constructionlawcanada.com