July 31 2000
Security for building claims has been under discussion in Germany recently. The principal often requires a surety bond with the obligation to pay on first demand from the contractor, in order to ensure proper performance of the building work. However, the extent to which this is permissible has been disputed.
The principal bears the risk that the contractor will not complete the contracted work to the required standard or within the time stated. Since the contractor must perform in advance, the principal has no obligation to pay him if he does not perform properly. However, any kind of non-performance leads to additional costs, such as remuneration for a substitute contractor who steps in at short notice or for damage caused by delay. These additional costs usually exceed the contractual remuneration costs. Further, the contractor is entitled to part-payments on account. It is therefore important for the principal to ensure performance according to contract.
To ensure the proper completion of the contract, it is often agreed that the principal may retain a percentage of the payments that are made to the contractor. In this case, the principal's general terms and conditions usually provide that a bank surety bond may be substituted for the retention. The bond is preferably furnished as a so-called 'on-demand bond', which means that the guarantor must pay as soon as the creditor calls on the bond. Objections are not initially permitted and cannot be raised until later through a claim for recovery.
Validity of Clause
The validity of such a clause is doubtful, since the principal improves his liquidity position rather than obtaining a kind of security. As specified, performance bonds are furnished to grant the principal security. On-demand bonds, in contrast, are generally considered to be a means of payment, as they allow quick access to money.
This is indisputable if individually negotiated by the parties. However, in the principal's general terms the content of the clause is subject to control under the provisions of the General Terms and Conditions of Trade Act. Pursuant to this act, any clause which puts the party upon whom the relevant general terms and conditions are imposed at an unreasonable disadvantage is invalid. The question of whether this can prevent the principal from using such a clause is disputed.
Federal Court of Justice Decision
Until recently the German Federal Court of Justice had only dealt with on-demand warranty bonds. It determined that if a principal's general terms contain a clause that entitles him to retain 5% of the contractor's remuneration for warranty, this clause must also provide for an adequate alternative means of security to replace the retention. Otherwise the clause is invalid. The court did not agree that an on-demand bond should be the only substitution allowed. It argued that after acceptance of the completed work, which is when warranty claims are usually asserted, it is the principal who bears the solvency risk. The relevant clause, however, transfers the solvency risk back to the contractor by granting the principal instant liquidity, and thus undermines the risk allocation provided by law.
On-Demand Performance Bonds
The extent to which the substance of the decision may be transferred, in general terms, to on-demand performance bond clauses is questionable. The two main lines of argument are as follows.
The Federal Court of Justice decision was based on deferment of the solvency risk. However, the case is different for a performance bond clause because completion is still owed and, before acceptance, the contractor bears the solvency risk. Since the assignment of risks provided by law is not altered, some legal experts argue that this clause does not put the contractor at an unreasonable disadvantage and is therefore valid.
In addition, the improvement in liquidity provided by a surety bond on first demand is justifiable in the case of a performance bond. Since the additional costs caused by non-performance can be significant, the principal has a considerable interest in attaining instant liquidity. Particularly in the case of delay, damage can be minimized if substitute performance is carried out quickly. Quick access to security on the part of the principal also suits the contractor's purposes.
On the other hand, it can be maintained that the further increase in the contractor's risk caused by a performance bond clause cannot be justified. The contractor also has an interest in liquidity. The law even allows the contractor to ask the principal for security for his claims. Some legal experts claim that the two clauses are comparable.
Some even consider the clause to be a case of excess security, arguing that if the applicable law offers the parties to a building contract any means of security, it does not provide for any kind of improvement in liquidity.
Another concern is the danger of abuse. On-demand bonds give the principal direct access to the money. In the event of liquidity difficulties, he might be tempted to use this money for his own purposes rather than for substitute performance.
The above is applicable only as far as clauses in general terms and conditions are concerned, and only if the contractor is not allowed to provide adequate alternative security.
In January a higher regional court ruled that the corresponding performance bond clause is valid. However, the unsuccessful party has appealed to the Federal Court of Justice. This decision is not expected to be made before 2001.
Until then, principals would be well advised to negotiate their securities individually. In this case, there is no objection to the stipulation of surety bonds on first demand. The alternative is to give the contractor a choice between several kinds of security, of which at least one can be considered to be 'adequate'.
For further information on this topic please contact Eckart Putzier at Clifford Chance Pünder by telephone (+49 30 2546 5800) or by fax (+49 30 2546 5900) or by e-mail (email@example.com).
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