Out-Law Guide 5 min. read

Ceding rights under on-demand guarantees in construction projects

'On-demand' guarantees are a common form of security in construction projects, often required by the project owner as security for the contractor to perform the works.

Subject to limited exceptions the project owner, or 'employer', is entitled under the guarantee to quick access to funds held available by the guarantor, on delivery of a demand that complies with the terms of the guarantee.

Co-written by Bavesh Pillay and Jan-Hugo Fyfer of Pinsent Masons, the law firm behind Out-Law. To contact Jan-Hugo, please email [email protected].

Where a project is debt financed, lenders will secure their credit by requiring the employer to cede its rights under both the construction contract and the security received from the contractor, including a performance or retention money guarantee. Lenders would seek to exercise these rights in the event of a default by the employer under the finance documents.

In these circumstances, the guarantee may state that the employer's rights have been ceded to lenders in security for the employer's debt; or ceded 'in securitatem debiti'. In other cases, the guarantee may provide that the employer may cede its rights thereunder and, if it does so, notice must be given by the employer to inform the guarantor that its right under the guarantee have been ceded to a lender or the security agent.

This seemingly innocuous wording can, in some circumstances, lead to uncertainty as to who has the right to make a demand under the guarantee – the lender or the employer. While the terms of the cession agreement between the employer and lender might resolve this deadlock, it is not always clear whether or not the guarantor is obliged or even entitled to have regard to the cession agreement.

Practical measures, together with a clear, shared understanding of the relevant legal principles, can address these uncertainties, and ensure that guarantees, particularly on-demand guarantees, and cessions in security serve the purposes required of them by parties in construction projects.

Operation of on-demand guarantees

An on-demand guarantee essentially gives the named beneficiary the right to be paid a guaranteed sum by the guarantor on receipt of a demand from the beneficiary that complies with the terms of the guarantee. That right may also be ceded by the beneficiary to a third party, and the guarantee may make express provision for the beneficiary's right to cede.

The guarantee provides for an independent obligation to make payment on receipt of a valid demand. Subject to limited exceptions (including, for example, fraud) the obligation to make payment under the demand is unassailable, irrespective of any underlying dispute under the construction contract.

The guarantor may not 'go behind' the guarantee in order to resist payment on the basis of reservations about a party's rights or entitlements to make a demand arising from other agreements, or other circumstances or facts extraneous to the guarantee or the demand itself. The guarantor's obligation to make payment can be said to be determined by the 'four corners' of the bond. A cession agreement between an employer and lender would be considered an 'extraneous circumstance' in this respect.

In light of these principles, if a guarantee beneficiary needs to be able to cede its right to another party, it must ensure that the guarantee makes provision for both the right to cede, and how to establish who is entitled to make a demand.

In the case of an out-and-out cession of the beneficiary's rights under the guarantee, the effect would be straightforward: one beneficiary is simply replaced with another and, from that point, the entity which makes the demand must be the cessionary and not the cedent. However, things are not always this simple.

Cession pursuant to project finance

In the project finance context an employer's cession of its rights under a guarantee is typically done as security for its obligations to project lenders.

Depending on the particular terms of the cession, the employer generally retains its right to make a demand under the guarantee until such time as there is, for example, an event of default under the loan agreement, when the employer's rights under the guarantee will vest in the lender.

If a guarantee makes reference to a cession of the employer's rights, but it is not clear from the terms of the guarantee and the demand whether the employer or lender holds the right to make a demand at the relevant time, the guarantor might refuse to make payment to avoid breaching the terms of the guarantee. Alternatively, if the terms of the guarantee and the demand do clarify the nature of the cession but this does not align with the parties' rights under the cession agreement, the demand might be interdicted (injuncted) for being fraudulent.

It is not sufficient for the guarantee simply to refer to the cession as a cession 'in securitatem debiti' since the terminology used is not determinative of where the right to make a demand vests.

The risk of a demand on a guarantee being unsuccessful can often be significant, especially where the guarantee is about to expire or if funds are urgently required.

Practical measures

It is imperative that the guarantee, any demand letter and any contractual documentation exchanged between the parties clearly and accurately reflects the position under the cession agreement. In particular, it must be clear when the employer has the right to make a demand on the guarantee, and the circumstances in which that right vests in the lenders.

A typical guarantee may be worded as follows, in a way that does not speak to the nature of the cession:

  • the employer is entitled to cede its rights under the guarantee to lenders or to other third parties, on written notice to the guarantor; and
  • the guarantor confirms that the guaranteed sum is held at the disposal of the employer or any cessionary, and that payment will be made to the employer or the cessionary on written demand from the employer or cessionary.

Where it is known at the time of executing the guarantee that the employer will cede its rights to a lender 'in securitatem debiti', this can be addressed in the guarantee. In this scenario, the guarantee should record this fact and also stipulate that the employer retains the right to make the demand unless and until the guarantor is notified otherwise by the employer.

A notice of cession is vital and must record the nature of the cession in clear terms. It should also set out the employer's and lenders' rights in relation to the guarantee, along with the triggers for the guarantor accepting a demand from lenders. It might stipulate that unless and until a further notice is received from the lenders informing the guarantor that the employer has been divested of its rights to make a demand on the guarantee, the employer remains entitled to make a demand.

For clarity, the guarantor should issue an acknowledgement in response to the notice of cession in which it confirms the parties' respective rights in accordance with the terms of the guarantee, cession agreement and notice of cession.

When a demand is made against the guarantee, the party making the demand should ensure that this refers to the relevant provisions of the notice of cession and acknowledgment of cession; confirm that it is entitled to make the demand; and explain why. The demand may include an endorsement or authorisation by the party not making the demand to the effect that the party making the demand is entitled to do so as an additional precautionary measure.

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