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Impact of variations on guarantees

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Guarantees and bonds of various types are widely used in the construction industry to protect employers against the insolvency, default or non-performance of a contractor. Guarantors usually promise under such agreements to ensure performance of obligations in the underlying contract or otherwise to compensate the employer in respect of breaches.

Courts have frequently considered whether guarantees are enforceable where the employer and contractor have varied the underlying contract without the permission of the guarantor. In particular, Courts have had to consider whether is it fair or reasonable in different circumstances to expect the guarantor to honour its promise to discharge obligations that may have been enhanced or altered from those which it originally agreed to guarantee.

The nineteenth century case of Holme v Brunskill established what became known as the ‘fundamental principle’: that any alteration to the original contract would release the guarantor from any obligation unless the alteration is ‘self-evidently insubstantial’. Given the risks associated with potentially voiding a guarantee (by making a variation which was not was ‘self-evidently insubstantial’), this case put the onus on the beneficiary of the guarantee to obtain the consent of the guarantor to any variation to the contract in order to escape voiding the guarantee.

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This raises particular issues in relation to construction contracts, which typically permit variations to the scope of works/ services and fees to be made under the contract’s internal mechanisms, without the need to vary the legal terms of the contract. Such variations can be substantial and significantly change the risk exposure for the parties and the guarantor beyond what it originally contemplated. Arguably however such variations to the scope are not variations of the actual contract terms or a breach of the ‘fundamental principle’.

This does give rise to the question of whether the guarantor’s consent should be obtained to such variations, despite them being contemplated by the underlying contract.

In an effort to provide greater clarity on this point, lawyers commonly draft guarantees to permit the parties to the underlying contract to vary its terms (or operate variation mechanisms under the contract) without invalidating the guarantor’s obligations under it. These types of clauses established what became known as the ‘preservation principle’ and tended to be drafted fairly widely in order capture any variations or instructions that could be made under a contract.

Reliance on such provisions does not come without risk however. From time to time courts have taken the view that the relevant clause permitting variations may be too vague and unfair if it’s effect is to make a guarantor liable despite significant or sweeping variations to the underlying contract. This came to a head in 2005 (Troidos Bank v Dobbs) where a couple of loan agreements (secured under a guarantee) had been replaced after the guarantee had been signed. The guarantee wording was that it would continue in force if the parties “agree to any amendment, variation, waiver or release…under the Loan Agreement”. Despite the parties agreeing to this wording, the court insisted that any variation that extended beyond the “purview” of the quoted preservation clause would not be a variation and would invalidate the guarantee. In this instance the replacement of the underlying contracts was a variation that exceeded the threshold of the ‘preservation principle’.

While case law in this area is relatively active, when amending or operating the terms of the contract, consideration should always be given to the terms of the guarantee and we recommend:

  1. Ensure that, so far as possible, any variations or instructions that are likely to be given under the contract are accounted for in the drafting of underlying contract and the guarantee.
  2. Obtain the written consent of the guarantor to any proposed variation that is not accounted for under the ‘purview’ of the preservation clause.
  3. If the underlying contracts are replaced or restated ensure that a new guarantee is obtained and do not rely on a preservation clause.

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