Liquidation of letter of guarantee due to the contractor's breach of contractual obligations in construction contracts

The main purpose of issuing a letter of guarantee is to provide security to the guarantee beneficiary, i.e., the employer, as a result of any failure of the contractor to perform its contractual obligations as stipulated in the contract. It guarantees the contractor’s proper performance of the project without delay or negligence. This Article covers the letter of guarantee’s importance, uses, types, cases and controls of liquidation as a penalty for the contractor’s failure to perform its contractual obligations.

I. Importance of letter of guarantee in construction contracts:

It is established, in law and practice, that binding contracts on both sides result in corresponding obligations. In general, construction contracts are at the forefront of such binding contracts. There are obligations by the employer that are offset by obligations by the contractor, to ensure the latter's seriousness about the performance of its contractual works, especially public utility contracts of which obligations, if breached or delayed, may cause public damage to society. The first obligation imposed by the employer on the contractor is to provide guarantees of the performance of the contract work. The letter of guarantee is of the utmost importance in this field.   

II. The most important types of letters of guarantee in construction contracts:

A) Bid Bond Letter:

 To ensure that they are serious about bidding and the project, a bidder must submit a bid bond, or tender guarantee, which purpose lapses after the tender is awarded. They are part of the performance bonds.

B) Performance Bond Letter:

A performance bond is submitted to ensure the proper performance of the contract according to the terms of the contract or the project. Its value is specified by agreement between the project owner and the contractor. It may remain valid, for example, for one year, and subject to increase. This undertaking is made by the client to the beneficiary to enable the latter to have been compensated if the client fails to fulfill its obligations. It serves as security as applicable. It may be canceled only by an official letter from the beneficiary. 

C) Advance payment guarantee letter:

In construction and building contracts, payments are made after the implementation of the contract or the project. However, sometimes the capabilities required to implement the project are significant in relation to the contractor’s resources. Hence, such requirement may be stipulated in the contract, that the executing party shall pay an advance or an advance payment.

D) Letter of guarantee for processing and manufacturing materials and equipment:

This letter is submitted for ensuring the processing and manufacturing of materials and equipment, especially in mechanical, electrical and chemical engineering construction contracts.

E) Technical guarantee letter:

This letter ensures the serviceability of equipment after processing and commissioning, for a period determined by the nature of the contract.

F) Letter of guarantee for machinery and equipment:

In certain cases, an employer requires the contractor to provide a letter of guarantee for advances paid for machinery and equipment under the contract.  The amount of guarantee is released after such machinery and equipment are recovered.

G) Letter of guarantee for full coverage of project or tender expenses:

This letter represents any advance by the client to the bank under the project in favor of the beneficiary. It acts as a performance bond.

H) Letter of guarantee for maintenance and repair of defects:

Some employers may require a "letter of guarantee for maintenance", while others keep a part of a letter of guarantee for proper performance execution until the end of the maintenance period. This happens if a certain period of maintenance is provided for in the contract so that the employer, when issuing the initial handover certificate to the same contractor, takes into account any future defects.

It should be noted that the bank letter of guarantee is not a guarantee from the bank to the client. It is an independent obligation, where the bank is committed directly to the beneficiary. Therefore, if the letter of guarantee is liquidated, the bank only pays such debt to the beneficiary and not the debt of its client.

III. Liquidation of letter of guarantee due to the contractor's breach of contractual obligations

Given that the letter of guarantee is a security for the beneficiary (the employer) that ensures the contractor’s performance of its contractual obligations. If a breach occurs by the contractor, the employer may request to liquidate the letter of guarantee to claim any compensation or expenses. This is directly made as follows:

A letter of guarantee, like other commercial instruments, is a standalone document whose fulfillment does not depend on an external event, nor the fulfillment of a condition precedent or maturity. Also, the letter of guarantee may not require or become ineffective where the client covers the amount of guarantee or any part thereof to the issuing bank, as such payment is a matter for the client and the bank issuing and has nothing to do with it.

In the case that the bank liquidates the guarantee to the employer at its request within such period as specified in the letter, and as the bank’s client did not cover the amount of that letter, then the bank may require the client to pay back any payment made by the bank. The provisions of Article (360) of the Egyptian Trade Law state as follows:

 “If the bank pays to the beneficiary the amount agreed upon in the letter of guarantee, it may have recourse against the remitter for the amount paid and its yield from the date of payment.”

The Court of Cassation also ruled that:

“A letter of guarantee, like other commercial instruments, is a standalone document whose fulfillment does not depend on an external event, nor the fulfillment of a condition precedent or maturity. The performance of guarantee is associated with an event that is attributed to the beneficiary.”

(Civil Cassation in Appeal 1342 of Judicial Year 49–Hearing of 12/12/1980)

Based on the foregoing, the following points may be considered liquidation of the letter of guarantee:

1. The bank letter of guarantee is not a guarantee from the bank to the contractor or the employer. It is an independent obligation, where the bank is committed directly to the beneficiary. Therefore, if the letter of guarantee is liquidated, the bank only pays such debt to the beneficiary and not the debt of its client.

2. A letter of guarantee, like other commercial instruments, is a standalone document whose fulfillment does not depend on an external event, nor the fulfillment of a condition precedent or maturity.

3. A letter of guarantee may not require or become ineffective where the client covers the amount of guarantee or any part thereof to the issuing bank, as such payment is a matter for the client and the bank issuing and has nothing to do with it.

4. If the client fails to pay the amount of guarantee to the bank, the bank may not reject liquidating the amount of guarantee to the beneficiary upon its request within such period as specified in the letter, under Article (358) of the Egyptian Trade Law which states that:

 “The bank may not refrain from paying the beneficiary for a reason ascribed to the bank’s relationship with the remitter or the remitter’s relationship with the beneficiary.”

5. In the case that the bank liquidates the guarantee to the employer at its request within such period as specified in the letter, and as the bank’s client did not cover the amount of that letter, then the bank may require the client to pay back any payment made by the bank, as stated above. In the implementation of this obligation, the contractor shall issue the order to his bank so that the bank issues an undertaking before the employer, the beneficiary, that the bank shall pay upon request a certain amount. The bank is authorized to credit in the account of the instructing client such amount when the guarantee is executed by irrevocable permission, in addition to the commission charged by the bank on the instructing client for the issuance of the letter of guarantee. This relationship between the instructing client and the bank is called “Back-to-Back Credit.”

It is evident that these three contractual relations are the main contract, the opening of a letter of credit and a letter of guarantee) may be economically related but legally independent and separate.

Finally, it should be noted that “Independence of the bank’s obligation to the beneficiary from the latter’s relationship with the customer” means that the client’s defenses against the beneficiary do not affect the bank’s direct obligation against the latter. The client is the one who files a legal action if it is determined that it is not indebted or that his indebtedness is not justified by any payments made by the bank to the beneficiary/ Then, it may claim to recover the payments made under the letter of guarantee, if the requirements for liquidation are not met.