So you’ve got a bank guarantee in case the lessee defaults. Is a security deposit better? Are either of them as good as cash? The short answer is ‘no’. There’s a lot more to guarantees than meets the eye. In this article, John Morrison examines the pros and cons of various forms of guarantees.

As part of the negotiation of the commercial terms of a lease, the parties will generally negotiate and agree upon the amount and form of the security to be provided under the lease. The most common forms of lease security are a bank guarantee, a cash security bond and personal guarantees. Many landlords will accept a bank guarantee in preference to a cash security bond.

The obtaining by a landlord of a bank guarantee to secure the performance of a tenant’s obligations under a lease is a well accepted commercial practice. This is due to the autonomous operation of a bank guarantee, allowing the landlord as beneficiary to demand payment under the bank guarantee from the bank and without the need to involve the tenant. In Wood Hall Limited v Pipeline Authority (1979) 141 CLR 443 at 457 Stephen J noted, in the context of a performance guarantee that, for so long as a form of security is “as good as cash” by having the quality of being instantly and unconditionally convertible to cash, it will be an acceptable form of security. But this observation may not be as pertinent in 2016!

The provision of security is intended to be a method of allocating risk under a lease as between the landlord and tenant. The principal reason for the landlord accepting a bank guarantee or cash security bond is that, if the tenant fails to comply with the tenant’s obligations under the lease, the tenant’s default will crystallise the risk and the landlord may call on the security.

But the making of the call may not be a simple or smooth process. The landlord’s ability to successfully call on the bank guarantee or cash security bond will depend on the terms of the lease. Where a bank guarantee is given, the form and terms of the actual bank guarantee will also govern its use. If the terms of either the lease or bank guarantee are in some way conditional or limited in application, the landlord may be unable to make a successful call on the security.

It is not unusual for a tenant to challenge the landlord’s right to call on a security and argue that the landlord, in making the call on the security, is in breach of an express or implied term of the lease. But the tenant is not the only person who may attack the landlord and seek to recover the proceeds of the security. What most people do not realise is that the landlord’s call on the security may also be open to attack from a third party, such as a liquidator or someone who has perfected an interest in the tenant’s assets under the PPSA.

The Importance of Lease Terms

In Lend Lease Pty Ltd v Sugar Australia Pty Ltd [2014] VSC 476 the Supreme Court of Victoria noted that a beneficiary’s right to call on a bank guarantee is governed by the terms of the contract, construed in accordance with the usual rules of construction. Each clause must be read and interpreted on its own construction.

For this reason, it is imperative that the landlord ensures that the security provision in the lease is drafted on clear and unconditional terms. The terms must not be capable of being construed as imposing some limitation on the landlord that ultimately frustrates the landlord’s ability to successfully call on the bank guarantee or cash security bond.

For example, a requirement for the landlord ‘to act reasonably’ or ‘to give notice’ may allow the tenant to argue that, in calling on the security, the landlord has acted contrary to the terms of the lease. Any attempt by the tenant to introduce concepts such as ‘a bona fide dispute’ or ‘actual breach’ will create limitations in favour of the tenant and, for this reason, should be resisted by the landlord.

Any amendments requested by a tenant, in respect of the security provision in the lease, must be carefully considered. What appears to be a simple or reasonable amendment may have a direct impact upon the landlord’s ability to make a successful call on the security. The lease provision dealing with the landlord’s ability to call on the security must be drafted in such a way that it cannot be construed to only permit the call to be made if the breach or default is actually proven.

In Universal Publishers Pty Ltd v Australian Executor Trustees Ltd [2013] NSWSC 2021, when called upon to construe the meaning of a bank guarantee provision, the court noted that the words ‘actual breach’ do not mean an ‘indisputable breach’, or a breach confirmed by the judgement of the court. The court held that, where the tenant disputes the landlord’s ability to call on the bank guarantee, the tenant must be able to establish that there is a serious question to be tried as to the existence of the breach of the lease.

If the security provision in the lease sets out procedural steps which must be followed in order to make a valid call on the bank guarantee or cash security bond, the landlord must ensure that it acts in strict compliance with each requirement. A failure to comply with a procedural step may be sufficient to prevent the landlord making a successful call on the security.

Terms of the Bank Guarantee

The terms contained in the actual bank guarantee are just as important as the terms of the lease. The landlord must undertake a close examination of the fine print of the actual bank guarantee to ensure the bank guarantee on its terms does not create conditions or limitations on the landlord’s ability to call on the bank guarantee.

The purpose for which the bank guarantee is stated to be given is of paramount importance. A bank will often use the term ‘rental bond’. This is limited to ‘rent’ and does not capture other obligations of the tenant under the lease and, for this reason, is unacceptable. The purpose for which the bank guarantee is given should be as broad as possible; for example, ‘the performance of the tenant’s obligations under the lease and any related agreement’ is preferable to the expression ‘rental bond’.

If an aspect of the terms of the actual bank guarantee is unacceptable, the landlord should reject the bank guarantee and notify the tenant of the changes that are required, to ensure the bank guarantee is on acceptable terms and in compliance with the requirements of the lease.

Injunctive Relief

If the landlord calls on the bank guarantee or cash security bond, the tenant may decide to challenge the landlord dealing with the security, by seeking an injunction to restrain the landlord from calling on or dealing with the proceeds of the security until such time as the issue in dispute is determined by the court.

In Clough Engineering Limited v Oil and Natural Gas Corporation Limited [2008] FCAFC 136 the Full Federal Court held:

“…subject to exceptions of fraud and unconscionability, the beneficiary of a performance guarantee granted in its favour as a risk allocation device, will be entitled to call upon the guarantee even if it turns out, ultimately, that the other party was not in default… It follows that clear words will be required to support a construction which inhibits a beneficiary from calling on a performance guarantee where a breach is alleged in good faith, that is, non-fraudulently.”

If the court is called upon to exercise their discretion to grant an injunction, the court will generally have regard to the following:

• the nature and strength of the tenant’s case. Is there a serious question to be tried, and can the tenant demonstrate a sufficient likelihood of success?;
• the course of action that results in the lower risk of injustice if the decision to grant the injunction is incorrect;
• the course of action favoured on a balance of convenience, by considering whether damages are an adequate remedy and the risk of harm to the reputation of the tenant.

To prevent the granting of an injunction, the landlord must demonstrate that the landlord’s call on the security is founded in an arguable claim that is considered not to be specious, fanciful or untenable.

A decision in favour of the tenant will result in the court restraining the landlord from making the call or dealing with the proceeds of the security, and in the case of a bank guarantee, preventing the autonomous operation of the bank guarantee.

Tenant in Liquidation

On the basis that a bank guarantee is issued by a third party (a bank), rather than an insolvent tenant, the proceeds of the bank guarantee have generally not been treated as being an ‘unfair preference’ under section 588FH of the Corporations Act 2001 (Cth).

A recent decision of the Federal Court of Australia may cast some doubt on the status quo. In Commissioner of Taxation v Kassem and Secatore [2012] FCAFC 124 the Federal Court found that, where a payment is made by a third party, including a bank, in accordance with the direction of their customer (tenant) or by or on behalf of their customer, the proceeds of the call on the bank guarantee may be treated as an unfair preference and be subject to clawback.

The effect of this is a risk that, in certain circumstances where the tenant is in liquidation, it may be possible for the liquidator to recover the proceeds of a call on a bank guarantee, on the basis that it amounts to an ‘unfair preference’ pursuant to the terms of section 588FA of the Corporations Act 2001 (Cth).

As a general rule, an unfair preference may occur where a landlord creditor calls on the bank guarantee within the six-month period preceding the date of appointment of a liquidator to the tenant. If the liquidator is successful, the court will order the landlord to pay the proceeds of the call on the bank guarantee to the liquidator.

Depending on the circumstances at the time of the call, the landlord may be in a position to defend the claim of unfair preference. The timing of the call on the bank guarantee will be crucial. If, at the time of making the call, the landlord had no reasonable grounds to believe the tenant was insolvent, the landlord may be able to rely on this defence to defeat the claim of unfair preference.

Cash Security Bond

Is the solution to the problems associated with a bank guarantee to require the tenant to provide the security by way of a cash security deposit in preference to a bank guarantee? Unfortunately there is no unequivocal answer to this question. There are advantages and disadvantages attached to both forms of security. The difficulties associated with the drawing down on a cash security bond may mean this form of security is not the true equivalent of cash as that term is used and understood by most people.

Unlike a bank guarantee, which is provided by a bank, a cash security bond is generally received directly from the tenant and held by the landlord on trust, subject to the terms of the lease. The tenant may challenge the use of a cash security bond in the same way as a bank guarantee. The risk of the landlord’s call on a bank guarantee being considered an ‘unfair preference’ also applies to the drawing down of a cash security bond.

In the context of a retail lease, most jurisdictions impose varying degrees of administrative requirements. The landlord and tenant must act in compliance with those requirements. In some instances, the legislation may limit the method of holding the cash security bond to a trust account or in an interest-bearing account in the names of both parties. In NSW, to call on a cash security bond held by NSW Fair Trading, the landlord must complete a claim form and obtain the signature of the tenant. In most instances, the administrative requirements create unwanted complications which add a further layer of compliance for the landlord to navigate.

In reality, with the exception of the autonomous operation of a bank guarantee, there is little difference in the comfort factor provided to the landlord by either form of security. But in the case of a cash security bond, further problems arise in the application of the PPSA.

Application of the PPSA

The Personal Properties Securities Act 2009 (Cth) (PPSA) has application to a cash security bond. The PPSA introduced a single national register of security interests for personal property (PPSR) and a rule-based system to determine priorities between competing interests.

So why is this relevant? The receipt of a cash security deposit under a lease creates a security interest in favour of the landlord, and the landlord becomes a secured party under the PPSA. A bank guarantee does not create a security interest under the PPSA. In order to perfect the security interest in the cash security bond, the landlord must register a financing statement on the PPSR.

A registered (perfected) security interest has priority over an unregistered (unperfected) security interest. The priority between perfected security interests is determined by the order of perfection (registration) on the PPSR.

Here comes the sting! If the landlord fails to perfect the security interest in the cash security bond the landlord may rank behind any other person who has perfected their security interest. For example, if the tenant’s bank has perfected an ‘all-assets’ security interest, then the bank will have priority and may be able to claim the cash security bond and gain priority against the landlord or a third party.

If the landlord perfects its security interest at a time when no other party has registered an ‘all-assets’ security interest (or a specific interest in the cash security bond), the landlord will gain priority against any third party claim made in respect of the cash security bond.

Costs

Whilst the landlord may have the right to make the call on the security, the value to the landlord of the bank guarantee or cash security bond may be substantially eroded or totally expended through costs incurred by the landlord as a result of a claim.

In the context of a retail lease, the landlord who is forced to defend the right to call on the bank guarantee may be at a significant disadvantage. The landlord may incur substantial legal costs defending proceedings commenced by the tenant, with no right to recover those costs from the tenant as each party generally must pay their own costs of proceedings.

The landlord may suffer a similar fate in circumstances where it is forced to defend a claim commenced by a third party, such as a liquidator asserting ‘unfair preference’ and claiming clawback of the proceeds of the security.

Conclusion

The fact that the landlord holds a bank guarantee or cash security bond does not mean that the landlord will be able to retain the proceeds in the event of a breach of the terms of the lease by the tenant. The landlord’s decision to call on the security will generally be scrutinised by the tenant and forensically examined by a liquidator or third party enjoying priority under the PPSA.

The ability to call upon a bank guarantee will be considered having regard to the terms of the lease. The landlord must ensure the lease is unambiguous and effective on its terms. If the terms of the lease do not entitle the landlord to make the call, or the landlord fails to strictly comply with the requirements of the lease, the tenant may be successful in enjoining the landlord’s ability to call on or deal with the proceeds of the security.

Before making the call on the security, the landlord must carefully consider the requirements to be satisfied under the terms of the lease in order to make a valid and enforceable call on the security. If the call is challenged, the landlord must ensure that it is in a position to demonstrate it has an ‘arguable claim’ rather than one that is specious, fanciful or untenable.

For the security to be properly characterised as being ‘as good as cash’ and to create some confidence that the security will continue to be available in the event of a default, requires the landlord, at the time of acceptance of the security, being satisfied that the financial position of the tenant is acceptable.

The description of a bank guarantee being ‘as good as cash’ may not be as appropriate as it was in 1979. Against the background of a proper and valid call, a bank guarantee issued under and supported by prudent terms should mean there is reasonable prospects of the bank guarantee being effective as security.

With the operation of the PPSA, a cash security bond is exposed to the risk of a claim by a party who has no direct interest in the lease. If the landlord has no intention of perfecting their security interest in accordance with the PPSA, then the landlord should not accept a cash security bond.

In order to maintain the value of the security provided by a tenant under the terms of the lease, the landlord should, wherever possible, spread the risk by using different forms of security. Where appropriate, the landlord should obtain a personal or inter-company guarantee in addition to the traditional forms of financial security. Hopefully this strategy may ensure the landlord can recover or limit its loss in the event of a default by the tenant.

There is no point becoming obsessed in the quest for the best form of security, as the outcome will never be certain. A prudent landlord can do nothing more than make sure they are in the best possible position to protect the security. As the saying goes, nothing is perfect! SCN