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Claims under a Guarantee

Occasionally under a contract the contractor is required to provide a joint and several guarantee with a manufacturer, guaranteeing a product and/or the installation of the product, against defects resulting from the failure of the manufactured goods or poor workmanship.

The guarantee is usually given at a point in time and for a set period of time (ie a 10 year guarantee) as specified by the manufacturer or contractor in a method statement or specification given to the end user. The guarantee usually takes effect from the date an authorized representative of the employer/main contractor certifies that the work has been completed to their satisfaction, which under a contract

is usually when a Practical Completion Certificate is given.

The contractor who provided the guarantee is therefore obliged to remedy any defects which may arise during the guarantee period. However when the contractor goes into liquidation disputes may emerge as to how any subsequent claims under the guarantee are to be dealt with.

Occasionally after a contractor has been wound up a Liquidator may receive claims from an employer purporting to have a right to claim against a guarantee given under the contract. Rather unsurprisingly this argument is normally raised when the employer is being pursued by a liquidator for payment of monies owing to the contractor who has provided the guarantee. The employer may purport to have a claim under the guarantee with respect to potential or future defects which may occur (ie as yet unknown and therefore unable to be quantified) and/or with respect to the cost of obtaining a replacement guarantee. The justification given for the purported claim is usually on the grounds that should a claim arise the contractor who has provided the guarantee is now in liquidation and is therefore no longer able to fulfil its contractual obligations under the said guarantee.

For example, the employer may run the following argument:-

  • The employer has a claim under the guarantee;
  • The said claim is a liability under the guarantee which is contingent upon defects being found during the guarantee period;
  • A contingent liability is a debt provable in a winding re Section 34(3) of the Bankruptcy Ordinance (“BO”);
  • The contingent liability should be set-off against any monies owing to the contractor now in liquidation as they are mutual debts re Section 35 of BO;
  • The liquidator should estimate the value of the contingent debt to enable the alleged claim to be quantified

One of the liquidators main roles is to ensure that realizations are maximized for the benefit of creditors and to admit/reject proofs of debt and claims from creditors and to subsequently apply the company’s assets towards discharging its liabilities. Accordingly when dealing with an insolvent contractor the issues of potential claims under a guarantee may have a significant impact on the realization of assets and thus the potential dividend available to creditors.

The Potential Claim under the Guarantee

There are essentially three types of claims purported or otherwise, which are occasionally made pursuant to a guarantee.

  • A claim for defects which have occured during the guarantee period.
  • A claim for defects which are anticipated to occur (and are therefore as yet uknown and unable to be quantified) during the guarantee period.
  • A claim with respect of the cost of obtaining a replacement guarantee.

Debts for which a creditor may or may not prove

Section 34(3) of the BO states: “all debts and liabilities, present or future, certain or contingent, to which the bankrupt is subject at the date of the bankruptcy and order...shall be deemed to be debts provable in bankruptcy”. This also applies to the winding up of insolvent companies and s263 of the Companies Ordinance sets out this in more detail.

What is meant by a “liability” is further explained in more detail in BO, s34(8), which provides that it includes:

  • any compensation for work or labour done;
  • any obligation or possibility of an obligation to pay money or money’s worth on the breach of any express or implied covenant, contract, agreement or undertaking...;
  • generally, any express or implied engagement, agreement or undertaking to pay or capable of resulting in the payment of money or money’s worth, whether the payment is, as respects amount, fixed or liquidated, as respects time, present or future, certain or dependent on any one contingency or on 2 or more contingencies, or, as a mode of valuation, capable of being ascertained by fixed rules or as matter of opinion.

Debts that are not provable include

  • demands for unliquidated damages arising otherwise than by reason of contract, tort or breach of trust (BO, s34(1)).

Accordingly an employer who purports to have a claim pursuant to a guarantee may endeavor to be a contingent creditor on the basis that such a claim constitutes a debt provable in a winding up.

Set-off

The employer may allege that the contingent liability should be setoff against any monies owing to the now insolvent contractor as they are ‘mutual debts’.

To briefly summarize section 35 of the BO, applies where, before the company goes into liquidation, there have been:

(a)mutual credits, or

(b)mutual debts, or

(c) other mutual dealings

between the company and any creditor.

In such circumstances, an account shall be taken of what is due from each party to the other in respect of the mutual dealings and the sums due from one party shall be set-off against the sums due from the other. The mutual dealings do not have to be in relation to the same transaction between the parties - although the mutual dealings must be between the same parties - and mutual dealings are not restricted to debts incurred under contracts.

The effect of the existence of a set-off in a liquidation is that only the net balance owing will be paid to (or due from) the liquidator ie only one sum will be owing. The purpose behind s.35 of BO is to do substantial justice between the parties. If there were no such thing as set-off in insolvency, it would mean that a creditor would be bound to pay his debt to the company in full and at once. However in relation to the debt owed to him by the company, he would have to enter a proof of debt in the liquidation and would only be entitled to receive a dividend from the liquidator months or even years later. In other words, to the extent that a set-off is available, the creditor gets 100% of the relevant amount.

Valuing a Contingent Claim

The Liquidator has a duty to quantify a contingent liability. This will enable any set-off to occur and also allow the Liquidator to safely proceed and distribute the assets.

Clearly where actual defects have occurred within the guarantee period and such claims can be fully substantiated then the quantification of a contingent liability is straightforward.

Where the purported contingent claim is with respect to future or potential claims which may arise under a guarantee then the Liquidator must consider this matter carefully. The Liquidator may endeavour to quantify the contingent claim by making enquiries of the previous management of the insolvent contractor, conduct his own investigations as to the likelihood that a claim will be made pursuant to the guarantee and establish whether the employer is able to produce evidence that a claim may exist.

The employer may also claim the cost of obtaining a replacement guarantee. To accept such a claim the Liquidator will need to be persuaded that there is legal basis for the insolvent contractor to provide an additional guarantee to cover any defective workmanship.

The Liquidator’s view

A claim under a guarantee from an employer may reduce or eliminate any monies which are properly due and payable to the insolvent contractor with respect to work completed prior to the contractor going into liquidation. Accordingly the Liquidator must carefully scrutinise the legitimacy of any claims made pursuant to a guarantee provided by the now insolvent contractor.

Claims for defects or poor workmanship from an employer which fall within the guarantee period and which can be fully substantiated are valid claims which the Liquidator is under a duty to allow.

However a purported contingent claim for potential or future claims which may arise under a guarantee is not a valid claim. This is because the guarantee is still valid even although the contractor is now in liquidation. The guarantee provided is to warrant the performance of a product or to ensure quality of workmanship and is not a guarantee of the solvency of the contractor. In other words, although the guarantee was provided by the company when it was (presumably) solvent the subsequent insolvency of the contractor does not render the product or the workmanship to be defective or of poor quality. If the employer had wanted a guarantee as to the solvency of the contractor then they should have asked for one at the commencement of the contract.

An employer should not use the insolvency of a contractor as an excuse to avoid making payment to a contractor for work which is properly completed and for which monies are properly due and payable. Should such a stance taken by an employer be valid then this would have serious ramifications for the construction industry in Hong Kong. In effect an employer would never have to pay any funds to a contractor in circumstances where a guarantee has been given regarding workmanship (including implied guarantees) unless and until that guarantee period has expired or alternatively an additional guarantee is provided. Such a position is simply untenable.

In the event that the guarantee was to state something along the lines of “upon the contractor going into liquidation the guarantee shall be deemed to be null and void and the cost of obtaining a replacement guarantee will be claimed against the guarantor” then the liquidator would appear to be obliged to consider such a claim. The claim however would need to be a fair and reasonable claim for costs incurred in procuring a replacement guarantee and thus could be deemed acceptable for a damage’s claim to be made against the defaulting contractor. This would also facilitate the right to set off with respect to any payment payable to the defaulting contractor.

Finally, the liquidation of an insolvent contractor may take a number of years to conclude as there may be arbitration cases, contractual disputes and general investigation work to be concluded. From a practical perspective it may therefore be in the best interests of creditors for a Liquidator to address the issue of potential claims under a guarantee by entering into an arrangement with another contractor whereby if there are any claims under the guarantee the new contractor undertakes to remedy same. It will be important to ensure that such a contractor is properly approved or registered to carry out all works required. Previously whilst acting as liquidators we have endeavored to make such arrangements by agreeing to pay a lump sum one-off payment to a contractor who has agreed to undertake all repairs for the duration of the guarantee period. By entering into such an arrangement the risk of incurring any liability for claims under the guarantee is passed from the Liquidator to the newly appointed contractor.

Ian Pearson
RSM Nelson Wheeler Corporate Asia Group

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