Oil & Gas, Commodity / Goods Sales and Infrastructure: Guarantees - the importance of complying with payment triggers

United Kingdom

The Commercial Court recently re-emphasised in Longulf Trading (UK) Ltd v Niyazi Onen Gida SAN AS & Anor [2019] EWHC 1573 (Comm) the importance of properly complying with the terms of a guarantee when making a demand thereunder. The Commercial Court decided that a demand for payment of a specific amount pursuant to a guarantee only triggered an obligation on the guarantor to pay the amounts demanded, and did not trigger an obligation to pay any future amounts.

While the Commercial Court’s decision relied heavily on the specific wording of the relevant guarantee, the decision serves as a reminder of the need to ensure demands for payment satisfy terms of a guarantee required to trigger the obligation on the guarantor to make payment.

Background

Longulf Trading (UK) Ltd (“LGT”) is an English trading company that procures raw materials from wholesale suppliers for manufacturing companies.

Under a procurement agreement dated 19 November 2016 (the “Procurement Agreement”), LGT agreed to procure seafood for resale to Dardanel Onentas Gida Sanayi A.S. (“Dardanel”), a Turkish company founded by Mr Niyazi Onen that produces canned fish products. Dardanel, in turn, agreed to:

  • take delivery of the seafood and pay for it;
  • pay a procurement fee to LGT on a monthly basis, which was calculated by reference to the amount owed by Dardanel to LGT (so that the higher the value of any outstanding payments for seafood delivered, the higher the procurement fee); and
  • pay interest at a rate of 15% per annum on sums not paid when due, accruing from the due date until the date of payment.

The Procurement Agreement was expressly stated to be conditional upon the provision of a guarantee. Thus, on 23 January 2016, Mr Onen and a company called Niyazi Onen Gida San A.S. (of which Mr. Onen is the chairman) (together, the “Guarantor”) executed a written guarantee in favour of LGT (the “Guarantee”).

The Guarantee

The Guarantee provided that:

  • The Guarantor guarantees the payment of “the Obligations”, defined as “all present and future debts and liabilities of [Dardanel] to [LGT]… in connection with or with respect to the Procurement Agreement” (clause 2.1); and
  • the Guarantor covenants to pay the Obligations if (i) Dardanel fails to meet its obligations under the Procurement Agreement, and (ii) LGT has issued a written demand for payment to the Guarantor. The demand must be accompanied by a statement setting forth the Obligations to be paid and the basis for the calculations made by LGT in order to arrive at the amount it is demanding from the Guarantor (clause 2.2).

The Dispute

LGT issued a number of invoices to Dardanel between September 2016 and February 2017 for seafood procured and provided to Dardanel. However, Dardanel failed to make payments against those invoices (the “Debt”) as they fell due.

On 9 November 2017, LGT issued a written demand to the Guarantor requesting that the Guarantor pays the Debt within 21 days. The demand also stated that LGT reserved its right to claim the full scope of the Obligations incurred by Dardanel, including interest over the Debt at 15% per annum (the rate agreed in the Procurement Agreement) and legal costs, if the Guarantors did not make payment within 21 days. If it did make payment within 21 days, LGT agreed to forego these additional amounts. In the event, the Guarantor did not pay.

Then, between June 2018 and January 2019, Dardanel also failed to pay the relevant monthly procurement fees. No written demand was issued to the Guarantor in relation to this failure by Dardanel.

Instead, LGT brought a claim against the Guarantor for the Debt, for the unpaid procurement fees between June 2018 and January 2019, and for contractual interest over those amounts at 15% per annum.

Decision

The Commercial Court confirmed that the Guarantee was valid, that Dardanel had failed to pay the Debt when it became due, and that LGT had issued a valid written demand on 9 November 2017 in relation to this Debt. Accordingly, the Guarantor was obligated to pay the Debt pursuant to clause 2.2 of the Guarantee.

With regards to the procurement fees and interest, the primary questions considered by the Court were: (i) whether these sums amounted to ‘penalties’ under English law and were therefore unenforceable, and (ii) whether the written demand of 9 November 2017 triggered the Guarantor’s obligation to pay these sums. The Commercial Court’s answers to these questions are summarised below.

  1. Penalties

The Commercial Court referred to the rule on penalties as set out by Lords Neuberger and Sumption in the Supreme Court decision of Cavendish Square Holding BV v Makdessi [2016] AC 1162:

The penalty rule regulates only the remedies available for breach of a party’s primary obligations, not the primary obligations themselves… the true test is whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation” (paragraphs 13 and 32).

In relation to the procurement fees, the Commercial Court determined that although the value of these fees was impacted by Dardanel’s breach of its payment obligations, the obligation to pay such fees was still a primary obligation that “forms part of the bargain between the parties”. It did not depend on any breach of a primary obligation and, therefore, the rule on penalties did not apply.

In relation to interest, the Commercial Court accepted LGT’s argument that the rate was not “out of all proportion” to LGT’s legitimate interest in timely payments, because LGT regularly had to make significant upfront payments to procure seafood on behalf of Dardanel. The interest rate was agreed to encourage prompt performance and provide protection to LGT (e.g. if it needed to procure bridging finance to cover gaps in cash flow), not simply to penalise Dardanel. On that basis, it was also not a penalty.

  1. Valid demand

The Commercial Court considered that clause 2.2 of the Guarantee was clear in requiring the written demand to provide details of the calculation of the sums which were being claimed, before the Guarantor’s obligation to pay such sums was triggered.

In relation to the procurement fees, the Commercial Court pointed out that the written demand dated 9 November 2017 did not provide details of the procurement fees, as none were due at the time. Thus, while it remained open to LGT to make a new written demand in relation to these fees, unless and until such further demand was issued, the Guarantor was not required to pay the procurement fees.

In relation to interest, the Commercial Court noted that the written demand specified the amount of interest that had accrued over the Debt since it became due and offered not to claim this amount if payment was made within 21 days. The Commercial Court considered that this was sufficient to comply with clause 2.2, so that the Guarantor’s obligation to pay interest was triggered by the written demand when it did not pay within 21 days.

However, in relation to future interest, the Commercial Court considered that the reservation of the rights in the written demand to claim further amounts was not sufficient to trigger the Guarantor’s payment obligation under clause 2.2. In coming to this conclusion, the Commercial Court placed emphasis on the fact that the written demand did not provide a calculation for interest that would continue to accrue, nor did it actually demand payment of future interest (it simply reserved its right to do so).

The Commercial Court did award LGT statutory interest over the Debt from the date on which the amounts should have been paid until the date of the judgment, at a significantly lower rate, and confirmed that, alternatively, it remained open to LGT to issue a written demand for contractual interest that had accrued since the date of the written demand.

Comment

Guarantees are widely used across a range of contractual structures and industries. 

Where the payment of a sum under a Guarantee is conditional upon the provision of a demand, it is important that the terms of demand are drafted to capture the entirety of the sum that might be sought. In this respect, there is a difference between reserving a right to make a future claim (which by implication suggests that such claim is not made in the demand) and expressing the demand to also relate to sums that will continue to accrue arising from the same underlying set of facts.  

The case also confirms the difficulties with arguing that a contractual obligation amounts to an unenforceable penalty under English law. In circumstances where a party can show that a payment obligation is not “out of all proportion to any legitimate interest”, the obligation will not amount to a penalty. In truth, it is rare that interest agreed between commercial parties will amount to a penalty.

Longulf Trading (UK) Ltd v Niyazi Onen Gida SAN AS & Anor[2019] EWHC 1573 (Comm) (21 June 2019) – before Christopher Hancock QC (sitting as a Judge of the High Court).