CONTRACTOR IS HELD BANKRUPT. DOES THE CUSTOMER HAVE TO PAY GUARANTEE WITHHOLDING?
Nikolay Andrianov, Partner

The so called “guarantee withholding” is common practice when there is a need to secure the contractor’s obligations under a construction contract to the customer. Essentially, when paying the contractor for works performed, a portion of their price (normally amounting to 5-10%) is retained by the customer and paid to the contractor upon expiration of the guarantee period, if within this period no defects are revealed in the works performed by the contractor (and delivered to the customer) for which the contractor is liable, or if such defects are removed, or upon occurrence of other events specified in the contract.

The security function of such guarantee withholding is that the customer that reveals defects in the works delivered by the contractor, may, at the expense of the guarantee withholding, satisfy its claims to the contractor (on proportionate reduction of the contract price, reimbursement of expenses to remove defects, payment of a penalty, etc.).

Despite this method of securing performance of obligations being common practice, the applicable laws do not define it as a separate and independent one. The closest to it is the institute of a security deposit provided for in Paragraph 8, Chapter 23 of the Russian Civil Code. The distinction is that the security deposit is paid by a debtor to a creditor, and the guarantee withholding is independently retained by the creditor (customer) from the amounts owed to the debtor (contractor).

Guarantee Withholding as Security

In order for a portion of the price of the performed works retained by the customer to be recognized as a collateral securing performance of obligations, the contract must specify what its security function is about (i.е., what claims and in what order may be satisfied by the customer on account of the “guarantee withholding”). If the security function of the “guarantee withholding” is not described in the contract, retaining portion of the price of the performed works cannot be recognized as a means of securing obligations, instead, it constitutes a regular deferred payment.

Such approach can be exemplified by Case No. А40-76599/09 heard by the Presidium
of the Supreme Arbitration Court of the Russian Federation. There, the parties entered into a contract for design and exploration works, under which 20% of the price of works was to be paid by the customer to the contractor upon obtaining a positive expertise of the design documents. By its resolution dated 18.01.2011 No. 11659/10, the Presidium of the Supreme Arbitration Court of the Russian Federation held that such contract term was in essence deferral of payment worded in violation of the provisions of Article 190 of the Russian Civil Code (obtaining a positive expertise does not constitute an event which must inevitably arrive, and by mentioning which a certain date may be determined).

In another case, the Presidium the Supreme Arbitration Court of the Russian Federation held as legally valid the inclusion in a construction subcontract of a term, under which the general contractor, to secure the subcontractor’s obligations as to the quality of works, retained monthly an amount at the rate of 5% of the cost of the performed works which was subject to return to the subcontractor upon signing of a delivery and acceptance certificate for the property completed in terms of construction in general and receipt of the reserved amount from the customer (Resolution of the Presidium of the Supreme Arbitration Court of the Russian Federation dated 23.07.2013 No. 4030/13).

The existing court practice both reflects the approach applied by the Presidium of the Supreme Arbitration Court of the Russian Federation in its resolution dated 23.07.2013 No. 4030/13 (E.g., Award of the West Siberian Region Commercial Arbitration Court dated 06.11.2015 in Case No. А45-4731/2015, Award of the Moscow Region Commercial Arbitration Court dated 04.02.2016 in Case No. А40-29328/15, Award of the North-Western Region Commercial Arbitration Court dated 18.04.2016 in Case No. А56-33596/2015, Award of the Urals Region Commercial Arbitration Court dated 05.05.2016 in Case No. А76-2869/2015), and the approach applied by the Presidium of the Supreme Arbitration Court of the Russian Federation in its resolution dated 18.01.2011 No. 11689/10 (E.g., Award of the West Siberian Region Commercial Arbitration Court dated 25.04.2016 in Case No. А03-20696/2015, Award of the Povolzhskiy Region Commercial Arbitration Court dated 20.07.2015 in Case No. А55-27207/2014, Award Commercial Arbitration Court Восточно–Сибирского region dated 20.11.2015 по case N А33-25479/2014). However, generally courts do not find anything particularly objectionable about the guarantee withholding clause (E.g., Award of the Moscow Region Commercial Arbitration Court dated 15.02.2016 in Case No. А40-56093/2015, Award of the Volgo-Vyatskiy Region Commercial Arbitration Court dated 26.08.2015 in Case No. А43-26228/2014, Award of the West Siberian Region Commercial Arbitration Court dated 11.05.2016 in Case No. А70-8804/2015, Award of the North-Western Region Commercial Arbitration Court dated 18.08.2015 in Case No. А56-19938/2014, Award of the North-Caucasus Region Commercial Arbitration Court dated 24.07.2015 in Case No. А32-30889/2014, Award of the Urals Region Commercial Arbitration Court dated 01.09.2015 in Case No. А07-25206/2014, etc.).

What Happens to Guarantee Withholding When Construction Contract is Terminated

In Paragraph 3 of Resolution dated 06.06.2014 No. 35 “On Effects of Contract Termination”, the Plenum of the Supreme Arbitration Court clarified that contractual terms that, by their nature, are presupposed to be applied after contract termination (e.g., guarantee obligations in relation to goods or works under a terminated contract; the term providing for subjecting contract related disputed to arbitration, agreements on court having jurisdiction, governing law, etc.) or are aimed at regulating the parties’ relations in the period following contract termination (e.g., conditions of return of the leased property after termination, procedure for return of the advance payment made, etc.), survive contract termination, and specified that the parties’ agreement may provide or otherwise.

Thus, following a general rule, terminating a construction contract must not entail occurrence with the customer of the obligation to pay the guarantee withholding to the  contractor earlier remaining to secure the contractor’s obligations as to the quality of the works performed before contract termination.

Simultaneously, deciding what happens to the guarantee withholding when a construction contract is terminated also depends on how fully the construction contract details the security function of such guarantee withholding. Thus, for instance, the Volgo-Vyatskiy Region Commercial Arbitration Court in its award dated 01.03.2016 in Case No. А33-17576/2014 concluded on the legality of recovering the guarantee withholding from the customer, since the parties’ obligations under the construction contract are terminated due to its cancellation, and the contractual terms do not contain an express agreement of the parties on the customer’s retaining amounts at the rate of 5% of the cost of the worked performed by the contractor as a means to secure proper performance by the latter those of the contractual obligations which, pursuant to Paragraph 3 of the Resolution of the Plenum of the Supreme Arbitration Court of the Russian Federation dated 06.06.2014 No. 35, survive contract termination.

Another example is the award issued by the North-Western Region Commercial Arbitration Court dated 06.08.2015 in Case No. А56-39004/2014 where the court, by reference to Paragraph 3 of the Resolution of the Plenum of the Supreme Arbitration Court of the Russian Federation dated 06.06.2014 No. 35, held as justified the refusal to satisfy the contractor’s claims on recovery of the guarantee withholding due to the fact that the customer’s right to retain the monies to secure the contractor’s performance of its obligations had arisen before the parties terminated the contract and it cannot be lost by reason of contract termination.

The North-Caucasus Region Commercial Arbitration Court in its award dated 28.04.2016 in Case No. А63-7485/2015, having applied Paragraph 3 of the Resolution of the Plenum of the Supreme Arbitration Court of the Russian Federation dated 06.06.2014 No. 35, concluded that, since the contract is terminated, courts need to look into the question of availability of the grounds to apply its terms upon termination. The court specified that by reason of termination the customer does not lose the right to submit to the contractor claims related to a defective quality of the performed works, however, this circumstance does not mean that the customer may retain the guarantee withholding following contract termination, if it fails to prove the scope and cost of removing the defects
revealed.

Although, courts often rely on the fact that contract termination by itself does not serve as the grounds for the customer’s returning the guarantee withholding (e.g., the award issued by the Moscow Region Commercial Arbitration Court on 26.09.2014 in Case No. А40-116274/13, on 19.01.2015 in Case No. А40-10519/14 and on 16.11.2015 in Case No. А40-28503/15, the Award of the North Western Region Commercial Arbitration Court dated 16.10.2015 in Case No. А56-50333/2014), but in other cases they specify that terminating a construction contract  does not affect the contractually specified dates and procedure for payment of the guarantee withholding to the contractor (e.g., the Award of the Federal Commercial Arbitration Court for the North Caucasian Region dated 21.05.2014 in Case No. А53-15213/2013).

What Happens to Guarantee Withholding When Contractor Goes Bankrupt

Holding that a legal entity is insolvent (bankrupt) pursuant to Paragraph 1, Article 124 of the Law on Bankruptcy entails issuing bankruptcy proceedings.

Under Paragraph 1, Article 131 of the Law on Bankruptcy, all the debtor’s property available as of the date of issuing bankruptcy proceedings and discovered in the course of the bankruptcy proceedings, constitutes bankruptcy assets which are later, in accordance with the procedure provided for by Article 142 of the Law on Bankruptcy, used to satisfy creditor’s claims.

Since the guarantee withholding is exercised by the customer from the amounts due to the contractor for the works performed, in the meaning of Paragraph 1, Article 131 of the Law on Bankruptcy, it must be included in the debtor’s bankruptcy assets. Such approach was the one applied, in particular, by the Moscow Region Commercial Arbitration Court in issuing the award dated 23.06.2015 in Case No. А40-126583/14, in which it specified that due to initiation of bankruptcy proceedings against the contractor the guarantee withholding retained by the customer which made part of the cost of works performed by the contractor, was subject to return to the contractor and inclusion into the bankruptcy assets, and that further retaining it was contrary to the purposes and aims of the bankruptcy proceedings. Similar conclusions were reached by the Moscow Region Commercial Arbitration Court in its award issued on 07.10.2015 in Case No. А40-200219/14, where it specified that due to the arbitration court’s award as to the contractor’s bankruptcy and issuing bankruptcy proceedings, the date for performance of previously arising monetary obligations is deemed to have arrived, and consequently, the guarantee withholding was subject to recovery from the customer.

Nonetheless, such viewpoint is not the only one possible.

Thus, for example, the North Siberian Commercial Arbitration Court in its award issued on 11.05.2016 in Case No. А70-8804/2015 specified that, pursuant to Article 126 of the Law on Bankruptcy, from the date when a commercial arbitration court pronounces an award on holding the debtor bankrupt and issuing bankruptcy proceedings, it is deemed that the date for performance of the debtor’s monetary obligations, but not its counteragents’, has arrived, that is why the fact of initiating bankruptcy proceedings against the contractor does not by itself constitute grounds for recovery of the guarantee withholding from the customer.

The North-Western Region Commercial Arbitration Court in its award dated 16.09.2015 in Case No. А56-58784/2014 also concluded that issuing bankruptcy proceedings against the contractor does not justify an early (prior to expiration of the guarantee period) recovery from the customer of the guarantee withholding, though this conclusion was based on the fact that the receiver did not have the grounds to declare waiver of contract performance in accordance with Article 102 of the Law on Bankruptcy.

The Federal Commercial Arbitration Court for the Povolzhsky Region in its award issued on 26.09.2013 in Case No. А65-31555/2012 came to similar conclusions by specifying that, since the receiver did not waive contract performance in accordance with the procedure provided for by Article 102 of the Law on Bankruptcy, the contract was effective and the date for payment of the guarantee withholding did not
arrive.

Such approach can hardly be recognized as a correct one, considering that bankruptcy proceedings, pursuant to Article 149 of the Law on Bankruptcy, are finalized by liquidating a debtor. Apparently, in the event of finalizing bankruptcy proceedings and liquidating the contractor before expiration of the guarantee period (or other period which the contract links to paying a guarantee withholding to the contractor), the customer is released from the obligation to pay the contractor the portion of the agreed contract price constituting the guarantee withholding, and the contractor’s creditors lose the possibility to satisfy their claims to the contractor on account of the guarantee withholding due[1].

Satisfying Customer’s Claims on Account of Guarantee Withholding When Contractor Goes Bankrupt

The issue of whether the customer returning the amount of the guarantee withholding to the pool of bankruptcy assets of the contractor which is held bankrupt may satisfy, on its account, its claims to the contractor related to a deficient quality of the performed works, has not yet been universally answered in court practice.

Under Paragraph 1, Article 126 of the Law on Bankruptcy, from the date when a commercial arbitration court pronounces an award on holding the debtor bankrupt and issuing bankruptcy proceedings, all creditors’ claims as to monetary obligations, payment of mandatory fees, other property claims, except for current payments specified in  Paragraph 1, Article 134 of the Law on Bankruptcy, and claims on recognition of ownership rights, recovery of emotional distress, vindication claims, on deeming transactions to be null and applying the consequences of their invalidity may be filed only in the course of bankruptcy proceedings. Creditors’ claims are subject to satisfaction complying with the priority provided for in Paragraph 4, Article 134 of the Law on Bankruptcy.

Being governed by these rules, in particular, the Federal Commercial Arbitration Court for the Volgo-Vyatskiy Region in its award of 27.12.2011 in Case No. А82-470/2011 concluded on the illegality of the customer’s satisfying its claims to the contractor on payment of a penalty on account of a guarantee withholding (same as any other amounts stipulated by the contract), specifying that the customer’s claims have to be dealt with within a bankruptcy case.

Similar conclusions were drawn in the award dated 10.02.2016 in Case No. А70-6085/2015 by the North Western Region Commercial Arbitration Court. In this award, the court also noted that, since from the date of initiating bankruptcy proceedings all the claims flowing from the guarantee withholding are subject to satisfaction only within a bankruptcy case by filing claims to be included in the register of creditors’ claims with the purpose of their further satisfaction in the order of priority stipulated by Article 134 of the Law on Bankruptcy, the customer in any event may not claim its retention rights.

In its award dated 28.07.2014 issued in Case No. А29-8426/2013, the  Federal Commercial Arbitration Court for the Volgo-Vyatskiy Region allowed a possibility of the customer’s satisfying, on account of the guarantee withholding, its claims to the contractor on payment of a penalty for breaching the contractual dates for provision of a bank guarantee by specifying that the contractor’s obligations on the payment of the penalty for the said breach constitute current obligations, and satisfying them on account of the guarantee withholding does not contradict the provisions of Articles 63, 134 of the Law on Bankruptcy which do not allow termination of a debtor’s monetary obligation by setting off a similar counterclaim, as the priority specified by the Law on Bankruptcy of satisfying creditors’ claims is not violated in this case.

In its Ruling dated 18.11.2015 No. 305-ЭС15-14523 pronounced in Case No. А40-89881/14, in which courts partially dismissed a bankrupted contractor’s claim on collection of debt in relation to payment for performed works by referring to defects subject to removal on account of a guarantee withholding, a Supreme Court justice concluded that such dismissal is not a set off which is disallowed in bankruptcy related cases.

The Federal Commercial Arbitration Court for the West Siberian Region in its award dated 06.04.2012 issued in Case No. А45-11668/2011 also came to the conclusion on absence of any signs of a set of in the customer’s actions that satisfied on account of a guarantee withholding its claims to the contractor on reimbursement of expenses to remove defects in the quality of performed works (in this case the customer paid to third parties for removing the contractor’s defects on account of the guarantee withholding).

The Commercial Arbitration Court for the Urals Region in its award dated 26.11.2015 issued in Case No. А60-53189/2014 dismissed a bankrupted contractor’s reference to the fact that the customer’s claim for reimbursement of expenses for removal of defective works which were debited from the amount of a guarantee withholding, had to be considered within a bankruptcy case; the reasoning of the Court was that in this case the customer’s claim was essentially a claim for a proportionate reduction of the contract price and was non-monetary in nature.

The approach under which a guarantee withholding serves primarily to satisfy a customer’s claims and the remaining balance is to be returned to the pool of bankruptcy assets of a bankrupted contractor for its further distribution among other creditors appears to be fair, however, it does not yet have a proper legal justification. It seems that the legal status of a customer retaining a portion of the contract price payable to a contractor as a guarantee withholding must be the same in the contractor’s bankruptcy case as the status of creditors whose claims to the contractor are securitized by its assets (Article 18.1 of the Law on Bankruptcy). Otherwise, the security function of the guarantee withholding would be lost. At the same time, the Law on Bankruptcy does not yet contain such normative principle. This issue is equally pressing in cases where in order to secure the performance of a bankrupt debtor’s obligations a security deposit was applied (Paragraph 8, Chapter 23 of the Russian Civil Code).

What Happens to Guarantee Withholding When Customer Goes Bankrupt

Under Paragraph 1, Article 126 of the Law on Bankruptcy, from the date when a commercial arbitration court pronounces an award on holding the debtor bankrupt and issuing bankruptcy proceedings, the date for performance of monetary obligations and effectuation of mandatory payments arising prior to initiation of the bankruptcy proceedings is deemed to have occurred. Within the meaning of this norm, the date for a customer’s performance of the obligation on payment of a contractor’s guarantee withholding must be deemed to have occurred as well. Such being the case, the contractor’s claims on payment of the guarantee withholding are subject to inclusion in the register of the customer’s creditors’ claims and satisfaction in the order of priority set out by Article 134 of the Law on Bankruptcy.

In Paragraph 3 of Resolution dated 06.12.2013 No. 66 “On Accrual and Payment of Interest on Creditors’ Claims in Bankruptcy Cases”, the Plenum of the Supreme Arbitration Court of the Russian Federation expressly stated that the Law on Bankruptcy allows filing claims in the event of a bankruptcy which dates are not yet due according to their terms. Considering this, a contractor’s claim for payment of a guarantee withholding may be included in the register of a customer’s creditors’ claims (and then satisfied on account of the bankruptcy assets), even where the payment of such guarantee withholding is contractually conditioned on, for example, expiration of a guarantee period for the performed works, which, as of the date of considering such claim, has not yet expired.

However, under Paragraph 3, Article 63 of the Law on Bankruptcy, for the purposes of inclusion in a bankruptcy case, the date for performance of a debtor’s obligations is deemed to arrive from the date when an arbitration court issues a ruling on institution of an observation period.

Nonetheless, despite an obviously justified nature of a contractor’s claim, in case its customer goes bankrupt, to demand a guarantee withholding to be returned, court practice has examples when a contractor was denied in satisfying such claims. Thus, in its award dated 01.03.2016 issued in Case No. А56-41388/2014, the North Western Region Commercial Arbitration Court concluded as to the absence of grounds for inclusion in the register of a customer’s creditors’ claims of a contractor’s claim on the return of a guarantee withholding by reasoning that such claim may acquire the nature of the customer’s indebtedness in relation to payment for works performed by the contractor only upon arrival of events with which a contract links occurrence with the customer of the obligation to pay a guarantee withholding. In the same award, the court noted that the contractor may file its claim on payment of the guarantee withholding in future bankruptcy case, if such claim acquires a different legal nature, that is, indebtedness for performed works.

[1] The debtor’s receiver may of course auction the contractor’s right of claim to the customer on payment of the guarantee withholding, however, the amount generated by selling such right of claim will most likely be significantly lower that the guarantee withholding payable.