REUTERS | John Kolesidis

Primary obligor: what is it, and would you like to be one?

One of my clients recently reorganised into a number of trading companies plus a holding company. They did not novate any existing contracts but wanted new contracts to be entered into by the appropriate trading company. The trading companies were brand new and therefore had no credit history. Some of the customers (and sub-contractors) were a bit “anxious” and asked for a parent company guarantee (PCG) from the holding company.

Fair enough, at least for the first few months. But when the first PCG turned up it tried to “improve” on the underlying contract. Instead of simply guaranteeing the performance (by the trading company) of its contractual obligations, the proposed guarantee document was littered with extra indemnities and other onerous obligations that went beyond those in the underlying contract. It also said that the holding company would be a “primary obligor”.

No greater liability

I asked for amendments to the effect that the guarantor’s obligations would be no greater (in amount or scope) than those of the trading company. The purpose of a parent company guarantee is credit enhancement, not deal improvement.

I also said that the holding company did not want to be a primary obligor. The guarantee should be a secondary obligation, in other words dependent on the underlying contact and the law relating to guarantees, not self-standing. If the holding company is asked have its own independent liability then the guarantee becomes more akin to an indemnity or a bond. This long established principle was confirmed by the Court of Appeal in IIG Capital LLC v Van Der Merwe and another [2008].

Risks for holding company

But why is this important? The main risk is that the holding company might face more exposure than the trading company and arrangements made in the management of the trading contract might not filter through into the guarantee. What if the underlying contract is varied or there is a waiver? What if the holding company has a set-off, or even a cross set-off? What if the underlying contract is suspended or terminated? Will the award of an adjudicator or court judgment have binding effect on the liability of the guarantor?

A commercial solution

I met a great deal of resistance. In fact, the deal almost fell through because the customer would not accept a PCG which was not a primary obligation and they would not accept my “no greater liability” clause.

In the end, we resolved the situation by getting the holding company and the trading company to sign the contract with the customer in joint names, with the trading company acting as agent for the holding company in the performance and management of the contract.

This solution has the air of simplicity to it but there is a bit of a twist in the construction industry.

This twist might well be a very good reason why a holding company would not want to be a primary obligor with a duty to perform (in the case of trading company default) or even being jointly named. If the holding company takes either of those roles it is (in theory at least) obliged to comply with and carry out the obligations under the trading contract. This can raise some difficult questions:

  • If the underlying contract falls away, is the guarantee compliant with the Construction Act?
  • Is the holding company covered by relevant insurance policies, for example professional indemnity, public liability, contractor’s all risks etc?
  • Would the holding company satisfy CDM requirements, for example in relation to design responsibilities?
  • Can VAT invoices be delivered by the “right” company for work done following a call on the guarantor to perform?
  • Are there any CIS issues? Can the holding company deal with payments to sub-contractors or receive payments from main contractors without deduction of tax?
  • Does the holding company even have the legal capacity to perform the underlying contract and are there any corporation tax or company law issues? Reorganisations are normally carried out for a reason.

My client’s group arrangements were such that (for the initial period following the reorganisation) the joint names solution worked well for them.

Do you want to be a primary obligor?

If you are asked to provide a PCG then, quite apart from the “no greater liability” point, you should be careful with primary obligations, not only from a liability perspective but also in terms of practical compliance, if the primary liability requires performance of the contract.

4 thoughts on “Primary obligor: what is it, and would you like to be one?

  1. Edward,
    Having worked as you know for employers, contractors and suppliers over the years, there’s no doubt advising a non-employer that I would have objected to the customer’s requirements in the way you did.

    However, I was intrigued by your comment in the second paragraph, “No greater liability” that “The purpose of a [PCG] is credit enhancement, not deal improvement”. On some major schemes where we are dealing with a contractor that is part of a larger group, I’ve felt especially where there is a partnering element, we should get the holding company to buy into the deal. It has at least 3 advantages:

    1. The holding company will give the deal even more pre-contract scrutiny.
    2. In the event of a material problem, the holding company is far less likely to cut the subsidiary adrift.
    3. Key people in the contractor’s organisation. will know they are being watched.

    Anyway, having come close to teaching Grandma Davies to suck eggs, I agree you don’t want the holding company to be “primary obligor”.

    Hope you’re still enjoying Panama!

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