By Christoph Mank, K&L Gates, Berlin
Standard terms and conditions in German construction contracts often contain requirements to provide a warranty bond to secure performance by the contractor of its warranty obligations under the contract. These requirements often stipulate the contractor to provide both a performance guarantee and a warranty bond.
The warranty bond secures the contractor’s warranty obligations during the warranty period (typically arising after the acceptance and take-over of the construction works) and is often in an amount of not more than 5% of the contract sum. This practice has been established due to prior case law by the German Federal Supreme Court. According to the Federal Supreme Court, the client´s security interest after acceptance of the construction is significantly lower than its security interest during performance.
A potential issue arises if security is provided both with regard to the contractual performance (in the form of a performance guarantee) and warranty claims (in the form of a warranty bond) and if these guarantees are combined in such a way that a security of more than 5% is granted to the client.
This issue was recently subject of several decisions of the Federal Supreme Court. In one case the contractor was obliged to provide a guarantee securing the contractual performance in an amount of 5% of the contract sum. Furthermore, the contract stipulated that the client was entitled to withhold 2% of the contract sum to secure its warranty claims if the contractor did not provide a warranty bond in an amount of 2%. The security agreement furthermore stipulated that the contract performance guarantee should only be returned by the client after unreserved acceptance of the final payment by the contractor and if (i) the contractor had duly performed, (ii) all claims (also from third parties) had been settled and (iii) the agreed warranty bond had been provided.
Decision of the German Federal Supreme Court
The Federal Supreme Court held that such a security agreement is invalid due to the combination of contract performance guarantee and warranty bond. Such a security agreement represents an unreasonable disadvantage to the contractor and grants the client an excess security.
As the return of the contract performance guarantee is made dependent on the unreserved acceptance of the final payment, the security agreement enables the client to keep its security for contractual performance even longer after the acceptance of the construction because an unreserved acceptance of the final payment is not mandatory. Rather, a dispute could arise regarding outstanding claims of the contractor, which could last for years, especially if the dispute is brought before court. In this way, the Court stated, warranty claims would be secured by the contract performance guarantee and the client would receive a security for its warranty claims for a period beyond the acceptance in an amount of 7%. The Court decided that this situation represents an unreasonable disadvantage to the contractor because the amount of the security provided for the period after acceptance, which has been accepted by the Federal Supreme Court at 5%, was significantly exceeded.
In contracts governed by German law, care should be taken in future to ensure that the contract performance guarantee and the warranty bond are not combined in such a way that they grant security to the client for a significant period after the acceptance of the construction, that exceeds the permissible amount of 5%. The replacement of the contract performance guarantee by the warranty bond should not be made dependent on the unreserved acceptance of the final payment by the contractor.