Bonds© Daniel Atkinson 2001Bonds are a useful means of creating financial security for the Employer for a Contractor`s failure to perform. The type of bond chosen will dictate whether the Employer indeed has security which is of any practical value, or whether it simply provides him with an expensive and time consuming legal remedy. A major risk for a party under a construction contract is that the performing party fails to complete its obligations under the construction project. Such situations can arise in all types of contract, in main contracts as well as subcontracts. The obligation may be either to pay or to complete construction in accordance with the construction contract. If the Contractor fails to perform, the Employer may be left with the difficulties of first protecting and making safe the site and then of finding another contractor to take over and complete the works, or of completing the works itself. The Employer will be left with the prospect of a significant financial burden and delay to the project which may jeopardise its commercial viability. Recovery from the contractor will involve legal action with further additional expense and the added uncertainty that there will be full recovery. If the Contractor is insolvent then the prospects of any substantial recovery are poor. If the risk of insolvency is small then retention under the contract may provide the Employer with sufficient security. Since the extent of the risk of insolvency is difficult to judge, it is common in the construction industry for Employers to require Contractors to provide a Bond usually for a value of 10% of the tender price by an approved financial institution. Less common in construction, but usual in international supply contracts, is a Bond for the risk of the Employer not paying in accordance with the contract. Despite the different possible situations when Bonds are used, the beneficiary will be referred to here as the Employer and the performing party as the Contractor. Although bonds can be provided by insurance companies as well as banks, the financial institution will be referred to here as the Bank.
The purpose of a Bond is to provide the Employer with some financial security in the form of a cash sum payable by the Bank for the Contractor`s failure to perform his obligations under the construction contract. The type of failures which are covered by the Bond depend upon the wording of the Bond, but one obvious risk and a reason for failure to perform is the insolvency of the Contractor. Guarantee or Bond?There are several types of Bond. The Employer must choose the right type if it is to be effective in providing the immediate funds required in the event of the Contractor`s failure to complete the works. Unfortunately the terminology used in relation to Bonds is often confusing and do not always accurately describe its legal effect. A bond in the strictest sense is a deed whereby the Bank promises to pay the Employer a cash sum in certain specified circumstances or on a specified date. The construction contract and the bond are interrelated, since the bond is a tripartite transaction involving the parties to the construction contract and the bond. Nonetheless the bond is a separate and wholly independent bargain enjoying autonomy. In that sense the bond is independent of the construction contract. There is no need for the Employer to provide evidence to support the call on the bond. Such bonds are also referred to as on-demand bonds. If the bond is a conditional on-demand bond then the Employer needs only to state that there has been default by the contractor under the construction contract. There is no need to prove the default, nor any need for the Employer to demonstrate that it has incurred recoverable losses. All the Employer has to do to call a conditional on-demand bond is to prepare in good faith a statement of damages arising under the construction contract. Subject to issues of fraud, the Employer only needs to comply with the formalities and procedures stated in the bond for the call on the bond to be valid. The Banks obligation to pay on the bond in the strictest sense, is therefore a primary liability, independent of the contractor`s liability under the construction contract. It has been held by the Court of Appeal in Edward Owen Engineering Ltd v Barclays Bank International Ltd (1977) that a guarantee or bond payable "on demand without proof or conditions" imposes an obligation on the guarantor to pay. This is irrespective of whether or not the person whose performance was guaranteed has in fact performed his obligations or was in default. The only exception is in cases of fraud of which the guarantor had notice. A performance guarantee on the other hand, creates a secondary liability which is dependent upon the contractor`s liability. Under a performance guarantee the Bank has the same defences as the Contractor in connection with the construction contract. The Bank is only liable to the extent that the contractor is liable and as limited by the guarantee. In construction this is important since the Bank will only be liable for the net sums due, i.e. subject to set-off. A valid call on the guarantee can only be made once such liability arises which may only be on substantial completion, depending on the terms of the construction contract. The Employer must show some default by the Contractor if he is to make a valid call on the guarantee, which may take the form of an Engineer`s certificate, depending upon the wording of the guarantee. A performance guarantee is also commonly referred to as a conditional on-default bond. The distinction between a bond (an on-demand bond) and a guarantee (a conditional on-default bond) is important, but not always easy to make. In IE Contractors Ltd v Lloyds Bank PLC (1990) observations were made on the principles to be applied in the construction of performance bonds. It was said that there is a bias or presumption in favour of a construction which holds a performance bond to be conditional upon documents rather than facts but that presumption is rebutable if the meaning is plain. It was also said that although in the case of letters of credit the documents presented must be precisely those called for, there was less need for such a doctrine in the case of the performance bonds. It was a matter of construction of the bond. The difficulties in deciding whether or not a bond is conditional or on-demand is demonstrated by the decision in Esal v Oriental Credit( 1985). The bank undertook to pay
This looked like a conditional bond but it was commercially interpreted by the Court of Appeal as unconditional because the initiating event was the demand and that it could not have been intended that the bank would be concerned with the assessment of whether or not there had been perfect performance. Financing BondsThe contractor who provides the conditional bond will usually pay either a lump sum or a small quarterly percentage charge for the facility. To achieve payment the employer will need to satisfy the Bank not only that there has been the necessary default under the bond but also that as a consequence he has suffered loss. The Bank will often have a counter-indemnity arrangement with the contractor. In the case of an on demand bond the Bank will usually be paid a percentage fee for the facility, and will be provided with a counter indemnity via another bank or series of banks from the contractor or its parent company. Legal IssuesThe main legal issues which therefore arise in relation to Bonds are
RemediesWhen a claim has been made under a guarantee, the principles which are applied by the courts when dealing with applications for an injunction to restrain a bank from paying over a guaranteed sum are well settled Themehelp Ltd-v-West and Others. First, letters of credit, performance bonds and guarantees are to be treated as autonomous contracts. Courts will not interfere on grounds extraneous to the credit or guarantee itself. Second, the sole exception is for instances of fraud, although even in such instances the law recognises the prima facie right of the guarantor to be the sole arbiter on whether payment should be refused on such grounds. Third, independently of the right of the guarantor to refuse payment on the ground of fraud, a party may apply for an injunction to restrain enforcement of a performance guarantee if he can prove fraud by the beneficiary of which the guarantor has knowledge. The evidence of fraud must be clear, the other party would have to be given the opportunity to answer the allegation and to fail to provide an adequate answer. The court would have to consider that the only realistic inference to draw is that of fraud. Challenges to Bonds Bonds usually contain a provision that the liability of the Bank is not discharged by changes in the underlying construction contract or forbearance by the Employer. This is because the established principle is that any variation in the terms of the underlying agreement which could prejudice the position of a guarantor will discharge him from all liability, unless he consents. It is not necessary that the guarantor should in fact be prejudiced, but only that he could be prejudiced. The guarantor is to decide for himself whether or not an alteration might prejudice his position, and whether to give his consent unless the alteration is self-evidently insubstantial, or beneficial to the guarantor. It is common for the Employer first to pursue remedies against the Contractor for any default, so that the Bank is unlikely to be troubled. If the Employer unusually sought recovery from the Bank, then the Bank would be indemnified by the Contractor for legitimate calls. The commercial risk for the Bank, is only the case where the Contractor is in default and insolvent, when the right of indemnification is of no value. The Bank will not therefore be overly concerned about the Contractor’s performance of the works. This may not always be the case, and the Bond may instead stipulate that the Bank is to be kept informed of actual or potential problems. Edward Owen Engineering Ltd-v-Barclays Bank International [1978] 1AllER1976The Plaintiff was an English company supplier which entered into a contract with a Libyan State entity buyer for the supply of greenhouses. The Plaintiff supplier provided an on-demand performance bond as required under he contract for 10% of the contract value. Payment by the buyer under the contract was in instalments and were to be made by irrevocable confirmed letters of credit payable at Barclays Bank International in England. The Libyan buyer instructed a Libyan bank to open an irrevocable documentary credit in favour of the supplier. This was contrary to the contract since it was not a confirmed letter of credit and payment was only to be made when authorised by the buyer. The Plaintiff was not satisfied with the letter of credit offered, and informed the buyer that they rescinded the contract and the guarantee. The buyer then called for payment under the on-demand bond and the plaintiff took steps to obtain an injunction to restrain payment under the bond. It was held that a bond payable "on-demand without proof or conditions" imposes an obligation on the guarantor to pay irrespective of default by the performing party, except in cases of fraud of which the guarantor had notice. It was held that so long as the buyer makes an honest demand, the banks are bound to pay. The banks will rarely, if ever, be in a position to know whether the demand is honest or not, or at any rate to be able to prove it to be dishonest. The only exception was clear fraud of which the bank had notice. It was not possible to say in this case that there was fraud still less that the bank had knowledge of it. The only remedy of the English suppliers was to sue the Libyan buyers for damages in the courts of Libya since they had exclusive jurisdiction under the supply contract. It was recognised by the court that it was not practicable for the English suppliers to invoke the jurisdiction of the Libyan courts, since it would be impossible to obtain a visa for that purpose. Despite the harshness of the consequences, the court nonetheless decided that the demand had to be met. Perar BV-v-General Surety and Guarantee Co Ltd (1994) CA 66BLR77The Main Contract was substantially the JCT Form with Contractors Design 1981 Edition. The performance bond was for 10 percent of the tender value of the contract and written in terms of default by the Contractor, and requiring notice to the Defendant within 14 days of the default. Before the works were completed, the Contractor went into administrative receivership on 7 June 1991. Clause 17.2 of the Main Contract provided for automatic determination of the Contractor’s employment. The Employer notified the administrative receiver on 11 June 1991 that it would not reinstate the Contractor’s employment pursuant to Clause 27.2. On 21 June 1991 the Employer notified the Defendant of a potential claim under the bond and subsequently assigned to the Plaintiff all rights under the bond. A writ was issued followed by an RSC Order 14A summons. In the Statement of Claim the Plaintiff alleged that the Contractor had abandoned the works on 10 June 1991, which required the Plaintiff to show an obligation to continue with the works as at 10 June 1991. Since the Contractor’s employment was terminated automatically on 7 June 1991, there was no cause of action for damages for abandonment of the works. There was no appearance on the face of the Statement of Claim of reliance on any breach of contract earlier than 14 days before notification on 21 June 1991. The claim was therefore dismissed at first instance. On appeal it was held that Clauses 27.2 and 27.4 were intended to be an exclusive code for the Employer’s and Contractor’s respective rights and duties consequent on the automatic termination. It was therefore impossible to say that there was an obligation to continue with the work once there had been an automatic termination. There was therefore no breach of contract and since the meaning of "default" in the bond was "breach of contract", the appeal was dismissed. The standard form of bond used with the ICE forms of contract is archaic and difficult to understand. The House of Lords has recently considered the matter in Trafalgar House Construction-v-General Surety Guarantee Company (June 1995). The essential questions was whether the bond was in the form of a guarantee which would allow the surety to take into account unpaid sums due for work done and cross claims for set off. In the Court of Appeal it was concluded that the bond was not a guarantee in the ordinary sense off seeing to it that obligations were performed. Instead it imposed an obligation to pay the damages sustained by the injured party when called on to do so. The Court of Appeal also held that the calculation of the sum payable under the bond should not take into account any debts or credits including the value of any set offs and counter claims. Finally, the Court held that the obligation under the bond was to pay what the injured party asserted in good faith to be the amount of damages. The Court of Appeal therefore considered the bond to be an on demand bond. This conclusion was reached because the commercial purpose of the bond was identified as being the provision of immediate funds for the injured party in the event of failure of performance by the other party. This effectively means that the injured party need only make the demand in the proper form and payment would have to be made. If payment was not made then application could be made to the courts under Order 14 of the Rules of the Supreme court. This had occurred in the present case. The Official Referee who had first been seized with the issue had taken the view that the surety had raised no arguable defence to the claim to be entitled to the maximum sum under the bond. The Court of Appeal agreed with the decision and dismissed the appeal. The issue then went to the House of Lords. The House of Lords took a different view. In the first place the bond itself contained indications that it was intended to be a guarantee. So, for instance, the description ‘the surety’ was used. Also there was provision that alteration of the terms of the construction contract would not release the surety from liability. This pointed to the bond being a guarantee. In addition there was relevant authority in decided cases which supported the view that the bond was a guarantee. The terms of the bonds in these cases could not be distinguished from the terms of the bond in the instant case. Since the bond was a guarantee this means that the surety could raise all questions of sums due and cross claims in the Order 14 application. The House of Lords also considered whether the particular words ‘damages sustained by the contractor thereby’ were sufficient to limit the liability of the surety. It was held that in order to do so the words used must be clear and unambiguous. That was not the case here. The use of the word ‘damages’ was more consistent with compensation arrived at after taking into account all sums due. If the parties had intended the obligation to apply solely to the additional expenditure incurred by the injured party, without reference to any sums normally set against it in an action of damages, this would have been simple. A form of words such as ‘the additional expenditure incurred’ would have sufficed. Cargill International SA-v-Bangladesh Sugar & Foods Corp [1996] 4AllER 563The issue before the court was a preliminary question of law, whether money paid under a performance bond to a party who has suffered no damage, is recoverable by the other party. The Main Contract required the Plaintiff to sell sugar to the defendant. The Plaintiff arranged a performance guarantee for 10% of the total value of the cargo. The assumption for the purpose of the preliminary issue, was that the plaintiff was in breach of contract in using an over-age vessel and its late arrival at the designated port. It was held that on application for an injunction, it is not pertinent that the beneficiary may be wrong to have called the bond because, after a trial or arbitration, the breach of contract may not be established. The concept in international trade and construction contracts, was that money must be paid without question, and the rights and wrongs argued about later, subject to terms under the bond to the contrary. However, it was implicit in the nature of the bond, that in the absence of clear words to the contrary, that there would at some future stage be an "accounting" between the parties when their rights and obligations were finally determined. The performance bond did not supplant the beneficiaries right to sue for damages; the beneficiaries rights were not exhausted when the bond was called, nor did it limit the level of recovery for the loss suffered. The corollary was that the other party can sue to recover any overpayment. The account party is always entitled to receive the overpayment, since his entitlement is founded upon the contract between himself and the beneficiary. The account party may hold the amount recovered in trust for the bank, where for example the bank had not been paid by him. In the instant case, the Bank unconditionally and absolutely bound itself to make payment on demand. It was held it had not been the parties intention that the buyer who could so easily call on the bond, should be able to retain for his own benefit a windfall profit. The basis of recovery of the overpayment was contractual rather than quasi-contractual. A term was to be implied in the contract that moneys paid under the bond which exceeded the buyer’s actual loss would be recoverable by the seller. Any term of the contract which enabled the buyer to call on the bond when he had suffered no damage, and retain the moneys, would be held to be a penalty from which the court would give relief by ordering repayment of the sums paid. Themehelp Ltd-v-West and Others (1995) CA AllER 1995 Vol 4The issues: In May 1992 the Plaintiff agreed to purchase the Defendant’s share capital in a company. The method of payment of the purchase price included three instalments. The third (and largest) instalment was secured by a performance guarantee. The guarantors irrevocably guaranteed that if the plaintiff defaulted on payment, and on receipt by the guarantors of notice from the defendants of such failure to pay, then they would pay the guaranteed amount to the defendants. The guarantee included a date for expiry of the liability under the guarantee. Before the final instalment was due, the Plaintiff started proceedings for recission of the contract and damages. Fraud was alleged, in particular that the Defendant had become aware by the date of the execution of the agreement that a major customer had decided to order all future supplies of the relevant product from a competitor. It was alleged that the Defendant knew that there was no basis for the assumption of continued demand by the major customer on which profit projections and the purchase price was based. The Defendant denied the allegations and insisted on its right to give notice to the guarantors to enforce the guarantee. The Plaintiff applied in the proceedings for an interlocutory injunction to restrain the defendants from giving notice. The guarantors were not party to the proceedings. The injunction was granted subject to confirmation from the guarantors that they would not enforce the time limit for expiry but extend it until after conclusion of the proceedings and any appeal. The plaintiffs appealed in the instant action. The Plaintiff appealed on three grounds, the first of which was that the injunction offended against the status of autonomy of guarantees. The Court of Appeal held that whereas there was settled authority for circumstances where at the date of application for the injunction there had been a claim under the guarantee, there was no such authority where application was made after a default had occurred but where no claim had yet been made under the guarantee. The authorities were all instances where the guarantor was joined as a party to the injunction application. In the instant case, the application was to restrain the beneficiary giving notice to the guarantor. It was held that where fraud is raised between the parties to the Main Contract, it is not a threat to the autonomy of the performance guarantee if an injunction is granted before the question of enforcement of the guarantee between the guarantor and beneficiary has arisen. The Court has jurisdiction to grant the injunction but did not consider whether this principle extended beyond instances of fraud, to cases where the beneficiary is alleged to be in non-fraudulent breach of the Main Contract. Oval (717) Limited-v-Aegon Insurance Company (UK) Limited June 1997The Defendant issued a performance bond which guaranteed performance by the Contractor up to a sum of £276,000. The contract works were not completed by the duly extended completion date. They were not completed later when Administrative Receivers of the Contractor were appointed. The Plaintiff’s Employer made a call on the bond due to the Contractor’s statement that they could not pay the net sum due to the Plaintiff under the contract. The Defendant refused to pay. The terms of the bond included a condition precedent to the right of the Employer to recover, in terms that the Employer should notify in writing of any non-performance or non-observance by the Contractor of the provisions of the construction contract within one month of the Employer’s knowledge of such default. The Plaintiff did not notify the Defendant of the Contractor’s failure to complete by the duly extended completion date within one month of knowledge of the default, but did properly notify of the later default in payment of the net sum due. It was argued for the Plaintiffs that the true construction of the condition precedent required notification of the default in relation to which the call was made and that this therefore had been complied with. It was held that on a true construction, the Bond was a contract of guarantee albeit in archaic language, relying on Perar BV-v-General Surety and Guarantee Co Ltd (1994) 66BLR72 in which similar terms were considered. It was held that the Plaintiff was required to notify the Defendant of those defaults which were appreciated by the Plaintiff at the time in relation to the contractual obligations extant at that time. He was required to notify no more to the Defendant than he notified to the Contractor subject to the event being self evidently insubstantial, or of obvious insignificance. It is left to the Defended to assess for itself the actual or potential significance of the information received. It was held that as the Plaintiff had failed to give the Defendant the required written notice of the contractor’s failure to complete the works by the duly extended completion date, the Plaintiff was not entitled to make a call and recover under the Bond since the Defendant has raised the issue of non-compliance with the condition precedent. Alstom Combined Cycles Limited v Aegon Insurance Company (UK) Limited (2001) TCCThe traditional form of bond with the ICE 6th Edition provides for the Insurer to pay to the Employer an amount representing damages arising from the Contractor’s default under the construction contract. This particular bond has been the subject of a House of Lords decision in Trafalgar House Construction –v- General Surety Guarantee Company (1995). The general comment was that the form is archaic and difficult to understand. As a result the form has been revised for the ICE 7th Edition. Nonetheless the original form of bond is still in common use. The original traditional bond was the subject in a decision in Alstom Combined Cycles Limited v Aegon Insurance Company (UK) Limited (2001) TCC. Henry Boot Construction Limited and Aegon Insurance Company (UK) Limited entered into a bond with Alstom Combined Cycles Ltd in connection with the construction of civil works at Connah’s Quay Power Station in North Wales. A number of disputes had arisen between Alstom and Henry Boot in connection with the Works which was under an amended ICE 6th Edition. Alstom claimed from Aegon payment under the Bond on the basis of Henry Boot’s alleged liability to pay liquidated damages for late completion of the works. Aegon applied for summary judgment against Alstom, on the basis that Alstom had no cause of action. As commented by His Honour Judge Richard Seymour QC, the application for summary judgment was a manoeuvre for advantage in a much larger war between Henry Boot and Alstom. Arbitration proceedings had also been commenced on various matters including the issue of the Defects Correction Certificate under the contract which is required to state when the Contractor had completed his obligations under the contract. The Bond provided that the obligation to pay was null and void on the date stated in the Defects Correction Certificate issued by the Engineer under the construction contract. This date is referred to as the Relevant Date. Aegon argued that it was discharged from all liability on the Relevant Date which in this case was stated to be 15th August 2000 in the Certificate. Once the Defects Correction Certificate had been issued it was as if the Bond had never existed. It did not matter that the action on the Bond had been commenced on 2nd August 2000, before the Relevant Date. Alstom accepted that if it was subsequently decided in pending arbitration proceedings that the Defects Correction Certificate should have certificated a date before the commencement of the action on 2nd August 2000, then any amount recovered on the Bond would have to be repaid to Aegon. Alstom argued however that on an interim basis Aegon was required to pay the sum due notwithstanding commencement of arbitration proceedings. His Honour Judge Seymour did not accept that the issue of the Defects Correction Certificate became null and void both prospectively and retrospectively. He held that the obligation created by the Bond only becomes null and void with effect from the date which should be specified in the Defects Correction Certificate as the date of Completion of the Works. He considered that it would be a very strange result if a liability to pay under the Bond which had crystallised prior to the issue of the Defects Correction Certificate simply vanished because the Defects Correction Certificate had been issued. He commented that while the language of the Bond was even more obscure than that of most documents of this kind, that on this point it was tolerably clear. To make commercial sense it was to be interpreted to mean that the obligation became null and void on the date when the works were in fact complete, whether this date was the date arrived at by the Engineer by a correct application of the contract or as a result of arbitration proceedings. In this case it was not possible to say what the Relevant Date was since arbitration proceedings were pending. It was held nonetheless that the Bond was not null and void on the date when Alstom made its demand upon Aegon, and therefore the application of Aegon for summary judgment failed. Although this disposed of the main issue, there was also an application from Aegon to stay the legal proceedings pending the arbitration proceedings. Judge Seymour held that he could grant a stay only if there was an arguable defence by Aegon to the application for payment by Alstom. In this case it was open to Aegon to argue that the alleged breach of the construction contract by Henry Boot was not a breach at all, and that Henry Boot was not bound to pay liquidated damages to Alstom because of the failure of the Engineer to grant proper extensions of time, issues which were part of the arbitration proceedings. Since there were arguable defences, and in order to avoid duplication and the risk of inconsistent findings in arbitration and litigation, a stay of proceedings was granted until final resolution of the arbitration proceedings. Aegon gave an undertaking to be bound by the outcome of the arbitration against Alstom. The decision does emphasis the difficulties that an Employer has in receiving payment under the traditional ICE bond for default by a contractor. The new ICE form of bond adopts a more restrictive but clearer approach. We have yet to see whether the new bond will succeed in avoiding expensive litigation. |