Legal Briefing

Calls on performance bonds: avoiding pitfalls

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Finance | 01 May 2012

Calling on a performance bond should result in swift receipt of the bond amount by the beneficiary. However, there are risks involved in making calls on performance bonds, which can result in complex proceedings leading to delay and cost. Partners Richard Ward and Ben Bruton of Eversheds report on this area of law with attention given to issues highlighted by recent case law.

This article examines:

  • The key clauses you would expect to find in a performance bond and the effect these clauses could have on a call.
  • The incorporation of uniform rules and the potential impact on how a bond could be interpreted.
  • The significance of the underlying contract and its relationship with the performance bond.
  • Evidentiary requirements and practical considerations that could help to avoid potential pitfalls.
  • Jurisdictional issues and strategic considerations.
  • Recent case law and its impact on the calling of performance bonds.

WHAT IS A PERFORMANCE BOND?

Performance bonds are a type of promise to pay or guarantee of payment provided by a third party (the surety or the guarantor) to an employer (the beneficiary) as security against the non-performance of a contractor (the principal). In the construction industry, the surety or guarantor is likely to be a financial institution, such as a bank or an insurance company and the amount of the security provided by a performance bond would typically be between 10 and 20% of the underlying contract value.

Performance bonds have regained some prevalence in recent years due to the effect the rising number of insolvencies has had in reducing the security provided by other risk management instruments, such as parent company guarantees. The advantage of performance bonds for employers is that, in the event that the non-performance of a contract is as a result of the insolvency of the contractor, or of their parent company, the employer retains some security by having the ability to call upon the third party to pay out on the bond.

While most developers are advised to seek both performance bonds and parent company guarantees, recent case law highlights the importance of paying careful attention to the drafting of performance bonds in order to avoid potential pitfalls when making a call on the bond.

TYPES OF BOND

Performance bonds can generally be categorised into three types; conditional bonds, on-demand bonds and hybrid bonds.

Conditional bonds

A conditional bond or a ‘see to it’ bond is characterised by the requirement for the beneficiary, when making a call on the bond, to have a judgment or award evidencing both a proven breach of the underlying contract, together with a loss suffered by the employer as a consequence of this breach. In this respect a conditional bond is generally seen as a guarantee, in that it imposes an obligation upon the guarantor, subject to the beneficiary establishing proven default in the underlying contract. It, however, differs from a guarantee in that the beneficiary is not required to first seek recovery from the principal.

On-demand bond

In contrast to this, a ‘pure’ on-demand bond is characterised by the absence of any conditions required to make a call on the bond other than the making of the call itself. In this way, a primary obligation is imposed upon the surety (or ‘bondsman’). In practice, the risk to an issuer of performance security of a call is significantly greater in view of the fact that loss, default or breach does not need to be proven. This risk is reflected in the increased costs of this kind of security compared to a conditional bond.

Hybrid bond

Hybrid bonds, as the name would suggest, could fall anywhere along the spectrum between conditional bonds and ‘pure’on-demand bonds. As a result of the varying degree of conditionality present in hybrid bonds, making a call on these bonds can create the most difficulties in practice. A hybrid bond will require some conditions to be satisfied by the beneficiary in order for them to make a call on the bond, for instance the beneficiary may have to produce specific documents evidencing the grounds under which they believe the principal has breached the underlying contract or the loss that they have suffered.

KEY CLAUSES IN A PERFORMANCE BOND

The Association of British Insurers (ABI) produced a model form of guarantee bond (the ABI bond), which they recommend for use in the UK construction industry in preference to on-demand bonds. It should be noted that the ABI bond is a guarantee as opposed to a bond and, as such, imposes an obligation on the guarantor subject to the beneficiary establishing default in the underlying contract. The wording of the ABI guarantee bond states:

‘1. The guarantor guarantees to the employer that in the event of a breach of the contract by the contractor, the guarantor shall subject to the provisions of this guarantee bond satisfy and discharge the damages sustained by the Employer as established and ascertained pursuant to and in accordance with the provisions of or by reference to the contract and taking into account all sums due or to become due to the contractor.’

This has the effect of making the call on the bond dependant on proving both the contractual liability of the principal as well as loss suffered by the employer as a consequence of the principal’s breach.

Key clauses in the ABI bond include: the bond amount, which limits the liability of the guarantor to a specified amount; the expiry date, which details that the trigger for expiry of the bond is the issuance by the employer of a certificate of project completion; an assignment clause, which grants the employer the ability to assign the bond in the event that the benefit of the underlying contract has been assigned; and a governing law and jurisdiction clause, which stipulates England and Wales as the appropriate jurisdiction and governing law of the bond.

While on-demand and hybrid bonds will contain similar key clauses to the ABI guarantee bond, the contents of these clauses will vary substantively to reflect the different degree of conditionality of these bonds. Due to the nature of hybrid bonds, there will be a level to which the employer must state or evidence the liability of the contractor when making a call on the bond and so any clauses dealing with this will need special consideration.

As always, all terms of the bond should be considered before making a call in order to ensure the bond call is effective and to avoid any practical difficulties.

EXPIRY DATE

It is important to look out for clauses dealing with the expiry date of the bond, especially given that there is usually a relationship between the trigger for the expiry of the bond and the underlying contract. Clauses dealing with the expiry of the bond could include specific procedures for renewing or extending the bond when certain circumstances are met. Careful consideration of these clauses should be given in respect of the timing of a call and the potential benefits that could be obtained by renewing or extending the bond. Depending on what type of bond has been purchased, it may be necessary to extend the bond beyond expiry in order to fulfil the procedural conditions required to make a valid call on the bond.

Fixed-term expiry dates should be treated with caution, as there is not only the risk of projects overrunning but there may well be events capable of triggering the expiry of the bond before the fixed expiry date (see Simon Carves Ltd v Ensus Ltd [2011] in Box 1).

THE UNIFORM RULES FOR DEMAND GUARANTEE OF THE ICC

When calling upon a bond, a party should check for the incorporation of any uniform rules. The Uniform Rules for Demand Guarantee (URDG) published by the International Chamber of Commerce (ICC) came into force on 1 July 2010. The URDG are a set of contractual rules designed to apply to demand guarantees and these rules can be expressly incorporated into a demand bond.

The aim of the URDG is to create safeguards against the unfair calling of demand bonds. The main way that this is achieved is through the implementation of minimum procedural requirements for the calling of demand bonds. For example, if the URDG are incorporated, then a call on a bond must be in writing and must also be accompanied by a statement from the beneficiary indicating how the principal is in breach of their contractual obligations.

The URDG also safeguard against unfair calling by requiring the guarantor, on receipt of a compliant demand, to, without delay, transmit a copy of the demand to the principal. This is so that the principal has the opportunity to seek the withdrawal of the demand from the beneficiary by way of agreement or by obtaining an injunction from the court.

As well as imposing minimum procedural requirements, incorporation of the URDG can also have a major impact on how a bond is interpreted (see Meritz Fire & Marine Insurance Co Ltd v Jan de Nil NV, Codralux SA [2011] in Box 2).

THE UNDERLYING CONTRACT

The terms of underlying contracts will often impact on a bond call and so it is essential that these are examined before calling on a bond (see Box 1)). The underlying contract could go so far as to stipulate the circumstances under which a call can be made.

CORPORATE DUE PROCESS AND FINANCIAL DUE DILIGENCE

In order to comply with the conditions of a bond, a beneficiary may have to provide statements from company directors to evidence that they have an honest belief that there has been a breach of contract by the principal or that the company has suffered a loss. To guarantee that all of the conditions of a call are satisfied, it should be kept in mind that there may be an amount of corporate due process required in order to get any appropriate authorisation or necessary documents such as witness statements or board minutes.

Financial due diligence on the contractor is advisable wherever there is a wider commercial context under which a call on a bond could be made and where a bond call could have the effect of jeopardising a broader commercial interest.

EVIDENTIARY REQUIREMENTS AND CHALLENGES TO A CALL

In a similar way, companies should consider and take immediate steps to obtain any evidence they might need in the event that their bond call is challenged. Beneficiaries are often required, when making a call, to specify what breach has been made by the contractor and the grounds upon which they are making a call. If the call is challenged, evidence may be needed to show that the call was not fraudulent. Beneficiaries should give careful consideration when specifying the breach as to what evidence they have available to support their specification.

JURISDICTIONAL ISSUES

If there are multijurisdictional issues and it is anticipated that any call will be resisted, then the beneficiary under a bond should have a clear strategy in place that can be implemented if a challenge is made. It is also important to take care when selecting the governing law and jurisdiction of the bond agreement. Some jurisdictions may be perceived to be more difficult than others or more uncertain, perhaps as a result of political bias or because litigation takes more time and so is more costly. Also, the approach of the courts to various procedures associated with litigation may differ and this could have a material impact upon a call. As a result of this, local advice should be sought to determine course of action.

The case of AES 3C Maritza East 1 EOOD v Credit Agricole Corporate and Investment Bankand Alstom Power GmbH [2011] (see Box 3) is an example of a case where, following a call made on an on demand performance bond governed by English law with the courts of England having jurisdiction, the contractor obtained an ex parte injunction in a French Tribunal de Commerce. Even though the beneficiary under the bond was subsequently able to establish the jurisdiction of the English court, and even though the French Court of Appeal overturned the injunction issued by the Tribunal de Commerce, the action taken by the contractor delayed the payment under the bond by around six months.

The AES v Alstom case is also a good example of where very strict adherence to the terms of the bond was held to be required to ensure that the call on the bond was valid.

PREPARATION FOR SUBSEQUENT PROCEEDINGS

The potential for subsequent proceedings following a call should be considered from the outset. If a contractor brings a damages claim as a result of the bond call, advance preparation could make the difference between success or failure. Equally, in the event of arbitration, taking time to consider the evidence in support of a specified breach when making the call in the first place will give consistency to the merits of the claim in the long run and potentially save time and costs further down the road. Adopting a project management approach from the outset will also be prudent especially where there are potentially complex issues and so time, costs and information will need to be managed effectively.

CONCLUSION

The provision of and reliance upon performance bonds is a key component of construction and engineering projects. With increased commercial and financial pressures, challenges to bond calls and more demanding bond terms will be increasingly prevalent. Consideration of the above issues will assist not only in the making of successful calls but also in the negotiation of appropriate bond terms.

Case law is developing in this area with each case being determined on the wording of the bond in question. Businesses should be alive to these developments and decisions and, if necessary, either update their standard documents as appropriate or ensure that appropriate terms are negotiated into draft bond terms they are presented with.

By Richard Ward, partner, and Ben Bruton, partner, Eversheds LLP.

E-mail: RichardWard@eversheds.com; BenBruton@eversheds.com.

BOX 1: SIMON CARVES LTD V ENSUS LTD [2011]

The case of Simon Carves Ltd v Ensus Ltd demonstrates the importance of looking at terms of the underlying contract when considering calling a bond. In particular, the case highlights the importance of looking at the relationship between the underlying contract and the expiry of the performance bond.

In this case, Simon Carves Ltd (SCL) was employed by Ensus Ltd (EL) in relation to the provision of a bioethanol process plant. In accordance with the contract, SCL purchased an on-demand performance bond from Standard Chartered Bank as security against their own contractual obligations. The bond stipulated a fixed-term expiry date of 31 August 2010:

‘This bond is irrevocable. This bond will be valid up to the earlier of:

6.1 14.00 hrs London time on 31 August 2010…;

6.2 the date on which all payments under this bond equal the bond amount.

The banks shall be liable to pay the bond amount or any part thereof under this bond only if the purchaser serves a written claim or demand on the bank (and which should be received by the bank) on or before 14.00 hrs London time on 31 August 2010, after which time this bond shall cease to be ineffective in all respects whether or not the original of this bond is returned to the bank…’

However, the underlying contract incorporated both the General Conditions of Contract for Lump Sum Contracts (‘the Red Book’), which were published in 2001 by the Institution of Chemical Engineers, together with special conditions agreed by the party. The Red Book provided for procedural requirements, which needed to be fulfilled for completion of the contract and one of these conditions was for an Acceptance Certificate to be issued by Ensus Ltd, subject to the plant passing various performance tests. In connection with this, Special Condition 3.7 of the underlying contract stated that: ‘Upon the issue of the Acceptance Certificate the performance bond shall become null and void (save in respect of any pending or previously notified claims).’

When problems with the plant became apparent in March 2010, EL called on SCL to perform remedial work. In the absence of SCL remedying the problems with the plant, EL undertook the work themselves as provided for by the contract. On 19 August 2010 EL issued an Acceptance Certificate subject to outstanding defects being rectified and towards the end of August 2010 EL were contemplating making a call on the their security.

SCL immediately relied on Special Condition 3.7 of the underlying contract in asserting that the issuance of the Acceptance Certificate meant that the bond was ‘null and void (save in respect of any pending or previously notified claims)’, and that no such claim had been made. SCL sought an injunction preventing EL from making a demand on the bond and the Court held that there was a strong case that the bond was null and void due to the issuance of the Acceptance Certificate and an injunction should be granted.

BOX 2: MERITZ FIRE & MARINE INSURANCE CO LTD V JAN DE NUL NV [2011]

The recent case of Meritz Fire & Marine Insurance Co Ltd v Jan de Nul NV, Codralux SA demonstrates that the incorporation of uniform rules does not just create minimum requirements for the calling of bonds but can also have a significant impact on how a bond is interpreted.

Here, advance payment guarantees (APGs), were issued by Meritz Fire & Marine Insurance Co Ltd (Meritz) to Jan de Nul NV (JDN) as security for advance payments made in relation to the building of two ships by Huen Woo Steel Co (HWS). The APGs expressly incorporated the Uniform Rules for Demand Guarantee (URDG) and, when the subsequent non-performance of the contract led to JDN calling on the APGs, all of the requirements of the URDG were met.

Prior to this, the shipbuilding contracts had been novated from HWS to Asia Heavy Industries without the consent of Meritz. HWS had by this time dissolved and as a result of this Meritz argued that they were no longer liable under the APGs as their liability was secondary to the liability of HWS. The court said that rather than focusing on the categorisation of the type of bond (see to it or on demand) the question at issue had to be resolved primarily by reference to the words used by the parties to define their obligations.

The Court of Appeal said that the intention of the URDG was that payment be made against documents without reference to the terms of the underlying contract. Therefore, the Court decided that the APGs should be interpreted as on-demand performance bonds imposing a primary obligation on Meritz. As all of the requirements of the URDG for making a call on the bond had been met by JDN, Meritz were obliged to pay out under the APGs.

BOX 3: AES-3C MARITZA EAST 1 EOOD V CREDIT AGRICOLE CORPORATE AND INVESTMENT BANK AND ALSTOM POWER GMBH [2011]

AES-3c Maritza East 1 EOOD (AES) employed two Alstom group companies, Alstom Power Systems GmBH and Alstom Bulgaria EOOD (together ‘Alstom’) under an engineer, procure and construct contract (EPC contract). An on-demand performance bond was issued to AES by Credit Agricole, with Alstom indemnifying Credit Agricole for any amounts paid under the bond. Alstom were looking set to fail to perform parts of the contract with due dates of 25 and 31 December 2010 when AES made a call on the bond for €93m. The call was challenged on the grounds that the evidence supplied by AES in support of their call on the bond only related to a demand of €27m.

Clause 4 of the performance bond stated:

‘The bank shall have no liability in respect of a demand which does not satisfy all the following requirements: […]

(b) the demand contains a statement (or statements) to the effect (or substantially to the effect) that either;

(i) the contractor has failed to comply with its obligations in accordance with [the EPC contract]; […]

(f) the demand contains any notice to or claim against contractor relating to the respective breach of its obligations to which the demand refers.’

The Court held the call to be invalid on the basis that the bond required the demand to be accompanied by notices to claims or claims against Alstom relating to the alleged breach of the obligations to which the demand referred. The court held that documents in relation to notice to or claims of €23m could not be ‘any notice or claim… relating to the respective breach to which the demand refers when’ the demand by AES was for €93m. While the court held the call to be invalid it was not found to be fraudulent on the basis that AES had an ‘honest but mistaken belief’ that the bond would cover prospective loss.

AES had also made a second demand on the bond for €96m where, in contrast to their first demand, the supporting evidence included with the demand related to the full amount of the demand ie €96m. Credit Agricole argued that this second demand was invalid as a fraudulent demand for the same amount of money had already been made. As the Court found the first demand to be invalid as opposed to fraudulent this argument failed and the second demand was held to be valid.