Bonds and guarantees
The purpose of a performance bond or guarantee is to ensure a third party delivers goods or performs services in accordance with the terms of an underlying contract. The issuer of a bond (usually a reputable trading bank) or a guarantee (often a parent company) undertakes to pay to the beneficiary (such as an Employer) a sum of money if the third party (such as a Contractor) fails to comply with its obligations under the contract. These bonds and guarantees are common forms of security in the construction industry. Perhaps unsurprisingly, the law in this area has undergone something of a shake-up in the past 12 months. Rebecca Saunders reviews some recent cases,1 and draws together some points to consider when entering into or making a call under a performance bond or guarantee.
Vossloh Aktiengesellschaft v Alpha Trains (UK) Ltd 2
This first case provides a reminder as to what constitutes an on demand performance bond, and what constitutes a conditional guarantee. The terms “performance bond” and “guarantee” are often used synonymously in the construction industry but they are in fact quite different forms of security.
Vossloh is the parent company of the Vossloh Group – a group of rail infrastructure and technology companies. Its subsidiary, Vossloh Locomotives (“VL”), manufactured and supplied trains to a number of companies owned by Alpha. This arrangement was recorded in a master purchasing agreement (“MPA”). In conjunction with the MPA, Vossloh provided a parent company guarantee of VL’s obligations under the MPA to Alpha, which included guarantees as to VL’s performance of the MPA, an undertaking to pay – on demand - sums owed to Alpha under the MPA in the event that VL did not pay, and an indemnity against any losses suffered by Alpha in the event VL failed to perform. Disputes arose between the parties and Alpha argued that the guarantee given by Vossloh was in the nature of an “on demand” bond in that it constituted an unconditional independent promise to pay on demand all amounts demanded, i.e. Vossloh’s liability was triggered by a demand alone. Vossloh argued that liability under the guarantee was triggered upon proof of a breach of contract, i.e. Vossloh’s liability was conditional upon a breach of the MPA by VL. In reaching his decision, the Judge, Sir William Blackburne provided a helpful summary of the law in this area:
“There is in this field of law a spectrum of contractual possibilities ranging from the classic contract of guarantee, properly so called, at the one end, where the liability of the guarantor is exclusively secondary and will be discharged if, for example, there is any material variation to the underlying contract between principal and creditor, to the performance or demand bond (or demand guarantee) at the other end, where liability in the giver of the bond may be triggered by mere demand and without proof of default by the principal (and indeed where it may be apparent that the principal is not in default). There may be little to distinguish (and it may not matter) whether the obligation undertaken is in the nature of a guarantee (strictly so called) or an indemnity. Where it does matter, the question is whether the liability to be enforced is secondary (or ancillary) to that of the principal (however qualified that liability may be), in which case the obligation is in the nature of a guarantee, or primary, in which case it will be in the nature of an indemnity and, if the latter, may be enforceable merely on demand (as with a performance or demand bond) or conditional on proof of default by the principal or on satisfaction of some other event or requirement. Where on the spectrum a particular case falls may call for a nice judgment on the part of the court faced with the task of construing the instrument in question. The instant case calls for just such a judgment.”
Alpha’s claim failed. The Judge held that there is a presumption that an instrument is not a performance bond unless it is issued by a bank in the form of a banking instrument. Alpha had not rebutted that presumption. The mere use of the expression “on demand” was insufficient to establish that the guarantee was in fact “on demand”. Vossloh’s liability was secondary to VL’s. To establish that Vossloh was liable under the guarantee, Alpha had to show that VL was in default in performing the underlying contract or making a payment that was due; Vossloh was not liable to pay against a mere assertion in that regard.
Simon Carves Ltd v Ensus UK Ltd 3
This case raises issues rarely addressed as to the extent to which a beneficiary may be prevented from seeking payment under a demand bond by the terms of the contract in respect of which the bond is provided. SCL was employed by Ensus to construct a bioethanol plant on Teesside. The contract incorporated the IChemE “Red Book” with some bespoke special conditions including one requiring SCL to provide a performance bond as security for its performance of the contract. This was duly issued by SCL’s bank, Standard Chartered. The bond itself was an unconditional autonomous document between Standard Chartered and Ensus, allowing Ensus to make a call on the bond at any time for any reason before its stated expiry date of 31 August 2010.
Importantly, the special conditions also provided that on the issue of the Acceptance Certificate by Ensus’s Project Manager, the bond would “become null and void (save in respect of any pending or previously notified claims)”. The conditions further provided that the bond should be returned to SCL as soon as it became null and void, “save where there are pending claims (including previously notified claims), in which case it shall be returned following final determination and (if applicable) payment of such claims and shall in the meantime remain valid”. If the bond was subject to a fixed expiry date, SCL should extend or replace the bond if it had not yet been returned by Ensus. If SCL failed to extend the bond, Ensus could call the outstanding balance of the bond and hold it as security, making any deductions for the amount of any outstanding claims. The Acceptance Certificate was issued on 19 August 2010 and listed a number of known defects which SCL was bound to make good, one of which related to odour emissions. SCL said that the bond was null and void and that it should be returned along with any retained monies because Ensus had not made any “claims” under the Contract. Ensus sought approval for return of the bond from its financiers – they declined, saying that Ensus needed the security for the list of defects attached to the Acceptance Certificate.
In late August 2010, with the bond about to expire, SCL and Ensus entered into talks about extending the bond. At the eleventh hour, under threat of a call from Ensus, the bond was extended to the end of 2010. It was later extended again to 28 February 2011. On 15 February 2011, Ensus issued a “claim” in respect of the odour problem. On 25 February 2011, SCL sought an injunction restraining Ensus from making a call. This was granted. However unbeknown to SCL, Ensus had already made a call earlier that week but the bank had not yet paid out on it, so SCL had to seek a variation to the injunction, requiring Ensus to withdraw its call. This was also granted. Following a full hearing, Mr Justice Akenhead held that the injunction was valid and should continue. He recognised that there was little authority addressing circumstances where there are contractual provisions between a contractor and employer which impose restrictions or prevent calls being made on bonds. The Judge summarised the law as follows:
(a) Unless fraud is established, the court will not prevent a bank from paying out on a demand bond provided the conditions of the bond itself have been complied with (such as formal notice in writing). However, fraud is not the only ground upon which a call on a bond can be restrained by injunction.
(b) The same principles apply in relation to a beneficiary seeking payment under the bond.
(c) There is no legal authority that permits a beneficiary to make a call on the bond when it is expressly disentitled from doing so.
(d) If the underlying contract clearly and expressly prevents the beneficiary from making a demand under the bond, it can be restrained by the court from making a demand under the bond.
(e) The court did not need to make a final determination on whether the underlying contract prevented payment at the interim injunction stage. It only needed to satisfy itself that the party resisting the demand had a “strong case”. It cannot be expected that the court at that stage will make in effect what is a final ruling.
AES-3C Maritza East 1 Eood v Crédit Agricole Corporate and Investment Bank and Another4
Maritza and two Alstom group companies were parties to a contract for the construction of a power plant in Bulgaria. Alstom, as contractor, provided an on-performance bond from its bank, Calyon, in favour of Maritza. The bond was separate and independent to the construction contract. The monies secured by the bond were payable to Maritza on receipt of a demand made in accordance with clause 4 of the bond, which provided that:
“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 the Contractor relating to the respective breach of its obligations to which the demand refers.”
It was clear by December 2010 that Alstom would fail to finish certain aspects of its works on time – it had deadlines for 25 and 31 December 2010 for completion of units 1 and 2. So on 20 December 2010, Maritza demanded 93m Euros from Caylon, which purported to cover Alstom’s existing liabilities and those it seemed clear would arise by 25 and 31 December when Alstom would be late. On 28 December 2010, before a court in France, Alstom obtained interim injunctions preventing Calyon from making any payment under the performance bond. Alstom took the view that the demand was ineffective because it only enclosed notices or claims against Alstom in the sum of 27m Euros – not the 97m Euros demanded. Three days later, Maritza applied for summary judgment to enforce the first demand. Then on 17 January 2011 Maritza issued a second demand against Calyon in the sum of EUR96.6m, this time attaching letters and invoices which substantiated the sum claimed. Alstom was granted a further injunction, Maritza applied for summary judgment and in late January 2011 both claims were heard in the TCC.
Mr Justice Ramsey decided that the question of whether there had been a relevant demand under an on-demand bond depended upon the wording of the particular bond. In this case, the bond was payable against an appropriately worded demand accompanied by such documents as the demand required and without proof of the existence of a liability under the construction contract. The only documents that were required were a notice to or claim against Alstom under the construction contract. Given that Maritza had failed to substantiate some 66m Euros of the sum it claimed under its first demand, that demand failed. However, Maritza substantiated all of the monies demanded the second time around, therefore that demand succeeded and Maritza was accordingly granted summary judgment in the sum of 96.6m Euros.
Hackney Empire Ltd v Aviva Insurance UK Ltd 5
HEL, the owner of the Hackney Empire engaged a contractor (“STC”) to carry out extensive refurbishment work to the theatre. Aviva issued a bond in favour of HEL to secure the performance of STC under the contract. Then HEL and STC entered into a side agreement which limited the amount of liquidated damages payable by STC and prevented the parties from referring disputes to adjudication for a period of time. They also agreed that if STC did not meet the target completion date, it would repay all of the sums paid under the side agreement. STC went into administration. HEL duly demanded repayment of the money paid under the side agreement, confirmed it had suffered losses as a result of STC’s failure to complete the work and made a claim under the bond for the full amount.
Aviva argued that the old rule in Holme v Brunskill meant that the payments to STC under the side agreement had discharged its liability under the bond. This rule provides that if there is any agreement between the principals (in this case HEL and STC) to alter the principal contract (i.e. the building contract) then the surety should be consulted and if the surety has not consented to the alteration, or if it is not self-evident that the alteration is unsubstantial or cannot be prejudicial to the surety, then the court will not go into the merits of the alteration or the question of whether it is prejudicial but will instead allow the surety to be discharged from its obligations. Aviva argued that they did not consent to the agreement and it was not self-evident that the alteration was unsubstantial or could not be prejudicial to Aviva. On this basis, the court should not go into the merits of the alteration in question or whether or not it is prejudicial but should allow Aviva to treat itself as discharged. HEL said that the rule only applied if the variation of the principal contract is such that it is increases the risk of default by the principal and therefore that there will be a call on the bond. HEL argued this is quite different to the position where the variation merely affects the amount of the surety’s ultimate liability but leaves the risk of default unchanged. Put another way, the payment of sums on account only create or increase the indebtedness but do not increase the risk of STC not performing under the building contract.
The court agreed with HEL. Whilst the side agreement did vary the building contract it did so only in two ways, both of which fell within the exceptions to the rule in Holme v Brunskill. This is because the side agreement effectively limited the amount of liquidated damages HEL could claim to £100,000.00 if STC met the target completion date (which was beneficial, rather than prejudicial, to Aviva) and it provided that neither HEL or STC would refer disputes to adjudication for an agreed period (which the court held was of no consequence to Aviva). However, the court held that whilst Aviva were not discharged from their obligations under the bond that bond did not extend to the obligations under the side agreement as these obligations had not been contemplated by Aviva when assuming liability under the bond.
Conclusion
Following Vossloh, it seems likely that the courts will only find that there is an “on demand” bond where it is clear on a proper interpretation of the document as a whole that the parties intended the liability of the bondsman to exist separately from the underlying liability of the contractor. Further, the use of the words “on demand” will not in every case suggest that a bond is in fact “on demand” in nature, if it is clear that on a proper construction the parties intended it to be “conditional” in the sense that there are preconditions to the issuer’s liability.
The Maritza case provides a reminder to beneficiaries seeking to make a call under a performance bond to comply with the formal requirements of the bond itself (specifically, providing the relevant supporting documentation if the performance bond so requires) before making a call; failure to do so can be fatal.
Some might argue that the Simon Carves decision means that employers will no longer be able to rely on performance bonds issued by banks – which the courts have historically avoided interfering with - to cover problems created by recalcitrant contractors. But that cannot be so. SCL demonstrated that it had a “strong case” that the bond had expired by virtue of the underlying contract. This, coupled with the concern about the effect a call on the bond would have on SCL, warranted the injunction being maintained. An employer cannot in effect agree to withhold from making a call on a bond by contract and then make a call; that is profoundly unfair and cannot be in the interests of commerce. If anything, this case serves to add a string to a very lean bow for contractors seeking to rely on the terms of an underlying contract as to the validity of a performance bond.
Finally the HEL case provides valuable clarification about the difference between varying the terms of an existing contract and entering into a separate side agreement, as well as of the importance of ensuring that everyone affected by the side agreement knows, and agrees with, what is going on.