Performance Bonds

Monday, May 28th, 2012

A refresher on Performance Bonds.

A requirement of a performance bond is not an uncommon occurrence on large projects and construction projects. Procurement specialists are usually presented with wording for the bond and often the bond is put in place without any discussion on negotiation. Keating Chambers (Barristers) offer this thought.

‘The word “bond” conjures up a mediaeval or Shakespearian image of usuary and of Shylock rubbing his hands at the prospect of his entitlement to the pound of flesh, only to have his hopes dashed on being told that he may  indeed have that flesh as provided, by the terms of the bond are so limited and do not extend to a right to spill a drop of blood. Further the terminology still used in some bonds would not have been out of place 400 years ago’.

Brian Farrington Ltd have extensively researched the broad subject of bonds. Authoritative comment is vital when studying any area of law. Those interested in bonds are advised to access the judgement of Sir William Blackburne (sitting as a judge of the high court) in the case of Vossloh Aktiengesellschaft and Alpha Trains (UK) Ltd [2010] EWHC 2443 (Ch). This case judgement is dated 5th October 2010. At para 21 it states:

 ‘A contract of suretyship is in essence a contact by which one person, the surety, agrees to answer for some existing or future liability of another, the principal (or principal debtor), to a third party, the creditor, and by which the surety’s liability is in addition to, and not in substitution for, the liability of the principal.’

Contracts of suretyship fall into two main categories: contracts of guarantee and contacts of indemnity. A contract of guarantee is a contract whereby the guarantor promises the creditor to be responsible for the due performance by the principal of his existing or future obligations to the creditor if the principal fails to perform them or any of them. A contract of indemnity denotes a contact where the person who gives the indemnity undertakes his indemnity obligations by way of security for the performance of an obligation by another.

Returning to the Vossloh case, para 28 the judge started: ‘ This brings me to the so –called ‘ performance bond’, sometimes known as a ‘performance guarantee’,  often as a ‘demand bond’ or ‘demanding guarantee’ or even as a ‘first demand guarantee’ . In the context of the present dispute I prefer the expression ‘demand bond’. In essence it is a particularly stringent contract of indemnity. It is a contractual undertaking by a person, usually a bank, to pay a specified amount of money to a third party on the occurrence of a stated event, usually the non-fulfilment of a contractual obligation by the principal to that third party. Sometimes the wording of the contract has the result that the liability of the person who has given the bond arises on mere demand by the creditor, notwithstanding that it may be evident that the principal is not in any way in default or even that creditor himself is in default under his contract with the principal. IT ALL DEPENDS ON THE WORDING OF THE INSTRUMENT (Our emphasis)’. 

Keating Chambers point out that:

 ‘The simple, or single, bond merely required payment on the due day but historically it became accompanied by a condition which, upon its performance, defeated the bond, and so rendered it not payable. So it came to be called the “conditional bond”. The bank’s undertaking on a first demand bond will ordinarily be to pay on demand without proof or conditions. As between the banks and the employer beneficially such a bond is tantamount to cash in the hand of the employer.’

An on-demand bond clearly presents risks for contractors, especially if they are in dispute with their employer (the contracting organisation). There have been cases where the parties have been in dispute and the contactors has sought an injunction against the surety bank to prevent them paying out the bond. On numerous occasions such injunction applications have been denied by the courts. The courts will look at the substance (rather than the label) of these clauses, in other words the courts examine the ‘true construction’ of the clause.

The Association of British Insurers (ABI) have produced an ‘ABI Model Form of Guarantee Bond’ (April 2004). It is accompanied by an explanatory guide. It is an excellent briefly document, answering a number of pertinent questions, including ‘How is the amount payable under the Bond calculated?’, ‘Can the form of Bond be amended?’, ‘What happens where the contractor becomes insolvent?’ and ‘Following insolvency, when will payments be

The complexity of on-demand bonds is further illustrated in AES-3C Maritza East 1 EOOD v (1) Credit Agricole Corporate and Investment Bank and (2) Alstom Power Systems GmbH [2011] EWHC 123 (TCC). The bond was provided for a power station project in Galabovo, Bulgaria.  The sum was not insignificant £96,604,166.83!
The bond was provided by Calyon, a French Bank from its head of office in Paris. The bond was governed by English law and the courts of England had non-exclusive jurisdiction to settle any dispute connected with it. What happened next?

This article contains general comments only and, in consequence, legal advice should be taken before reliance is placed upon it in any particular circumstances.  For procurement risk advice, and to find out what happened in Galabovo contact