Performance Bonds & Bank Guarantees

Performance Bonds & Bank Guarantees

There are a range of options available owners to protect them against the non-performance of a contractor such as retention, liquidated damages, indemnity and set-off provisions, parent company or shareholder guarantees,  performance bonds, bank guarantees and others.

This Article focuses on the use of performance bonds and bank guarantees.

Performance bonds and bank guarantees may be either conditional or unconditional. They are normally issued by banks or insurance companies.

A conditional bond or bank guarantee may only be called on actual proof of default and damage, such as an arbitration award or court judgment, and the payment will only cover the proven loss sustained by the owner/beneficiary up to the amount stated in the bond or bank guarantee.

An unconditional/demand bond or bank guarantee does not require any proof of default, and the owner/beneficiary will generally receive payment of the full amount upon the presentation of a written statement to the issuer stating that the contractor has failed to perform. In the absence of fraud and, in certain jurisdictions unconscionable conduct, the issuer must pay upon the receipt of a demand provided the demand notice, and any other documents required by the bond or bank guarantee, are in order.

The distinction between conditional and unconditional bonds and bank guarantees is not always clear due to ambiguous drafting or the creation of hybrid bonds or bank guarantees. In Simple terms a conditional bonds and bank guarantees can be identified by:

1)   wording which makes payment under the bond or bank guarantee conditional upon the proof of breach of the underlying contract (as opposed to mere notice of a breach) by the contractor

2)   the existence of notice provisions as to the existence of a default or of the intention to claim, as conditions precedent to any call on the bond or bank guarantee

3)   the bond or bank guarantee being signed by the contractor. Unlike the unconditional bond or bank guarantee, the conditional bond or bank guarantee depends on the obligations owed by the contractor to the owner under the contract, and the contractor must be a party to it

4)   the absence of words typically found in unconditional bonds or bank guarantees such as ‘…on receipt of its first demand in writing…the bank/surety will fulfil its obligations under the bond or bank guarantee without any proof or conditions…’.

Hybrid bonds and bank guarantees arise where payment of a demand under what is essentially an unconditional bond or bank guarantee is made subject to conditions such as:

1)   the production of an architect/surveyor/engineer’s certificate stating its opinion that there is a breach of the contract and the amount stated in the demand is the appropriate compensation for the breach

2)   authentication of the signature of the owner in the demand

3)   authentication of the signature of the architect/surveyor/engineer in the certificate.

Such conditions should be rejected by an Employer seeking an unconditional bond or bank guarantee. Issuers are unlikely to seek clarification of hybrids or vague wording during negotiation, because where a dispute arises, an unclear bond or bank guarantee is likely to be found to be conditional, which is in their own and their customers’ favour. Further conditions to an unconditional performance bond or bank guarantee arise where the contract provides conditions to the payment of the demand (for example, that the contractor is in breach and has failed to remedy the breach within the stated time after receiving notice from the owner requiring him to do so). This type of clause creates obligations between the owner and contractor separate from the obligations between the owner and the issuer of the bond or bank guarantee. This could lead to the owner being in breach of contract by calling on the apparently unconditional bond or bank guarantee. To avoid this problem, it is in the Employer’s interests that the contract does not mention the performance bond or bank guarantee or any related conditions.

Where a conditional bond or bank guarantee contains no express provision fixing the time of release or expiration, the bond or bank guarantee is usually released upon:

the surety satisfying damages sustained by the owner in the event of a default of the contractor

the determination of the contract due to the insolvency of the contractor (subject to the maximum liability stated in the bond or bank guarantee)

the performance of all the contractor’s obligations under the contract.

Without an express time limit, it may be argued that the sureties’ liability continues until every single obligation of the contractor under the contract is performed, or even continues indefinitely. Generally guarantors whether banks or insurance companies will not contemplate issuance of bonds without an expiry date but contractors should always ensure that an expiration date is stated in the guarantee.

An Employer calling on an unconditional bond or bank guarantee simply gives a written demand to the issuer stating the contractor’s failure to perform. In the case of a hybrid bond or bank guarantee, it must ensure it complies with any other requirements or formalities. The courts and arbitrators applying the laws of those jurisdictions will generally only intervene if there is clear evidence of fraud. However, a high degree of strictness applies and mere allegations of fraud or unconscionably are insufficient to prevent a call. The courts will not entirely ignore the underlying contract as shown in the judgments of Themehelp Ltd v West [1996]  and  Balfour Beatty Civic Engineering v Technical & General Guarantee Co Ltd [1999]   If the contractor has lawfully avoided the underlying contract, or there is a failure of its consideration, the court might prevent a call on the bond.

With a conditional bond or bank guarantee, enforcement is unlikely to be achieved quickly unless:

1)   the default of the contractor is so obvious that it plainly cannot be disputed

2)   no defence or set-off is available to the contractor/surety in answer to the call.

The difficulty with conditional bonds and bank guarantees is the need for proof of:

1)    actual default and damage suffered. A mere assertion of default and damage will not suffice

2)    the actual amount of damages suffered.

Accordingly, it is not recommended legal proceedings be commenced to recover bond or bank guarantee money unless it is clear that the default and damage is undisputable.  The position under the law is that the owner’s right to call on the bond or bank guarantee depends on the court’s construction of the bond or bank guarantee.  If the bond or bank guarantee guarantees the contractor’s performance, the owner has to establish damages occasioned by the breach of conditions (and if the owner succeeds, they recover the amount of damages proved). If the bond or bank guarantee is conditional on facts other than the contractor’s performance, the owner can establish the relevant facts, and does not need to prove a breach.  The court presumes that bonds or bank guarantees are to be conditioned upon the presentation of documents, rather than the existence of facts, unless it is obvious that the existence of facts is required.

When requesting bonds or guarantees the Employer should state these clearly within the invitation to tender documentation and preferably include a formatted example for the Contractor to follow and allow for in his tender. Where there is no such invitation to tender or the bonds guarantee are nor clearly specified in an invitation to tender or bid then the parties need to consider the following before negotiating the content of any such bonds or guarantees:

Owners should require an unconditional bond or bank guarantee, with a right to assign and charge the benefit of the bond or bank guarantee on the beneficiary. For the reasons mentioned above, no conditions regarding the calling of the bond or bank guarantee should be included in the contract.

Contractors should try to insert conditions in respect of the bond or bank guarantee in the contract.

A governing law should be inserted in the bond or bank guarantee.

The bond or bank guarantee should be executed as a deed to avoid problems with consideration.

Consideration should be given to the desired effect of the performance bond or bank guarantee and any alternatives (such as liquidated damages). The level of comfort sought should be balanced against any potential impact on the contract price.

The notice requirements, for example, form of notice and address for service of notices.

Ensure that the insolvency of the contractor is referred to expressly as a default allowing the owner to call the bond or bank guarantee.

Ensure that it is expressly provided that the bond or bank guarantee is not to be rendered void due to any alteration of the contract between the owner and the contractor.

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