The Cash Cow

On demand’ guarantee bonds are a typical form of contractual security in the UAE construction industry, particularly on large projects. Their use in theory, is to afford the employer with secured funds from a surety, in the event the defaulting party does not perform under a contract or becomes insolvent.

Prior to the onset of the liquidity crisis last year, the general attitude of an employer (as a beneficiary) would have been to threaten the encashment of a bond to impose commercial pressure on a contractor to perform. A call upon an on-demand bond would have been made if strictly necessary e.g. in the event of material or persistent default.

Due to the current liquidity crisis, employers are under increased pressure to view a bond as an alternative source of finance as opposed to an instrument of security. In these circumstances, the position of lenders is fraught with difficulty given their commercial reputation may be tarnished if they refuse to pay out.

Attraction

The obvious attraction of ‘on demand bonds’ is that beneficiaries of such bonds do not need to incur substantial costs and wait until a favourable arbitration or local judgement is awarded before the surety of a bond pays out monies. Monies paid out, could in theory be put to effective use by appointing an alternative contractor to complete the project and potentially reduce the impact of delays and disruption. The attraction is heightened in circumstances where the employer’s finances are not altogether strong.

It should however be noted, the costs of obtaining such a bond are normally passed on to the employer which may artificially raise the contract price.

Future Industry Trend

Given the current lack of liquidity and the prevailing ‘wait and see’ approach now taken by stakeholders, it is possible sureties might harden their attitude to their exposure on such bonds. This would be particularly the case on large construction projects whereby there would be more emphasis on due diligence on the financial strength and resources of the contractors. The employer’s claim history on projects together with its finances may also come under the microscope.

It would not be surprising if ‘on demand’ bonds become a feature of the past and become ‘conditional’ like they are in Europe and the US.

The nature of conditional bonds such as those currently proposed by FIDIC would for instance, require a beneficiary of such a bond to only claim for amounts which are ‘properly’ due. Furthermore claims under FIDIC bonds must be established strictly in accordance with the contract provisions.

This possible change in the form of performance bonds is likely to shift contractual risk on to the employer. The employer will have to ensure it can be reasonably certain of its grounds for claiming and to serve proper notice to allow the contractor a period of time to remedy its breach. In practical terms this will cause the employer to ‘front load’ its costs in the preparation of claim (in advance of any arbitration or litigation proceedings) as well as sustaining the financial effect of any alleged breach before the surety under the bond is lawfully obliged to pay out.

Therefore payment by a surety would only be made as a last resort as opposed to being pretty much immediate.

Hidden Danger

A contractor procuring a bond may try to resist a call on a bond on the basis monies paid out to the beneficiary may never be fully recovered by the contractor in legal proceedings or arbitration even if the call by the beneficiary was later found to have been without merit.

Conversely, an employer will seek to rely on its rights in calling upon such a bond for immediate payment because it has paid a premium for such security in the event of contractor led default. A frustration of an employer’s call in the form of the contractor seeking temporary relief by way of attachment or injunction type proceedings can have potentially serious financial consequences for the project as a whole. Indeed the financial survival of the protagonists may be at stake.

Temporary Relief?

Given that lenders usually have to act promptly in complying with a call upon a bond (typically made before any formal dispute has commenced) contractors may have to act very fast in trying to prevent the lender from paying out to a beneficiary of a bond.

Regardless if formal arbitration proceedings have commenced, it is unlikely the Contractor will have sufficient time to obtain the relief sought from an arbitral tribunal. This is due to the fact it takes time for a tribunal to be appointed or for a tribunal (once appointed) to convene to consider the application for relief.

Furthermore, given that arbitral proceedings are conducted in private and that a lender is not a formal party to the arbitration, it is difficult to ascertain with any reasonable certainty, the likelihood of an arbitral tribunal providing interim relief and even so the practical enforcement of an award on the surety in practice.

The attractiveness of immediate resort to the local courts is therefore heightened. Whilst we unfortunately do not have directly applicable remedies under the Federal Civil Procedure Law or guidance as to how the local courts would treat an application for injunctive relief by a contractor by way of a provisional attachment order, it would appear the contractor would generally have to establish that:

The amounts claimed are disproportionate to the current amount being guaranteed under the bond; or

The claim was evidently fraudulent or there was demonstrable bad faith.

It should be noted however, that even if a contractor is successful in obtaining such relief, it is possible any interim relief may be overturned by way of an appeal by an employer thereby providing little practical comfort overall to the contractor.

Conclusion

Given a current popular buzzword that ‘cash is king’, the likelihood of calls upon on demand bonds at least in the short to medium term is likely to be high. Calls are likely to meet with stiff resistance from Contractors particularly on large projects where the amounts in dispute are high, the issues are complex and the contractor’s survival and reputation are at stake.

Disputes over entitlement to cash under these bonds may be viewed as a large ripple to an impending wave of more formal and high value disputes, as disputes over bonds and the underlying contracts are inextricably linked.

The response times of parties making and resisting a claim and the avenues in pursuing such claims relating to bonds will be critical. This however naturally presupposes the paperwork of the parties is all in ‘cherry pie’ order and the availability of an arbitral tribunal or a local judge to deal with such applications on a short term basis.

Perhaps the attraction of ‘on demand’ bonds may not be so tempting after all?

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