On-demand bonds are not foolproof

KATIE LISZKA* looks at the circumstances in which the beneficiary of an on-demand performance bond may be prevented from calling on the bond for reasons outside the terms and conditions of the bond itself.

THE recent global financial crisis has brought the performance security documentation provided on construction projects into sharper focus. Employers are looking to protect themselves should current and future projects get into trouble and are considering more carefully the security provided.
Unfortunately, some parties are in the position of having to consider what terms they signed up to in better times and whether or not they can enforce the security. An employer commonly requires a performance bond and, where there is a parent company, a parent company guarantee, as security for the performance of the contractor’s obligations. These requirements are usually contractual obligations in the underlying construction and engineering contract. Of the different types of bond available, the on-demand performance bond offers the employer the most robust form of protection.

It is worth considering the purpose of an on-demand bond and the advantage it offers to an employer. The key advantage is that the bond can be called even if there is an underlying dispute under the contract, allowing the employer ready access to cash. An on-demand bond operating in this way is also advantageous for the bondsman as it does not want to be concerned with merits of the underlying claim in respect of which the call is made. But does on-demand always mean on-demand?

If it doesn’t mean “when requested” and requires something more, the commonly perceived benefits are potentially seriously undermined. This article considers two cases, one in the Special Tribunal related to Dubai World and the other an English case in the Technology and Construction Court. Both case concern interim applications to restrain the employer from calling on an on-demand performance bond. In both cases, the applications were successful and the employers prevented from making the calls.

Recent cases

Simon Carves Limited v Ensus UK Limited [2011] EWHC 657 (TCC) relates to a process plant to produce bioethanol at a site in Teesside, in the north-east of England. The contract was an IChemE Red Book, as amended by special conditions agreed between the parties. The special conditions of the contract obliged Simon Carves to provide a performance bond “as security for all and any of the contractor’s obligations and liabilities under the contract…” The bond would become null and void, save for any pending or previously notified claims, on issue of the acceptance certificate. The contract also provided for the return of the bond once it had become null and void, save where there were pending claims. The word “claim” was not defined in the contract. However, there was a clause which stated that any claim “shall be supported by a written statement of the grounds and summary of material facts upon which it is based”.

The acceptance certificate was issued, “subject to outstanding defects being rectified as per the attached schedule and subject to resolution of liability of certain of the rectification works…” As the acceptance certificate had been issued, Simon Carves claimed that the performance bond was null and void and should be returned. Ensus UK’s position was that arguably there was a “claim” in the form of the list of defects and the bond, therefore, should not be returned.

The decision in this case confirmed, amongst other things, the following:

• Fraud is not the only ground on which a call on an on-demand bond can be restrained;

• If the underlying contract clearly and expressly prevents the beneficiary of the bond from making a demand, the beneficiary can be restrained from making a call on the bond; and

• At the interim injunction stage, the court has to be satisfied that the party seeking the injunction against the beneficiary of the bond has a strong case.

The judge granted the injunction on the grounds that Simon Carves had a strong case that the bond should be treated as null and void under the terms of the underlying contract. This was regardless of the fact that a call on the bond, as between the beneficiary and the bondsman, remained valid. This decision does not undo the principle that the bondsman need not be concerned with the provisions of the underlying contract. It does, however, mean that close attention should be paid by the employer to any terms in the underlying contract regarding the provision of and ability to call on the bond itself, as an employer may be prevented from calling on an on-demand performance bond if such a call is in breach of those terms. The Simon Carves case is clear that express provisions restricting a call are required.

The case of Bin Belaila Baytur General Contracting LLC v Nakheel PJSC and Standard Chartered Bank (DWT/APP25/ 003/2010) concerned two construction contracts relating to villa developments at Jumeirah village in Dubai, UAE. The contracts were governed by the laws of Dubai and the UAE, even though the documentation was drafted in English. Nakheel, the employer, was concerned about the slow progress of the works and issued formal notices under the contracts to that effect. It was also concerned that the contractor was short of money and Nakheel had directly paid a subcontractor. Nakheel at first delayed and then eventually ceased payment to Bin Belaila Baytur of amounts certified as payable under the contracts. Both parties purported to terminate the contract and what then developed was a dispute over who terminated the contracts and on what grounds. Nakheel then made a call on the performance bonds, for the full amount. However, before payment was made, Bin Belaila Baytur applied for an order restraining Nakheel from doing so before the final accounts had been finally determined.

In the proceedings, the judge framed the question as to whether Nakheel had bona fide legal grounds to justify its demand for payment of the full amount under the performance bonds. In answering this question, the court looked at the terms of the contracts, which limited the right to call on the bonds. The clause required the employer to give the contractor notice of “the nature of the default in respect of which the claim is to be made”. This clause was interpreted as restricting the right of the employer to call on the bond in situations where there is a bona fide claim for payment in respect of which the bond provides security, and to restrict the amount of the call to the amount of that bona fide claim for payment.

The court, in this case, was not satisfied that there were bona fide legal claims to justify the demand for payment. The judge went on to acknowledge that Nakheel had not served the appropriate notice and that the court thought that Nakheel should not have been in a better position than if it had served such notice. Again, the court was concerned with the provisions of the underlying contract which limited the right to make a demand on a bond.


What conclusions can be drawn from these decisions? Both decisions give effect to the parties’ underlying contract. The cases focus on preventing the employer from calling on the bonds in breach of contract rather than whether the employer is entitled to claim in accordance with the terms and conditions of the performance bond between it and the bondsman. So, the position of the bondsman in not having to interrogate the merits of the underlying claim in respect of which the call is made is preserved.

Even if the bond is on-demand and the demand is in accordance with the terms and conditions of the bond, the beneficiary may be restrained from making the demand if the underlying contract restricts it from doing so. During negotiation of the contract documents and prior to making a call on an existing on-demand performance bond, careful attention should be paid not only to the wording of the on-demand performance bond itself, which has been the primary focus in the past, but also to the terms of the underlying contract relating to the agreement of the contractor to provide such a bond and the circumstance in which it can be called. The best position for an employer is to have no restrictions on its ability to call on a bond. If it is unable to achieve this position, the restrictions should be carefully and unambiguously drafted to avoid the call being prevented in circumstances that the employer did not intend.

An employer needs to be aware of any restrictions in the underlying contract on the ability to call on the bond and how these may be interpreted or the employer may find that it does not have the security it thinks it has and on-demand does not in practice mean on-demand.

Gulf construction Online

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