CONSTRUCTION DISPUTE AVOIDANCE NEWSLETTER (number 49)

CONSTRUCTION DISPUTE AVOIDANCE NEWSLETTER (number 49) BONDS AND GUARANTEES In difficult economic times, procuring security for performance of obligations will be a significant concern for many parties to the construction process. Two principal types of security are available to protect employers against contractors failing to perform their obligations, or becoming insolvent, or both. The two types of security documents are a performance guarantee and a performance bond. What is the difference between them? MARCH 2013 Tokyo office RECENT PUBLICATIONS Performance Guarantees On-demand Performance Bond Performance Bond: On-demand or Conditional? The use of Uniform Rules The Problems of Variations Form of Bond Conclusion Contacts Please click here to request a hard copy. Performance Guarantees A guarantee is normally given by a third party bank or other financial institution although in some cases a parent company may be the guarantor. The guarantee provides that the performance of the obligations in an underlying contract is guaranteed so that, if a contractor fails to perform or pay money, the guarantor will be responsible for the performance of the obligation. His liability is therefore secondary to the obligation of the contractor in the underlying contract. RELATED LINKS > Herbert Smith Freehills > Our construction and engineering disputes practice > Our Tokyo office An example of a performance guarantee can be found at Annex D to the FIDIC red book. The features of this guarantee are as follows: A "Bond Amount" is specified; typically this is 10% of the contract sum. The Bond Amount may reduce upon the issue of the taking over certificate for the whole of the works. The guarantor will satisfy the damages sustained by the employer upon proof of breach by the contractor of his contractual obligations or on the occurrence of any of the matters specified in clause 15.2 (termination by employer). These include the contractor becoming insolvent or giving a bribe, which are not in themselves breaches of contract. Page 1

There is a "waiver" clause providing that the guarantor's obligations are not discharged by any allowance or indulgence on the part of the Employer or by any variation or suspension of the works or by any amendments to the underlying contract. This is intended to overcome the rule in Holme v. Brunskill referred to below. An "Expiry Date" is specified, normally six months after the expiry of the defects notification period for the works. Any claim under the guarantee not received by the guarantor before this date is ineffective. The Uniform Rules for Contract Bonds published by the ICC apply to the guarantee. On-demand Performance Bond By contrast, liability under an on-demand performance bond (of which an example can be found at Annex C to the Red Book) is not dependent upon proof of breach of obligations by the contractor. Liability is therefore primary. The features of this type of security are as follows: A "guaranteed amount" is fixed. Sums not exceeding the guaranteed amount are to be paid upon receipt by the guarantor of a demand in writing and a written statement stating that the contractor is in breach of his obligations under the contract and the respect in which he is in breach. The demand must be signed by the employer and authenticated by its bankers. The demand and statement must be received on or before an "expiry date" whereupon the bond expires. Later demands will be ineffective. The employer may require the contractor to extend the bond if the performance certificate under the contract has not been issued by 28 days before the expiry date. The bond is subject to the Uniform Rules for Demand Guarantees published by the ICC. Performance Bond: On-demand or Conditional? The question of whether a bond is properly to be classed as "on demand" or "conditional" on performance of obligations can be crucial to the prospects of recovery. If a bond is properly described as "on demand" then there is no need to show that a breach of obligation in the underlying contract has occurred and recovery should be forthcoming upon service of a demand in the proper form. A number of recent cases in the English Courts have addressed the issue of the distinction between these two types of security but there are indications that the courts are becoming concerned at the increasing complexity of arguments on this issue and the growing case law. In the most recent case, Wuhan v. Emporiki (Court of Appeal 19 December 2012) the Court of Appeal referred to a well-known text book and set out four features which give rise to a presumption that the bond is on-demand. These are: INDEX OF PREVIOUS NEWSLETTERS February 2013 Retention of title clauses January 2013 Asia Quarterly Edition: Claims arising from Delays and Scope changes December 2012 ADR in construction disputes: arbitration and disputes boards are not the only answer November 2012 FIDIC subcontract 2011: A critique of the alternative dispute resolution procedures October 2012 Asia Quarterly Edition: Contractual rates of interest in construction contracts September 2012 FIDIC Sub-Contract: First Edition August 2012 A Significant New Decision: Walter Lilly v Mackay July 2012 July 2012 Asia Quarterly Edition: Challenges in the enforcement of dispute board decisions June 2012 EPCM contracts: a more sophisticated procurement methodology? May 2012 Limiting liability April 2012 Asia Quarterly Edition: Notice Requirements in Construction Contracts A Southeast Asia perspective March 2012 Force majeure clauses: FIDIC, ENAA and drafting bespoke clauses It relates to an underlying transaction between parties in different jurisdictions; and It is issued by a bank or similar financial institution; and It contains an undertaking to pay "on demand" (with or without the words "first" and/or "written"); and It does not contain clauses excluding or limiting the defences available to a guarantor In the Wuhan case it was found that the first three characteristics existed and therefore the bond was in an on demand form. It remains to be seen what attitude the courts will take where a lesser number of features is present and there are other indications that the bond is intended to be given by way of guarantee only. It follows that prospective beneficiaries of security documents should be vigilant to ensure that they are getting the protection they expect. A "mix and match" approach where the Page 2

security document contains some features referable to an on-demand bond and some to a performance guarantee will give rise to uncertainty. Restraints of Calls on Bond From a beneficiary's point of view, an on-demand bond is a powerful weapon. There is no need to prove breach of the underlying contract and, in theory at least, only a demand is needed to trigger payment. However there are some limitations on the beneficiary's power to call the bond as follows: The demand must be in strict accordance with the terms of the bond whether as to form, timing or documents required to be annexed AES v Credit Agricole (2011) BLR 249. If the bondsman is able to prove fraud on the part of the beneficiary, an injunction may be granted to restrain a call on the bond Edward Owen v. Barclays Bank (1978) QB 159. In some common law jurisdictions an injunction against a call has been granted on the grounds of unconscionability on the part of the beneficiary JBE Properties v Gammon (2011) 2 SLR 47 (Singapore). If the underlying contract between the employer and contractor prevents the beneficiary making a demand under the bond, an injunction may be available to prevent the call Simon Carves Ltd v. Ensus UK Ltd [2011] EWHC 657. In this case the contract stated that the bond would become null and void after the issue of an acceptance certificate. An injunction was granted to prevent a call after that date on the grounds that the underlying contract expressly disentitled the beneficiary from making a call. The use of Uniform Rules As mentioned above, on-demand bonds commonly incorporate the ICC Uniform Rules for Demand Guarantees last revised in 2010. These are produced by the ICC with a view to striking the most reasonable balance between the interests of all the parties involved through setting out rules by which those parties abide when interpreting and enforcing on-demand bonds. Some features of the rules are: A bond is independent of the underlying contract and the undertaking of a surety to pay under the bond is not subject to claims or defences arising from any relationship other than between the guarantor and the beneficiary. If the bond permits a demand to be made in electronic form, it should specify the format and the electronic address for the demand. If the bond is silent as to whether the demand must be made in electronic or paper form, it must be made in paper form. A demand must indicate in what respect the contractor is in breach of its obligation under the underlying contract and this information may be provided in a separate document to the demand. This requirement may be excluded by the terms of the bond. A non-compliant demand does not result in the loss of the right to make a subsequent compliant demand unless the bond excludes this right. Unless otherwise provided a surety must determine that a demand is compliant (or not) within five business days following its presentation. It must give notice of rejection to the beneficiary within that time or it will be precluded from claiming that there has been a non-compliant demand. If no expiry date is stated, the bond terminates after three years from the date of issue. The Problem of Variations Another significant issue in relation to security documents is the rule that variation of the underlying contract whether by written agreement or conduct may serve to discharge the security. In common law jurisdictions this rule dates back to the case of Holme v. Brunskill (1877) 3 QBD 495 and was well illustrated by the recent English case of Aviva v. Hackney Empire (Court of Appeal, 19 December 2012). In this case the contractor had fallen into delay but claimed for loss and expense and entered into negotiations with the employer. The employer agreed to advance further sums on account of any potential liability but without any admission. A side letter recorded this arrangement. However the contractor subsequently became insolvent and the employer sued the guarantor for losses sustained as a result of the contractor's failure to perform. The Court of Appeal decided that the payments made under the side letter were extra-contractual and did not discharge the guarantor's liability. Losses sustained as a result of breaches of the underlying contract could be recovered from the guarantor notwithstanding the provisions of the side letter. However the sums paid under the side-letter could not be recovered under the guarantee as they did not relate to obligations in the underlying contract. Page 3

Form of Bond Many countries make provision for bonds or guarantees to be in a specific form or to be executed in a particular way. The English Statute of Frauds 1677 which is still in force is an example. It requires an agreement constituting a guarantee or some memorandum or a note of it to be in writing and signed by the party to be charged therewith. Therefore a purely oral guarantee or one not fully evidenced in writing will be unenforceable. This issue was addressed in the recent case of Golden Ocean v. Salgaocar Ltd [2011] EWHC 56. There had been a long sequence of correspondence between the parties conducted by email. The correspondence related to a ship charter and involved the beneficiary, the debtor and the guarantor. There was a close connection between the debtor and guarantor. The correspondence was conducted by email and there had been a consistent reference to the guarantee throughout. The last item in the sequence of correspondence confirmed the final issues relating to the charter, not the guarantee which had already been agreed. It was not disputed that email correspondence can amount to "writing". However there was a dispute as to whether the guarantee was evidenced in writing. The Court held that since the guarantee had been repeatedly referred to in earlier correspondence which eventually agreed it, an agreement in writing was reached at that stage. There was nothing objectionable in such an agreement being recorded in the contents of a sequence of correspondence partly relating to other matters. Conclusion Bonds and guarantees can be a useful weapon in the employer's armoury of resources for obtaining redress in the case of breach of contract or insolvency of the contractor. However, these security documents must be carefully drafted to ensure they provide the required degree of protection. A contractor will factor the cost of provision of a bond or guarantee into his bid and if the security offered is not of sufficient strength, then the employer should insist on revisions since otherwise he will be paying upfront for a lesser level of protection than anticipated. As the project progresses the employer must ensure that he does not inadvertently invalidate the bond or guarantee, for example by varying the underlying contract without the protection of a "waiver" clause. All cases referred to are English unless otherwise stated. Page 4

Contacts Peter Godwin (managing partner) T +81 3 5412 5444 peter.godwin@hsf.com Emma Kratochvilova (partner) T +81 3 5412 5412 emma.kratochvilova@hsf.com Dominic Roughton (partner) T +81 3 5412 5432 dominic.roughton@hsf.com Brad Strahorn (senior associate) T +81 3 5412 5453 brad.strahorn@hsf.com David Gilmore (partner) T +81 3 5412 5415 david.gilmore@hsf.com To ensure that you continue to receive this newsletter, please let us know if you change your contact details (email new details to emma.kratochvilova@hsf.com). To unsubscribe, click here. Should you wish to discuss any of the issues outlined in this newsletter, or any other legal issues that may be relevant to your business, please do not hesitate to contact us. Herbert Smith Freehills LLP 2013 The contents of this publication, current at the date of publication set out above, are for reference purposes only. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action based on the information provided herein. Page 5