Bonds in Action - on demand and preserving your rights
Bonds are a common feature in construction and engineering projects. Their purpose is simple- to provide one party with security in the event the other party defaults. Perhaps not surprisingly, given the current economic climate, there have been a number of cases coming out of the courts on the topic of bonds. Fiona Rossetter, one of our Senior Associates, has written an article looking at these cases. The article was first published in Construction Law in April 2012.
This excerpt considers how the courts differentiate between on demand and conditional guarantees and what you need to do to preserve rights under bonds which are reaching their stated expiry date.
On demand bonds v conditional guarantees: spot the difference
The advantage of an on demand bond is that the employer does not require to provide the grantor - normally a bank - with any proof of default. The employer simply issues a demand, in the form or manner prescribed by the bond, and provided the bank is satisfied the demand has been properly served, the bank must pay the demanded sum. The employer therefore gets the benefit of access to the guaranteed funds without first having to go to the time or expense of proving the contractor's default. The bank's liability is independent to that of the contractor.
Conditional guarantees make the liability of the guarantor dependent on the underlying liability of the contractor. So the guarantor will not be required to release any funds under the guarantee without first being provided with proof of the contractor’s default which would typically be by way of an adjudicator’s decision or court judgment.
Very clear wording is required to create an on-demand, as opposed to a conditional, obligation to pay a guaranteed sum.
There is a presumption that a bond or a guarantee is not on demand unless it has been issued by a bank and takes the form of a banking instrument. Although that presumption is rebuttable, the test set by the courts is high. Simply using words such as "to pay on demand all sums due" may not be enough. The following cases illustrate how difficult it can be to rebut the presumption.
In the case of Marubeni Hong Kong v The Government of Mongolia 13 April 2005, the Mongolian Ministry of Finance guaranteed the obligations of a Mongolian company. It issued a guarantee letter which stated that it "unconditionally pledges to pay to you upon demand all amounts payable under the agreement if not paid when the same becomes due…and further pledges the full and timely performance by the buyer of all terms and conditions of the agreement".
The court had to determine whether the letter granted by the Ministry of Finance constituted an on demand or conditional obligation. Was the use of the wording "unconditionally pledges" and "upon your simple demand" enough to constitute an on demand obligation? The court took the view that it was not. The court referred to the fact there was a presumption that this was a conditional guarantee as it had not been issued by a bank. The court also considered that the reference to amounts "due" under the agreement required proof that the sums were due under the agreement: a mere assertion that they were due would not suffice.
A similar decision was reached in the case of Vossloh Aktiengesellschaft (VAG) v Alpha Trains (UK) 5 October 2010. In that case VAG were the parent company of Vossloh Locomotives. VAG guaranteed Vossloh Locomotives’ obligations under an agreement with Alpha to manufacture and supply trains. Alpha sought to enforce the terms of the guarantee against VAG. The guarantee contained wording as follows:
VAG “undertakes with each Beneficiary that whenever a Guaranteed Party does not pay any of the Secured Obligations as when the same shall be expressed to be due, the Guarantor shall forthwith on demand pay such Secured Obligations’, (emphasis added).
Alpha argued that the guarantee was on demand and they did not require to prove default on the part of Vossloh Locomotives before VAG were required to honour the guarantee. VAG disagreed. They said that Alpha required to prove breach by Vossloh Locomotives of the underlying agreement.
The court agreed with VAG. It considered that the wording in question, when looked at in light of the rest of the guarantee, required proof of default.
The message from the courts is clear: where a bond or guarantee is not being granted by a bank, if the obligation is to be on demand, the wording used must leave no room for doubt. If proof of default is not required then to avoid any doubt, that must be expressly stated.
Preserving rights on expiry
Bonds will typically be expressed as expiring on a particular date or the occurrence of a particular event, for example, completion or the end of the defects period. There is often however a carve-out for claims intimated prior to expiry. The question is what constitutes intimation of a claim? That was something the court considered in the case of Simon Carves v Ensus March 2011.
Simon Carves were employed by Ensus to design and construct a bioethanal plant on Teesside. Under the terms of the contract, which was an lChemE Red Book, Simon Carves had to provide Ensus with an on demand bond, which they did. The bond stated that it would expire on 31 August 2010. The contract however contained a provision which provided that on the issue of the Acceptance Certificate the bond would be "null and void save in respect of any pending or previously notified claims".
Following take-over, but prior to the issue of the Acceptance Certificate, a dispute arose between Simon Carves and Ensus in relation to odour emissions. Ensus issued a number of defect notices to Simon Carves. The Acceptance Certificate was then issued on 17 August 2010 and the odour emission was noted as defect on that Certificate.
Simon Carves agreed to extend the bond but under reservation of its position that the bond was, in fact, null and void as the Acceptance Certificate had been issued and no "claim" had been made by Ensus. Simon Carves then sough an injunction to prevent the bond being called upon.
Ensus argued that the defects notices, together with the note on the Acceptance Certificate, were enough to constitute a “claim” and therefore they remained entitled to rely on the bond.
Although the court did not have to finally decide the matter, this being an application for an injunction, it made the following points. "Claim" was not defined under the contract, but clause 19.5 did state that claims were to be supported by a written statement of grounds and the material facts which were relied upon. On the basis of the evidence before it, the court found that no "claim" had been made prior to the issue of the Acceptance Certificate. The court considered there was a distinction between the operation of contractual machinery, i.e. the issue of defects notices, and the making of a claim.
So where a bond is approaching expiry but there is a carve-out in respect of existing claims, to ensure that rights are preserved, proper notice must be given of the claim in accordance with any underlying contractual definitions.
