A recent High Court case suggests that the courts will require clear and unambiguous words to establish that a performance bond or guarantee was intended to be payable merely on demand, as opposed to on the default of a contractor.
Performance bonds are a familiar feature of the construction industry. In the construction context, a performance bond is a form of security, generally provided by a contractor to an employer, consisting of an undertaking by a third party (known as the "bondsman" or the "surety") to make a payment to the employer in specified circumstances. There are two main categories of performance bond - "conditional" and "on demand", which differ as follows:
- Under an "on demand" bond the bondsman (ordinarily a bank) is required to pay out whenever the employer demands payment, irrespective of whether or not the contractor is in default under the underlying construction contract. A bondsman can only refuse make payment on a regular demand for payment if the demand is clearly made fraudulently or dishonestly. Although many UK contractors are reluctant to provide "on demand" bonds for domestic projects, they are used widely in international projects.
- Under a "conditional" bond the bondsman is only required to pay out if the contractor is in default under the underlying construction contract. "Conditional" bonds are a common feature of construction works undertaken within the UK, in which circumstances the bondsman will often be an insurer or the parent company of the contractor (as in the case discussed below).
Given the fairly arcane law in this area and obscure wording of many bonds, the courts often have difficulty in working out whether a bond is "on demand" or "conditional". Historically, the courts used a complex set of rules drawn from banking law to decide whether or not a bond was "on demand". Fortunately, in recent years the courts have increasingly said that principles drawn from the banking cases are of only limited applicability in performance bond cases involving the construction industry - these cases often turn on very different facts and the drafters of the agreements will often be unfamiliar with the more technical aspects of banking law. The courts stress that given the onerous nature of the bondsman's obligation under an "on demand" bond, only clear words will suffice to establish that the parties intended a bond to be "on demand" rather than "conditional".
The Vossloh Case
This modern trend is evidenced by a recent High Court judgment
in Vossloh. The claimant was the parent company of a group of
companies that manufactured locomotive rolling stock. One of
the claimant's subsidiaries contracted to supply the defendant
with a number of locomotives. The claimant provided a parent
company guarantee (the "Guarantee") in favour of the
defendant, which guaranteed the performance of the contracted
works. The defendant subsequently alleged that the
locomotives were faulty, and made a call on the
Guarantee.
At the time of the call the defendant had neither established in
court the liability of the claimant's subsidiary nor shown that
it had expended any money in repairing the locomotives. It
followed, therefore, that the only way that the defendant could
make a call on the Guarantee was if it showed that the Guarantee
was similar to an "on demand" bond, rather than a
"conditional" bond. The Guarantee stated that if
the claimant's subsidiary did not make payment to the defendant
against a secured obligation when the same was said to be due, the
claimant would be obliged to pay such sums as were said to be due
"on demand", and that all sums payable under the
Guarantee were to be payable "on demand".
Despite the use of the words "on demand", the High Court
held that a proper reading of the Guarantee showed it to be a
"conditional" bond, and that accordingly the defendant
had first to establish the liability of the claimant's
subsidiary in the sums claimed before it could make a valid call on
the Guarantee.
Commercial Implications of Vossloh
- The courts will generally only find that there is an "on demand" bond where it is clear on a proper interpretation of the document as a whole that the parties intended the liability of the bondsman to exist separately from the underlying liability of the contractor. The use of the words "on demand" will not in every case suggest that a bond is in fact "on demand" in nature, if it is clear that on a proper construction of the bond the parties intended it to be "conditional". A bond may provide that if certain conditions are fulfilled (e.g. the contractor being in default) then the bondsman will make payment "on demand". In such a case the bond is not truly "on demand" because of the preconditions to any call on it.
- Parties to bonds should be very careful to ensure that the wording of a bond or guarantee properly expresses their intentions. It was implicit in Vossloh that if the Guarantee in question were found to be of an "on demand" nature, the call on it would have to be honoured, even though liability and quantum remained to be established. As we have stressed in previous Law- Now articles, contractors should be alive to what giving an "on demand" bond entails.
- From a bondsman's perspective, having clear wording in a bond is every bit as important to it as it is to the beneficiary of the bond, so that the bondsman knows when it is required (or not required) to make payment when a demand is made on the bond.
- A further matter, in the international context, is that performance bonds will usually specify the governing law and jurisdiction to apply to the bond, which will usually be the home jurisdiction of the bondsman. Courts in many jurisdictions are unfamiliar with the nuances of bond wording and its significance, whereas in England there is an established body of knowledge on the meaning of particular wordings. Choice of jurisdiction is therefore particularly important.
Reference: Vossloh Aktiengesellschaft v Alpha Trains (UK) Ltd [2010] EWHC 2443 (Ch)
This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq
Law-Now information is for general purposes and guidance only. The information and opinions expressed in all Law-Now articles are not necessarily comprehensive and do not purport to give professional or legal advice. All Law-Now information relates to circumstances prevailing at the date of its original publication and may not have been updated to reflect subsequent developments.
The original publication date for this article was 18/10/2010.
