What, when, how and what if: a comprehensive guide to the deterrent that construction companies hope will never be used.
Bonds and guarantees should probably be labelled, ‘Handle with care’.
Often required in construction projects, they are there to back up contract obligations and, like any good deterrent, hopefully never be used.
If activated, the consequences are potentially severe for the contractor that has its security called, or alternatively, for an employer if its security fails to respond.
So what exactly are these devices and how do they work?
Where might they be deployed?
Most commonly to protect an employer against non-performance of contract obligations. But they can also be used, for example, either where an employer makes an advance payment, to enable release of retention, or in a bid bond.
What does a bond or guarantee do?
The third party that issues the bond or guarantee promises a payment to, for instance, an employer if the contractor fails to perform a specified contract obligation.
Just how that promise is activated depends on whether it is an on-demand bond or a conditional guarantee, often referred to as a ‘performance bond’.
How do you tell an on-demand bond from a conditional guarantee?
The answer may not always be straightforward. It is not simply a matter of the words used, which may even misdescribe the bond or guarantee.
The courts will look at the real nature of the obligations involved.
The difference is important because, under a conditional guarantee, payment is normally conditional on an employer establishing liability under the relevant construction contract.
Under an on-demand bond, however, the bond issuer has a primary obligation to pay on demand, without the need to prove any default.
What key issues tend to arise?
Since default by the contractor has to be established before payment is made under a conditional guarantee, a claim under the guarantee may prompt argument as to whether the circumstances justify the call.
In contrast, a demand that complies with an on-demand bond’s terms is all that is required, and the argument may then be as to whether it really is an on-demand bond.
How is a call on an on-demand bond made?
On-demand bonds are usually payable against an appropriately worded demand, accompanied by any required supporting documents, normally without proof of liability under the construction contract.
Can a court intervene to stop a call on an on-demand bond?
The courts will only interfere with on-demand bonds in very limited circumstances, generally where there is a seriously arguable case of fraud, where it is clear that either the party calling the bond knew that it was not due or did not have any grounds for believing, in good faith, that it was due.
On rare occasions they have also granted an injunction to stop a call where the construction contract, expressly or impliedly, prevents the beneficiary from making the call.
It must, however, be clearly established that a party was not entitled under the construction contract to make the demand.
Could a bond or guarantee be put in place to pay out against an adjudication award?
In theory, yes, but with some difficulty, because an adjudication award may only be temporary and could be superseded by a subsequent court or arbitration decision that requires money, awarded and paid over, to be handed back.
Does it matter if the construction contract has been amended?
Any amendment of the construction contract will not normally release the issuer from its separate obligation to make payment under an on-demand bond.
Amendment of a construction contract supported by a conditional guarantee might, however, put enforceability of the guarantee at risk, unless protective wording is included in the bond.
Can money incorrectly paid out under an on-demand bond be recovered?
This depends on the terms of the bond and the construction contract but, in principle, recovery of money paid out may be possible if it can be proved that the reason for the call was invalid and/or that, as a result of the alleged breach of contract, the party that called the bond suffered no loss, or less than the sum called.
So what do parties need to check?
In case a call on a bond does become a reality, rather than something both parties hope will never happen, they need to be clear what it is and how it works.
Is it an on-demand bond, under what conditions can it be called, and what is the procedure?
One day it might be seriously important to know the answers.
Joseph Otoo is a senior associate and Jonathan Olson-Welsh is a partner in the construction and engineering group at Mayer Brown International