Contractual security
Bonds, warranties and guarantees
Adrian Smith MEd MSc FRICS FHKIS
College of Estate Management
Building Futures
Why contractual security?
• To provide some reassurance that contractual
obligations will be honoured.
• Provided, often as options, by some forms of
contract (e.g. FIDIC and NEC3).
• May apply to the main contract, to sub-contracts
or to service contracts e.g. consultancy
appointments.
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Problems
• Understanding what protection is
available.
• What should be used when?
• Issues with drafting of the documents.
• Common pitfalls.
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Definitions
Guarantee:
An undertaking of: “if he does not do X, then I will”
Warranty:
An assurance that specific facts or conditions are true
or will happen. The other party may rely on that
assurance and seek a remedy if it is not true.
Bond:
An arrangement where the performance of a
contractual duty by one party (the principal) to another
(the beneficiary) is backed up by a third party (the
bondsman, surety or guarantor).
A bond is therefore a form of indemnity
( Alfred McAlpine v Unex Corporation (1994)) Building Futures
Purpose of bonds
So what might we want a bond for?
Usually either:
• to provide security for the contractor’s
performance;
• to secure payment eg retention or advance
payment bonds;
• to cover specific obligations eg bid bonds.
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How do bonds work?
The principal (usually a contractor, subcontractor, or consultant) pays the surety (the
bondsman) a fee in order to guarantee his
obligation to the beneficiary (usually the client).
If the obligation is not performed, then the surety
compensates the beneficiary for the loss.
The surety will then attempt to recover his losses
from the principal under a counter-indemnity.
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Contractual requirements
What if the contractor fails to provide a bond
required by a contract?
Where contracts specifically require contractors to
obtain bonds, failure is a breach sufficient to allow
termination of the contract. Swartz and Son (Pty)
Ltd v Wolmaranstadt Town Council (1960).
It was the view of the court in Sweett v Michael
Wight Homes (2012) that the employer would be
justified in withholding the value of the bond from
payments due to the contractor.
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Contractual requirements
What if a contract administrator fails to secure a
bond from the contractor?
May amount to professional negligence. Convent
Hospital v Eberlin & Partners (1990)
But see also Sweett v Michael Wight Homes
(2012)
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Sweett (UK) Ltd v Michael Wight
Homes Ltd (2012)
• Sweett were Employers Agent under a JCT 2005 Design
and Build Contract and agreed to “prepare contract
documentation and arrange for its execution”.
• There was a contractual requirement for a bond.
• Contractor went into liquidation. No bond.
• Case began as Sweett suing for their fees after the
employer failed to pay. Employer counterclaimed that
Sweett were guilty of negligence in failing to ensure a
bond was in place.
• Sweett found to have no liability because they had
merely agreed to “arrange” execution not to “ensure”.
• Therefore no absolute obligation.
(cont’d)
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Sweett (UK) Ltd v Michael Wight
Homes Ltd (2012)
Court’s reasoning:
• Sweett had made it an obligation under the contract
for Contractor to provide a bond;
• Sweett kept the Employer informed that the
contractor had not provided one;
• Sweett had continually chased the Contractor for
the bond, and contractor had given assurances that
it was “in progress”;
• Employer had not pressed Sweett to take any
further action;
• Work was progressing well on site and no-one
seemed unduly concerned.
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Bonds - basic legal principles
Principle 1 - Primary obligation
A true on-demand bond
• An undertaking to pay a sum of money to the employer
without any reference to the liability of the contractor.
• Only constraint is that the call must not be fraudulent.
• Therefore unless there is clear evidence of fraud,
payment must be made. Balfour Beatty Civil
Engineering v Technical and Guarantee Co Ltd (2000).
• There is a presumption that a bond is not “on-demand”
unless it is issued by a bank. Not strictly true, but most
are.
Building Futures
Headline
'On-demand' bonds make
unwelcome comeback
Construction Manager March 2011
Building Futures
Bonds - basic legal principles
Principle 2 – Secondary obligation
Usually called a Default Bond.
Liability is contingent upon proof of a breach
by the contractor.
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Bonds and Guarantees
Much confusion over the terminology:
•
•
•
•
On-demand bonds.
Simple bonds.
Performance bonds.
Conditional ondemand bonds.
• Surety bonds.
• Surety guarantees.
• Parent company
guarantees.
• If there is a dispute what matters is what they
are, not what they are called.
• The court will decide on the basis of the wording
of the document.
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Marubeni HK and South China v
Government of Mongolia (2005)
• Government of Mongolia Ministry of Finance
guaranteed the obligations of a Mongolian company.
• Issued a letter stating that it “…unconditionally
pledges to pay to you upon demand all amounts
payable if not paid when they become due [and]
pledges the full and timely performance by the buyer
of all terms and conditions of the agreement”
• Court decided this was not an on-demand bond
because the reference to monies “not paid when
they become due” would require proof that payment
had not been made.
• The document was therefore a default bond.
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VAG v Alpha Trains (UK) (2010)
• VAG were the parent company of Vossloh
Locomotives, and guaranteed its obligations to
supply trains to Alpha.
• Guarantee said that VAG “undertakes…that if
[Vossloh] fails to pay any secured obligations
when [they] are expressed to be due then
[VAG] shall forthwith on demand pay…”
• Is this an on-demand bond?
• No! It requires proof of failure to pay.
• It is therefore a default bond
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Clough Engineering Ltd v Oil and
Natural Gas Corporation (2008)
• Contract concerned development of an oil and gas
field off the Indian coast.
• Contract required Clough to provide an
unconditional and irrevocable bond for 10% of the
contract sum “…in the event of the contractor failing
to honour any of the commitments entered into
under this contract”.
• Disputes arose, which caused ONGC to terminate
the contract and call on the bond.
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Clough Engineering Ltd v Oil and
Natural Gas Corporation (2008)
• Bond stated that the bank would pay on first
demand “….on breach of contract by the
contractor without any demur, reservation,
contest or protest or reference to the
Contractor”.
• Clough argued that the wording prevented a
claim on the bond because breach had to first
be proved.
• Rejected at first instance and also on appeal.
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Lesson…..
• On-demand bonds, particularly if not issued
by a bank, require absolutely clear wording
which leaves no room for doubt.
• If proof of default is not required then the bond
must clearly say so.
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On-demand bonds
“I promise to pay you £x on receipt of your written
request without prior proof of any conditions”.
• Automatically payable once a request has been
made.
• Can be risky - no proof of default required.
Edward Owen Engineering v Barclays Bank (1978)
• English supplier provided an on-demand bond to a
Libyan customer to cover default on a contract
• Customer himself defaulted, and called in the bond
• Court found that the bond must be honoured.
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Conditional on-demand bonds
Pure on-demand bonds are comparatively
rare. Most will have some conditions attached:
• a statement from the architect or engineer that
the contractor hasn’t performed;
• a warning notice served on the contractor;
• and so on….
Therefore they are called conditional ondemand bonds.
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AES-3C Maritza East 1 Food v
Credit Agicole Bank (2011)
• An on-demand bond stated that it was payable against
an appropriately worded demand accompanied by any
notice to the contractor relating to breaches of
obligations to which the demand referred.
• Maritza claimed €97m enclosing notices amounting to
€27m. Bank refused.
• Maritza then resubmitted claiming €96.6m and
enclosing notices for the same amount. Bank paid
€96.6m.
• The bond was on-demand, and required no proof that
the amounts were due, but it was conditional upon the
notices being served in the correct form.
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Trafalgar House Construction
(Regions) Ltd v General Surety &
Guarantee Co Ltd (1995)
• Document described as a bond, and
treated as a default bond at first instance.
• Court of Appeal decided it was actually an
on-demand bond.
• Finally the House of Lords decided that it
was really a guarantee.
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Guarantees
Under English law, a contract of guarantee must
as a minimum be evidenced in writing (s4 Statute
of Frauds 1677).
The memorandum must:
• identify the parties;
• include the material terms;
• be signed by the party to be charged
(defendant).
It must also be made as a deed, otherwise it will
not be enforceable..
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Guarantees
Actionstrength Ltd. v International Glass
Engineering (2003)
Actionstrength were a sub-contractor – main
contractor became insolvent.
Employer promised to pay Actionstrength
direct if they would complete their work.
Employer subsequently refused to pay Actionstrength sued on the basis of the
employer’s promise
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Guarantees
Court said “no”!
Employer’s offer was not recorded in writing,
and could therefore not constitute a legal
guarantee.
Do not be persuaded by oral assurances from
third parties.
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Guarantees
Kleinwort Benson Ltd v Malaysia Mining
Corporation Bhd (1989)
“it is our policy to ensure that the business of
[the subsidiary] is at all times in a position to
meet its liabilities to you [under the loan
agreement]”.
Subsidiary became insolvent. Kleinwort
Benson went to the defendant for payment.
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Guarantees
Kleinwort Benson Ltd v Malaysia Mining
Corporation Bhd (1989)
Court of Appeal held that there was no
obligation created by the letter.
It expressed an intention at the time the letter
was written and not a promise that the policy
would continue.
Lesson:
If you want a guarantee, make sure that you
get one!
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Calls on the bond
The bondsman will only pay out if:
• any conditions have been met;
• if the bond actually covers the
circumstances of the case;
• in the case of a default bond, if it can be
proven that the default has in fact
occurred.
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Examples
Perar BV v General Surety and Guarantee (1994)
A general performance bond to guarantee the obligations
of a design and build contractor.
Bond conditional upon the contractor’s default.
Contractor went into administrative receivership so
contractor’s employment automatically terminated, but
contract not terminated.
Held by the Court of Appeal that “default” meant “breach
of contract”, and the contractor’s insolvency did not
constitute default.
Bond did not therefore cover the circumstances of the
case.
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Examples
Following Perar, bond wording altered to include
contractor’s insolvency as well as default.
Such a bond used in a similar form of contract in
Paddington Churches Housing Association v Technical
and General Guarantee (1999).
Bond promised to reimburse the employer’s “net
established and ascertained damages”.
Held however that these could not be calculated until the
works had been completed by another contractor, and a
full statement of account drawn up.
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Resisting calls on the bond
Why would you want to?
Because once a successful call is made the
bondsman will immediately claim his money
back under the counter-indemnity.
Counter indemnities are almost always written
in strictly on-demand terms
So what can be done?
Very difficult with pure on-demand bonds.
Easier with conditional or default bonds
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Resisting calls on the bond
The Guarantor guarantees to the Employer that, in the
event of a breach by the Contractor, the Guarantor shall
satisfy and discharge the damages sustained by the
Employer as established and ascertained in accordance
with the provisions of the Contract and taking into account
all sums due or to become due to the Contractor.
Can it be proved that there has been a breach?
Can you put enough doubt into the bondsman’s mind?
Are the damages claimed “established and ascertained”?
Does this require a decision of a Court or an arbitrator?
Are there any sums due to the Contractor?
Have they been ascertained and agreed?
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Variations
In general, it is a basic rule of most forms of
guarantee that any variation to the risk covered
will invalidate the guarantee.
Not applicable in the case of pure on-demand
bonds because no proof of default is required.
Is an issue in the case of conditional ondemand and default bonds.
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Variations
So what about variations in construction
contracts?
For example where a contractor is initially
engaged to complete a project on a shell and
core basis, and is subsequently instructed to
carry out fitting-out work as well?
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Variations
Historic position set out in Holme v Brunskill
(1878)
“If there is any alteration to the terms of the
guaranteed contract, the surety ought to be
consulted and his consent sought. If the surety
does not consent then the surety is
discharged….except in cases where it is selfevident that the alteration is unsubstantial or
must be beneficial to the surety”
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Variations
The Wardens and Commonality of the Mystery of
Mercers of the City of London v New Hampshire
Insurance (1991)
Contractor entered into an advance payment bond for
£4.5m. Contractor subsequently went into liquidation and
employer claimed on the bond.
However, employer had failed to give possession of the
site until 10 weeks after the contractual date, and so was
claimed by the bondsman to be in breach of contract.
Bondsman refused to pay .
High Court agreed.
Court of Appeal disagreed. Default was insufficient to
constitute a repudiatory breach.
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Bond therefore remained in force.
Variations
What if there had been a fixed end-date on
the bond in New Hampshire Insurance and
the completion date (and the need to call on
the bond) occurred after this date?
Would the bond have still been available?
Highly unlikely!
Watch out for the knock-on effect of any
variation.
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Solution…
Either draft a bond which provides for
variations to the construction contract (such
as the standard FIDIC form).
OR
Keep the bondsman informed of all significant
variations and seek his advice and consent.
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Drafting and interpretation
Historically, the courts took the view that in cases of
ambiguity a guarantee should be strictly construed in
favour of the guarantor.
“…the court [will] in case of doubt lean in [the surety’s]
favour. Neither equity nor law will put a construction on
the document which results in imposing on the surety any
more than….he must be said expressly to have
undertaken….” Hilbery J. in Eastern Counties Building
Society v Russell (1947).
Later qualified as “a fair but strict reading of the language
of the guarantee” First National Finance Corp. v Goodman
(1983).
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Drafting
But beware ambiguity…..
Rainy Sky S.A. v Kookmin Bank (2011)
Rainy Sky and others entered into ship-building contracts
with Jinse Shipbuilding in Korea.
Jinse procured an advance payment bond from Kookmin
Bank in return for advance payments from the buyers.
Jinse became insolvent and Rainy Sky attempted to
reclaim their advance payments under the bond.
Kookmin refused to pay on the grounds that the bond did
not cover the specific circumstances of the insolvency.
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Drafting
Dispute was about how the words used in the
bond contract should be interpreted.
In his judgment (p.8), Lord Clarke states:
“The issue between the parties….is the role to be
played by considerations of business common
sense in determining what the parties meant….” .
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The purposive approach
Courts have moved to a purposive approach to the
interpretation of contracts. They will look beyond the bare
words used.
“In order for the agreement….to be understood, it must be
placed in context. The time has long passed when
agreements….were isolated from the matrix of facts in
which they were set and interpreted purely on internal
linguistic considerations….We must inquire beyond the
language and see what the circumstances were with
reference to which the words were being used, and the
object….which the person using them had in view.” Lord
Wilberforce in Prenn v Simmonds (1971).
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The purposive approach
“If detailed and syntactical analysis of words in a
commercial contract is going to lead to a conclusion
that flouts business common sense it must yield to
business common sense”. Lord Diplock in The Antaios
(1976)
Kookmin Bank therefore lost their argument, and the
bond was enforced.
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When does liability under the
bond expire?
• Typically on a given date, or upon the
occurrence of a particular event, eg
completion of the contract, end of the
defects liability period etc.
• There will typically be provisions to cover
claims made prior to expiry.
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Examples
De Vere Hotels v Aegon Insurance (1998)
• Bond stated that it would end upon the issue of a
certificate of practical completion.
• Contractor bankrupt and his employment therefore
terminated.
• A second contractor appointed to complete the work,
and a certificate of practical completion issued.
• Employer claimed against the bond for losses arising
from the first contractor’s bankruptcy – bondsman
refused to pay on the grounds that their liability ended
once the practical completion certificate was issued.
• Court said no.
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Simon Carves Ltd v Ensus UK
Ltd (2011)
• Construction of a bioethanol plant in the UK.
• Contract was IChemE Red Book.
• Simon Carves (contractor) provided an ondemand bond expiring on the 31st August 2010.
• Contract 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 handover, but before the issue of the
acceptance certificate, a dispute arose concerning
odour emissions.
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Simon Carves Ltd v Ensus UK
Ltd [2011]
• Ensus issued a number of defect notices.
• Acceptance certificate issued on the 17th August
2010, and odour emissions were listed as a defect.
• Contractor agreed to extend the bond, but reserved
its position that the bond was null and void since
the acceptance certificate had been issued and no
claim had been made.
• Contractor then sought an injunction to prevent
calls on the bond.
• Ensus argued that their defect notices and defects
list constituted a claim, and that they were therefore
entitled to rely on the bond.
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Simon Carves Ltd v Ensus UK
Ltd [2011]
• Court made a distinction between the
operation of the contract and the bond.
• Operation of the contract did not constitute a
claim on the bond, and a separate claim
was required.
• Contractor’s injunction was therefore
granted.
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An interesting footnote….
What if a claim is made, and paid, by an
employer on an on-demand bond, but the
contractor believes the amount paid is
excessive compared to the actual
employer’s loss?
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Spiersbridge Property Dev’t v
Muir Construction (2008)
A construction contract in Scotland.
Muir arranged for an on-demand bond with Bank
of Scotland for 10% of the contract sum
(£590,000) in the event that they failed to perform
all of the conditions of the contract.
Spiersbridge claimed under the bond, and were
paid in full.
The Bank then reclaimed the £590,000 from
Muir, under their counter-indemnity, and Muir
paid in full.
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Spiersbridge Property Dev’t v
Muir Construction (2008)
Muir however argued that the amount paid out under
the bond was significantly greater than the loss
Spiersbridge could have suffered as a result of their
breach, and that as a result Spiersbridge had made an
unjustified gain at their expense.
They therefore argued that a term should be implied
into the construction contract requiring Spiersbridge to
account for that gain, and that they should only be
entitled to keep an amount equal to their actual losses.
The remainder to be returned to Muir.
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Spiersbridge Property Dev’t v
Muir Construction (2008)
Muir’s argument relied on two questions:i) In contract, is there a common-law duty to account
for such payments?
ii) If the payment made under the bond is greater than
the loss sustained, is the payee entitled to keep it?
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Spiersbridge Property Dev’t v
Muir Construction (2008)
Is there a common-law duty to account?
“….it seems to me implicit in the nature of a bond….that,
in the absence of some clear words to a different effect,
when the bond is called, there will, at some stage in the
future, be an ‘accounting’ between the parties in the
sense that their rights and obligations will be finally
determined at some future date.”
Morrison J. in Cargill International v Bangladesh Sugar &
Food Industries (1996) later confirmed by the Court of
Appeal in Comdel Commodities Ltd v Siporex Trade
(1997)
So yes.
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Spiersbridge Property Dev’t v
Muir Construction (2008)
If the payment made under the bond is greater than
the loss sustained, is the payee entitled to keep it?
“…I take the view that if there has been a call on a
bond which turns out to exceed the true loss
sustained, then the party who provided the bond is
entitled to recover the overpayment.
Lord Denning in State Trading Corporation of India
Ltd v E.D. & F Man (Sugar) Ltd (1981)
So no.
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Spiersbridge Property Dev’t v
Muir Construction (2008)
“….absent clear words to the contrary, I would
expect that in the normal case the calling of a bond
will be followed in due course by an accounting
under which the party receiving payment…. will
retain only the amount of his proved losses.”
Lord Glennie in Spiersbridge v Muir (2008)
He therefore decided that a term should be implied
into the main contract requiring the payment to be
accounted for.
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Warranties
An assurance from one party to another that
specific facts or conditions are true or will
happen.
The other party may rely on that assurance
and seek a remedy if it is not true.
Typically used on projects where property
developers immediately sell on completed
schemes to third party purchasers.
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Why collateral warranties?
Because a contractual arrangement provides
opportunities to recover economic losses
which would not normally be recoverable in
tort.
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Who needs them?
• Funders to provide a direct right of action
against design teams in the event of
defects in design.
• Employers to provide a direct right of action
against sub-contractors.
• Third party purchasers to provide a right of
action against contractors in the event of
defects.
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Safeway Stores v Interserve
Project Services (2005)
•
•
•
•
Chelverton Properties were property developers.
Interserve were their contractors.
Safeway were the third party purchasers.
Interserve entered into a warranty with both
Safeway and Chelverton.
• “The contractor shall owe no duties or have any
liability under this deed which are greater or of
longer duration than that which it owes to the
developer under the building contract”.
• Intention is clearly that the contractor takes no
more risk under the warranty than under the
building contract.
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Safeway Stores v Interserve
Project Services (2005)
• There was a dispute between Chelverton and
Interserve over defects to the two storey car park,
which was resolved by a deduction from the final
account.
• Chelverton became insolvent before paying the
balance of the final account (£1.2m).
• Safeway then paid £400k to rectify the defects and
sought to recover under the warranty.
• Interserve successfully claimed that since they
would not have been liable to Chelverton for the
costs, they should have no liability to Safeway
under the terms of their warranty.
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Questions?
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