The name is Bond… On-demand Bond

A brief insight into the most used form of security in the construction industry, bonds and guarantees, after the recent judgment of Autoridad del Canal de Panamá v Sacyr, S.A. & Ors put these forms of security instruments back in the limelight.

Introduction

First and foremost, even though the industry refers to the terms “bond” and “guarantee” interchangeably, one must appreciate that they are not the same thing. Bonds come in two forms:

1) On-demand bonds

These bonds, otherwise known as simple bonds, impose a primary obligation on a third party to pay in the situation where the contractor fails to perform the building contract, without the employer having to sue the contractor and prove breach of contract. In simple terms, it is a promise to pay the bearer of the bond with no conditions attached. An IOU, but which are typically very expensive to procure.

2) Default bonds

A default bond, on the other hand, requires the employer to establish a breach on the part of the contractor for the payment under the bond to be made, and so are far less expensive than on-demand bonds. Whilst this may be called a bond, it is in fact, and rather confusingly, a form of guarantee.

The facts

The Employer engaged a consortium of companies to undertake works by designing and constructing a set of locks for the Panama Canal. Under the contract, the parties entered into different forms of guarantees each subject to English law and jurisdiction. The consortium contractor fell into financial difficulties and the Employer made various advance payments.  In return, the contractor  agreed to provide an advance payment guarantee given the Employer’s concern as to the contractor’s ability to perform the contract and repay to the employer the monies advanced, if required.

One of the conditions precedent to the contractor’s entitlement to an extension to the final repayment date of the guarantee in question was a requirement for the contractor to obtain a letter of credit.  The contractor failed to do so and the Employer therefore brought English High Court proceedings seeking a declaration that it was entitled to make demands for about $290m in the event that the advance payments remained unpaid after the final repayment date. The Employer argued that the advance payment guarantee was an on-demand bond and therefore no breach of contract on the part of the contractor was necessary to be established in order for payment under the guarantee to be made.

Held

The Court found that the guarantee in question was not an on-demand bond. Mr Justice Blair relied on the wording of the guarantee, in particular clause 2.1 which stated that:

“Each of the Guarantors, jointly and severally:

(a) as primary obligor and not as surety, unconditionally and irrevocably, jointly and severally guarantees to the Employer the payment by the Contractor of the Guaranteed Amount as and when due pursuant to the Contract; and

(b) if the Contractor is in breach of any of its obligations as set out in sub-paragraph (a), shall upon demand by the Employer from time to time, forthwith perform the obligations of which the Contractor is in breach in the same manner that the Contractor is required to perform such obligations according to the terms of the Contract.”

This wording, versions of which are commonly found in other bespoke forms of surety, clearly indicated that a demand under the guarantee had to be considered in the context of the contractor’s obligations under the principal contract. The judge concluded that this wording was contrary to the essence of an on-demand bond, rather that the instrument was a “see to it” guarantee (i.e. a default bond) in which the guarantor promises to ‘see to it’ that the principal will fulfil its obligations under the primary agreement. If the principal fails to fulfil those obligations, then the principal will be in breach under the primary agreement and the guarantor will automatically be in breach of its obligations under the guarantee in the event that they are not, in those circumstances, complied with.