Building Futures

Contractual security

Bonds, warranties and guarantees

Adrian Smith MEd MSc FRICS FHKIS

College of Estate Management

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, sub-

contractor, 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. Building Futures

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.

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Headline

'On-demand' bonds make

unwelcome comeback Construction Manager March 2011

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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:

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• On-demand bonds.

• Simple bonds.

• Performance bonds.

• Conditional on-

demand 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.

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. Building Futures

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 on-

demand 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! Building Futures

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 on-

demand 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 self-

evident 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.

Bond therefore remained in force. Building Futures

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). Building Futures

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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.

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).

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 on-

demand 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. Building Futures

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. Building Futures

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?