Bonds and guarantees are forms of security. The security is provided by a third party so in a typical arrangement, A contracts with B but A also enters into a separate agreement with C to protect itself against any failure by B. There are different types of bonds and the exact wording of the bond instrument is crucial in determining this as exemplified by the case of Caterpillar Motoren GmbH & Co KG v Mutual Benefits Assurance Company

An on demand bond is a form of security obliging the bondsman to pay simply on demand but usually accompanied by documentation as prescribed by the bond.  The issuer's obligations are not affected by disputes over the underlying contract between the beneficiary and the primary obligor, and the beneficiary is usually entitled to payment simply on submitting a statement that the primary obligor has failed to perform the contract.

On conditional bond is one which is expressed to be “conditioned” upon a particular event or events and commonly upon the satisfactory performance of the contractor. If in substance the bond guarantees the contractor’s performance, the employer has to establish damages occasioned by the breach or breaches of conditions and, if it succeeds, it recovers the amount of the damages proved.

A hybrid bond is one which contains both “on demand” language and “conditional” language. The problem with hybrid bonds is that they can be difficult to interpret, leading to uncertainty as to their effect – far from ideal for an instrument that is supposed to provide security to an employer if the contractor fails to carry out the works in accordance with the contract.  This is exactly what happened in this Caterpillar Motoren GmbH & Co KG v Mutual Benefits Assurance Company.

The facts were straightforward. The claimant, Caterpillar, entered into contracts to deliver two power plants in Liberia. It also entered into two sub-contracts with International Construction & Engineering Inc (ICE) for the provision of construction services for both power plants, which were in materially identical terms. Each required ICE to procure an advance payment bond (APB) and a performance bond (PB) in favour of Caterpillar, which it did. The APB was defined as “an instrument… that guarantees the due performance by [ICE] for an advance payment made by [Caterpillar] to [ICE] for sundry activities and/or task [sic].” The PB was defined as “an instrument… that guarantees the due performance of all Work by [ICE]”.

The question for the court was whether the bonds were on demand or conditional.

The court relied on the Court of Appeal case of Wuhan Guoyu Logistics Group Co Ltd and another v Emporiki Bank of Greece SA, in which it gave guidance to “commercial men” about this type of bond and said that “while everything must in the end depend on the words actually used by the parties there is… a presumption that, if certain elements are present in the document, the document will be construed one way or another.” It gave the following guidance. 

“Where an instrument (i) relates to an underlying transaction between parties in different jurisdictions, (ii) is issued by a bank, (iii) contains an undertaking to pay ‘on demand’ (with or without the words ‘first’ and/or ‘written’) and (iv) does not contain clauses excluding or limiting the defences available to a guarantor there will be a presumption that it will be construed as an ‘on demand’ bond or guarantee.”

The court in Caterpillar adopted this approach. While only part of the test set out in Wuhan was met, the court concluded that there was nothing in the background or the language of the instruments which was capable of rebutting the presumption that, on balance, the language used showed that the instruments were intended to be “on-demand”.

While Caterpillar’s  claims under the bonds were ultimately successful, it was not achieved without a fight. If parties intend a security instrument to be on-demand, it should not contain any reference to “guarantees” or “guaranteeing performance”. It should not include “saving” provisions preserving the bond provider’s liability.

http://www.bailii.org/ew/cases/EWHC/Comm/2015/2304.html