Jane Davies Evans, 3 Verulam Buildings
This is an extract from the third edition of GAR’s The Guide to Construction Arbitration. The whole publication is available here.
Purpose of security
Security in the form of bonds and guarantees is a well-established feature of construction projects.
Bonds or guarantees are, with limited exceptions, sought by the employer to secure the contractor’s performance, and to protect advance payments made for mobilisation of the contractor to site and/or the purchase of long-lead or high-value components or materials. In addition, on-demand bonds or guarantees are regularly used in the construction industry to enable the early release of retention monies. Less frequently, the contractor may also require security to ensure there will be sufficient funds available for an impecunious employer to make payments as and when they fall due, or to protect against regime change when working for public entities in potentially unstable jurisdictions.
Types of security
Before considering the different forms of security typically given in international construction projects, it is important to note that there are essentially two different types of obligations encompassed by such securities, each with different requirements and consequences. In particular, the security provided may impose on the issuer:
- an autonomous contractual obligation to pay a specified sum of money on the occurrence of a specified event or presentation of a particular document; or
- an accessory obligation to be answerable in the event that a third party fails to perform a contractual obligation or make a payment owed to the beneficiary under the underlying contract.
Unfortunately, there is little consistency in the terminology applied to bonds and guarantees, which causes some confusion and makes it difficult to determine whether a particular security encompasses an autonomous or accessory obligation merely by looking at its title.
Generally speaking, security instruments imposing autonomous obligations tend to be referred to as on-demand bonds or guarantees, first-demand bonds or guarantees, demand bonds or guarantees or standby letters of credit, whereas security instruments imposing accessory obligations are often labelled guarantees, default bonds or surety bonds.
The greatest confusion in the construction sector probably arises from the fact that where these instruments are used as performance security, both types (representing autonomous and accessory obligations) are often labelled as performance bonds or performance guarantees. The situation is not assisted by the fact that, while standard forms are available, they are rarely used in practice, with most employers and issuers of security insisting on their own bespoke wording.
Whether a particular instrument is treated as imposing an autonomous or accessory obligation is a matter of construction of the instrument in question and not dependent on the label attached by the parties. In light of the different legal characteristics of the two, and the consequences that flow therefrom (as set out further below), the question of the proper construction of such security instruments frequently gives rise to litigation or arbitration and is the subject of numerous reported decisions of the English courts.
In this chapter, autonomous contractual obligations will be referred to as ‘on-demand bonds’ or ‘on-demand guarantees’ and accessory contractual obligations will be referred to as ‘conditional guarantees’.
As will be seen below, the distinction between autonomous and accessory obligations is of fundamental importance. The key difference is that an on-demand bond or guarantee is (subject to intervention by the local courts as discussed below) payable against documents, whereas a claim under a conditional guarantee requires proof that there was a breach of the underlying construction contract.
Autonomous obligations – on-demand bonds and guarantees
The most common forms of security used on international construction projects are on-demand bonds and guarantees. An on-demand bond or guarantee usually stipulates on the face of the bond or guarantee itself what document will have to be presented to the issuer in order to receive payment. All that the beneficiary will have to do is issue a demand in accordance with the terms of the bond/guarantee and present the required documents.
The documents required vary from case to case. The most common forms of on-demand bonds and guarantees simply require the employer to demand payment, combined with a formal declaration from the employer that the contractor has failed to perform its obligation under the construction contract. In practice, it is not unusual in the construction industry for on-demand bonds or guarantees to include a pro forma demand letter that the parties negotiate as part of the negotiation of the construction contract and security itself. Additional requirements may include (1) a statement from a specified person that the contractor is in breach of its obligations (for example, the relevant minister or attorney general for public works contracts); or (2) a certificate from a third party (for example, the engineer or the dispute adjudication board). Less common requirements can include provision of an arbitration award or judgment in respect of the underlying construction contract.
The employer beneficiary of such an on-demand bond or guarantee will generally seek to obtain security with the least onerous documentation requirements, such as, for example, a simple demand or certificate issued by the employer, whereas the contractor will seek the additional protection provided by a third-party certificate or judgment. Ultimately, the terms of the security will depend on the parties’ respective bargaining positions and/or what terms the available issuers are prepared to accept.
Theoretically, when the issuer of the security receives a demand for payment, it simply checks that the demand and supporting documents comply with the terms of the security and, if so, makes payment to the employer. Again, theoretically, the issuing bank is not concerned with the question whether there has in fact been a default by the contractor under the underlying construction contract, which renders the payment due.
In Edward Owen Engineering Ltd v. Barclays Bank International Ltd, Lord Denning MR observed:
All this leads to the conclusion that the performance guarantee stands on a similar footing to a letter of credit. A bank which gives a performance guarantee must honour that guarantee according to its terms. It is not concerned in the least with the relation between the supplier and the customer; nor with the question whether the supplier is in default or not. The bank must pay according to its guarantee, on demand, if so stipulated, without proof or conditions. The only exception is where there is a clear case of fraud of which the bank has notice.
In practice, depending on the commercial relationship between the issuer of the security and the contractor (or the counter guarantor as the case may be), the issuer may notify the contractor (or the counter guarantor) upon receipt of a demand before making payment. The issuer will do so for one of two reasons: (1) if the issuer is concerned that it may not be able to enforce the security it is holding in relation to the bond/guarantee; or (2) to give the contractor the opportunity to make direct payment and avoid an act of default under the terms of the agreement between the contractor and the issuer.
Where a contractor fears that the employer is about to make a demand, or where the contractor has been informed that a demand has been made by the issuer, the contractor may attempt to block the demand by a court injunction. The traditional approach of the English courts was to limit injunctions to situations where there was clear evidence of fraud.
Accordingly, in the 2007 decision in Permasteelisa Japan KK v. Bouyguesstroi and Bank Intesa SpA, the English Technology and Construction Court discharged an interim injunction obtained by a subcontractor to prevent the main contractor (a Russian subsidiary of Bouygues Bâtiment International) from making further calls under an on-demand guarantee pending the resolution of the underlying dispute in arbitration, The judge (Ramsey J.) found that there was no basis for maintaining the status quo pending the outcome of the arbitration, in the absence of fraud.
This approach has to some extent relaxed in recent years both in England and elsewhere.
In Simon Carves Limited v. Ensus UK Limited the English Technology and Construction Court had to consider the extent to which the terms of the construction contract pursuant to which the performance security had been issued might prevent the employer from seeking payment under the security. In Simon Carves, the underlying construction contract provided that the security would be ‘null and void’ and was to be returned to the contractor immediately once the acceptance certificate was issued save in respect of pending claims. The acceptance certificate was issued, albeit with a list of defects attached; one month later the employer issued a defects notice under the mechanism for notifying defects during the defects liability period. The judge, after reviewing a long line of decisions, held that: ‘fraud is not the only ground upon which a call on the bond can be restrained by injunction’ and that ‘if the underlying contract, in relation to which the bond has been provided by way of security, clearly and expressly prevents the beneficiary party to the contract from making a demand under the bond, it can be restrained by the Court from making a demand under the bond.’ The judge found that the security was null and void under the terms of the construction contract as between the employer and the contractor, and injuncted the employer from making a demand under the bond.
The judge also provided a useful explanation as to the extent to which the commercial consequences of a call on an on-demand bond or guarantee are relevant when an English court is deciding whether to grant an injunction or not:
40. It is well known that bonds are regularly called for on substantial and public procurement projects. These bonds can be conditional bonds or as in this case, unconditional or on-demand bonds. Contractors are required to provide them from an acceptable bank or surety. The banks are not uncommonly the main banks which fund the contractors (albeit that it is not clear that this was the case here); the banks providing the bonds will usually have security and counter-indemnities so that they are secured when and if they have to pay out on the bond to the beneficiaries. It is often the case that banks will not provide more than a certain number of bonds or bonds beyond a certain value to any one contractor. If a bond is called, it may be difficult for the contractor to have that bank provide another equivalent bond for another job at that time.
41. I have formed the view that damages would not be an adequate remedy. My reasons are the same as set out in my earlier judgements on this matter which I will not again set out in detail. Broadly, they are that the calling of the bond as in this case gives rise to a very real risk of damage to the commercial reputation, standing and creditworthiness of [the Contractor] which would be very difficult to quantify; there would be a very real risk that [the Contractor] would not pre-qualify for tenders because often tenderers have to disclose whether there have been recent calls on the bonds and if so on what grounds. There was evidence that there had been an earlier call on the bond but I attach little importance to that in commercial terms because the unchallenged evidence is that it was done by agreement to secure speedy payment; in those circumstances, the call could be readily explained. An added factor is that if, as I have held, [the Contractor] does have a strong case on the continuing validity of the bond as between it and [the Employer], the commercial advantage of not having the bond actually called or the loss of that advantage is unquantifiable.
The English Technology and Construction Court reached a similar conclusion in Doosan Babcock v. Mabe. In Doosan Babcock, the employer had commenced commercial production of electricity from a power plant for which Doosan Babcock had provided two boilers. The on-demand guarantees provided by Doosan Babcock expired on their terms on the earlier of a specified date or the issue of a taking-over certificate. The employer did not issue a taking-over certificate, relying on a contractual provision that permitted use of the boilers without the issuance of the taking-over certificate as a temporary measure. The judge granted an injunction preventing the guarantees being called, finding that there was a strong likelihood that Doosan Babcock would be able to demonstrate that the use of the boilers was not temporary, or that the employer was in breach of the underlying supply contract in not issuing the taking-over certificate.
However, the English authorities do not all speak with one voice. More recently, in MW High Tech Projects UK Limited & Another v. Biffa Waste Services Limited, Biffa sought to set aside an interim injunction restraining it from calling on a retention bond. The underlying construction contract between Biffa and MW had provided that it was a condition precedent to Biffa’s right to call on the retention bond that Biffa first call on a parent company guarantee in respect of the same matter. MW argued that Biffa should be restrained from pursuing a call on the retention bond because, although Biffa had first made a call on the parent company guarantee, that call was not ‘valid’, such that the condition precedent had not been satisfied. In discharging the interim injunction, Stuart-Smith J. reviewed the decisions in Simon Carves and Doosan Babcock. He held that, ‘if and to the extent that the subsequent decisions of Akenhead J. in [Simon Carves] or Edwards-Stuart J. in [Doosan] suggest that a less rigorous test is to be applied, I respectfully consider that the views of Ramsey J [in Permasteelisa Japan KK v. Bouyguesstroi and Bank Intesa SpA  EWCH 3508 (QB)] prevail as being in accordance with the substance of the decisions of higher authority… It seems to me, both on principle and authority, that the only established exceptions to the rule that the court will not intervene should be where there is a seriously arguable case of fraud, or it has been clearly established that the beneficiary is precluded from making a call by the terms of the contract’. It therefore remains to be seen whether the English courts will embrace the wider exceptions endorsed in Simon Carves and Doosan.
The English Technology and Construction Court faced a novel attempt to injunct a call on an on-demand performance bond in J. Murphy and Sons Ltd v. Beckton Energy Ltd. The underlying construction contract was an amended version of the FIDIC design and build form of contract. The employer issued a notice of intention to call the bond in relation to liquidated damages for delay. The contractor relied on the 2015 UK Privy Council decision in NH International (Caribbean) Ltd v. National Insurance Property Development Co Ltd that an employer could not make a claim for payment against the contractor under the contract, unless the claim had been notified ‘as soon as practicable’ under clause 2.5. The contractor argued that demanding paying when no notice had been given in accordance with clause 2.5 engaged the fraud exception, permitting the judge to intervene. The judge refused the injunction finding that on the specific wording on the amended FIDIC contract, the parties had expressly removed the obligation to notify claims for liquidated damages under clause 2.5. The judge held further that the contractor was confusing liability to pay delay damages and the contractual mechanism for enforcing that liability, and the injunction would have been refused even if his analysis of the contract amendment was incorrect.
Other jurisdictions take different approaches. The authors are currently involved in arbitrations where bonds have been ‘frozen’ by local courts on the basis that ‘freezing’ the bonds – injuncting the employer from making a call or the bank from paying out if a demand is received – pending the outcome of the arbitration preserves the status quo between the parties. Quite aside from the legal soundness of this approach and the immediate impact of an injunction on the employer’s cash flow, these injunctions can cause significant difficulties if the court does not require the relevant instrument to be extended for the duration of the arbitration and any subsequent challenge proceedings. Indeed, it is not unknown for contractors to seek an injunction for the purpose of ‘running down’ the remaining duration of the security until it expires.
The Singaporean approach to attempts to stop payment under on-demand bonds is of note, with the courts accepting unconscionability – which the Singaporean courts describe as a broader concept than fraud, including abusive calls, bad faith and dishonesty – as a reason for injuncting calls on on-demand bonds and guarantees.
Accessory obligations – conditional guarantees
A less common form of security in the construction context is the conditional guarantee. By contrast to the autonomous obligations found in on-demand bonds and guarantees, in order to make a claim under a conditional guarantee, the employer will first have to prove that the contractor has in fact failed to perform his or her obligations under the construction contract, and thereby caused the employer loss.
Accordingly, claiming under a conditional guarantee is no less complicated or cumbersome than suing the contractor himself. It will require a detailed factual investigation to prove that the contractor is liable under the construction contract, and may well result in arbitration or litigation proceedings.
If the employer brings a claim under the guarantee, the guarantor will be able to rely on all the defences available to the contractor under the construction contract. Accordingly, the contract of guarantee cannot be viewed in isolation, but must be considered together with the underlying construction contract. To that extent, the liability of the guarantor and the liability of the contractor are co-extensive.
In addition, and to the extent not otherwise provided by the guarantee itself, the general law of suretyship provides additional protection, and possible defences to the guarantor such that the guarantor will be released from liability if there have been any material changes to the terms of the underlying construction contract without his or her consent or where the employer has given additional time to the contractor to perform.
Consequently, it is in most cases considerably more difficult and takes considerably more time for an employer to obtain payment under a conditional guarantee than under an on-demand bond or guarantee and, as a consequence, these instruments perform different functions. Whereas an on-demand bond or guarantee protects the employer’s cash flow and enables him or her to obtain payment on account of his or her loss without delay, the main advantage of a conditional guarantee is that it offers a second source of payment if the contractor is insolvent or does not have sufficient monies to sums awarded in respect of his or her failure to perform. In the authors’ experience, save for parent company guarantees (which often take the form of a conditional guarantee), it is now more usual for major international contractors to provide on-demand guarantees; conditional guarantees are becoming the exception.
Autonomous or accessory obligations?
For guarantees governed by English Law, two Court of Appeal decisions may assist in ascertaining whether a guarantee imposes an autonomous or accessory obligation on the guarantor.
- In Marubeni Hong Kong v. Mongolian Government the English Court of Appeal held that, when interpreting a document that was not a banking instrument, the absence of language in the document itself describing the document as a demand bond or similar, created a strong presumption against the document being an autonomous bond rather than merely as a see-to-it guarantee imposing only secondary liability.
- In contrast, in Wuhan Guoyu Logistics Group Co Lt v. Emporiki Bank of Greece SA, the Court of Appeal held (citing Paget’s Law of Banking) that, where an instrument (1) related to an underlying transaction between parties in different jurisdictions; (2) was issued by a bank; (3) contained an undertaking to pay on demand (with or without the words ‘first’ or ‘written’); and (4) did not contain clauses excluding or limiting the defences available to a guarantor, there is a presumption under English Law that the instrument is a demand guarantee.
Procuring the security
In the construction industry, security tends to be provided (in ascending order of cost to the contractor) by group companies, banks, and specialist surety or insurance companies:
- Guarantees from the parent company or another group company of the party to the original construction contract are the least expensive form of security for the contractor (subject, of course, to the cost to the group if the security is called by the employer);
- Guarantees or bonds issued by a bank. These tend to be ‘on-demand’ instruments, as banks are generally reluctant to become involved in investigating or assessing the merits of demands or dispute. The underlying construction contract will often specify what bank (or banks) will be acceptable to the employer, for example, specifying the required location and credit rating of the issuing bank.
- Guarantees or bonds issued by specialist surety or insurance companies, who will carry out a risk assessment before deciding to underwrite the contractor’s obligations, charging a premium for this service.
- Standby letters of credit issued by banks. These are very similar to on-demand bonds and share the key characteristic that they are payable against documents (rather than proof of liability) and impose an autonomous obligation on the bank independent of the underlying transaction. Standby letters of credit are not frequently used in the construction industry; they are sometimes used to secure delivery of key components where significant up-front payments are required, or as a mechanism for making (and securing) payment where the employer is a government in an unstable jurisdiction.
With the exception of parent company guarantees, when procuring a bond or guarantee, the contractor will need to pay an issuing fee, with further fees payable whenever the bond or guarantee is extended in duration or value. Many international contractors increasingly enter into facility agreements with their bank, pursuant to which the bank will provide a number of commercial banking services, including the provision of bonds and guarantees. The alternative is for the contractor to enter into an ad hoc arrangement with its bank or a commercial provider of bonds and guarantees on a project-by-project basis. In both cases, the contractor will typically have to commit that all sums paid to the contractor under the construction contract will be paid into a specified bank account located at the issuing bank, which ultimately bears the risk on the guarantee or bond. In addition, the contractor will have to provide security to the value of the bonds and guarantees. A combination of blocked funds in cash accounts and security over the contractor’s fixed and floating assets is typical. The need to provide security in relation to the value of the bonds and guarantees limits the amount of bonds and guarantees that a contractor can procure at any given time.
While it is generally cheaper for the contractor to procure bonds and guarantees under a facility agreement than on an ad hoc basis, the consequence of a demand being made on security procured under a facility agreement can be catastrophic for the contractor. Most facility agreements contain default clauses, whereby a call on an on-demand bond or guarantee constitutes an act of default under the facility agreement unless the contractor is able to make immediate direct payment of the sums demanded to the bank. An act of default may entitle the bank to call in all loans, lines of credit and security provided under the facility agreement whether related to this construction contract or otherwise. Further, cross-default provisions are increasingly common in facility agreements, whereby an act of default under one facility agreement constitutes an act of default under other facility agreements, including facility agreements made with other banks. In short, making a demand on an on-demand guarantee or bond may result in the contractor being unable to continue trading. For this reason, calling an on-demand guarantee or bond tends to be the action of last resort for an employer.
In an international context the employer will typically require that the contractor procures an on-demand bond or guarantee from a bank in the employer’s home country. This arrangement is advantageous for the employer, who can recover monies quickly in their home country without first having to issue proceedings against the contractor in another jurisdiction, or having to pursue a foreign bank to enforce a demand for payment under the guarantee or bond. Unless an international contractor has a significant presence in the foreign jurisdiction, the contractor will not normally have the commercial relationship in place, or available security, to procure a guarantee or bond from a local bank directly. The normal arrangement is for a chain of back-to-back guarantees and counter guarantees to be set up through a series of SWIFT messages, linking the local bank that issues the guarantee to the employer to a bank in the contractor’s home jurisdiction that has the commercial relationship with the contractor. Where a demand is made by the employer, the demand will be passed up the chain; the bank in the contractor’s home jurisdiction that has the direct relationship with the contractor will provide the funds, which are then fed back down the chain to the employer.
In most situations, the flow of funds from counter guarantor to guarantor is seamless. The chain of guarantees and counter guarantees may be broken if the international community places the employer under sanctions prohibiting the passing of financial benefit to the employer. While the local bank may not be subject to these sanctions, the international banks that have provided counter-guarantees may be prohibited permanently from honouring the counter-guarantees. In practice, this may result in the local bank (or a bank somewhere in the chain) defaulting on the security.
Forms of security required on international construction projects
The most common forms of guarantees or bonds required on international constructions projects are set out below.
Tender security or bid bonds
Where a large contract is put out to tender, the employer will spend considerable time and money in choosing a suitable contractor. If the prospective contractor withdraws prior to entering into a binding contract or refuses to accept the award of the contract or fails to procure the performance bond required to support the contract, the employer may have to re-open the tender process, incurring substantial delay and additional expense. Accordingly, invitations to tender will often require tenderers to submit a bid bond or tender guarantee for a specified sum. The bond will be released if the tenderer is not selected, or once the tenderer has entered into the construction contract and provided the required performance bond. A bid bond will almost invariably take the form of an on-demand bond or guarantees.
Advance payment guarantees or bonds
In many construction projects the employer will make advance payments to the contractor providing some immediate finance to mobilise to site, purchase materials, or otherwise prepare for the construction works. In exchange, the contractor will often be asked to procure a bond or guarantee to secure the repayment of the advanced funds in the event that the contractor becomes insolvent or fails to perform the contract. The advance is typically ‘clawed back’ by the employer through deductions from the interim payments made to the contractor, with the value of the security reduced in parallel.
The purpose of performance bonds or guarantees is to protect the employer from a failure by the contractor to perform the construction contract. If the contractor acts in breach of contract, the employer is likely to suffer loss (e.g., in the form of delay or through having to order replacement works) and the issuer of the bond or guarantee undertakes to pay the employer a sum of money to compensate him or her for this loss. Even though the purpose of a performance bond or guarantee is frequently described as ‘securing the due performance of the contract’, with the exception of parent company guarantees, the issuer or guarantor does not undertake to compel the contractor to perform the services (which would be out of his or her power in any event). The contractor is incentivised to perform the construction contract by their own autonomous obligations under the same, as well as obligations owed to the issuer under a counter-indemnity.
Performance bonds and guarantees are typically provided by way of on-demand bonds or guarantees, save in exceptional circumstances where the balance of negotiating power between the parties is such that the contractor is able to negotiate a conditional guarantee.
Parent company guarantees
The purpose of a parent or group company guarantee is to provide the other party to the construction contract with recourse to a group company with a better financial standing than the contracting party. This is particularly relevant for international contracting, when the contractor will often set up a subsidiary within the jurisdiction of the employer for the sole purpose of undertaking the specific project. This subsidiary will typically have no assets save for the income paid under the construction contract, which will likely be insufficient to meet the employer’s claims if there is substantial non-performance.
The value of such a guarantee depends on the creditworthiness of that group company and care needs to be taken that the guarantee is provided by a group company that holds (and will continue to hold) substantial assets. For smaller construction groups it is normal for the ultimate parent company guarantee to provide such a guarantee. However, many larger, listed international contractors have internal policies limiting access to guarantees from the ultimate parent company to the most significant projects entered into by the contractor, subject to board approval and clear limits on the parent’s potential liability.
Retention bonds and guarantees
In construction contracts, the employer is generally entitled to retain a percentage of the contract price (typically 5 per cent) pending completion of the work to form a retention fund. The retention fund is available to the employer to ensure the contractor completes any snagging works and rectifies defects during the defects liability period. It is normal for 50 per cent of the retention monies to be released on practical completion, with the remainder released at the end of the defects liability period.
It is increasingly common for construction contracts to permit the contractor to have an earlier release of the retention monies in exchange for providing an on-demand bond or guarantee. This results in improved cash flow for the contractor without compromising the employer’s security.
In some cases, where the contractor has concerns regarding the employer’s financial standing, the contractor may seek a payment bond or guarantee to cover a percentage of the contract sum. Since the contractor is generally paid in stages as the work progresses, this should provide sufficient protection to the contractor in respect of payments outstanding for completed works. As noted above, in certain jurisdictions and sectors, security for payments will be made by way of standby letters of credit.
Security instrument versus construction contract
One of the main challenges in a major international construction project involving multiple parties and multiple contracts occurs when the parties to the various contracts do not sign up to consistent dispute resolution procedures. This is typically the norm regarding security instruments and construction contracts, given that most banks require disputes under the security to be resolved by their local courts, while the construction contract will usually specify international arbitration.
This can cause considerable problems in the context of conditional guarantees. As set out above, a claim under the guarantee requires the same proof that the contractor is liable as would be required if the employer sued the contractor directly. However, in the absence of an express provision in the guarantee that the guarantor will be bound by the findings in proceedings between the employer and the contractor, an award or judgment in those proceedings will not be binding on the guarantor, and in principle, the guarantor would be entitled to demand that the matter be re-litigated. The decision of the Commercial Court in Autoridad del Canal de Panamá v. Sacyr S.A. & Others provides a recent example. That case is one of many concerning the major construction and engineering project for the widening of the Panama Canal by a third set of locks. Autoridad del Canal de Panamá (ACP) was the employer under the project. The contractor (GUPC) was a Panamanian company, owned in varying proportions by the four defendants. The main contract between ACP and GUPC was governed by Panamanian law and prescribed arbitration in Miami under the ICC Arbitration Rules. There were three separate types of guarantee given by the first to fourth defendants to secure advance payments made by ACP to GUPC. These were all governed by Panamanian law with Miami ICC arbitration clauses. In 2015, ACP made further advance payments, and the defendants provided further guarantees governed by English law and subject to the exclusive jurisdiction of the English courts. ACP commenced proceedings in the English courts seeking declarations that it was entitled to payment under six of the advance payment guarantees governed by English law (the APGs). ACP contended that the guarantees were demand bonds and that it was entitled to payment under the APGs as a result of GUPC’s alleged failure to repay advance payments pursuant to the main contract. GUPC and the defendants filed a request for ICC arbitration under the main contract and various other guarantees, seeking declarations that repayments of the advance payments were not due or payable under Panamanian law and the relevant agreements. The defendants sought a mandatory stay of the English proceedings under Section 9 of the English Arbitration Act 1996 on the basis that they concerned matters that should have been referred to arbitration, alternatively a stay under the court’s inherent jurisdiction or case-management powers on the basis that it would be more appropriate for the parties’ disputes to be resolved in the arbitration proceedings. Blair J. rejected both contentions. The mandatory stay was refused because the subject of the parties’ controversy in the English proceedings was a claim under the APGs: while the issue of the liability of the GUPC (as the principal debtor) was necessarily bound up with the nature of the instrument as a guarantee, GUPC’s underlying liability was not the matter that had to be decided by the English court. While acknowledging the risk of inconsistent decisions, Blair J. also rejected a stay on case-management grounds.
Blair J. came to the same conclusion in Deutsche Bank AG v. Tongkah Harbour Public Co Limited, in which the defendants sought a stay of court proceedings brought under a guarantee pending the outcome of arbitration under the underlying contract. He said:
The more substantial point argued by [the guarantor] is that since its liability under the Guarantee is of a secondary nature, the court should stay the proceedings under its inherent jurisdiction, and/or under its case management powers, pending the arbitration. I reject that submission also. A claim under a guarantee may raise similar or even the same issues as the claim against the principal debtor, but the covenant to pay is given by a different party, here the parent company. [The Claimant] is entitled to enforce the Guarantee if it can make good its claim, regardless of the claim against the principal debtor. The fact that there may be…substantial overlap between the claims does not affect this conclusion…
Accordingly, from the employer’s perspective it would be preferable if claims under the underlying contracts and those under the security instruments could be consolidated and heard at the same time to avoid the risk of inconsistent decisions. However, unless all parties agree, such consolidation may be difficult to achieve in the context of conflicting arbitration or jurisdiction clauses.
This issue is less pertinent in the context of on-demand bonds. As set out above, an on-demand bond is theoretically independent of the underlying contract and the issuer’s obligation to make payment arises on the presentation of the correct documentation. Accordingly, any proceedings between the employer and the contractor under the main construction contract should be of no or limited relevance to the issuer, and there should not be any need for consolidated proceedings. However, as noted above, courts are increasingly showing a willingness to block payments under on-demand bonds and guarantees pending the outcome of the corresponding dispute under the construction contract.
Claims under the construction contract relating to the security
Where the security is blocked by a court, or the employer refuses to return the security to the contractor for some other reason, the contractor will often bring claims in arbitration proceedings under the construction contract seeking immediate return of the bond or guarantee, and damages in relation to the prolonged duration of the bond or guarantee. The damages typically include the cost of maintaining the security beyond the date when the contractor says the security should have been returned, and losses associated with maintaining the security. Regarding the latter, where a bond or guarantee is blocked pending resolution of the underlying disputes, the contractor’s ability to tender for new projects (which themselves require bonds or guarantees) will be restricted, creating the possibility of a claim for loss of opportunity to earn profits on other projects.
Similar claims may be made where the project has been prolonged owing to employer-risk events.
Reconciling sums awarded under the construction contract with monies already recovered under the security
A practical issue concerning the interaction between an on-demand guarantee and claims under the construction contract arose in Fluor v. Shanghai Zhenhua Heavy Industry Co., Ltd. Fluor had engaged the defendant to fabricate steel monopiles for an offshore wind farm, with the defendant’s performance secured by an on-demand warranty bond issued in euros. Fluor called the bond and received the secured sums. In subsequent litigation, Fluor was awarded damages in excess of the monies recovered under the bond. The parties agreed that credit should be given by Fluor for the monies received under the warranty bond, but disagreed as to how the credit was to operate. The judge found that:
- euro sums awarded to Fluor was simply netted off the bond monies; and
- the remaining euro sum was to be converted into sterling at the exchange rate prevailing on the date Fluor received the bond monies, irrespective of when Fluor actually converted the euros into sterling.
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