Performance bonds and bank guarantees are commonly used as forms of security under construction and engineering contracts. Calling on a performance bond or bank guarantee requires, in most countries, “strict” compliance with the wording of the bond or guarantee. A recent Australian case demonstrates just how “strict” an approach banks are entitled to take to demands on such instruments.

The Performance Bond

In Simic v New South Wales Land and Housing Corporation [2016] HCA 47 (7 December 2016), two unconditional performance bonds were procured from a bank by a construction contractor in favour of the employer, being the New South Wales Land and Housing Corporation. The problem arose because, due to a mistake by the contractor, the “New South Wales Land and Housing Corporation” was referred to in the performance bonds as the “New South Wales Land & Housing Department trading as Housing NSW” – a body that did not exist.

When the employer made a demand on the performance bonds, the bank refused to accept the demand, on the basis that the employer was the “New South Wales Land and Housing Corporation” and not the “New South Wales Land & Housing Department trading as Housing NSW” as named in the bonds.

Strict Compliance

The High Court of Australia (Australia’s highest court) held that the bank’s refusal to accept the demand under the performance bonds was justified. The court acknowledged that performance bonds (and bank guarantees) are “autonomous” financial instruments, meaning that they are to be construed on their own terms and independently of the relationship between the contracting parties (in this case, the employer and the contractor). The basic obligation of the bank is to examine whether the demand fulfils the requirements of the bond. If it does: the bank must pay. If not: the bank may refuse to make payment to the person making the demand. Because the bank is usually not involved in the parties’ underlying relationship, it is entitled to take a “strict” approach in determining whether a demand does, or does not, fulfil the criteria laid down in the bond for a demand for payment.

Here, because the identity of the person making the demand under the bonds was not (and never purported to be) the “New South Wales Land & Housing Department trading as Housing NSW”, the bank was entitled to reject the demand because of this failure of identity. Although such a result could seem unduly “strict” or technical, it produces certainty for banks and institutions who provide bonds and bank guarantees, because it means that they are not required to investigate the underlying relationship of the parties, for example to determine whether the performance bonds should have named the “New South Wales Land and Housing Corporation” as the beneficiary of the bonds, but due to a mistake did not.

Rectification

However, the outcome of the litigation was not disastrous for the employer, because the High Court went on to decide that the wording of the performance bonds should be changed or “rectified” to reflect the true name of the intended beneficiary, i.e. the “New South Wales Land and Housing Corporation”. There was no issue that the parties’ intended the “New South Wales Land and Housing Corporation” to be named in the bonds, and that due to a mistake the wrong name had been used. The courts of common law and other jurisdictions have powers to rectify the terms of written documents in such circumstances as these. The effect of rectifying the bonds would then be to entitle the employer to make a valid demand under the bonds, which the bank would be required to honour.

Commercial Implications

Mistakes are an everyday fact of life, but the mistake made in this case – a simple misdescription of the beneficiary of the performance bonds, was particularly costly, because it necessitated going to the highest court in Australia to have it corrected. Apart from highlighting the need for great care in preparing the wording of performance bonds and bank guarantees, Simic also gives comfort to banks and financial institutions in knowing that they are entitled to take a “strict” approach to demands for payment under such instruments. This obviates what could otherwise be the heavy burden of banks being required to investigate the factual background of every demand for payment.