In the absence of a clearly drafted document, the question of whether a guarantee is in fact a performance (or on demand) bond often arises - a problem accentuated by the recent market practice of including indemnities, conclusive evidence clauses and on demand payment clauses in contracts purporting to be guarantees.

The distinction is an important one. A guarantee is a promise to perform a contract or to ensure that a contract is performed following the default of the primary obligor. It is a secondary obligation, the guarantor's liability being contingent upon the liability of the primary obligor.

In contrast, a performance bond is a direct primary undertaking to pay a specific amount to someone on the occurrence of a particular event, most often triggered by the production of a notice specifying the amount due and demanding payment thereof.

Performance bonds were originally developed as specialist banking instruments for trade finance transactions. Given this, there exists a presumption that where such contract is not granted by a bank in a banking context, it does not amount to a performance bond (Marubeni Hong Kong and South China Limited v the Mongolian Government [2005] EWCA Civ 395).

This distinction had, however, become hard to draw in the wake of IIG Capital LLC v Van Der Merwe & Anor [2008] EWCA Civ 542. In this case the Court of Appeal provided that a directors’ guarantee containing wording commonly used in guarantees throughout the market was, by virtue of this wording, a performance bond, rebutting the presumption referred to above (see our Knowledge area at www.macroberts.com for MacRoberts Banking Law e-update - Guarantors - Be Warned! from 02/07/08 for further case details).

In 2010, in Carey Value Added, S.L. v Grupo Urvasco, S.A. [2010] EWHC 1905 (Comm), the High Court sought to distinguish the IIG case and held that there was a stateable case that a document did not amount to an on demand bond where:

  • although expressed as primary obligations, the obligations of the guarantor were co-extensive with the obligations of the principal under the underlying documents;  
  • the primary obligations of the guarantor became effective only when due by the principal; and  
  • the guarantor’s indemnity was qualified to the extent of the principal's liability to the lender and as such was also co-extensive and was not unqualified.  

In the recent case of Vossloh Aktiengesellschaft v Alpha Trains (UK) Ltd [2010] EWCH 2443 (CH) it again fell to the High Court to consider the distinction. In this case Alpha Trains (UK) Ltd ("Alpha"), a train operator, entered into a series of contracts with Vossloh Locomotives ("Vossloh") under which Vossloh was to manufacture, operate and service trains for Alpha. Vossloh Aktiengesellschaft (the "guarantor"), the parent company of Vossloh, provided a guarantee (the "guarantee") to Alpha in relation to Vossloh's obligations under the contracts.

Alpha subsequently complained that a large number of the locomotives supplied to it by Vossloh had defects. Alpha claimed that Vossloh was liable for a sum in excess of €17 million for breach of contract and sought to recover this amount from the guarantor under the guarantee. The defects were not admitted by Vossloh and liability under the contracts was the subject of separate proceedings. Therefore, the guarantor argued that nothing was owed under the guarantee until breach of contract by Vossloh as primary obligor had been established. Alpha, however, claimed that guarantee was on its true construction a performance bond which obliged the guarantor to pay the sum demanded immediately without proof of default by Vossloh.

As the guarantor is not a bank, the question before the High Court was whether the facts of the case and the language of the guarantee were enough to rebut the presumption that the contract was not a performance bond.

The High Court held that despite the inclusion of an on demand payment clause, a waiver of defences clause and a conclusive evidence clause, that the guarantee did not amount to a performance bond. In particular, the critical factor was that the guarantee was drafted on the premise that a default by Vossloh had occurred. This meant that the guarantor's obligations were secondary, supported by primary obligations which only came into effect following default by Vossloh. It, therefore, followed that any obligation on the part of the guarantor to make payment to Alpha was contingent on the outcome of the proceedings regarding Vossloh's liability.

The decision in this case therefore follows on from the Carey case providing much needed clarification on the distinction between a guarantee and a performance bond.

In light of these decisions, beneficiaries and guarantors should seek legal advice before entering into a guarantee or on demand bond in order to ensure that the document is clearly drafted so as to have the intended legal effect.

There is limited authority on this subject in Scotland, however, it is likely that the above case law would be persuasive authority in the Scottish Courts.