Bank guarantees, banker’s undertakings and performance bonds are all types of security that are offered by contractors to employers. Though differently described, and quite often different in form, they are given for the same purpose. That purpose is to provide protection to an employer in the event of a default of the contractor or the contractor’s insolvency.
Making a demand on a contractor’s security of this sort generally signals the death of the relationship between an employer and contractor. Such situations arise infrequently, though it is important to know where you stand if a demand is on the horizon.
The term ‘performance bond’ is used here to refer to all types of bonds that are contractually required to be issued by a contractor and which are payable on demand. This term is used for convenience and it is equally common for a performance bond to be described as a “performance guarantee” or, as mentioned above, a bank guarantee. However, these documents are not guarantees; they are primary obligations which lie with the issuing bank or surety, and operate entirely independently of the underlying construction contract. Similarly, the term “performance” is something of a misnomer, as the obligation to pay exists irrespective of the performance or non-performance of the contractor.
The term ‘performance bond’ is used to capture all forms of bonds that are intended to be irrevocable, unconditional and payable on demand.
As good as cash
The intent of the terms “unconditional” and “on demand” is to indicate that proof of default under the construction contract is not required in order to enforce the performance bond.
With this in mind, performance bonds are often seen as being as good as cash in the sense that, at any time and for any reason, an employer can issue a demand and receive payment.
In theory this is how performance bonds operate, though there are a few practical issues to be borne in mind when drafting performance bonds, and also when considering whether to make a demand.
Making a demand
In the context of a construction contract, making a demand on a performance bond is a significant event. A demand will have an immediate and (often) sizeable impact on a contractor’s finances. It is also common that the market in which the contractor and employer operate will learn that a demand has been made and this can have consequences for each party’s reputation.
If a decision is made to call on a performance bond it is usually advisable to move quickly to make the demand. The requirement for speed arises as the contractor who provides the performance bond is generally aware that a demand could be made, and as a result, will often take steps to prevent the proceeds of any demand finding their way to the employer.
The most common step taken by contractors in this situation is to head to court to seek an injunction, that is, a court order that either the employer be restrained from making a demand on the performance bond, or, that the issuer of the bond be restrained from paying the employer. Timing becomes crucial if an injunction is sought as a delay of a few days or even hours could result in the demand being made and funds being transferred to the employer (it is for this reason that contractor’s often seek to be given advance notice before an employer can issue any demand; a few hours is all that can be needed to instruct lawyers and rush to court).
Courts will not prevent a party calling on a performance bond or receiving the funds under a performance bond unless the party in whose favour the performance bond is given is acting fraudulently or unconscionably, or, more commonly, because the party has made a contractual promise not to call on the bond.
Does the contract prevent a demand being made?
Making a demand on a performance bond is not simply a matter of completing a demand notice and awaiting payment (though more on this below). It is first necessary to understand whether the contract permits such a demand being made.
Courts take the view that if a party in whose favour the performance bond has been given has made a contract promising not to call on the performance bond, breach of that contractual promise can be prevented by injunctive relief. For example, if an underlying contract states that demands can only be made where there has been a material default of the contractor, if there has been no such material default and a demand is made purely for the convenience of the employer, a court can restrain the employer from making any demand on the performance bond. This restraint will apply notwithstanding that the bond itself is described as being unconditional and payable on demand. Courts grant injunctions in this situation principally because the demand is not made in good faith, and to permit the demand being made would see the court actively permit a breach of contract.
In the case of Clough Engineering v Oil & Natural Gas Corp Ltd1 , the construction contract stated that the performance bond could be called “in the event of the Contractor failing to honour any of the commitments entered into under this contract”.
The contractor sought to restrain the employer’s demand on the performance bond arguing there was a genuine dispute about whether the contractor had in fact failed to honour its commitments. The court ultimately held that the demand could be made but did so by looking at both the construction contract and the wording of the performance bond (which stated that payment should be made “notwithstanding any disputes pending”).
The issue encountered above can most easily be overcome if the construction contract expressly deals with when demands can be made. For instance, wording that provides that the employer may have recourse to the performance bond if it believes that the contractor has not performed its obligations under the contract, and that the contractor will not take steps to restrain the employer from having recourse to the performance bond will go towards ensuring performance bonds are “unconditional and on demand”.
Of course, contractors who fear having demands made on performance bonds issued on their behalf should seek to include conditions within the construction contract which specify the circumstances in which a demand can be made. This would provide some ammunition, should the need arise, if a demand was to be made without proper cause.
How is a demand made and paid?
Performance bonds are often explicit in noting that they are payable on demand and without regard to the performance or non-performance of the contractor under the contract. However, they are often less clear about how, in practice, demands are made and how and when monies are to be paid. For instance, performance bonds often specify demands are to be made “in writing on the bank”. Does this mean a demand needs to be made on the bank’s head office, or will the local branch suffice? Does the demand need to specify that the contractor has breached the contract, and, if so, what level of detail is required? Is a demand to be physically delivered to the bank or can a demand be made by email? Does the original performance bond need to be presented when making a demand? Can payment be made by cheque and should the original performance bond be released in return for payment by a cheque?
Where the performance bond is silent or unclear on these issues most employers will take steps to ensure their demand is viewed as valid and in compliance with all contractual requirements. These steps can involve locating the original guarantee, having the employer’s representative and/or one or more directors sign the demand letter, and hand-delivering the guarantee and accompanying demand on a bank’s head office. This process can take time.
It is not suggested that performance bonds be drafted to address each of the procedural issues that could arise in the context of making a demand. However, including a template notice of demand along with the performance bond is sensible. This template can include who can make a demand on behalf of the employer, where demands are to be sent, when payment is to be made and how funds are to be transferred. Addressing these issues can ensure that, once the difficult decision to call on a performance bond is made, the actual process of receiving payment is a mere formality.