Previously Published by Construction Law May 2023
Bond markets have been in upheaval recently, with knock-on impacts on decisions on whether to make or defend calls on performance security on construction projects. Louise Woods, Ciara Ros, Jarrod Gutsa and Lauren-Emma Parrott of Vinson & Elkins examine the issues.
In the first quarter of this year, we saw the continued impact of federal interest rate changes on Treasury yields in the US. Europe has also seen significant upheaval in its bond markets, with policy makers calling for a halt on reinvestment into bond buying schemes. These attempts to tackle inflation have placed the issue of financial security at the forefront of the global news. While the issues and risks with government bonds are not necessarily interlinked with the day to day of construction projects, the liquidity of the bond or guarantee providers (i.e. the contractor’s bank or parent company), remains a constant consideration for contractors and owners alike.
Bonds and Guarantees in Construction Contracts
A performance bond or guarantee is commonly used in the construction industry as a means of insuring a project owner (or upstream party) from the risk of the downstream party failing to fulfil their obligations. Construction contracts generally require the downstream party, (being either the head contractor (“Contractor”) or subcontractor) to provide security to the upstream party (being either the Contractor or project owner (“Owner”)) for the performance of their works. Such security is generally required to be provided by way of a bond or guarantee (or both).
Generally a performance bond will be issued by the Contractor’s bank (the “Surety”) in favour of the Owner. The bond or guarantee is its own standalone instrument separate from the underlying construction contract. The Owner may seek to call on the bond or guarantee (subject to the conditions of the bond) for sums the Owner alleges it is entitled to under the construction contract. If the call is accepted the Surety will pay the Owner directly for the sum claimed, up to the amount of the bond or guarantee.
There are a variety of types of bonds that may be used, with the strictest being an ‘on demand’ or ‘unconditional’ bond, which allows a call to be made simply upon a written demand by the project owner (which is compliant with the terms of the bond) and shall be paid out by the Surety (absence fraud). Conditional bonds and guarantees generally require the bond holder to provide evidence that the Contractor has not performed its obligations under the contract and is in default.
Both bonds and guarantees can be issued by banks, specialist companies, or insurance companies. Guarantees may also be provided by companies in the same group to each other, usually a parent company of the Contractor.
Checklist for Making a Call on Security
Irrespective of whether you have an on demand bond or a performance guarantee, there are fundamentals that should be checked before any call on the security is made. The below is not intended to be an exhaustive list. Bond and guarantee calls are technical in nature and what may seem like a minor error, such as misspelling a party’s name, may constitute grounds to prevent a call being made.
- Read the terms carefully. Every bond and guarantee will be drafted differently, so it is key not to make assumptions or rely on a demand you made in respect to a previous bond.Preparing a summary of the key terms, and steps to take to call on each security, when it is provided, is likely to minimise the risk of mistakes being made.
- Has the security expired? If the security has already expired it is very unlikely that a call can be made. It is best practice to keep a register of expiry dates to avoid unexpected risk if the project is delayed.
- Do you have the original physical bond/guarantee? In order to call on security, you may be required to have the original physical security. Check to ensure that you have the original in your possession before attempting to make any call. If you attempt to call using a photocopy (when the original is required), the call will likely be rejected and you will “tip-off ”the other party.
- Have you got the right parties? Check that you are making a call against the correct entity. For example, are you calling on the right branch of the bank, in the right country, if one is specified; are you making the call against the right company and not another group entity? Is the bond payable to “bearer” on demand? Or is the bond issued in favour of an express company that must be the entity to make the call?
- What is the bank’s liability? Are you attempting to call for more than the amount of the security? Is this subject to any reduction as a result of other mechanisms in your contract, or deductions stated on the face of the security (such as for bank fees and expenses)?
- Is there a trigger for payment or a call to be made? Does the security contain any trigger for a call to be made? If so, have the requirements been met? For example has the contractor defaulted, and if so, how? Does the security require it to be a certain type of default or must a certain action or inaction have been recorded?
- Are there any specific requirements to make a valid call? For example, does the security specify that the call must be made in writing; must it be delivered by registered post, by a certain time of day; must it contain specific wording; must it be signed by a specified individual?
Defending a Bond/Guarantee Call
If a call has been made, but has not been paid out, you will have to move quickly. Calls on security can be paid out within a matter of hours or days depending on the institution receiving the call. The following is a non-exhaustive list of matters a party should consider when defending any bond/guarantee call.
- Check the checklist above. Has the entity making the call on the security satisfied all of the terms and conditions? If not, this is a good place to start defending the call, as you may be able to argue that a valid call has not been made.
- What evidence do you have to challenge a default (on a conditional bond or guarantee)? Do you have project minutes or records which show that the call is not valid because a default has not occurred? Alternatively, are you able to show that the Owner has accepted the default in some way? If the security is unconditional, demonstrating that there is no default may not be enough to prevent a call.
- Has the bond expired or is there an argument that it is required to be reduced or returned? The expiration date for the security (if there is one) should be stated in the terms. Check whether it has expired. Review the terms of the construction contract to see if there is an argument that the security is required to be returned or reduced under the terms of the construction contract, or if the type of default is covered by the security. In addition, review whether the security has been voided or altered as a result of a variation or other contractual mechanism.
- Is there any evidence of fraud? Demonstrating fraud is typically a high bar, therefore clear evidence will be required.
- The proper forum for legal proceedings to prevent the call. If you wish to prevent a call on a bond or guarantee you will need to consider the proper venue to bring legal proceedings, which may be a different forum than the dispute resolution procedure under the construction contract. It is imperative that you issue proceedings in the correct jurisdiction. Because, if you choose the wrong forum, the security may be paid out.
In sum, although the general principles of a bond or guarantee can be reasonably straightforward, the drafting of the instrument can vary significantly, so the key takeaway is to review carefully the terms with your legal team before making a call or seeking to defend. The risks set out in the above checklist should also be kept in mind when agreeing to the terms of the security in the first place, to avoid complex issues when seeking to enforce your rights in respect of the project performance.