Bond calls - still as good as cash?

By Julian Brooksbank and Philip Norman11 June 2008

Julian Brooksbank

Julian Brooksbank

Two judgements have modified the view that On Demand Bonds are as good as cash in hand. Julian Brooksbank and Philip Norman of Pinsent Masons look at situations where breaches of contract have overridden Bond calls.

Contractors are often required to give performance security, usually by way of Bonds. While they are often a requirement of the construction contract, these Bonds are separate contracts, governed by their own terms - the value and method of call. Few stipulate the conditions to be satisfied before they are called.

In fact the large majority are 'On Demand', which is to say the Bondsman pays upon the Employer's demand, without investigating default of performance in the underlying contract or the Contractor's objections. These 'On Demand Bonds' are generally considered as good as cash, as the Bondsman's primary obligation is to satisfy the call.

A difficulty arises where the underlying construction contract and Bond do not provide the same conditions precedent before a call can be made. A conflict arises between satisfying the terms of the Bond or those in the construction contract.

This question was considered in Sirius International Insurance Company (‘S') v FAI General Insurance Limited and others (‘F'). Here, ‘S' provided insurance to another party (‘A'). ‘S' reinsured with ‘F' on the condition that if any claim were made against ‘S', ‘S' would not pay without ‘F's' agreement. ‘F' provided ‘S' with an On Demand Bond as its performance security. ‘A' made a claim on the insurance and ‘S' paid it without obtaining ‘F's' agreement. ‘S' claimed on its reinsurance agreement, but ‘F' refused to pay because it had not agreed ‘S's' pay out. ‘S' called the On Demand Bond.

‘S' argued the Bond was a separate agreement, unaffected by the call conditions under the reinsurance contract. The court rejected this, holding ‘S' could not make a call in breach of the reinsurance contract's terms, even though the terms of the Bond did not contain such limitations. It was confirmed on appeal that even though the Bond was different, the terms of the underlying contract could not be ignored, as it was that contract that gave rise to the Bond in the first place. While the Bondsman had to satisfy the Bond call, it did not mean ‘S' could ignore the conditions precedent before calling it.

This decision appeared to erode the fundamental purpose of On Demand Bonds - an autonomous security, as good as cash in hand.

Ramsey J considered a similar situation in Permasteelisa Japan KK (‘P') v Bouyguesstroi (‘B'). ‘B' was engaged as Engineering Procurement & Construction (EPC) contractor for an office facilities project on Sakhalin Island, Russia. ‘B' subcontracted curtain walling works to ‘P' and ‘P' procured an On Demand Bond as its performance security in the following terms -

"...we [the Bank] hereby guarantee unconditionally and irrevocably undertake to pay to the Contractor on its first demand, despite any objection from the Subcontractor, such sum as the Contractor may claim... such sum shall not in aggregate exceed the amount of this guarantee..."

The Subcontract required ‘P' to be in breach of its obligations and, following the requisite notice and cure period, to remain in breach before a call was made.

Disputes arose and ‘B' served notice of default on ‘P'. ‘P' rejected the notice, doing nothing during the cure period. The calculation of the cure period was expressed in calendar days, but it was unclear whether the day of service was counted or whether time ran from the following day. ‘B' calculated its time from the day the notice was served and called the Bond immediately upon its expiry. ‘P' sought an injunction preventing the Bond call, or for a freeze order relating to the bond proceeds, arguing it was not in breach and the cure period had not expired.

The court did not grant the injunction and dismissed ‘P's' claim. It confirmed the Sirius judgment holding -

"the Court has the power to grant injunctions over performance guarantee funds when the performance guarantee is called in breach of restrictive underlying contract conditions. In Sirius the Court of Appeal stated where conditions were not fulfilled the Claimant could not draw down the funds and in appropriate cases the court could restrain a draw down. This was decided on the meaning of the contractual provisions and therefore it was not necessary to deal with autonomy."

Ramsay J gave his reason for declining ‘P's' claim and distinguishing this case from Sirius as follows -

"The Court of Appeal in Sirius found an express term of a contract where it was positively established it had been breached, so that no draw down was permitted. In my judgment, the same does not apply when only a seriously arguable case of breach has been established."

It is clear from these authorities, that while the autonomous nature of an On Demand Bond is preserved, the Court can give effect to restrictions imposed on calls contained in the underlying contract. Whilst the Bondsman must comply with the call, if clear provisions in the construction contract are clearly breached, the court may prevent the beneficiary from obtaining the funds. Only having a seriously arguable case that there is non-compliance with the conditions precedent is insufficient.

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