Bondage Nightmares

Sometimes it seems that Clients want it all. The cheapest price, the shortest programme, the Contractor assuming as much risk as possiblesound familiar' And then to top it all, the subject of parent company guarantees or other third party guarantees is raised.
 
 

Sometimes it seems that Clients want it all. The cheapest price, the shortest programme, the Contractor assuming as much risk as possible……sound familiar? And then to top it all, the subject of parent company guarantees or other third party guarantees is raised.

 
Have you been asked to enter into a third party guarantee by one of your clients recently? If not, you may soon be. The credit crunch, rising raw material prices and the predicted slow-down in economic activity is not exactly good news for the construction sector. Let’s face it, things are going to be tough out there for the next couple of years and Clients and their advisors know it. It is exactly these economic circumstances that ultimately lead to a demand in the provision of a Parent Company or other third party guarantees.
 
Parent Company guarantees is a subject matter in itself and this article deals solely with third party guarantees and in particular contract guarantee bonds.
 
Let’s start at the beginning. What do I mean by a contract guarantee bond?
 
In the context of construction and expressed in its simplest form, a contract guarantee bond is a three-way contract under which a third party, usually a bank or an insurer (“the surety”), agrees to compensate an Employer for any losses it incurs should the Contractor fail to comply with the terms of the building contract. Bonds in the UK are normally set at a value of 10% of the contract price but I have seen them set as high as 30% in the past.
 
There are two types of contract guarantee bonds in common use in the UK. These are “performance bonds” and “on demand bonds”.
 
What is a “performance” bond?
 
A “performance” bond is a guarantee by a third party, usually an insurance company, to pay the Employer the value of a loss incurred by the Employer where the Contractor has failed to comply with the terms of a building contract. Although dependant upon the precise wording, most forms of “performance” bond will provide some of the following features:
 
  • A right for the Employer to recover only those damages payable by the Contractor to the Employer under the building contract and only where the Employer has been unable to recover them from the Contractor, e.g. insolvency.
  • An obligation on the Employer to mitigate any losses flowing from any alleged breach of the building contract by the Contractor.
  • A clear date or milestone, such as the issue of a practical completion certificate, when the bond ceases to have effect.
 
What is an “on demand” bond?
 
An “on demand” bond is a guarantee by a third party, usually a bank, to pay the Employer the full value of the bond at any time the Employer considers appropriate. The problems with this type of bond are:
 
  • There is no defence that a Contractor or the surety can use to resist payment of the bond value to the Employer other than fraud.
  • Where an “on demand” bond has been provided by the Contractor’s bank, the value of the bond will be treated as a liability and the value of the Contractor’s overdraft facility reduced accordingly.
  • It is unclear how a Contractor can recover monies paid to an Employer under an “on demand” bond even where it can be shown that the claim made by the Employer is unfair or even vexatious.
 
Whilst in certain circumstances, and subject to precise wording, it may be appropriate for a Contractor or Sub-Contractor to agree to enter into a “performance” bond, in my view there are no circumstances when a Contractor or Sub-Contractor should ever consider entering in-to an “on demand” bond.
 
“On demand“ bonds remain the preserve of the rich, extremely brave or downright foolish! If you don’t believe me then perhaps you will take more interest in what the Courts have had to say on this subject.
 
"In recent years there has come into existence a creature described as an ‘on demand bond’ in terms of which the creditor is entitled to be paid merely on making a demand for the amount of the bond.....  All that was required to activate it was a demand by the creditor stated to be on the basis of the event specified on the bond".
 
Lord Jauncey in Trafalgar House Construction (Regions) Limited v General Surety and Guarantee Co Ltd [1996]
 
"Performance guarantees in such unqualified terms seem astonishing.... And I understand that such guarantees are drawn up partly or wholly without any, or any apparent justification, almost as if they represented a discount in favour of the buyers.  In such cases the contractors are then left merely with claims for breaches of contract against their employer and the difficulty of establishing and enforcing these claims."
 
Mr Justice Kerr in RD Harbottle (Mercantile) Ltd v National Westminster Bank [1977]

"...A demand might have to be met by the guarantor (surety)...Not only when there are substantial breaches of contract, but also when the breaches are insubstantial or trivial, in which case they bear the colour of a penalty rather than liquidated damages: or even when the breaches are merely allegations by the customer without any proof at all: or even when the breaches are non-existent.  The performance guarantee then bears the colour of a discount on the price of 10% or 5% or as the case may be.  The employer can always enforce payment by making a claim on the bond and it will then be passed down the line to the ....supplier ..... a possibility that the ..... contractor, if he is well advised, will take it into account when quoting his price for the contract".
 
Lord Denning in Edward Owen Engineering v Barclays Bank International [1979]:

If you are going to enter into an “on demand” bond, why not offer the Employer a 10% discount on the contract price instead? This comment may sound stupid but an “on demand” bond for the same value is tantamount to the same thing!
 
Peter Vinden is a practising adjudicator, mediator, expert and conciliator. He is Joint Managing Director and Chairman of Vinden and can be contacted by email at pvinden@vinden.co.uk
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