The Lifeblood of International Commerce?
Tuesday, 23rd February 2016
Various forms of security are often sought by employers particularly in the construction industry. Predominantly, at contract stage employers call for Parent Company Guarantees and/or bonds.
A Parent Company Guarantee ("PCG") is a guarantee from a contractor's parent company that the contractor will fulfil its obligations and that the parent company will carry out those obligations in the event that the contractor fails to do so. A PCG is subject to the strength of the financial covenant of the parent company.
By contrast, a bond is obtained from an independent third party at a cost to the contractor (albeit this will often be passed to the employer, having been factored into the contract price).
Bonds can provide employers with valuable protection against contractor non-performance. Where a contractor fails to fulfil its obligations under a building contract, and/or becomes insolvent, the employer can look to the issuer of the bond (often known as the "bondsman" or "surety") for payment to cover its losses (or some of them).
Before issuing a bond, the bondsman may well want to assess the contractor's ability to perform its obligations under the contract and may well ask for details of the contractor's business, including accounts, contract details and so on. Furthermore, a party procuring a bond will often have to enter into a lengthy counter indemnity with the bond provider (giving the bondsman the right to seek to recover monies from the contractor (or its parent company) in the event that it has to pay out under the bond).
A bond will fall into one of two categories: an on-demand bond (sometimes known as an unconditional bond) or a default bond (sometimes known as a conditional bond).
On-demand bonds impose an obligation on the surety (usually a bank) to pay a pre-determined sum to the employer where the grounds for calling on the bond have been met. The surety's obligation to pay is independent of the contractor's obligations in the underlying contract, meaning that there is no need for the employer to establish loss by bringing a claim against the contractor in order to receive the pay-out.
This is incredibly beneficial for employers as (depending on the exact wording of the bond), all they typically have to do to receive payment is submit a statement that the contractor is in default and that it has suffered a loss. The on-demand bond is particularly popular in the context of process plant contracts but unsurprisingly they can be difficult and costly to procure.
On demand bonds have been described by the courts as "the lifeblood of international commerce". However, having historically allowed parties to resist calls on bonds only in clear cases of fraud or where it was "positively established" that the call on the bond was in breach of the underlying contract, two separate cases heard in the Technology and Construction Court over recent years demonstrated a willingness on the part of the courts to "relax" the rules and widen the grounds on which a bondsman could resist a call on an on demand bond. Employers were concerned about the potential erosion of the protection of this type of bond.
However, in the case of MW High Tech Projects Ltd v Biffa Waste Services Ltd  the court has reverted to the more stringent test.
The facts were that Biffa had entered into a contract (the EPC contract) for the design, construction, installation and testing of the plant, the completion date of which was to be determined by reference to the testing regime, with liquidated damages payable for non-completion.
MW High Tech, as EPC contractor, was required to procure a parent company guarantee, a performance bond and retention bond.
The works were delayed and Biffa terminated the contract and then sought to recover sums due in respect of liquidated damages under the bond.
The terms of the bond were that it was a condition precedent that Biffa would first call on the PCG. Biffa made the call on the PCG and then proceeded to call on the retention bond (which was payable on demand).
MW High Tech alleged that the call was not "valid" because the underlying contractual basis for making it was unfounded. It fell to the court to decide whether Biffa's right to call on the bond was subject to the call on the PCG being "valid" under the construction contract.
The High Court held that it was not. Rejecting MW High Tech's argument, the court found that there was no justification for implying a term that the call under the PCG must be "valid" before the employer was able to call on the on-demand bond. The court restated the current law that it may only intervene in the call of an on-demand bond if:
1. there is a seriously arguable case of fraud; or
2. it is "positively established" that the beneficiary of the bond is precluded from making a call by the underlying contract.
The court held that point 2 applied when the underlying contract clearly precluded the right to draw down on the bond. However, the court would not intervene simply because the alleged breach upon which the employer relied as the context for its call under the PCG was unfounded. The court was not willing to extend the law in this way, as this would eliminate the perceived commercial benefits of an on-demand bond, which would be "unacceptable". Further, the court confirmed that it is not sufficient for there to be a "seriously arguable" case that the employer is not entitled to draw down; the more rigorous "positively established" test must be adopted.