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Security for payment: Bonds and guarantees

Jonathan Hosie, Partner, Mayer Brown International LLP

OR projects both large and small, one of the single biggest

risks in today's market is supply chain insolvency. It is
perhaps a truism but a supply chain is only as strong as the
weakest link. For those contractors who may become
overstretched, their debt providers are increasingly likely to pull
the plug rather than to provide a credit extension; banks
continuing to rebuild their balance sheets with the result that credit
support for contractors at each tier within the supply chain
continues to be tight.
It is against this commercial backdrop that the issue of
performance security is addressed in this paper. I propose to
examine the difference between bonds and guarantees, to illustrate
some of their key features and explain the consequences of one
form as against the other. There are, of course, other forms of
performance and payment security, such as reservation of title
provisions, vesting certificates and escrow accounts. These other
forms of security are beyond the scope of this paper but the point
is that when considering insolvency risk, parties should look at all
of the options. However, let's have a look now at a bit of law
because getting this right (or wrong) can have serious
consequences. The rules are strict and therefore have the potential
to trap those who do not take care with the forms of agreement
they enter into.

The difference between a performance bond and a guarantee

A supply chain is only as

strong as the weakest
link. Why payment and
performance security is
important on civil
engineering projects

A performance bond is a specialist banking instrument originally

developed for trade finance transactions. It imposes a primary
contractual obligation on the issuer to pay the beneficiary a
specified sum of money on its first demand for payment. The
beneficiary is entitled to payment on submitting a statement (or
certificate) that the underlying obligor is in default of the contract
and the beneficiary has suffered a loss. In a construction context,
the obligor would be the contractor, the beneficiary is the
employer and issuer is the contractors bank.
Compare to this a guarantee. This is a contract of surety which
creates a secondary obligation to support a primary obligation of
one party to another. A guarantor's liability under a guarantee is
contingent on the underlying obligation. However, instruments
described as guarantees usually also incorporate primary
obligations such as a supporting indemnity, but it has been held
that a guarantee like this is still a secondary obligation that only
comes into effect once the secondary obligation (such as default
under the construction contract) is triggered.
All of this, of course, is pretty dry legal stuff. What brings it alive
are the facts of cases where parties argue as to whether the
performance security is in the form of an on-demand bond or
whether it is simply a guarantee. This arises usually where there is
a demand for payment against the performance security but the
breach giving rise to the demand is disputed. That dispute as to
liability under the underlying contract would normally be sufficient
to postpone a call under the guarantee; this is only triggered by a
default which is admitted or determined by a tribunal. On the other

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There is a rich source of judicial guidance on the issue. So much so,

that even experienced judges at first instance may find that the
instrument in question is a guarantee but another three judges
sitting in the Court of Appeal arrive at the opposite conclusion on the
same documents.
hand, if the performance security is in the nature of a bond then it may well be expressed
on terms to be payable on demand, irrespective of any dispute as to whether or not the
underlying contract has, in fact, been breached.
These very issues have been argued out in numerous cases over the years such that
there is a rich source of judicial guidance on the issue. So much so, that even
experienced judges at first instance may find that the instrument in question is a
guarantee but another three judges sitting in the Court of Appeal arrive at the opposite
conclusion on the same documents.

Shipbuilding and civil engineering

This debate is well illustrated by the recent case of Wuhan Guoyu Logistics Group Co Ltd v
Yangzhou Guoyu Shipbuilding Co Ltd and Emporiki Bank of Greece SA (2012). This case
arose in connection with a claim under a document entitled Payment Guarantee which
was provided by a Greek bank. The underlying transaction was a shipbuilding contract for
a vessel with a sale price of US$41,250,000, payable in five instalments. The second
instalment of $10,312,500 was payable following receipt by the buyer of the vessel of a
refund guarantee issued by the seller's bank, being the Bank of China. The Greek bank
provided finance to the buyer for its purchase of the vessel and issued the payment
guarantee to the Bank of China in respect of the second instalment of the price. However,
the second instalment was not paid. The seller then brought proceedings in the
Commercial Court in London claiming summary judgment under the payment guarantee,
arguing that this was payable on demand. Perhaps not surprisingly, the Greek bank argued
that the instrument was a guarantee and if the second instalment was not due, there could
be no liability under the payment guarantee.
At first instance, the Greek bank was successful. However, the seller took its case to the
Court of Appeal which reversed the first instance judgment. In doing so, the Court of
Appeal re-confirmed the policy of the court in matters of international trade which
depends upon commercial parties having certainty of performance via guarantees and
other instruments which are expressed to be payable on demand. In particular, the Court
of Appeal quoted with approval Pagets Law of Banking (11th edition) where, under the
heading of Contract of Surety Ship v Demand Guarantee it is stated:
Where an instrument (i) relates to an underlying transaction between the parties in
different jurisdictions, (ii) is issued by a bank (iii) contains an undertaking to pay on
demand (with or without the words first and/or written) and (iv) does not contain
clauses excluding or limiting the defences available to a guarantor, it will almost always
be construed as a demand guarantee... In construing guarantees it must be remembered
that a demand guarantee can hardly avoid making reference to the obligation for whose
performance the guarantee is security. A bare promise to pay on demand without any
reference to the principal's of obligation would leave the principal even more exposed in
the event of a fraudulent demand because there would be room for argument as to
which obligations were being secured.
In the Wuhan Guoyu Logistics case, the Court of Appeal referred to the presumption
enunciated by Paget... and supported by previous authority and said that the first instance
judge ought in my respectful view to have had much more regard to the presumption than
he did. It is perhaps illustrative to identify the features of the payment guarantee with
which the first instance judge took to be indicative that the performance security was in
the nature of a guarantee rather than a surety bond. He was said to have relied on the
following indications, with greater or lesser enthusiasm:
i) The document is called a guarantee.
ii) When referred to in the exhibits to the contract, it is called an irrevocable letter
of guarantee.
iii) Clause 1 contains the core obligation guaranteeing the due and punctual payment
of the second instalment and identifies the second instalment in the terms set out in
clause 2 without at that stage saying anything about agreeing to pay on demand.
iv) Clause 3 relating to interest requires the buyer to be in default.

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(v) Clause 4 follows on from clauses 1, 2 and 3 and calls for payment in the event that
the buyer fails punctually to pay and goes well beyond what is needed for the purpose
of identifying the obligation for which the security was being given.
vi) The closing words of clause 4 would be unnecessary if the document was an
on-demand guarantee.
vii) The later words of clause 7 were only necessary if the document was a true see to
it guarantee.
viii) The bank was not providing the guarantee for a set fee but was closely connected
with the whole transaction which it was financing.
ix) Although the contractual background did not provide any sure guide to the
contracts correct interpretation, the judge was struck by the fact that the bank could
find itself having to pay up to the amount of the second instalment without any refund
guarantee being in place from the seller's bank to secure its return. The refund
guarantee had to be provided before the second instalment was due under the contract
and indeed arbitrators have now held (subject to any appeal for which leave might be
given) that because it was not provided in the appropriate terms, the buyer was not in
fact obliged to pay the second instalment. The judge evidently thought reciprocity was
appropriate.
Notwithstanding all these pointers towards the document being a guarantee, the Court of
Appeal felt it appropriate to follow the guidance offered by Paget and concluded that the
document sued on was in fact an on-demand guarantee. As such, judgment was given in
favour of the seller and the Greek bank was required to pay out $10,312,500.
Of course, the arrangements here could have equally applied to a civil engineering
project. An employer may be required to make an advance payment to its civil
engineering contractor for off-site fabrication of certain works. The contractor provides an
advance payment guarantee, as security for repayment in the event the said works do not
arrive as designed. However, the fabrication goes awry and what is delivered is said not to
be in accordance with the specification. The employer calls on the advance payment
guarantee but the contractor says the goods are compliant with the specification or it is
just a temporary disconformity which will be put right. Whether the advance payment
guarantee is a bond or a guarantee will determine whether the employer gets its money
back there and then.

Claims for more than the loss?

Interesting issues can also arise where, even though the performance security is in the
form of an on demand guarantee, the claim is in fact for a sum greater than the claimant's
actual loss. It has been held that in the context of a performance bond or advance
payment guarantee, a demand which the maker does not honestly believe to be correct as
to its amount is a fraudulent demand (Uzin Terimpex v Standard Bank plc (2007) 2 Lloyds
Rep 187). These principles can also find application in the construction sector. For instance,
in Simon Carves Limited v Ensus UK Limited (2011) EWHC 657, Mr Justice Aikenhead had to
consider a claim under a form of performance security, where the contract containing
provision which stated that upon issue of an acceptance certificate the bond was to
become null and void in respect of any pending or previously notified claim. An
acceptance certificate had been issued but was followed by a call on the bond. After
hearing evidence, the court found that there was a serious question to be tried as the case
[was] a strong one for suggesting that the call might be a fraudulent one. However, the
threshold for establishing fraud in such circumstances is a high one.
These risks may be militated by the use of appropriate contract terms. An example is
found in the FIDIC suite of contracts, sub-clause 4.2 of which states:
The employer shall not make a claim under the performance security, except for
amounts to which the employer is entitled under the contract.
If your civil engineering contract contains such a clause this will provide a useful
measure of protection against the risk of a call by an employer for a sum in excess of
its entitlement.
In a tough economic climate, employers and their funders increasingly look for as much
performance security as they can get and on increasingly stringent, even on-demand
terms. Care needs to be taken when agreeing the terms as to which side of the line you
fall; guarantee or bond?
Jonathan Hosie, Partner, Mayer Brown International LLP
Member of the Contracts and Dispute Resolution Panel of the Chartered Institution of Civil
Engineering Surveyors
jhosie@mayerbrown.com
www.mayerbrown.com