Constructing safety nets

A version of this article was first published in Construction Law, October 2014.

Notwithstanding the economic upturn, many UK contractors are still tendering for work at negative margins; sustaining losses; and arguably operating one major dispute away from the brink.  This article examines the common forms of security used by employers to safeguard performance by contractors, and/or protect against insolvency, and considers the degree of comfort they afford.

Key points

• Whilst the recent increase in morale in the construction industry has inherent value, the risk of contractor insolvency remains.
• The commonplace traditional forms of informal security can give rise to significant disputes surrounding categorisation and interpretation.
• The apparent desirability of a performance bond, which can be called upon without recourse to any underlying default, must be examined in light of the risk that recovery may prove costly and time-consuming.
• The appropriate financial instrument (if any) should be determined by reference to the degree of risk being taken, such that the: category, effect, cost to implement, and enforceability of the instrument, all warrant careful consideration.
• Assuming the concerns in this area of law can be assuaged, using appropriate drafting, the real objectives may yet require a conceptual shift, so as to focus on more robust vetting and monitoring processes in addition (or instead).

One step at a time

An improving economy has markedly revived the construction industry in recent times. Increases in public and private sector infrastructure expenditure, and support for the real estate market precede a further reduction in corporation tax due in April 2015, and the insolvency statistics¹ for Q2 2014 show a decrease in company liquidations, administrations and voluntary arrangements in England and Wales.  Notwithstanding this decrease, a sector breakdown of total liquidations in the 12 months ending March 2014 showed the highest incidence (2,614) was in construction.

As a contractor’s worth is frequently in his receivables, such as debts, claims, retention and work in progress, and given contractors are still contending with rising material and energy prices (giving rise to fairly low profit margins) there are enduring concerns surrounding the effect of extended payment terms on the supply chain, in terms of cash flow and solvency.

All things considered, while the financial recovery is well under way; the power imbalance between employers and contractors means employers will continue to require informal forms of security, outside the construction contract.  The common approach is for employers to require a performance bond or guarantee, and take comfort from the assumption it will provide a sizeable all-purpose safety net should things go wrong.

My word is my bond?

Performance bonds and guarantees are forms of informal security that are firmly established in the sector, and have traditionally been the most common strategy for managing risk in construction projects.  There is a vast range of standard documents, yet further uncertainty is introduced in that bespoke terms are frequently agreed.  In general, a performance bond is a deed by which a third party (often referred to as a bondsman) is obliged to make payment to the beneficiary (typically the employer) of a stipulated sum on a date or the happening of an event (often the default or insolvency of a contractor).

The performance bond is generally a condition precedent to the construction contract, and the employer is usually reassured by the option to call on a solvent paymaster should the contractor default or become insolvent.  Unlike a parent guarantee, a performance bond also protects the employer against the risk of group insolvency.

However, in practice the title of "performance bond" or "guarantee" may be meaningless because there is little uniformity and the instrument is often such an amalgam of terms it is difficult to accurately categorise.  What is essential is the nature of the obligation taken, and in particular whether the beneficiary can call on the bondsman or guarantor without reference to the liability of the contractor (which is a primary obligation), or whether the obligation is related to a failure to perform under another contract (i.e. a secondary obligation).
Given these instruments are often entered into as an afterthought to the underlying contract; are open to interpretation; and frequently give rise to significant disputes, it is probably time to question how effective they actually are at achieving the commercial "safety net" functions they are meant to perform.

The substance of the instrument: Bond or guarantee?

In Meritz Fire & Marine Insurance Co Ltd v Jan De Nul NV [2010] EWHC 3362 (Comm) and [2011] EWCA Civ 827 the buyers of dredgers being built by a Korean shipyard agreed to make advance payments against the purchase price.

To secure return of those payments in specified circumstances, they obtained advance payment guarantees (“APGs”) from the insurer Meritz. The APGs, which were “materially in the same terms”  were expressly subject to the "Uniform Rules for Demand Guarantee of the International Chamber of Commerce No. 458"², which state that the terms of the underlying contract are of no concern to the beneficiary and the guarantor.

The Korean shipbuilder unilaterally transferred the contract to another company and was promptly dissolved.  Thereafter, the contract was again transferred and the buyers claimed the work fell into significant delay. Unsurprisingly, the buyers terminated the contract and demanded repayment and interest from Meritz under the APGs.

Before Beatson J., Meritz argued that the APGs were not performance bonds, which absent fraud, created primary obligations to be honoured irrespective of the underlying contract, but instead were classic contracts of guarantee imposing only secondary obligations.

Despite the wording of the APGs being inconclusive, and the presumption that a guarantee which is not issued by a bank will not be construed as an "on demand" bond³ , Beatson J. found the APGs were performance bonds or demand guarantees, and entitled the buyers to succeed; noting:

“Looking at the broad structure of the APGs and, at this stage standing back from an analysis of their particular wording, it is noteworthy that they have three of the four attributes which the editors of Paget's Law of Banking… state will lead an instrument 'almost always [to] be construed as a demand guarantee'… The three attributes are: (a) the underlying transactions, the shipbuilding contracts, are between parties in different jurisdictions; (b) the APGs do not contain clauses excluding or limiting the defences available to a surety in a classic guarantee where the surety's liability is secondary; and (c) the undertaking is to pay on demand, in this case… to pay 'within thirty (30) days after demand is made'.”

He also considered that subjecting the APGs to the Uniform Rules was an indication that the parties regarded them as demand guarantees, and rejected the argument that there was inconsistency between the terms of the APGs and the Rules.

Dismissing the insurer’s appeal to the Court of Appeal, Longmore LJ stated that Meritz’s argument that the APGs should be categorised as guarantees that required the buyers to prove liability, was “extremely difficult” given incorporation of the Uniform Rules, which expressly exclude consideration of the underlying contract.

The construction afforded in Meritz therefore reinforced the enduring canon that parties must actively scrutinise the wording of their agreement, and may pay a high price if they fail to ensure the terms accord with their intentions.  In particular, it highlighted that incorporation of other provisions such as the Uniform Rules must be carefully considered.

As the APGs were engaged by provision of specific documents, without regard to whether any assertion in the documents was correct in law Meritz should also serve as a reminder that if the issuing party’s obligation to pay depends on the presentation of a document, it will remain a primary obligation and the court will not assess the validity of what is asserted in the document.

The weight of the presumption

Another shipbuilding case, Wuhan Guoyu Logistics Co Ltd v Empoiki Bank of Greece SA [2012] EWCA Civ 1629, gave rise to a dispute as to whether a security document called a guarantee in its face, was in fact an "on demand bond" or a guarantee.

In Wuhan, the purchase contract provided for payment by installments and the bank provided a payment guarantee in favour of the seller, with the bank agreeing to:

“…IRREVOCABLY, ABSOLUTLEY and UNCONDITIONALLY guarantee, as primary obligor and not merely as surety, the due and punctual payment by the BUYER of the 2nd instalment of the Contract Price”

and that

“In the event that the BUYER fails to punctually pay the second Instalment… then, upon receipt by us of your first written demand stating that the Buyer has been in default of the payment obligation for twenty (20) days, we shall immediately pay to you or your assignee the unpaid 2nd Instalment… without requesting you to take any or further action, procedure or step against the BUYER or with respect to any other security which you may hold.”

The Judge at first instance found the wording required default and so created a guarantee in the traditional sense, and accordingly the Bank was not liable.  However, the Court of Appeal disagreed, and in a detailed judgment, after setting out the points for and against the wording creating a guarantee, and mindful of the need to assist parties in determining their obligations, Longmore LJ stated:

“The only assistance which the courts can give in practice is to say that, while everything must in the end depend on the words actually used by the parties, there is nevertheless a presumption that, if certain elements are present in the document, the document will be construed in one way or the other.”

As to those elements, Longmore LJ noted that where an instrument:

• relates to an underlying transaction between the parties in different jurisdictions;
• is issued by a bank;
• contains an undertaking to pay “on demand”; and
• does not contain clauses excluding or limiting the defences available to a guarantor – it will almost always be construed as a demand guarantee⁴.

The Court of Appeal gave considerable weight to this presumption in reaching the conclusion that the document in question was an on demand guarantee.

While lower courts can be expected to adopt and apply the presumption as suggested, it is still a presumption that may be rebutted, and given the plethora of different wording used in the industry, the level of certainty one might ordinarily expect following such a judgment seems unlikely to be realised.

This therefore remains a knotty area of the law where the form in which much security is expressed, has struggled to marry the commercial objectives with the legal obligations created.  Given the majority of bonds (especially in domestic markets) are default bonds, which do not offer a great deal of protection at all, it is unlikely that employers have taken much comfort from the judgments in Meritz and Wuhan.

The significant cost of putting performance bonds (and some guarantees) in place and the difficulties in their enforcement in practice, perhaps suggests the time is fast approaching to seriously explore bond alternatives.

Are we there yet?

Prudence dictates solvency should be carefully considered and determined at the pre-qualifying and tender stage, by way of effective vetting procedures and thorough financial risk assessments, as a performance bond or guarantee generally remains a poor substitute for such processes.  Furthermore, if sufficiently comprehensive and rigorous, such processes still present the best opportunity (in principle) to remove the requirement for a safety net altogether.

Although well-established and typically executed by way of short agreements, performance bonds and guarantees often create confusion or give rise to onerous obligations that are disproportionate to the construction project.

Notably, the UK government has expressed an intention to limit the circumstances in which on demand bonds should be used, and to place emphasis on other methods to reduce risk, such as: contract management, monitoring procedures, and contractual step-in rights⁵, which perhaps reflects an understandable and obvious concern that such bonds have particular drawbacks.

In the meantime, parties may still consider a "belt and braces" approach to construction contracts is best, but if that results in indiscriminate use of financial protection regardless of project requirements or pre-contract procedures, they will be missing the point.  The better approach appears to be to aim to reduce the risk of the worst happening, from the outset, not just mitigate its effects once it occurs, as testing the construction of the document’s wording after the event may well be an unhappy leap of faith.

¹ The Insolvency Service: Insolvency Statistics – April to June 2014 (Q2 2014).   

² Beatson J. in Meritz Fire & Marine Insurance Co Ltd v Jan De Nul NV [2010] EWHC 3362 (Comm) at [24].

³ See Marubeni Hong Kong v Government of Mongolia [2005] EWCA Civ 395.

⁴ As cited in Paget’s Law of Banking, 11th edition

⁵ See Procurement Policy Note – Supplier Financial Risk Issues, Information Note 02/13 18 February 2013.