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17.2BONDS AND GUARANTEES

A bond or guarantee is an arrangement under which the performance of a contractual duty owed by one person (A) to another (B) is backed up by a third party (C). What happens is that C promises to pay B a sum of money if A fails to fulfil the relevant duty. In this context A is commonly known as the principal debtor or simply principal; B is called the beneficiary; and C is called the bondsman, surety or guarantor.

In the construction context, such backup is likely to come from one of two sources. First, there are parent company guarantees, under which the contractual performance of one company within a corporate group is underwritten by other members of the group. The undoubted importance of such guarantees derives from the combination of two factors. First, many companies operating within the construction industry are seriously under-capitalized (despite forming part of a financially stable corporate group). Second, English company law does not treat a parent company as responsible for the debts of its subsidiaries, unless such responsibility is expressly taken on.

The second type of protection against contractual failure consists of bonds, which are normally provided (at a price) by a financial institution such as a bank or an insurance company. Some organizations, many of them from the USA or Canada, have specialized for many years in the provision of bonds for the construction industry. Unfortunately, and despite repeated criticism from the courts, these specialists continue to draft their bonds in a form that is archaic, obscure and full of traps for the uninitiated.

17.2.1Nature of bonds

It is possible for almost any contractual obligation to be the subject of a bond, but in practice they are normally found in certain commercial fields where their use is well established. In the construction context, the obligations most commonly guaranteed in this way are the following:

Payment: For example the employer’s duty to pay the contractor or the contractor’s duty to pay a sub-contractor. A contractor may also provide a bond in favour of the employer, in return for an early release of retention money or, indeed, instead of the normal retention provisions. If defects are then found in the building, the employer can call on the bond, rather than the retention money, to finance the necessary remedial work. There is an optional requirement in JCT SBC 11 for such a retention bond, and also for bonds covering advance payments to the contractor and payment for off-site materials or goods. These last two bonds, both of which are ‘demand bonds’ (see Section 17.2.2), provide the employer with some recourse in the event that the contractor fails to fulfil obligations that have been paid for.

A specific obligation: For example a promise by a sub-contractor not to withdraw a tender. This may be of practical importance where, say, a main contractor tenders on the basis of bids received from sub-contractors. A main contractor, having been awarded the job, who finds that a sub-

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contractor’s bid is no longer open for acceptance, may then have to pay a significantly higher price to another sub-contractor for that part of the work.

Performance of the contract in general: This is the most common type of bond, in which every aspect of the contractor’s performance is guaranteed. An optional requirement for the contractor to provide such a bond is found in both ICC 11 and in the FIDIC Conditions of Contract. JCT SBC 11 contains no such provision; however, the contract is frequently amended to require a bond, normally to a level of 10% of the contract sum. It should be noted that, where there is such a requirement, failure by the contractor to

obtain a bond will be regarded as a sufficiently serious breach to justify the employer in terminating the contract.9 Moreover, a contract administrator

who fails to check that a required bond is in place may be liable to the client for professional negligence.10

It is perhaps not always fully appreciated that the true underlying purpose of a bond is to give financial protection where the principal debtor, whether it be the employer or the contractor, becomes insolvent. This is because a defaulting party who remains solvent can of course be sued directly. Moreover, even if the beneficiary chooses to sue the surety instead of the principal, the surety has an automatic right of recourse against the principal. Indeed, the surety’s overall risk is further reduced by the possibility of seeking contribution from another defaulter. Thus, for example, if a defect in a building is partly the fault of the contractor and partly due to negligent design by the architect, a surety for the contractor can claim a contribution from the architect under the Civil Liability (Contribution) Act 1978.

Given this intention to protect the beneficiary against another party’s insolvency, the decision of the Court of Appeal in Perar BV v General Surety & Guarantee Co Ltd11 came as something of a shock to the construction industry. The defendants in that case provided a general performance bond to guarantee the contractual obligations of a design and build contractor, in which they undertook to pay damages to the employer in the event of the contractor’s default. The contractor went into administrative receivership, whereupon the contractor’s employment was automatically determined. It was held by the Court of Appeal that, since ‘default’ meant simply ‘breach of contract’, the contractor’s insolvency did not constitute default. Nor, once its employment had been determined, could the contractor be guilty of a breach of contract in failing to continue with the works. In effect, therefore, the bond provided no protection in precisely the circumstances where it was needed.

In an attempt to avoid the problem that arose in the Perar case, some bonds state expressly that the contractor’s insolvency, as well as a breach of contract, shall trigger the bondsman’s obligation. Unfortunately, however, it appears from the case of Paddington Churches Housing Association12 that, where JCT SBC 11 is concerned, this wording may not necessarily have the desired effect. This is because the bondsman in that case promised to satisfy the employer’s ‘net

9 Swartz & Son (Pty) Ltd v Wolmaranstadt Town Council 1960 (2) SA 1.

10Convent Hospital v Eberlin & Partners (1990) 14 Con LR 1.

11(1994) 66 BLR 72.

12Paddington Churches Housing Association v Technical and General Guarantee Co Ltd [1999] BLR

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established and ascertained damages’, and it was held that those damages do not become ‘established and ascertained’ until the works have been completed by another contractor and a statement of account has been drawn up in accordance with what is now clause 8.7.

17.2.2Types of bond

The type of bond normally found in the construction industry is the conditional bond, under which the surety agrees to pay if and when certain specified conditions are satisfied. In the case of a performance bond, the most likely such condition would be any default (i.e.breach of contract) by the contractor. In order to call for payment, the employer must provide evidence of both the contractor’s default and the resulting losses suffered by the employer.13

A second type of bond is the unconditional or demand bond, something which has spread into the construction field from international trade. Such a bond entitles the beneficiary to call upon the surety for payment whether or not there has been default under the principal contract, provided only that the call is not fraudulent.14 This means that, unless the surety has clear evidence of such fraud, payment must be made.15 The use of these bonds in construction contracts is on the whole undesirable since, while the employer may not intend to call on such bonds irresponsibly, the contractor cannot rely on this and must therefore increase the tender price to cover the cost of something which is not really necessary. A preferable alternative, for an employer who requires extra security, would surely be to increase the size of the retention under the contract.

17.2.3Creation of bonds

A contract of guarantee must either be made in writing or at least evidenced by writing, in order to satisfy Section 4 of the Statute of Frauds 1677. In practice it will frequently be made in the form of a deed, and it should certainly take this form wherever the bond is given after the main contract is entered into. This is because the beneficiary in such a case will not have given any consideration in return for the surety’s promise and thus, unless made by deed, it will be unenforceable.

The duration of a guarantee depends upon the terms in which it is given. If no specific time limit is mentioned, then a surety for the contractor’s performance is not released by completion or even by the final certificate but remains liable, as does the contractor, for any breach of contract which comes to light within the relevant limitation period. Perhaps because of the potential length of this period, some guarantors now make express provision for release when the final certificate

13Nene Housing Society Ltd v National Westminster Bank Ltd (1980) 16 BLR 22; confirmed by the House of Lords in Trafalgar House Construction (Regions) Ltd v General Surety & Guarantee Co Ltd

(1995) 73 BLR 32.

14Edward Owen Engineering Ltd v Barclays Bank International Ltd [1978] QB 159; Simon Carves Ltd v Ensus UK Ltd [2011] EWHC 657 (TCC); [2011] BLR 340.

15Balfour Beatty Civil Engineering v Technical & General Guarantee Co Ltd (2000) 68 Con LR 180.

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is issued. Some instead provide for release on a fixed date, but this is undesirable from the employer’s point of view since, if the contract period is extended, the bond may cease to operate before the works are completed.

The financial limits of liability are invariably expressed in the contract of guarantee. It should be made clear, in order to avoid disputes, whether the overall limit includes interest on money due and legal costs. It is also worth noting that some bonds provide for the entire sum guaranteed to become payable on any breach by the principal, regardless of how serious or trivial that may be. If this is the case, the provision is likely to be struck down as a ‘penalty’ and the beneficiary will be entitled only to so much of the sum as will compensate for the actual loss which has been suffered.

17.2.4Release of surety

Apart from limits expressly contained in a bond or guarantee, there are a number of situations in which a surety is entitled to avoid liability.

General principles

Today, the giving of bonds and guarantees is a lucrative commercial enterprise for financial institutions. In Victorian times, however, bonds were more commonly given by benevolent uncles to guarantee the debts of extravagant nephews! Perhaps because of this, the law appears rather too ready to find a reason for releasing the surety from the guarantee.

It has on occasion been held, by analogy with the law governing insurance contracts, that the surety cannot be held responsible unless all material facts (such as unusually difficult construction conditions) were disclosed when the guarantee was entered into. However, it was confirmed by the House of Lords in the leading case of Trade Indemnity v Workington Harbour & Docks Board16 that there is no general rule to this effect. In that case a firm of contractors submitted the lowest tender (£284,000) for a civil engineering contract which, as is common, provided that the contractors must satisfy themselves as to site conditions. The engineers warned the contractors that their excavation prices were far too low for ground with high water levels and gave them an opportunity to withdraw. When the contractors maintained their tender figure the employers, advised by the engineers, insisted on a bond of £50,000. The bondsman later sought to be released, claiming that these matters should all have been disclosed. However, it was held that, since the contract clearly showed that adverse ground conditions were solely at the contractor’s risk, the employers owed the bondsman no duty of disclosure.

It should also be borne in mind that, while the general law does not require the beneficiary to sue the principal before claiming against the surety, nor even to give notice to the surety that the principal is in breach of contract, either of these requirements might be imposed by the contract of guarantee. If this is so, then noncompliance by the beneficiary may entitle the surety to be released from the

16 [1937] AC 1.

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guarantee. In Clydebank District Water Trustees v Fidelity Deposit of Maryland,17 for example, an employer’s failure to give written notice of a contractor’s delay, which might lead to a claim for liquidated damages, proved fatal to a call on the bond. This was despite the fact that the employer’s claim did not relate to liquidated damages at all, but to the cost of having the work completed when the original contractor became insolvent. This might seem a thoroughly unreasonable outcome, but it has been held that a term requiring the employer to give written notice of every breach of contract by the contractor should not be struck down as ‘unreasonable’ under the Unfair Contract Terms Act 1977.18

Alteration of contract terms

Any material variation in the terms of the main contract releases the surety’s obligation, since it alters the nature of what is guaranteed. Oddly, perhaps, this applies even to alterations that appear to be for the benefit of the principal, such as where the beneficiary waives or compromises a claim against the principal. The reason why this releases the surety is said to be that the removal of pressure from the contractor may make it more likely that the contractor will breach the contract and so render the surety liable.

In accordance with this approach, guarantors of payment obligations have been held to be released where the creditor agreed to accept a late payment from the principal, though not where the creditor merely acquiesced in a payment that was late. As for performance obligations, complete discharge of a surety has followed a knowing overpayment by the employer, the payment of an instalment before it was due, and agreement by the employer to give the contractor extra time to complete. However, an employer who unintentionally overpays the contractor will not thereby lose the right to claim against the surety, and nor will one who fails to discover or even acquiesces in the contractor’s breaches of contract. An employer advancing payments for works yet to be completed or to contractors on the verge of insolvency, may cross the threshold of being prima facie prejudicial, offering guarantors a total absolution from liability.19

17(1916) SC (HL) 69.

18Oval (717) Ltd v Aegon Insurance Co (UK) Ltd (1997) 85 BLR 97.

19Hackney Empire Ltd v Aviva Insurance UK Ltd [2012] EWCA Civ 1716.

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