On Demand v Conditional Bonds - A Contractor’s Perspective

• Types of Bonds

• On Demand versus Surety Bond

• Insurance of the risk

• Accounting considerations

The primary purpose of a bond is to protect the client from the effects of a failure of the contractor to meet his contractual obligations while the primary aim is to provide the client with recourse to a third party for the completion of the contract and/or financial compensation for the costs, up to an agreed limit.

The commonly found types of bonds used in the construction industry are:

Tender Bonds; Performance Bonds; Advanced Payment Bonds; Maintenance Bonds and Retention Bonds.

The main sources of bonds are banks for “On Demand” or “Non Conditional Bonds”, and surety companies for “Conditional Bonds” or “Default Bonds”.

On demand bonds or guarantees will give the client a very strong position when a dispute arises as the bondsman, usually a bank, will pay the sum on first demand as long as the demand has been made in accordance with the conditions stated. The converse is of course true for the contractor who finds that any unfair calling of the bond will need to be resolved afterwards as the bank will refuse to get embroiled in any contractual dispute instead explaining the importance of maintaining their commercial integrity by honouring without argument the bond.

There are occasions when the legality of paying on demand has been called into question, particularly where the contractor felt that the call of the bond was fraudulent. However, in the majority of instances it will be difficult to prevent a bank from paying - Edward Owen Engineering Ltd v Barclays Bank International (1978) - and therefore prudent to consider insuring the risk of unfair calling of such a bond.

Insurance for unfair calling of an ‘on demand’ performance bond, political risks, non-honouring of arbitration awards plus capricious calling is available in the insurance market at surprisingly affordable rates. However, such insurance is subject to review and acceptance by the insurers of, amongst other things, the contractual documentation, the bond wording, a counter idemnity, the financials of the beneficiary and cross border interests.

The wording of the bond is of course important in determining whether the security is to take the form of an “on demand” bond, or a guarantee which is conditional and subject to the normal incidents of suretyship, and in Trafalgar House Construction v General Surety and Guarantee Co Ltd (1995) the House of Lords held that the bond in force was a guarantee. It was different from an on demand bond and to establish liability under it, proof of damage was required and a mere assertion was insufficient. Therefore the surety was entitled to raise against Trafalgar House the question of sums due to the subcontractor and its cross claims.

The Court of Appeal in Hong Kong has recently reaffirmed in Dragages et Travaux Publics (HK) Ltd (January 2001) the importance of using clear and unambiguous language if it is intended that a bond is to be an ‘on demand’ bond.

The clear message arising from this case is that for a bond to operate it is important that the operative parts of the bond are drafted as clearly as possible in order to make the intentions clear.

The alternative to the on demand bond is a default bond which is a contract of guarantee (or suretyship) where the surety contracts to make good any proven loss to the client as a result of the contractor’s failure to perform.

The surety company in issuing a default bond is in a different contractual position to the bank issuing a demand guarantee and will undertake a more detailed and extensive investigation into the contract and the contract conditions. This is because as the surety is binding himself into the main contract conditions, it is necessary for him to fully investigate all aspects that may affect his future obligations.

The important and reassuring aspect to a contractor of a default bond is that any loss claimed by the client must be proven and contrary to the situation with a bank and an on demand guarantee, the surety will argue first and pay later. Most importantly a surety will check first to see that mechanisms under the contract are being used and that both parties are complying with the terms and conditions. It is therefore a much more equitable arrangement and therefore offers more comfort to a contractor who is not in default.

It should not be overlooked, however, that the surety would generally require a counter-indemnify, ideally from the parent company if there was one. In the event of a call upon a default bond the surety is entitled to be indemnified to the full value paid out or incurred by the surety. This applies even to the extent that the surety has the right to defend any action instigated by the client and recover costs incurred in the defence under the counter-indemnity.

In granting a bond a surety company will conduct more extensive investigations than a bank because the surety does not have the same close relationship as the bank with the contractor, particularly with the contractor’s up-to-date financial position. Consequently, despite the counter-indemnity, the surety will require a detailed investigation into all aspects of the contract and the contractor.

Therefore when making a bond application the contractor will have to ensure that he can convince the surety that he, as a contractor, is an acceptable risk. The surety in assessing the application will look to see whether the contractor satisfies certain criteria, namely character, capacity and capital.

Although a contractor will avoid where possible giving on demand bonds they are often a requirement particularly from government organisations in the Region. There are also occasions where they cannot be avoided such as where a contractor is required to provide security for an advanced payment. In such situations it is important to include a reducing formula so that the bond amount reduces to reflect the value of work done and expires once the value of the work done exceeds the value of the advanced payment. The bond should not be allowed to continue until completion otherwise there is the risk that it will be used as a performance guarantee rather than what it was designed to achieve.

In particular, and with respect to performance bonds as the most common type of bond, the evidence that has been presented can only lead to one conclusion for the contractor and that is a surety issued performance bond is evidently advantageous and less risky than alternatives. This aids the contractor’s cash-flow as it places no restrictions on the assets of the company, nor its overdraft facilities.

-by Nicholas Seymour, Managing Director, Battersby Kingsfield Limited