BuildLaw, Issue 18 Editorial Part 3

Bonds and Guarantees

A recent UK Court of Appeal judgment in Aviva Insurance Limited v Hackney Empire Limited considered the issue as to whether an advanced payment of the price due under a building contract could discharge a bondsman from its obligation to make payment under a bond, unless the terms of the contract provide otherwise.
Hackney Empire Limited (HEL) employed Sunley Turriff Construction (STC) to carry out a refurbishment of the Hackney Empire Theatre. Aviva Insurance Ltd (Aviva) entered into a guarantee in favour of HEL in the sum of just over £1.1 million, securing the performance of the STC’s obligations.
STC fell into delay with the project and made claims for loss and expenses from the theatre. Following STC’s threat to adjudicate and a subsequent settlement meeting chaired by one of the theatre’s benefactors, Lord Alan Sugar, the theatre proposed a side agreement to pay STC £1 million “on account” in installments of £500,000, £250,000 and £250,000.
Not long after the second installment was paid, STC went into administration and was subsequently liquidated. HEL employed other contractors to complete the refurbishment and suffered losses over £3.1 million which included the sum of £750,000 paid to STC under the side agreement. HEL sought to recover the the full amount of the bond from Aviva.
The issue for the Court was whether HEL’s agreement to make payments to STC “on account” effectively varied the building contract and was prejudicial to Aviva’s position such that Aviva was discharged from the bond.
Having reviewed the authorities, Lord Justice Jackson held that the correct principles to be applied are:
  • The rule in Holme v Brunskill only applies where the parties to the underlying contract have varied the terms of that contract without the consent of the surety;
  • Advance payments of the contract price made by an employer to a contractor may have the effect of discharging the liability of the surety. On the other hand, additional payments (whether by gift or loan) made by the employer to a contractor outside the terms of the original contract do not have that effect; and
  • A surety will not be released from liability by reason of contractual variations or advance payments if (a) he has specifically consented to what was done or (b) there is an indulgence clause which covers what was done.
The Court held that Aviva was not discharged from its obligations as a bondsman by virtue of the side payments made by HEL to STC. On the facts of the case, Lord Justice Jackson held that the £750,000 was a loan to STC. The basis of the agreement between HEL and STC was that if STC could substantiate a loss and expense claim then it would retain the value of that claim from the £750,000. Equally, if STC could not substantiate its claim then the money would be repaid to HEL. Lord Justice Jackson noted that the £750,000 did not form part of the original contract sum and was not a sum certified by the architect. Aviva was therefore not discharged from the bond but Aviva’s liability did not extend to cover any failure by STC to repay the £750,000. It followed that Aviva’s liability was limited to losses caused by STC under the building contract.
It is not uncommon for payments to be made to contractors “on account” pending proper substantiation of a claim. In this case the parties documented the position by way of the side agreement and this was a key element in the judge’s finding that that the money was not an advance payment made under the contract but an additional arrangement outside of the main contract.
The case provides a useful summary of the law in relation to bondsman's obligations and the circumstances in which a bondsman may be discharged from its obligation owing to the conduct of the underlying parties to the building contract. 
Meanwhile, the question as to whether a security document is an on-demand bond or a guarantee continues to occupy the courts as on-demand bonds experience a resurgence in popularity in difficult financial times.
In the article titled ‘’Guarantees or On-Demand Bonds’  Nicholas Gould of Fenwick Elliot discusses the recent UK Court of Appeal decision in Wuhan Guoyu Logistics Group Co Ltd v Emporiki Bank of Greece SA [2012] EWCA Civ 1629. The case provides important guidance on how to distinguish an on-demand bond from a guarantee, the difficulties in drafting those documents and the implications of failing to get the drafting right.
Labeling a document a guarantee as was the case in Wuhan will not of itself be conclusive. As Longmore LJ stated, “while everything in the end must 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 one way or the other”. 
Many of the issues in this case resulted from inconsistencies in the drafting. The document was found to be an on-demand bond rather than a guarantee, despite the document containing six ‘pointers’ in favour of  a guarantee and only four in favour of it being an on-demand bond.
It is therefore the content and commercial context of the document, not its title, which is of paramount importance. Once again the case highlights the need for clear and consistent drafting to avoid arguments.
A recent case from the Court of Appeal of New South Wales, Australia, Segboer v AJ Richardson Properties & Anor [2012] NSWCA 253 highlights the importance of complying with the formalities for deeds as regards both execution and delivery.
In this case the contractor tried to argue that the bond in favour of a developer had not been “delivered”, because, although it had been validly issued by the bank as a deed, the bank had retained the original and the developer only had a faxed copy.
The contractor had arranged for a bank to issue an unconditional performance bond (or ‘guarantee’ as it was referred to) in favour of the developer as security for the contractor’s obligations under its building contract with the developer. The performance bond was issued by the bank as a deed and the bank kept the original of the bond and the developer was faxed a copy.
The developer called on the bond and, following legal proceedings, the bank paid the developer the amount demanded.
The contractor claimed that the performance bond was invalid because it had not been ‘delivered’ – the original remained with the bank. It argued that the developer was not entitled to call upon the bond unless it presented the original to the bank, which of course it could not have done, as the original never left the bank.
The Court held that there is no need for a document which purports to be a deed to be physically delivered before it is effective as a deed, noting that “[t]he critical question is whether the party executing the deed has evinced an intention to be bound immediately”.
The Court held that the bond had been “delivered” to the developer and therefore it was valid and enforceable even though the developer did not possess the original. Crucially the court found that the fact that the bond was faxed to the developer, and the original not sent to it was irrelevant because by executing the performance bond and placing no preconditions on when the bond would take effect, it was clear that the bank intended the bond to take effect immediately.
The case serves as a timely reminder of the importance of careful drafting of bonds and their proper execution and delivery to ensure they are binding and enforceable.
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