Hold it right there

The purpose of a performance bond is to ensure a third party delivers goods or performs services in accordance with the terms of an underlying contract. The issuer of the bond (usually a bank) undertakes to pay to the beneficiary a sum of money if the third party fails to comply with its obligations.

A recent case concerned an “on-demand” performance bond, and raises issues as to the extent to which a beneficiary may be prevented from seeking payment under a demand bond by the terms of the contract.

Simon Carves Ltd (SCL) was employed by Ensus UK Ltd (Ensus) to construct a bioethanol plant. One of the contract’s conditions required SCL to provide Ensus with a performance bond as security for its performance. This was issued by SCL’s bank to Ensus, and was initially in the sum of £18.4m.

Importantly, the special conditions to the contract provided that on the issue of the acceptance certificate by Ensus’ project manager, the bond would “become null and void”. The conditions further provided that the bond should be returned to SCL as soon as it became null and void, “save where there are pending claims (including previously notified claims), in which case it shall be returned following final determination”. If the bond was subject to a fixed expiry date, SCL should extend or replace the bond if it had not yet been returned by Ensus.

On 19 August 2010, Ensus’ project manager issued an acceptance certificate. This listed a number of known defects that SCL was bound to make good. One of these defects related to odour emissions from the plant. Ensus asserted that the odour was attributable to a fault with the plant’s dryer system caused by SCL, and sought to retain the bond as security for this alleged defect. But SCL argued that the odour was attributable to the way in which Ensus had chosen to operate the plant, and in any event, no claim had been made under the contract, which obliged SCL to maintain the bond. SCL accordingly asserted that the bond was null and void and that it should be returned along with any retained money.

SCL sought an injunction restraining Ensus from making any demand under the bond, which was granted.

The decision

On 15 March 2011, Mr Justice Akenhead held that the injunction was valid and that it should continue in its current form. He summarised the law in this area as follows:

• Fraud is not the only ground upon which a call on a bond can be restrained by injunction
• There is no legal authority that permits a beneficiary to make a call on the bond when it is expressly disentitled from doing so
• If the underlying contract expressly prevents the beneficiary from making a demand under the bond, it can be restrained by the court
• The court did not need to make a final determination on whether the underlying contract prevented payment at the interim injunction stage. It only needed to satisfy itself that the party resisting the demand had a “strong case”. It can not be expected that the court at that stage will make in effect what is a final ruling.

Importance of the contract

Given their importance to commerce, the courts are usually loath to interfere with irrevocable obligations assumed by banks in the form of performance bonds and related instruments except in circumstances where fraud is alleged. However in this case, SCL demonstrated that it had a “strong case” that the bond had expired by virtue of the underlying contract. This, coupled with the concern about the effect a call on the bond would have on SCL, warranted the injunction being maintained.

Some might argue that this decision means that employers will no longer be able to rely on bonds to cover problems created by recalcitrant contractors. But that cannot be so. An employer cannot in effect agree to withhold from making a call on a bond by contract and then make a call; that is profoundly unfair and cannot be in the interests of commerce. If anything, this case serves to add a string to a very lean bow for contractors seeking to rely on the terms of an underlying contract as to the validity of a performance bond.

Simon Tolson is senior partner and Rebecca Saunders is an associate at Fenwick Elliott