Act I: Hackney Empire advances its contractor 750k. Act II: the contractor goes bust. Act III: Hackney tries to recover the money under its surety bond. Now, at last, the denouement …

Performance bonds are typically given by banks or insurance companies to an employer as security for the performance of the contractor and importantly, in the event of a termination of the building contract for default, as security for the cost of replacing a defaulting contractor.

In Hackney Empire vs Aviva Insurance [2011] EWHC 2378 which concerned the refurbishment of the Hackney Empire Theatre, the employer (Hackney) had obtained a conditional or default bond in the sum of just over £1m to secure the contractor’s obligations under the building contract.

The court was satisfied that the advance payment was a new obligation and the building contract was unaffected

The contractor fell into considerable delay on the project. Facing claims for payment from the contractor arising from the delay and with productions booked for the opening of the theatre, Hackney agreed to advance the contractor £1m on account of the contractor’s claims in order to ensure that the works were completed as soon as possible (Hackney had been advised that the claims might be worth up to £1.8m). The advance payments were to be paid in three instalments. The first two instalments of £500,000 and £250,000 respectively were duly paid, the second instalment being paid once the parties had entered into a side agreement. Unhappily for Hackney, the contractor went into administration prior to completion causing losses of over £3m to Hackney. Hackney sought to recover the advance payments and liquidated damages of £205,000 under the performance bond.

The insurer, Aviva, relied on the rule in Holme vs Brunskill to argue that the arrangements to make advance payments to the contractor had discharged its liability under the bond on the basis that the insurer had not consented to the payments.

Holme vs Brunskill, in summary, is authority for the rule that any amendment to the underlying contract, after the giving of a guarantee, without the consent of the surety, will discharge the surety under the guarantee, unless the alterations are self-evidently not substantial or ones which cannot be prejudicial to the surety.

Therefore, in order to avoid the situation where a bond is discharged by an alteration to the terms of the underlying contract, a bond usually contains “indulgence” provisions. These provide that the bond is not discharged or invalidated by alterations to the building contract, changes in the extent and the nature of the work or allowance for additional time for completion made during the project. The bond in the Hackney case contained such a clause.

In relation to the payment of £500,000, the court held that the rule in Holme vs Brunskill did not apply because the arrangements did not constitute an alteration to the terms of the underlying building contract. Even if the arrangements had constituted a variation of the building contract, they would have fallen within the indulgence clause.

In relation to the payment of the £250,000, the court held that the extent to which the building contract was varied by the side agreement was either beneficial to Aviva, or of minimal consequence (and therefore fell within the exceptions to the rule in Holme vs Brunskill).

In other words, the bond was not discharged by the payment arrangements. However, that was not the end of the matter since the court next considered whether the payment arrangements fell within the scope of the bond.

The issue was whether the advance payment arrangements constituted a variation of an existing obligation or the entering into of a new obligation. The court was satisfied that the advance payment was a new obligation and the building contract was unaffected by the side agreement which was a separate arrangement between the parties. Following Trade Indemnity Company v Workington Harbour and Dock Board (1937), the court held that Aviva never had an obligation in respect of the advance payment arrangements, and therefore had no liability in respect of the contractor’s failure to repay the £750,000. On this ground alone Aviva was not liable to Hackney for any part of the advance payment.

The case confirms that the rule in Holme vs Brunskill is not triggered unless there is an alteration in the underlying contract. It also demonstrates the importance of including an indulgence clause in the conditional bond to prevent its discharge should alterations be made without the consent of the surety.

Although payment of advance payments is understandable when a contractor’s cash flow is tight, and performance on site is deteriorating, employers cannot assume that they will be able to recover such sums under the bond.

Chris Hill is partner in Norton Rose