Feeling the pinch and tempted to sign up to the harsh conditions of a performance bond? Read this first

‘Credit insurance shortage will bring down SMEs” ran a headline in last month’s Building (12 December). The report went on to highlight the reluctance of many banks and insurers to provide performance bonds for smaller contractors. Such bonds protect employers against losses suffered because of a contractor’s defective work or delay, up to the value of the bond – which is usually 10% of the contract sum. It also kicks in on a contractor’s insolvency. So it seems that, at just the time that twitchy employers are asking for the added security that a bond provides, such bonds are becoming more difficult to obtain.

With many performance bonds, the employer has to show a breach of contract or a default on the part of the contractor. If this is disputed, the employer will have to prove its case in adjudication (hence the term “adjudication bond”) or in some other way. Only then will the bondsman – the bank or insurer – pay up (the bondsman usually recovers the payment from the contractor’s bank account under a counter-indemnity). In these cases, the employer is paying mainly for protection against the contractor’s insolvency.

With other bonds, however, the employer can simply assert a breach or failure, and the bondsman must pay. These “on demand” bonds originated in the world of banking and international trade, but have been seen in construction for some years. A recent case in the Technology and Construction Court, Permasteelisa Japan KK vs Bouyguesstroi and Banca Intesa Spa, highlights the problems that they can give a contractor – or, in this case, a cladding subcontractor.

The subcontractor provided a performance bond for a project in Sakhalin under which the bondsman would pay “on first demand, despite any objection of the subcontractor” any sum (up to the amount of the bond) claimed by the main contractor, a subsidiary of Bouygues. Bouyguesstroi duly demanded a payment from the subcontractor, corresponding to delay damages, and the cost of additional labour and cranage. When the subcontractor refused to pay, Bouyguesstroi called on the bondsman to pay instead. The subcontractor immediately applied to the court for an injunction to stop the bondsman from making any payments.

The subcontractor said it was not in default under the contract in the first place. It also argued that Bouyguesstroi had not met certain requirements under the bond – in particular, that it had not allowed 10 days to elapse between its notice of the default and its call to the bondsman. The judge accepted that the subcontractor had a “seriously arguable case” on both points. However, the question was: as a matter of law, was that enough to prevent the bond being called?

Even in times when work is scarce, contractors should avoid bonds that have the dreaded words ‘on demand’ anywhere in them. It should be said however that a court will look at the whole document

No, said the judge. He held that this was an “on demand” bond, akin to a letter of credit in the banking world. He reiterated a comment often heard in these cases, namely that the commercial effectiveness of such bonds could be destroyed if contractors could stop payment merely by showing some form of arguable case on the merits. Showing fraud or dishonesty is of course another matter – but those are serious allegations and need clear evidence.

One lesson, obviously, is that, even in times when work is scarce, contractors should avoid bonds that have the dreaded words “on demand” anywhere in them. It should be said however that a court will look at the whole document. In a case decided in 2005 involving the government of Mongolia, the court held that the bond did not allow the beneficiary to simply call it without proving a default, even though it contained the words “on demand”. Here, there were other words in the bond that suggested that it had not been intended to have that effect. It was also significant, in that case, that the bondsman was not a bank or insurer.

Another possible escape route for a contractor caught with a demand bond is to prove a failure of the employer to comply with the requirements of the bond itself. In Permasteelisa, the subcontractor could show only an arguable case about this. However, an explicit failure to give notice of default within a stipulated time, or to the correct person, might well be different.

Given the current economic conditions, contractors and subcontractors may feel pressure to sign up to ever harsher performance bonds. As the Permasteelisa case shows, they should be aware of the dangers.