Bonds are a crucial part of contractual relationships, but do you know your on-demand bond from your conditional bond? A recent case should help you

Bonds and guarantees are a crucial piece in the jigsaw of construction contract relationships. Typically they enable an employer to safeguard against non-performance or failure of a contractor up to a maximum sum or for a percentage of the value of a project. This can be claimed against a bank, other financial institution or a parent company. However, not all bonds are the same. In the construction field there are generally two types of bonds, namely “on-demand” and conditional bonds. Rather confusingly, each may be described as a performance bond but they are quite different in nature.

An “on-demand” bond is payable when a compliant demand for payment is presented without requiring the employer to prove any breach of contract by the contractor. By contrast, a right to payment will only arise under a conditional bond if the employer proves that the contractor is in breach, and therefore recovery is inevitably long and drawn out compared to an on-demand bond.

Not surprisingly, therefore, employers would far prefer on-demand bonds but market conditions are such that these are rarely available, at least in the domestic sphere. Internationally the position is somewhat different. By way of example, FIDIC appends an on-demand bond to its standard suite of contracts. 

How can you be sure which type of bond you have in place? The issue arose in the recent case of Vossloh against Alpha Trains, decided on 5 October 2010. The bond in this case looked like an on-demand bond. It stated that all sums payable under it should be paid on demand and that the guarantor should give his guarantee as principal debtor, not merely as a surety. Such wording may be indicative of an on-demand bond, but the answer was not so clear-cut. 

The court looked in detail at the wording of the bond. It observed that in the main clause the guarantor gave guarantees of the “due and punctual observance and performance” by the contractor, and the “due and punctual payment” in each case of all its obligations. The court decided that this was the “classic language” of a conditional bond and that the true intention of the parties was that the guarantor would pay up in respect of any failure by the contractor to meet its obligations, provided such failure was proved by the employer.

The reference to sums being payable “on demand” referred to a liability “hereunder”, which was simply another way of referring back to the obligations addressed in the above clause and was at best regarded as neutral wording. 

A further clause provided that the guarantor could only rely on the contractor’s defences after the guarantor had complied with its main obligations. The court said that this amounted to a “pay now, argue later” provision and if it were really in an on-demand bond, such a provision would not be necessary as the contractor’s defences would be immaterial.

Finally, there was a clause providing that the employer’s certificate setting out the amount of any obligations not paid by the contractor would be conclusive evidence of such amounts against the guarantor. This was again regarded as a supplementary provision dealing only with the amount, rather than the issue of liability. 

The context may also be important. Earlier case law indicates that, (if the guarantee is not given by a bank) there is a strong presumption against it being in an
on-demand bond unless there is clear wording to that effect. In the case of Vossloh against Alpha, the guarantee was given by a group company on behalf of its affiliates and so the presumption did apply. Where the guarantee is given by a bank, as often occurs in the construction arena, the presumption may not be appropriate.

The moral of this case is that when it comes to bonds, you cannot read the book by just looking at the cover. The court itself described this area of law as: “bedevilled by imprecise terminology”. What mattered for the court’s decision was the substantive nature of the obligations being guaranteed and not just their general description.

Ann Levin is a partner and Michael Mendelblat is a professional support lawyer at Herbert Smith