On-demand bonds to protect advance payments are a really good idea, but a recent case shows that you have to give the courts as little room for interpretation as possible

There is an increasing trend for contractors to demand advance payments from developers before embarking on construction projects. Advance payments are usually provided in exchange for the provision by the contractor of an advance payment bond that pays out if, for example, the contractor goes bust. This arrangement is also common in the shipbuilding industry.

Although an on-demand payment bond is a neat way of protecting developers against contractor insolvency after the former has handed the latter a large advance, a recent decision in the Court of Appeal has highlighted the importance of getting their wording right.

The case of Kookmin concerned the use of on-demand payment bonds for shipbuilding contracts provided by a shipbuilder called Jinse, in exchange for a large down-payment.
Jinse provided the on-demand bond from Kookmin Bank of Korea. Later Jinse went bust and the purchaser made a call on the bond. Kookmin refused to pay out and they all ended up in court in England.

The relevant paragraph of the bond (paragraph two) stated that “pursuant to the terms of the contract, you [the buyer] are entitled, upon your rejection of the vessel … your termination, cancellation or rescission of the contract or upon a total loss of the vessel, to repayment of the pre-delivery instalments of the contract price …

”Paragraph three said that “in consideration of your agreement to make the pre-delivery installments under the contract … we hereby … irrevocably and unconditionally undertake to pay to you … on your first written demand, all such sums due to you under the contract”.

The underlying contracts (of which there were six) entitled the buyers to repayment of its money in the event that Jinse went bust, following which Jinse would be able to terminate the contract.

The question taken to appeal revolved around the meaning of the phrase in paragraph three of the bond, “all such sums due to you under the contract”, and more specifically, the phrase “such sums”.

You would be forgiven for thinking that the phrase “all such sums due to you under the contract” meant what it said: that is, if the buyers were entitled to any money under the contracts from Jinse, and Jinse failed to pay, the bond would kick in.

The first instance judge and a lone dissenting judge in the Court of Appeal would agree with you. Why else have an on-demand bond if it is not to protect the buyer against contractor insolvency? The Court of Appeal would not agree. It said that “all such sums due to you under the contract” referred to the pre-delivery instalments only becoming repayable in the circumstances referred to in the preamble-type paragraph two of the bond, and not to them becoming repayable in any circumstances under the underlying contracts. The bond therefore only paid out if Jinse terminated the contract and Jinse was only entitled to do so once it had paid back the advance payments.

You would be forgiven for thinking that the phrase ’all such sums due to you under the contract’ meant the bond would pay out. the court of appeal did not agree

The Court of Appeal’s literal approach in interpreting this bargain seems out of kilter with the guidance and approach taken in cases such as Chartbrook vs Persimmon, where more of a business common-sense approach was adopted. However the Court of Appeal in Kookmin said there may have been any number of commercial reasons why Jinse would not want the bond to pay out in the event of its insolvency and so the court refused to give the bond a wider interpretation.

The moral of this story is that great care must be taken when drafting recitals and introductory paragraphs in bonds. In the construction industry more and more firms are asking for advance payments before they start a project, and for any employer looking to protect advance payments, an on-demand payment bond is a good idea. However, as the decision in Kookmin has shown, there are real dangers in drafting unnecessary recitals or introductory paragraphs.

The Court of Appeal’s decision has been appealed to the Supreme Court, so watch this space.

Joe Griffiths is a partner at Manches