Can an employer who benefits from a performance bond provided by a contractor ever be prevented from claiming on the bond?

As the number of construction companies becoming insolvent shows no sign of reducing, it has never been more important to ensure that you are protected against the risk of those in your supply chain becoming insolvent. An increasingly common method of protecting against insolvency is a performance bond.

A performance bond is a written guarantee from a third party (usually a bank or an insurance company) which ensures payment of a specified sum to the beneficiary of the bond (e.g. an employer) in the event that the party providing the bond (e.g. a contractor) defaults on its contractual obligations.

In this article, we look at some of the recent case law on the effectiveness of performance bonds as a means of security.

AES-3c Maritza v Credit Agricole Corporate & Investment Bank

AES engaged Alstom to build a power plant. Alstom provided a performance bond in AES’ favour, the terms of which required Credit Agricole (the “Bank”) to pay AES within 3 days of a demand being made, provided the demand was accompanied by copies of the notices or claims which AES had sent to Alstom in relation to the alleged breach of contract.

Alstom had failed to complete the first section of its works on time and it was clear that the second section of the works would also be delayed, although the second completion date had not yet passed. AES submitted a demand to the Bank for payment of €93m in late completion payments.

AES provided the Bank with copies of letters of demand which AES had sent to Alstom requesting payment. However, the letters of demand only showed that €27m was owed to AES. This was because much of the €93m being claimed did not become due under the contract until the date for completion of the second section of the works had passed. The Bank refused to honour the bond, arguing that AES had not complied with the terms of the bond because it had not provided evidence that AES was entitled to recover €93m from Alstom.

Shortly afterwards, when the date for completion of the second section of the works had passed, AES submitted a new demand for €96m. This time AES provided supporting evidence which showed that €96m was indeed due from Alstom. AES then issued legal proceedings to recover the money owed to it by the Bank.

The Court held that AES’ first demand had been invalid because AES had not complied with the requirement for its demand to be supported by evidence of the claim for payment it had made against Alstom. Although AES argued that the bond allowed it to claim costs that would inevitably become due in the future, the Court took the view that the parties to the bond would never have intended that AES would be able to submit a claim for sums payable by Alstom in the future, even if it was inevitable that those sums would eventually become due. It was necessary for AES to provide valid proof that the entire sum claimed was due so that the Bank could decide whether or not to pay.

However, AES’ second demand was enforced because AES had supplied the supporting documentation required under the terms of the bond.

Simon Carves v Ensus UK

Simon Carves was employed by Ensus to construct a bioethanol plant. Simon Carves provided a performance bond of £18.5m to Ensus. The contract between the parties provided that the bond would become void (save in respect of any previously notified claims) on the date Ensus issued an Acceptance Certificate confirming that the works were complete.

When Ensus began operating the plant in early 2010, foul emissions began escaping into the surrounding area. Ensus issued a Defect Notice under the contract and the parties got into dispute about the source of the problem. Despite this, Ensus issued the Acceptance Certificate in August 2010 along with a snagging list, which included the remedial works necessary to address the emissions problem.

In late August 2010, just before the bond was due to expire, Ensus requested that Simon Carves extend the bond. Simon Carves agreed to extend the bond until February 2011, but nevertheless made it clear to Ensus that they considered the bond to be void because the Acceptance Certificate had now been issued.

In February 2011, Ensus formally notified Simon Carves that it considered them liable for the defects and attempted to claim on the bond. Ensus argued that notwithstanding the terms of the contract, English law requires that performance bonds must always be honoured, unless there is clear evidence of fraud.

The Court found that Ensus was not entitled to claim on the bond (even though the bond had not expired) because the terms of the engineering contract meant that the bond was to be treated as void once Ensus had issued the Acceptance Certificate.

Ensus had never made any formal claim against Simon Carves before issuing the Acceptance Certificate (the issue of the Defect Notice was simply a contractual requirement, not a formal claim). Accordingly, Ensus had deprived itself of its ability to claim on the bond by issuing the Acceptance Certificate too early. Ensus should have formally notified Simon Carves of its intention to make a claim before issuing the Acceptance Certificate.

Hackney Empire v Aviva Insurance

Hackney Empire engaged a contractor to carry out extensive refurbishment works to the Hackney Empire Theatre. The contractor provided a performance bond via Aviva worth £1.1m. The works were significantly delayed and the contractor got into serious financial difficulty.

In order to try and ensure completion of the project, Hackney Empire entered into a side agreement with the contractor. The parties agreed that in return for an advance payment of £1m, the contractor would complete the works by a particular date. Unfortunately, the contractor went into administration before the works were complete. At this point Hackney Empire had made advance payments of £750,000 under the side agreement.

As a result of the contractor’s insolvency and the significant delays to the project, Hackney Empire suffered losses of around £3m, including substantial LADs. The only way for Hackney Empire to recover its losses was by claiming on the bond. However, Aviva argued that it was no longer liable under the bond because the parties’ decision to enter into the side agreement without notifying Aviva had severely disadvantaged Aviva in its role as the contractor’s surety.

Aviva also argued that even if it was still liable under the bond for the contractor’s breaches of the building contract, it was not required to reimburse Hackney Empire for the £750,000 paid under the side agreement which the contractor had also breached.

The Court held that Aviva’s position as surety was not prejudiced by the payment of £750,000 made by Hackney Empire to the contractor. Aviva was no worse off because Hackney Empire had attempted to keep the project on track by improving the contractor’s cashflow. Indeed, the advance payments to the contractor were actually intended to speed up completion of the project, thereby decreasing the contractor’s liability to Hackney Empire. This benefited Aviva as the surety. Accordingly, Aviva could not escape liability under the bond just because the parties had entered into the side agreement. Hackney Empire could therefore recover the losses it had suffered as a result of the contractor’s breaches of the building contract.

However, Aviva was not liable to reimburse Hackney Empire for the £750,000 paid under the side agreement. The Court decided that it was unfair and unreasonable to require Aviva to assume the additional risk of the contractor failing to comply with a side agreement which Aviva had no knowledge of. Hackney Empire was therefore left out of pocket because it had failed to take steps to ensure that the payments made under the side agreement were also covered by the bond.

Summary

Although performance bonds seem like a reliable form of security, these cases demonstrate that in reality there are a number of ways in which a claim under a bond can be defeated. Anyone who has provided or benefits from a performance bond should take note of the following lessons which can be learnt from these cases:

• When making a claim on a bond, it is essential to comply exactly with the terms of the bond. Failure to provide necessary documentation, such as evidence of your entitlement to payment, could prejudice your ability to make a claim.
• The beneficiaries of bonds should be aware of the effect of any clause in the underlying building contract which restricts their ability to rely on the bond and take steps to ensure that their position is not prejudiced by such a clause.
• Where a bond has been provided, the parties to the building contract should always consider whether it is necessary to inform the surety about events occurring under the contract. Failure to inform a surety about increased financial risk means the beneficiary of the bond may be deprived of its ability to make a claim.