Out-Law Analysis 10 min. read

How to make a construction contract bond call

Bonds can provide an efficient and effective remedy for a party’s breach of performance or other obligations under a construction contract due to the common usage of standard form wordings and the long-lasting recognition of bonds as ‘the life blood of commerce’ and something akin to cash in hand.

In some instances, however, courts have found that some calls are invalid and unenforceable for failing to comply with the demand procedures. It is therefore essential to make a bond call complying precisely with the procedure and requirements of the bond itself. Otherwise, employers could be left without any recourse against the bondsman after the bond’s expiry, and unable to recover the full amount of damages from a contractor.

There are several practical aspects and considerations when calling a bond. By incorporating international rules, it will usually reduce the legal uncertainty of case law in this area.

From the employers’ perspective, bonds serve to protect them from the risk of defective or non-performance of the contract and provide them with an effective means to obtain compensation in case the risk materialises. More specifically, on-demand bonds are more favourable to employers given that the thresholds for making a demand are much lower than that for default-based bonds.

From the contractors’ perspective, bonds may have a significant impact on their financial viability and naturally they would prefer to negotiate and enter into default-based bonds requiring proof of breach and damages before a call can be made.

However, the nature of the bonds as an on-demand or default bond is a matter of substance other than form. Employers are advised to take a holistic view when determining the type of bond they are dealing with, and the relevant proof required.

A demand must be made in accordance with the stipulated requirements and procedures set out in the bond itself, and therefore, it is advisable to strictly adhere to these.

For parties intending to enter into an on-demand bond, the incorporation of the ICC Uniform Rules on Demand Guarantees No.758 (URDG 758) ensures that the terms of the bond are interpreted uniformly across jurisdictions, as it is based on a discrete body of rules, and therefore reduces the potential legal uncertainty that exists in case law and court interpretation.

The URDG 758 is not a set of rigid rules. Parties may modify or exclude the rules to suit their commercial needs but any such intention to deviate from the rules must be spelled out in clear terms. The incorporation of the URDG 758 may afford parties with more clarity and certainty in enforcing the bonds but they are also reminded that the rules must be complied with strictly for a call to be valid and enforceable and any intention to deviate from the rules must be stipulated clearly in the terms of the bond instruments.

Nature of bonds

The procedures for calling on a bond differ depending on the nature and type of bond. The beneficiaries of bonds, typically employers or main contractors, should be aware of the nature and type of the bonds when making any call since it will have an impact on the correct procedures to be followed.

The two key types of bonds are on-demand bonds and default bonds. Although the distinctions between the two types of bonds are quite significant, it is not always easy to differentiate them in reality, particularly considering that many labels and expressions are attached to both, such as surety bond, default bond, payment guarantee, performance guarantee, and demand guarantee. However, ultimately the question is one of substance, not form; in other words, the nature of a bond depends on whether it fits the criteria of a particular type of bond irrespective of its label. 

The major distinction is that an on-demand bond imposes a primary obligation on the bondsman to pay, while a default-based bond imposes only a secondary obligation.

A primary obligation is an obligation that is independent of the underlying construction contract, and no proof of breach is required for the beneficiary employer to demand payment. A secondary obligation means that the bondsman’s duty to pay is dependent on, and closely related to, the underlying contract such that the employer will need to prove the contractor’s breach and the extent of its losses before it is entitled to make a demand.

Despite the differences between the two types of bonds not always being clear cut, there are a number of specific factors relevant when seeking to identifying the type of bond.

  • The parties to the bond should expressly and unambiguously state whether it is intended to operate on an on-demand or default-based basis. Under an on-demand bond, it is not necessary to make the contractor a party since the bondsman’s payment obligation is separated from the contractor’s breach of the underlying contract. However, in the case of a default-based bond, the contractor is sometimes required to be a party to the bond agreement.
  • It is more likely an on-demand bond if the bond in question provides for a ‘pay first, argue later’ mechanism for payment. The triggering provisions of an on-demand bond often require the bondsman to accept the employer’s demand as ‘conclusive evidence’ of the sum payable. This provision confirms that the bondsman’s obligation is primary under the bond and not concerned with the extent of the contractor’s breach of the underlying contract. However, if it is subsequently established that the beneficiary employer’s actual loss is less than the sum paid under the demand, the excess will be repayable by the enriched employer. In contrast, a default-based bond generally requires the demand to be accompanied by documentary evidence or other proof of the relevant breach of the underlying contract and the beneficiary employer’s losses. The bondsman may otherwise refuse to pay if no evidence is produced.
  • Given the secondary nature of a default-based bond, an alteration or variation in the terms of the underlying contract without the bondsman’s consent may discharge its payment obligations under the bond. Examples of such variations include changes to the time for payment or contractor’s performance. Therefore, parties may sometimes get away from this general rule by including a "time and indulgence clause" in the bond. The provision allows the employer and contractor to vary the underlying contract without the bondsman’s consent, without releasing the latter's payment obligations. Such a provision is not necessary for an on-demand bond given any variation of the underlying contract is irrelevant to the primary obligations under the bond.

However, these factors are not exhaustive and certainly not conclusive. Some factors may weigh more heavily, and various contradicting factors may be present in one single bond.

For example, in the English case of IIG Capital v Vander Merwe, an instrument purported to be a ‘guarantee’ contained both a ‘time and indulgence provision’ indicating a secondary obligation and therefore it was a default bond, as well as provisions that the employer’s demand is ‘conclusive evidence’ of the amount payable indicating a primary obligation and therefore it was an on-demand bond. The court balanced all the factors and decided that the ‘guarantee’ in question was in substance an on-demand bond. According to the courts’ reasoning in interpreting a bond document, an employer seeking to make a call should take a holistic view in determining the nature of bond and the relevant proof required.

Ideally, parties should set out in clear terms the form of bond intended at the outset.

Valid and enforceable calls on bonds

A call based on a sufficient triggering event for the bond can be invalid and unenforceable because the call procedure is not followed. Two seemingly distinctive lines of authorities have been developed in different common law jurisdictions regarding the level of compliance required.

A more relaxed ‘in substance compliance test’ was adopted in the English case IE Contractors Ltd v Lloyd’s Bank Plc and Rafidian Bank decided by the Court of Appeal in 1990. In that case, the terms of the bond provided that the sums to be paid under a demand was the beneficiary’s “claim for damages”. The actual demand made asserted only breach of contract but did not mention damages. The judge found that, although not clearly expressed, the claim made was indeed in substance a claim for damages for breach of contract. It was therefore held to be a sufficient demand.

In another Australian case Simic v New South Wales Land and Housing Corp, the court adopted a so-called ‘strict compliance test’. The facts were relatively straightforward. The beneficiary's name in the bonds was mistakenly entered and when the beneficiary made a demand for payment under the bonds, the bank refused to pay because it was not the named beneficiary. The judge adopted the principle of strict compliance and ruled in favour of the bank because the condition of payment that the money be paid to the named beneficiary under the bond was not satisfied.

The position in Hong Kong Special Administrative Region (SAR) is considered in the recent case West Kowloon Cultural District Authority v AIG Insurance Hong Kong Limited. The bond in this case could be called in respect of damages suffered by the employer, but the actual demand which adopted standard form wording made reference to damages that the employer suffered and “will continue to suffer”. The Court of Appeal ruled that the demand was invalid as the additional reference to future damages did not fulfil the requirement of the bond. The Court of Appeal considered that the plain meaning of the words of the demand were clear, and accordingly favoured the strict compliance test when making its decision.

Although these cases may seem irreconcilable, the rationale underlying all the decisions is the same.

It is ultimately a matter of interpretation of the bond document to ascertain the parties’ intention as to whether a demand complies with the bond. The difference in the decisions turns on their own unique facts.

In the IE Contractors case, the demand was written in both English and Arabic and the language in the requirement was quite lengthy and vague and the court found that the parties could not have intended strict compliance. In the Simic case, the courts emphasised the position that banks or other sureties should not be expected to investigate the relationship between the contractor and the employer, and therefore the bank did not need to investigate whether the name of the beneficiary employer was entered correctly. 

In practice, however, parties’ intentions are largely a matter of the courts’ interpretation. Even where cases appear to be largely similar in the facts, courts have in the past come to a different conclusion with the slightest tweak in the courts’ interpretation of those facts.

Looking at the cases, the best way to encash a bond is certainly to strictly adhere to the procedure and language set out in the bond itself. But often this is easier said than done. As is clear from the West Kowloon case, the reality is that sometimes the adoption of standard form demand, the omission of certain wordings, or even attempts to make a demand all-encompassing can render a demand invalid and unenforceable.

ICC Uniform Rules on Demand Guarantees No.758

Given these potential procedural uncertainties in enforcing a bond, parties often opt for the incorporation of internationally recognised rules in their bond instruments. National courts will then be bound by the rules of construction set out in the terms of the bonds themselves.

For parties intending to adopt an on-demand bond, the ICC Uniform Rules on Demand Guarantees No.758 (URDG 758) is an option available. The URDG 758 came into force on 1 July 2010, and it is a set of voluntary contractual rules that can be incorporated into all demand guarantees which are commonly on-demand bonds and advance payment bonds. Courts have recently recognised that the rules are a stand-alone code and not interpreted by the rules of national law (Tecnicas Reunidas Saudia for Services and Contracting Co Ltd v Korea Development Bank). This offers parties the comfort that their bonds will be interpreted uniformly and consistently irrespective of the jurisdiction in which the bond is made or called.

There are three major principles underlying the URDG 758:

  • The autonomy principle provides that the demand guarantee is independent from the underlying contract. The conditions giving rise to the obligation to pay are set out exclusively in the guarantee itself.
  • The documents principle, closely related to the first principle, provides that the guarantors deal with documents and not with goods, services or performance to which the documents may relate.
  • The strict compliance principle, which states that the documents submitted must comply strictly with the requirements of the guarantee, although such discrepancies may have no practical effect. Since the URDG 758 prevails over national law in interpreting the bond, the incorporation of the rules will render the line of authorities proposing a more relaxed “in substance compliance test” of minimal persuasive value.

A direct ramification of the first two principles is that any changes in the underlying relationship between the employer and contractor will not affect the bondsman’s obligation to pay.

The UK case Meritz Fire & Marine Insurance Co Ltd v Jan de Nil NV and Codralux SA,  provided a vivid illustration of the principles. In this case, the bondsman issued advance payment guarantees to an employer as security for the advance payments made to the contractor. The guarantees expressly incorporated the URDG. The contract was subsequently novated to a new contractor without the consent of the bondsman. When the new contractor defaulted, the guarantees were called but the bondsman refused to pay, arguing that it was no longer liable under the guarantees because the original contractor had dissolved. The court did not accept the bondsman’s argument and held that it was obliged to pay as the URDG stipulated that payment is to be made against documents without reference to the terms of the underlying contract.

In terms of the procedures for calling the bond, the demand must be supported by a statement from the beneficiary indicating in what respect the applicant is in breach of its obligations under the underlying relationship. However, it is unnecessary for the beneficiary to produce any documents evidencing the breach given it is an on-demand bond. If the parties intend to include any conditions for demanding payment, the bond must specify a document to be presented when making the demand to indicate compliance with that condition. This is in line with the documents principle of the URDG rules. The bondsman may disregard any other conditions that do not specify a document in making payment.

Once a demand fulfils the minimal substantive and procedural requirements under the rules, there is essentially only one reason for the contractor or bondsman to raise objections to payment – the fraud exception. The burden is on the contractor or bondsman to prove that the beneficiary did not honestly believe in the validity of the demand. However, fraud is notoriously difficult to prove and in almost all cases alleging fraud, such arguments have failed.

Co-written by Jason Wong of Pinsent Masons.

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