The beauty of performance bonds

Alex Innes continues his series about ways banks can manage the risk of lending.

Performance bonds are designed to ensure that the seller delivers goods or performs services in accordance with the terms of the contract and at the agreed time; with the issuer of the bond undertaking to pay to the buyer a sum of money if the seller fails to deliver or perform in accordance with the terms of the contract. Typically performance bonds are granted by a bank to support the obligations of its borrower; but a bank may also be seeking to rely on a performance bond if it is providing funding to a purchaser.

A performance bond is often viewed as a standard contract, but recent cases illustrate that the bond and the provisions that govern it need to be very carefully negotiated.

In one case, a performance bond was issued in respect of the obligations of a contractor under a building contract, and it contained a provision that it would become null and void when the completion certificate was issued, other than in respect of any pending or previously notified claims. The certificate was issued and included an extensive list of defects. The contractor argued that the list of defects was not a “claim” under the contract, and so the performance bond was null and void. The court determined that as it was not clear that the list of defects was intended to be a claim, the bond was null and void and was not able to be enforced.

This illustrates the importance of understanding the provisions that determine the expiry of a performance bond.

Another case considered the distinction between advance payment guarantees and performance bonds, and when a “guarantee” may inadvertently be a performance bond. An advance payment guarantee is used when a seller is provided with funds by the buyer in order to perform the contract. Effectively the guarantee will provide that if the seller fails to perform its contractual obligations, the issuer of the guarantee will refund the advance payments made by the buyer. This is a secondary obligation that depends on the performance of the seller; whereas a performance bond is a primary obligation under which the issuer of the bond undertakes to pay the buyer a sum of money if the seller fails to perform its contractual obligations.

A Purchaser entered into a contract with a Seller, and a Guarantor issued an advance payment guarantee to the Purchaser, and the Purchaser then started making advance payments, relying on the guarantee. The Seller then merged with another entity and that business was later transferred to a new party, being Seller 2. After various attempts to accommodate Seller 2 by extending delivery times, the Purchaser served notices of default under the contract. A few months later, the Purchaser demanded payment under the guarantee. Seller 2 was subsequently declared insolvent.

The Guarantor argued that it was not liable under the guarantee because (1) it had guaranteed the liabilities of the Seller, not Seller 2; and (2) of the material variations to the contract as a result of the merger and of variations to the delivery dates under the contract. The Purchaser argued that the guarantee was effectively a performance bond and if that was the case, the objections of the Guarantor were irrelevant.

The court held that the guarantee was a performance bond and therefore enforceable against the Guarantor as a primary obligation; for the following three main reasons: (1) the payment under the guarantee was triggered by a demand on presentation of certain documents; (2) the guarantee was irrevocable and unconditional; and (3) the guarantee stated that it was subject to the rules of Uniform Rules for Demand Guarantees, which was an indication that the parties regarded it to be a demand guarantee.

This illustrates the need to be clear as to the form of document required, and to ensure that it is appropriately drafted.

As transactions often rely heavily on the enforceability of performance bonds (and guarantees) it is essential to take appropriate advice.

Semple Fraser LLP is one of Scotland’s leading commercial law specialists, offering advice of the highest quality across a range of areas. With lawyers qualified in both Scots and English law, we are able to deliver a full banking service throughout the UK. The Banking & Finance Group of Semple Fraser LLP has expertise in all areas of banking and property finance, and works closely with the other specialists areas of the firm to provide the complete service to clients.

For more information on these topics, please go to www.semplefraser.co.uk, or contact Alex Innes on 0131 273 3771 or alex.innes@semplefraser.co.uk 

Alex Innes is Head of the Banking & Finance Group of Semple Fraser LLP.

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