Performance Bonds – Safe Haven or Myth of Security?

Introduction

For many years performance bonds and bank guarantees (“Bonds”) have been an integral part of transactions in the world of commerce and the construction industry. It has been described as the lifeline of international commerce[1] and the bedrock on which large scale transactions rest. It therefore comes as no surprise that just as several industries are adapting to the changing needs of the market, banks and insurance companies who have traditionally provided such Bonds have increasingly moved away from singularly assuming such risks to a more modern form of syndication aimed at providing the needed security to support large scale transactions while limiting their individual exposure at the same time.

Ideally, Bonds give the party for whose benefit the Bond was issued some comfort that should a contracting party fail to honour its side of the bargain, it can easily call on the Bond which to all intents and purposes, is money held on account until there is sufficient basis for claiming it. However, in spite of the seeming ease of calling on Bonds (on its terms), recent trends of Principals[2] putting impediments calculated at defeating calls on Bonds have a tendency of undermining the very foundation which has held the fabric of international commerce together for centuries. Such actions have largely undermined the efficacy of Bonds leading many to question whether Bonds provide a safe haven or a myth of security.

The ideal situation

 Typically, when A enters into a contract with B to say provide a service, B may require A to provide a Bond as a condition for the performance of the service. Usually, the value of the contract influences the amount of the Bond since it is meant to give some comfort to the benefitting party (the party in whose favour the Bond is issued). B therefore engages his bankers or insurers to provide a Bond as agreed in the contract. B’s banker or insurers then take security, a collateral or obtain a promise of indemnification from B together with payment of the requisite fees for issuing the Bond. The Bond is issued in A’s favour. On paper, a fairly straightforward process.

The reason for taking security is to give B’s bank something (usually an asset or security over accounts) that they can easily go against once a demand on the Bond has been honoured. If B repays the money paid by its bank, B can exercise legal control over the asset. On the other hand, if B does not repay the money paid by its bankers, the bank merely proceeds to recover its money (by enforcing the security). A is the Beneficiary, B is the Principal and B’s bank/insurers is the Bond Issuer.

Generally, although Bonds serve the same purpose, no two Bonds are the same on its terms. Some Bonds can simply be on demand without the need to prove any default, while with others the party calling on the Bond must establish a default as justification for calling on the Bond. Regardless of the terms of the Bond, one thing remains that: it is important for a party making a call on the Bond to make that call in line with the terms of the Bond. Ideally, once a demand has been made in accordance with the terms of the Bond, the Bond issuer is bound to pay.

The practice or real world situation

Understandably, whenever a Beneficiary makes a call on a Bond, to put it bluntly: all hell breaks loose! The Bond Issuer usually a bank or insurance company projects an image of a responsible institution ever willing to sign a cheque or wire money just so it can in turn recoup the money from its client.  Behind closed doors, it sits on the edge and gathers its best streetwise professionals for a clandestine battle. The Principal whose financial position will most likely change is in a frenzy while the Beneficiary  simply cannot wait to get what in its estimation is unquestionably its. And it is in the midst of all this confusion and fanfare that brilliant ideas are birthed to defeat the call on Bonds.

In far too many instances desperate attempts have been made to defeat calls on Bonds that have been properly made. And in majority of those instances, the courts have been called upon to determine whether calls on Bonds have been properly made or attempts at defeating them are purely motivated by a party’s desire to escape from the bargain it voluntarily struck.

 The position of the law

London has been the centre of international commerce for centuries. It comes as no surprise that the English courts developed this area of law during the period of economic boom when English companies took out Bonds for contracts in and out of England. The disputes arising from such Bonds set the stage for English courts to blaze the trial.

Under English law, a call on a Bond must be honoured according to its terms unless the call on the Bond is fraudulent. This rule was laid out by the English courts in Edward Owen Engineering Ltd v. Barclays Bank International Ltd [1978] 1 All ER 976. Oddly, the mere fact that there is ‘fraud’ is not a basis for not paying a Bond. The alleged fraud must have been done by the beneficiary in making the call on the Bond[3] to the Bank’s knowledge.[4]

Further, it is not enough to merely allege fraud: the alleged fraud must be “very clearly established”.[5]  Thus, the only basis on which a bank can refuse to pay a Bond is when there is clear evidence of fraud by the Beneficiary in calling on the Bond which the bank knows of. This position of the law as set out in Edward Owen has been adopted by majority of the common law world (with very slight modifications) including Ghana.

Edward Owen concerned a dispute over a Bond issued under a contract for the construction of greenhouses. The party in default under the contract called on the Bond while the innocent party tried to prevent the bank from paying. A Libyan company engaged an English company to construct greenhouses. As a precondition of the contract, the English company was required to provide a performance bond “payable on demand without proof or conditions” in favour of the Libyan company. The English company provided the performance bond in line with the contract.

The Libyan company was also required to provide confirmed letters of credit for the payment of the contract price. The Libyan company provided the letters of credit but failed to provide confirmed letters of credit as agreed under the contract. The English company informed the Libyan company that because the Libyan company failed to provide confirmed letters of credit, the performance bond provided by the English company had no effect. On receiving the letter, the Libyan company called on the performance bond.

In response to the call, the English company obtained an injunction against its bankers (who provided the performance bond) to prevent them from paying the bond. Subsequently, the English company’s bankers filed an application based on which the injunction was dismissed/lifted. The English company appealed against the decision of the High Court.

On appeal, the court discharged the injunction and ordered the bank to pay the bond even though Libyan company was itself in default.  The court was of the view that “the only circumstances which would justify the bank not complying with the demand … .is this, if it had been clear and obvious to the bank that the buyer had been guilty of fraud ^[6]”. In simple terms: because the terms of the bond stated that it was payable on demand without proof, the call on the bond was rightly made. Edward Owen set the stage for a long line of decisions in this area of law.

The case of Ghana

 The decision in Edward Owen received support in the Ghanaian court in Jescan Construction Ltd v Hippo Ltd & Ors [2016] 94 G.M.J where the Court of Appeal reversed the decision of the High Court granting an injunction preventing a bank from paying an unconditional Bond.

In Jescan, C was employed by E to construct warehouses and other facilities C was required to provide (1) a bank guarantee for mobilisation payments received under the contract and (2) a performance bond for the execution of the contract. C instructed its bankers to provide two guarantees in satisfaction of its obligations under the contract. Subsequently, the project manager terminated C’s contract for non-performance and mismanagement. The Project Manager certified that C owed under the contract because the work conducted by C was below the value of the loans given to C for the construction. E then made a call on the guarantee. C sued in the High Court seeking an injunction to prevent payment of the guarantee. The High Court decided in favour of C.

On appeal, the court explained that Bonds are essentially contracts which the courts have always strived to enforce as closely to the intention of the parties as possible. The mere naming of a contract as a “bond” or “guarantee” does not grant the “bond” or “guarantee” a superior status or change the legal effect of such a contract. If it is apparent from the wording of the Bond that a bank is required to pay on demand without proof or contestation, pay on proof or occurrence of certain factors, or pay unconditionally or irrevocably, the courts must interpret the contract to reflect the bargain struck by the parties to bring commercial certainty to such agreements. The court held that from the wording of the Bond, the parties intended it to be unconditional, and in the absence of fraud on the guarantee itself, the decision of the High Court granting the injunction was wrong.

The million-dollar secret

While majority of the common law world have followed the decision in Edward Owen, the courts in Singapore have included unconscionability as a separate ground for refusing to honour a call on a performance bond[7] which they distinguish from a letter of credit. Although Ghana has largely followed English law on Bonds, it seems from the decision in Jescan that there is a tenuous distinction between the English and Ghanaian law positions to the extent that Ghanaian law limits the fatality of fraud to the guarantee itself and not necessarily fraud on the call on the guarantee as is the English position. As Torkonoo JA (as she then was) opined “the fraud in question is not fraud as between the contractor and employer, as seemed to have weighed on the mind of the trial judge in this suit, but fraud regarding the performance guarantee itself. In the present case, there were no allegations of fraud regarding the guarantees.”

Ghanaian courts have long exhibited a penchant for ensuring justice is done in all cases but this penchant, dare I say, has not outweighed the need to bring commercial certainty as regards Bonds. Factors typically taken into account in enforcing contracts like the bargaining power of parties and unconscionability do not seem to come to play in determining whether a call on a Bond must be honoured. The net effect is that the law is quite clear – Bonds are to be honoured in line with their terms. To refuse a call on an unconditional Bond, all that you need to do is to find fraud regarding the Bonds (if you are the Issuer) or make sure there is no element of fraud with the Bond if you are the one smiling all the way to the bank. At least, you now know what to do to make sure you don’t lose out.

The Take away

Clarity with the law can only do so much to prevent an overly ambitious person from being too smart for his own good in a quest to defeat a call on a Bond. But on the brighter side, the courts almost always seem to come through for innocent parties caught in the middle of predominantly needless fights. Performance bonds are far from being a safe haven (as people will always try to be too smart for their own good), but what cannot be denied is that Bonds are definitely not a myth of security if you cross all your “t’s” and dot all your “i’s”.

Photo by Cytonn Photography on Unsplash

[1] Harbottle (Mercantile) Ltd v National Westminster Bank Ltd [1977] 2 All ER 862

[2] (the party required to perform an obligation for which the bond was issued)

[3] Edward Owen Engineering Ltd v. Barclays Bank International Ltd [1978] 1 All ER 976

[4] Harbottle (Mercantile) Ltd v National Westminster Bank Ltd [1977] 2 All ER 862

[5] Edward Owen Engineering Ltd v. Barclays Bank International Ltd [1978] 1 All ER 976 per Browne LJ at 984

[6] Lord Justice Lane stated at page 986

[7] The courts in Singapore have consistently held that unconscionability is a separate and independent ground for defeating a call on a performance bond. Consequently the courts have granted  interlocutory injunctions in cases where a party establishes a strong prima facie case of unconscionability ( see Bocotra Construction Pte Ltd and others v Attorney-General [1995] 2 SLR(R) 262; GHL Pte Ltd v Unitrack Building Construction Pte Ltd and Another [1999] 3 SLR(R) 44 and JBE Properties Pte Ltd v Gammon Pte Ltd, [2011] 2 SLR 47.