PERFORMANCE SECURITIES

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Cory Lydia Palmer
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CONTRACTOR'S LEGAL GUIDANCE NOTE WINTER 2008 EDITION Scope PERFORMANCE SECURITIES This Contractor s Legal Guidance Note briefly considers the types, commercial functions and uses of performance

1 CONTRACTOR'S LEGAL GUIDANCE NOTE WINTER 2008 EDITION Scope PERFORMANCE SECURITIES This Contractor s Legal Guidance Note briefly considers the types, commercial functions and uses of performance securities in the context of the building and engineering fields. What and Why? The essence of a performance security is a promise by one contracting party (the "Obligor") to pay another contracting party (the "Beneficiary") up to a specified sum of money in the event of an actual or alleged default by a third party (the Primary Obligor ) of its contractual obligations owed to the Beneficiary. There are many types of performance security and an enormous range of documentation in circulation. Performance securities have strong roots in numerous commercial spheres, including the international trade (including homogenous commodities, such as hydrocarbons), commercial banking, capital markets transactions and infrastructure projects. Such a diversity of usage has led to a plethora of terms describing what is basically the same thing be it the type of performance security in question or the titles of the parties to the performance security. In construction and engineering projects performance securities are used to secure the performance of the contractor/subcontractor/supplier or, occasionally, the developer of its obligations under the "Underlying Contract". Underlying Contract Beneficiary Performance Security Primary Obligor Counter-indemnity Obligor Figure Bonding obligations Labels Can Be Misleading In construction and engineering projects there are certain common situations where security will usually be provided by way of the provision of a performance security. A practice has developed of describing a type of performance security by reference to the relevant situation. Common examples include: Advance payment performance securities (where the performance security is provided by the contractor as counter-security for advance payments; Page 1 of 6

2 bid/tender bonds (as security for losses sustained by the developer in the tender process should the bidder fail to follow through in the tender process); retention bonds (as security in lieu of the developer withholding retention monies from the contractor under the building contract); performance bonds (as security for losses sustained by the developer should the contractor fail to perform its obligations under the construction contract); offsite material bonds (where items of high value are paid for before they are delivered to site); Perhaps the most important rule when dealing with performance securities is that the specific wording of the particular performance security in conjunction with the relevant norms and rules of the law governing the performance security, determine its scope, meaning and effect. The wording will affect how the particular performance security operates in practice and what liabilities it imposes on the Obligor and this varies widely. Primary and Secondary Obligations In distinguishing between different types of performance securities it is usually critically important to determine whether the performance security imposes a primary or secondary obligation on the Obligor. If the Obligor is liable to the Beneficiary without reference to the liability of any other person, that is a "primary obligation". If the Obligor s liability to the beneficiary is contingent on a third party being in breach of an obligation owed to the Beneficiary then that is a "secondary obligation". Thus, in the context of a performance security, as referred to above: if the Obligor is obliged to pay on the performance security regardless of the Primary Obligor s liability under the Underlying Contract then the Obligor has a primary obligation to the Beneficiary; or if the Obligor's liability under the performance security is contingent on a breach of an obligation of the Primary Obligor under the Underlying Contract, the Obligor s obligation to the Beneficiary is secondary, i.e. a suretyship obligation. Typically, performance securities containing primary obligations are referred to as on demand bonds or (somewhat confusingly) demand guarantees while secondary obligations tend to be called performance guarantees. Types of Primary and Secondary Obligations Perhaps the clearest example of a performance security imposing a primary obligation is one obliging the Obligor to pay the secured amount to the Beneficiary when he asks for it without any requirement for the Beneficiary to provide evidence to support the call on the performance security e.g. on demand without proof or conditions hence the common use of the epithet on demand. In practice, in order to better safeguard the Primary Obligor, it is common to find additional documentation being required from the Beneficiary. For example: (a) (b) (c) (d) a statement that the Primary Obligor is in default, copies of warning notices to remedy the default given to the Primary Obligor under the building contract, a certificate of a third party appointed under the contract (e.g. an engineer or architect), or an adjudicator s award or a court order or judgment. Even where the performance security calls for such additional documentation, the performance security may still impose a primary obligation on the Obligor, where, for example, subject to compliance with the formalities and procedures stated for calling the performance security, the Obligor is primarily obliged to pay the secured amount. Such a performance security is often referred to as a "conditional on-demand bond". To further emphasise that the performance Page 2 of 6

3 security is creating a primary obligation, many such performance securities will expressly entitle the Obligor to rely on the provision of the necessary documents, as conclusive evidence that the amount claimed is due. This helps make it clear that, subject to compliance with the given formalities and procedures, the Obligor must pay despite any protest from the Primary Obligor. Clearly, the more onerous the conditions for calling the performance security, the closer it is to a secondary obligation, a surety. In creating a secondary obligation the Obligor s liability to the Beneficiary will be limited by the lesser of the secured amount and the amount of the Primary Obligor s liability to the Beneficiary for the relevant default. In order to gain a right to make a call on the performance security, the Beneficiary will therefore have to establish a liability arising from the Primary Obligor's default hence the use of the epithet on default. Adjudication Bonds are now becoming a feature in engineering construction projects. As their name implies, they usually give the developer the right to call the performance security where it obtains an adjudicator's decision against the contractor. Adjudication Bonds are commercially recognised as falling somewhere between a primary and secondary performance security. Their nature and extent is, however, still in the stage of some development. Is there any reason why they would not be of interest to developers and contractors in other jurisdictions where a statutory adjudication regime applies? "No" is probably the correct answer. The FIDIC "Rainbow Suite" conditions for international construction contracts, published in 1999, incorporate model forms of performance security based on the ICC's Uniform Rules for Demand Guarantees (ICC Publication no. 458) (the "URDG") and provide for the settlement of disputes initially by a Dispute Adjudication Board. The decision of such Board, which is provisionally binding upon the parties, must be rendered within 84 days. There is no reason why the parties could not agree that any call on a demand guarantee must be accompanied by a decision from the Board stating that the contractor is in breach of contract and the amount of the damages resulting from the breach. Archaic Language As discussed above, the use of jargon in describing performance securities often leads to confusion about what a Primary Obligor is agreeing to provide. In addition, Performance securities have long been (and continue to be) criticised for the use of jargon and archaic language in the body of the document. This has led to, and continues to cause, confusion about the nature of the obligations of the Obligor. As long ago as the 1930 s in Britain, Lord Atkin (a British Law Lord) observed: I may be allowed to remark that it is difficult to understand why businessmen persist in entering upon considerable obligations in old-fashioned forms of contract which do not adequately express the true transaction. (Trade Indemnity v Workington Harbour and Dock Board (1937)). More recently, still in Britain, Sir Michael Latham felt the need to repeat this concern when he recommended in his 1994 report that performance securities should be drafted using modern language. Nevertheless, despite the efforts of organisations such as the ICC and FIDIC, unfortunately the practice of drafting performance securities using archaic language persists. When Is a Primary or a Secondary Obligation Required? The type of performance security actually required (or its required legal function) depends mainly on the reasons why the performance security is being sought (or its required commercial functions). However, given the added complications of calling on a secondary obligation there is a temptation for developers to seek a primary obligation in all cases. Such a practice overlooks a number of other factors influencing the choice of performance security: Factors favouring a primary obligation performance security Perhaps the most common reason for (and commercial function of) seeking a performance security is to provide security for losses resulting from the Primary Obligor being unable to complete the performance of its obligations due to insolvency. The Beneficiary may need to be able to make a demand under the performance security in order to realize an immediate source of cash to finance completion of the project. A secondary obligation will not be appropriate given the likely delay in being able to call the performance security as a consequence of the need to establish and, probably, prove the liability of the Primary Page 3 of 6

4 Obligor. A primary obligation, with little or no restriction on the requirements for calling the performance security (i.e. a "clean bond") is more appropriate. The other common commercial function of a performance security is to provide security for the Primary Obligor's liability for any failure to perform its obligations under the Underlying Contract. A primary obligation will allow the Beneficiary to call for payment immediately without having to establish the liability of the Primary Obligor. This may be considered necessary if the performance security is being provided as security in lieu of retention monies, or as security for advance payment monies that the Beneficiary has made. But where the Beneficiary's concern is primarily that the Primary Obligor will be unable to meet the liability once proven, he may be comfortable with a secondary obligation. The Obligor is likely to prefer to issue a primary obligation so as to avoid the need for any involvement in disputes concerning the alleged default in performance and any resulting liability for which the bond provides security. Where a project is being financed by third parties, the bond can provide an asset over which the project lenders can take security (for example, by way of an assignment of the bond itself). Under several legal systems the rights of the Beneficiary under a bond establishing a secondary obligation are not assignable, however those under a bond establishing a primary obligation are assignable. Consequently, project lenders will usually insist on the latter. Factors favouring a secondary obligation performance security The Obligor will almost always require recourse against the Primary Obligor in the event a successful call is made on the bond, usually in the form of a counter-indemnity (see the Figure above). In the case of a primary obligation, the Obligor (usually a commercial bank) will often also require a cash deposit at the outset, which can be drawn down in the event the bond is called. When a secondary obligation is given, the Obligor (often an insurance company) will usually only require a premium payment in addition to the provision of the counter indemnity. Consequently, a requirement for a primary obligation performance security might be considerably more expensive for the Beneficiary. The separation of a primary obligation from the Underlying Contract inevitably opens up the possibility of the performance security being used unfairly. Given the limited ability of a Primary Obligor to challenge a call on a primary obligation performance security, such a call (or even the threat of such a call) considerably affects the commercial position of the parties. In effect, if a call is made on the performance security, the onus will be on the Primary Obligor to seek to recover from the Beneficiary of the performance security rather than the Beneficiary having to seek to recover from the Primary Obligor, as would be the case if there were no performance security to make a call. Consequently, primary obligation performance securities can be used as a "sword of Damocles": " perform or I will call the bond" " pay liquidated damages or I will call the bond". For this reason, a would-be Primary Obligor will often be reluctant to provide a primary obligation performance security. The Primary Obligor's record (or that of any affiliated companies) of calls made upon performance securities it has (or they have) procured is likely to affect its (or their) ability to procure performance securities in the future. This will make Primary Obligor reluctant to provide Primary Obligation performance securities, in circumstances where they are not really essential. As mentioned above, sometimes insufficient thought is given to the type of performance security actually required in the particular case. The biggest consideration is often not the matching of the type of performance security with the commercial objectives of the developer, but only the commercial balance of power between the parties when the contract is being prepared. This can lead to protracted negotiations and is probably, at least partially, responsible for the unclear and convoluted drafting often encountered. Many of the problems arising could be avoided if the parties fully considered the most appropriate form of security required and this was clearly established between them at the outset in pre-contractual discussions. Amount of the Performance Security This should be apparent on the face of the instrument. Performance securities are typically valued at somewhere between 5% and 10% of the Contract Sum (although not everyone shares Page 4 of 6

5 experiences of this range of values). But specific arrangements can be made to reflect the purpose of the security. For example, the secured amount may (a) decrease upon the occurrence of certain events (e.g. practical completion); or (b) increase as a percentage of the payments made to the Primary Obligor by the Beneficiary. Advance payment bonds normally decrease in value as the advance payment is accounted for through interim valuations. Offsite materials bonds increase as materials are paid for and then decrease in value as materials are delivered. Performance bonds might run until the end of a warranty period, in which case they will often reduce on practical completion. In the case of other types of performance security, the amount of the performance security is likely to be linked to the purpose for which security is being taken. For example, a Retention Bond will be taken as security in lieu of a retention monies being deducted from interim payments under the contract. Consequently, the amount secured should be at all times reflective of the variable value of the retention monies. Obviously, this can become quite complicated. How Much Can the Performance Security be Called For? Is the Beneficiary entitled to call for the whole amount of the secured amount or can it only seek compensation for the amount of its losses from the Obligor? Again this will depend on the type of performance security. Clearly, in the case of a secondary obligation, the liability under the performance security is at least limited to the Primary Obligor's liabilities vis-à-vis the Beneficiary secured by that performance security. Consequently, the Beneficiary is not entitled to claim any sum in excess of that liability notwithstanding that the performance security is issued for a greater amount. Obviously, it is also possible for the terms of the performance security to further exclude recovery of a particular type of liability under the performance security, although this would be quite unusual. In addition, it is worth bearing in mind that the normal law of guarantees applies to a secondary obligation. Consequently, in the absence of express provisions to the contrary, the Obligor is likely to be able to take account of the Primary Obligor's set-offs and cross-claims when making payment to the Beneficiary under the performance security. Primary Obligors should look out for exclusive jurisdiction clauses. For example, Article 28 of the URDG, which states that unless the parties agree otherwise, disputes between the Obligor and the Beneficiary shall be settled exclusively by a court in the country of the Obligor or if the Obligor has more than one place of business by a court of the country of the branch which issued the performance security. The Primary Obligor will find it difficult to achieve a strict stepdown of this provision in any subcontracts with foreign subcontractors, since those subcontractors (as would-be Primary Obligors under the subcontract performance security) will often insist that local banks in the subcontractor s country supply them. If a bank in the subcontractor s country issues the performance security, then, by virtue of the exclusive forum provision, the Primary Obligor will be forced (as Beneficiary under the subcontractor's performance security) to bring (or defend) suit in the courts of the country of the subcontractor an obvious disadvantage. In order to avoid this problem, the subcontract performance security might need to be provided by an international bank with branches outside the home jurisdiction of the subcontractor. If the performance security creates a primary obligation on the Obligor then the Beneficiary will be entitled to receive an amount not exceeding the secured amount on the making of the demand. However, the English courts have inferred certain limits on the scope of the Beneficiary's right to the secured amount: If the amount of the bond is not sufficient to satisfy [his] claim for damages he can bring proceedings for his loss, giving credit for the amount received under the bond. Conversely if the amount received under the bond exceeds the true loss sustained, the party who provided the bond is entitled to recover the overpayment. (Cargill International SA v BSFIC (1996)). Reliance on such an implied term (given the theoretical basis for the implication is unclear) obviously introduces considerable uncertainty as to what events do actually entitle the Page 5 of 6

6 Beneficiary, as between the Primary Obligor and the Beneficiary, to call the performance security. In addition, the Beneficiary does not hold any overpayment on trust for the Primary Obligor and so the Primary Obligor may be vulnerable to any insolvency of the Beneficiary. For these reasons, it is prudent for such issues to be dealt with in clear terms in the contract between the Primary Obligor and the Beneficiary. Conclusion This is an area of law and practice that has been rendered overly complex by the use of jargon and archaic language. But once it has been established by close analysis of the text of the particular performance security being preferred by the developer whether it creates a primary or secondary obligation, much of the law applying to the interpretation and exercise of the performance security becomes clearer. Nonetheless, performance securities are not straightforward legal instruments and as such the input of legal counsel possessing substantial relevant experience is recommended. Pinsent Masons 2008 Page 6 of 6

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