Performance Bonds, The Wording Matters

Various commercial contracts require one party (the Principal) to have a performance bond issued by a reputable bank or insurance company (the Issuer). The purpose is to protect the recipient of the performance bond (the Beneficiary) from the Principal’s contractual defaults without having to worry about the Principal’s financial position.

Performance bonds have been used in commerce for a long time. Those who have read or watched ‘The Merchant of Venice’ by William Shakespeare may recall that Shylock granted Antonio a loan on the strength of a bond. The terms of the bond were that if the money loaned was not repaid within certain timelines, Shylock would take a pound of flesh from Antonio’s body, in whatever part that Shylock chose. Shylock was, however, unable to enforce the bond when the matter turned litigious. The wording of the bond, arguably, contributed to Shylock’s inability to enforce it.

To date, it is not unusual for disputes to arise from the wording of bonds. A key issue being whether a bond is conditional or on-demand. The practical and commercial implication of the resolution of the issue determines whether the Issuer is bound to make payment immediately or later (often after dispute resolution).

As the name suggests, on-demand bonds are payable by the Issuer once called in by the Beneficiary. They may have phrases such as “We hereby irrevocably and unconditionally guarantee that we will notwithstanding any objection by the Principal immediately pay to you the sum of X upon receipt of the Beneficiary’s first written request…” The trigger for payment in such cases would simply be the
Beneficiary’s written request.

The express wording of on-demand bonds makes them payable immediately when they are called in by the Beneficiary. Whereas it is not unusual for the Principal to go to court seeking to suspend or stop payment being made by the Issuer, courts are often reluctant to grant such orders except in clear cases of fraud.

Conditional bonds, in contrast, are only payable upon the occurrence of certain contractual conditions. A conditional performance bond may have a phrase such as “now the condition of this bond is that in the event of any default by the Principal, the Issuer shall pay the Beneficiary the sum of X.”

The question of whether the conditions set out in conditional bonds have been satisfied frequently arises in litigation. Often, the Issuer and or Principal would argue that the conditions have not been met and accordingly no payment is due. In such circumstances, the Issuer would resist making payment until the dispute has been conclusively determined. This may take a considerable amount of time. It also carries the natural risk of the Court finding that the conditions have not been met and therefore the Issuer is not obliged to pay.

While the differences between conditional and on-demand bonds seem easy and straightforward, litigation on bonds seems never-ending so much so that the English High Court in the case of Paddington Churches Housing Association vs Technical and General Guarantee Company Ltd [1999] EWHC Technology 246 (22 March, 1999) observed that:

“This case provides yet another example of the failure of a person or body for whose protection a bond was given to understand the nature of the protection provided.”

Before issuing or accepting performance bond(s), it is critical to closely examine the language used in the document. The devil is always in the details. Legal counsel is advised.

Disclaimer: The information contained in this article is of a general nature and is not intended to address the circumstances of any particular individual or entity. While the information is accurate as at date hereof, there can be no guarantee that the information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.