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20 April 2017

Financial security in infrastructure projects

Evolution of the case law concerning on demand bonds

1970s - orthodox position

Since at least the 1970s[i]  the English courts have shown a commitment to upholding these commercial arrangements. When contractors have asked them to intervene and prevent on demand instruments being paid, the courts have declined to do so. However, the courts set out two limited exceptions where they may intervene:

  1. Where the terms contained in the bond itself provide criteria for a valid call, such as where the bond is stated to expire on a fixed date or on the issuing of a certificate (practical completion, making good defects etc). The court may consider and apply provisions of this nature and intervene where it finds the call to be invalid or prohibited.
  2. The courts may intervene where the employer commits clear or obvious fraud by calling on the bond and this is known to the bondsman. For example, if the employer calls on the bond solely because it is having cashflow difficulties, and the contractor has obviously performed the works correctly, a case for fraud could potentially be made (provided the contractor notifies the bondsman of the ulterior motive).

2000s - a new exception

In 2003[ii], the courts created a new exception for another type of on demand instrument known as a letter of credit. They found that where there is an express prohibition on making a call – not in the terms of the bond itself but in the underlying contract (i.e. the construction contract) – the employer may be restrained from making such a call. This was applied in 2011 in the context of on demand bonds, in the case of Simon Carves Ltd v Ensus UK Ltd [2011] EWHC 657. In that case, under an ICE Red Book form of contract (as amended) for the construction of a bioethanol plant, the bond was "null and void" upon the issuing of an Acceptance Certificate. The project team expressed concerns about defects in the works but proceeded to issue the Certificate. The court found that the employer should be held to the terms it expressly agreed in the contract: from the time of issuing the Certificate it was no longer entitled to call on the bond. If the works had extensive defects in them, the employer would simply need to pursue the contractor for damages in the usual way.

The position was taken further in 2013 with the Doosan Babcock cases[iii]. The circumstances were similar to the Simon Carves case but with two differences: the relevant term was in the bond itself (stating that the bond expired on the issuing of a Take-Over Certificate), and no such certificate had actually been issued. Rather, the contractor's argument was that the employer was required under the terms of the construction contract to issue the Certificate. The contractor was able to establish that the works – supplying and installing boilers for a power plant in Brazil – had actually been taken over and used for several months to generate some 7,500 hours of power. The employer was contractually required to provide a Take-Over Certificate in these circumstances, and its failure to do so was found to be a breach of contract. The court was concerned that if it did not intervene, the employer would be taking advantage of its own breach in calling on the bond and receiving payment of the bonded sum. An injunction was therefore granted to restrain the employer from doing this.

These cases establish that if the construction contract expressly sets out circumstances under which the bond will expire or a call on the bond will be prohibited, the courts may intervene to enforce those terms and prevent a call which according to the contract is invalid or prohibited.

2015 - extending the exception

However, in 2015, in MW High Tech Projects UK Ltd v Biffa Waste Services Limited [2015] EWHC 949 at [34], Stuart Smith J suggested that the exception should also apply where the contract contained an implied term prohibiting the making of a call on the bond. Although this comment is not "law" as it was not strictly necessary for the deciding of the case, it foreshadows a near future in which the courts will entertain arguments from contractors that their construction contracts have such an implied term preventing the employer calling on the bond. Whether the courts ultimately agree to intervene on the bond call is likely to depend in large part on the background to the transaction and the terms of the contract; for example in 2007 the courts found that in the circumstances of that particular case there was no implied term preventing the employer calling on the bond[iv].

What is the threshold for an interim injunction?

The courts are grappling with other issues in relation to this new exception. The judge in Simon Carves said that the courts can issue an injunction if satisfied that the contractor has a "serious case" that in the circumstances the contract prohibits the call on the bond. The judge in the Doosan Babcock cases agreed, but also held that where it is argued the employer is relying on its own breach of contract in calling on the bond, the contractor only needs to show a "reasonable prospect of success" (a lower threshold). The judge in MW High Tech disagreed with both of these positions, stating that the contractor must "positively establish" the breach. This is a significantly higher threshold, especially given that injunctions against bond calls are frequently applied for at the last minute and dealt with on an urgent interlocutory basis rather than by a final hearing. It remains to be seen which of these thresholds prevails.

Ramifications for transactions and litigation

These developments in the English law have ramifications for infrastructure participants at the transactional stage; it may be prudent to receive legal advice on the provisions of the construction contract dealing with security. Employers may prefer little or no wording in the construction contract save to say that the contractor must provide a bond in the form set out in a schedule. Contractors on the other hand may wish to restrict the circumstances under which the bond may be called. For example, the bond may expire on a certain date, or on the issuing of a certificate; the employer may only be permitted to make a call where the defects or delay are "material" or "substantial"; or a mandatory notice procedure may be stipulated. Further, contractors may wish to provide expressly that any sum that is called on and paid in excess of the true value of the defects or delay must be reimbursed to the contractor promptly[v].

At the litigation stage, i.e. once a call on the bond has been made, contractors may use the wider grounds on which an injunction can be granted, and employers may need to defend such an application, often at very short notice. For example, in 2016, a contractor argued that under an amended FIDIC contract an Engineer Determination needed to be made before any liquidated damages liability arose – LADs were the basis of the call on the bond[vi]. The employer was required quickly to collate and tender a considerable amount of evidence about its financial position and the project taking a turn for the worse, in addition to all the legal arguments to be prepared. The court ultimately disagreed with the contractor’s view of the contract and permitted the employer to proceed with its call.

Special rules for URDG bonds

Different rules may apply in relation to on demand bonds which are subject to the International Chamber of Commerce’s Uniform Rules for Demand Guarantees (URDG 758). The Rules require the employer to provide a statement indicating in what respect the contractor is in breach of the construction contract. This suggests that if such a statement is not provided, or the statement merely states that the contractor is in breach without identifying how, the bondsman may be required to reject the call. It also suggests that contractor insolvency may not be a sufficient ground in itself for the making of a call on a URDG bond.

The Rules also require the bondsman to inform the contractor or party requesting the guarantee of any call which is made; in the absence of such a provision the bondsman would likely be prohibited from doing this. Using a URDG bond may therefore increase the likelihood of an injunction application. Employers should therefore exercise caution when agreeing to accept a URDG bond.

Jurisdictional issues

When dealing with international infrastructure projects particular attention should be paid to questions of governing law and jurisdiction. The point is illustrated by AES 3C Maritza East 1 EOOD v Crédit Agricole Corporate and Investment Bank [2011] EWHC 123, concerning the construction of a power plant in Bulgaria. The EPC contract and bond were stated as being governed by English law. The employer made a call on the bond which t

he contractor disputed, so the contractor applied to the French courts (given the bondsman was a French bank) for an interim injunction restraining the payment of any sums, which the courts granted. Shortly afterwards, the employer obtained a summary judgment from the English courts requiring the bondsman to pay the bonded sum, however the English courts stayed execution of the judgment until such time as the French courts lifted the interim injunction. The rationale was that the English courts could not force the bondsman to do something which would breach a French court order. Such issues may need to be considered at the transactional stage of international projects.

As a result of the recent developments in the case law, it is clear that the position under English law has shifted considerably from the starting point that on demand bonds are payable unconditionally (save for fraud) without reference to the construction contract. It will be important in the years to follow for infrastructure participants to stay abreast of the further developments in the law in this area.

[i] Edward Owen Engineering Ltd v Barclays Bank International Ltd [1978] QB 159; RD Harbottle (Mercantile) Limited v National Westminster Bank Ltd [1978] QB 146.

[ii] Sirius International Insurance Co v FAI General Insurance Ltd [2003] 1 WLR 2214.

[iii] Doosan Babcock Ltd v Comercializadora de Equipos y Materiales Mabe Limitada [2013] EWHC 3010 and [2013] EWHC 3201.

[iv] Permasteelisa Japan KK v Bouyguesstroi and Bance Intesa SpA [2007] EWHC 3508.

[v] In the absence of such an express condition, contractors may need to argue that such a condition is implied: Wuhan Guoyu Logistics Group Company Limited v Emporiki Bank of Greece SA (No 2) [2013] EWCA (Civ) 1679 at [21].

[vi] J Murphy & Sons Ltd v Beckton Energy Ltd [2016] EWHC 607.

This article was written by Alex Ottaway, associate. For more information please contact Alex on +44 (0)20 7427 1057 or