Performance Bonds at the Time of Coronavirus

Calling a performance bond involves a delicate balance of factors. Such evaluation is not simplified by the COVID-19 pandemic. Below is an overview of key issues regarding bonds in this context.

Performance Bonds on Default
Subject to the language of each specific bond, conditional or on default performance bonds (as secondary obligations) may be collected only if non-performance by the main obligor is established by a judgment or an award (according to the settlement dispute mechanism selected by the contractual parties). The main obligor that has performed its obligations is then entitled to oppose the call.

Performance Bonds on Demand
Courts in the United Kingdom (UK) have held that:

• Unconditional or on demand performance bonds are payable “on demand without proof or conditions” (Edward Owen Engineering Limited v. Barclays Bank International Ltd. and another, EWCA [1978] 1 Q.B. 159 https://swarb.co.uk/edward-owen-engineering-ltd-v-barclays-bank-international-ltd-ca-1978/) . Although generally referred to as “unconditional”, it may be worth mentioning that these bonds are indeed conditional upon the presentation of timely and compliant documents.
• Manifest Fraud is an exception to the rule that Courts do not intervene (MW High Tech Projects UK Limited and another v. Biffa Waste Services Limited [2015] EWHC 949 (TCC) http://www.bailii.org/ew/cases/EWHC/TCC/2015/949.html
• Fraud is not the only ground which entitles not to pay under a call. If the underlying contract clearly prevents the beneficiary from calling the bond, the latter can be restrained by the Court from calling a bond on demand (Simon Carves Limited v. Ensus UK [2011] EWCH 657 (TCC) https://www.bailii.org/ew/cases/EWHC/TCC/2011/657.html).
• In Trafalgar House Construction (Regions) Ltd. v. General Society and Guarantee [1995] 1 AC 199, the House of Lords has affirmed in passing: 
  “In recent years there has come into existence a creature described as ‘on demand bond’ in terms of which the creditor is entitled to be paid merely on making a demand for the amount of the bond … all what was required to activate it was a demand by the creditor stated to be on the basis of the event specified in the bonds.”

As to civil law systems such as, for example, in Italy, a performance bond is held to be on demand when it is to be paid by its issuer in spite of any defence available to the supplier, or contractor or obligor, under the main contract from which the bond arises:

• In a still leading decision, the Italian Supreme Court has held that “The arbitrariness of the beneficiary’s call, and correspondingly the power and duties of the guarantor to refuse payment, may be established … exclusively if the guarantee has ceased to exist in a manifest, certain and unchallengeable way and the call is prima facie abusive.” (Società Italiana Cauzioni c. Banca Commerciale Italiana [1993], 19 March 1993, no. 3291, Foro pad. 1995, I, 380). https://www.bailii.org/ew/cases/EWHC/TCC/2011/657.html.
• The performance bond on demand is not a traditional guarantee since it switches the financial risk from the main obligor to the guarantor, and the performance due by the guarantor may be different from the one due by the obligor (Joint Chambers of the Italian Supreme Court, in A.T.E.R. v. Lloyd Italiana Assicurazioni [2010] 18 February, no. 3947). https://brsa.lawfed.com/wp-content/uploads/2020/06/Cass.-n.-3947-del-2011.pdf .
• A large majority of Italian authorities and commentators characterizes on-demand performance bonds as an unconditional, non-ancillary, and independent obligations, even if doubts as to such independency have been raised by some commentators.
• The only ground which allows the issuer of the bond not to pay is the beneficiary’s fraud (exceptio doli, fraude manifeste), i.e. when the call (i) is prima facie fraudulent or (ii) it is manifest that it has not been made in good faith.
• When the issuer has evidence that non-performance by the main obligor is due to force majeure, it is submitted that he is facing a fraudulent call to pay that bond and should reject it, in line with its duty of loyalty to its customer.

Requirements for Force Majeure due to the COVID-19 Pandemic
Even if coronavirus immediately calls to mind force majeure, it does not necessarily amount by itself to force majeure, when it is just the basis on which emergency measures are adopted around the world. 

Coronavirus legislation may justify non-performance under the underlying contract; the pandemic crisis may impact the call of the bond issued with regard to that contract, as well as its procedural follow-up. Applications have been filed to obtain a freezing order to block the call, others to obtain an order to pay the performance bond. 

Typically, in order to be treated as force majeure, emergency measures by a State affecting the underlying contract must satisfy not only the requirement that they be beyond the control of the main debtor, but also that they be unforeseeable and cannot be overcome. Civil law jurisdictions use a similar test.

The restrictions imposed by a State to prevent the COVID-19 pandemic from spreading (such as restrictions that prevent the supplier, contractor or obligor under a contract from performing its obligations) may fall into the ambit of force majeure. Two examples: 

• If a supplier is unable to manufacture the sold products in its country due to coronavirus emergency measures, but may secure them in another country, from which they may be delivered to the Purchaser, such measures do not seem to amount to force majeure. On the contrary, if that business is the unique supplier of such products, the coronavirus emergency measure should amount to force majeure. 
• Similarly, contracts entered into after such emergency measures have been issued may lack the unforeseeability factor.

Negative Aspects of a Fully Independent Obligation
The choice between the issue of a conditional and an unconditional bond gives rise to very different obligations. In-house counsel of the main obligor should ensure that the main obligor is perfectly aware of the consequences of the choice of an unconditional bond. Also, the issuer of the bond should check that the main obligation is aware of this.

The choice between conditional and unconditional bonds, which is frequently decisive as to the effects of a call, switches the burden of proof of non-performance from the creditor (the beneficiary of the bond) to the main obligor. It is understandable that the beneficiary does not like to have to wait to collect until the issue as to the performance or non-performance by the main obligor has been argued and decided through litigation. Issuers do not like to be involved in conflicting claims to pay or not to pay. However, the present structure of unconditional performance bonds allows abuses, and in-house counsel should be aware of the significant advantages their client’s business grants to the beneficiary by accepting to issue an unconditional bond. 

Beneficiaries of unconditional bonds may be tempted to make abusive calls. In the very limited time available to the issuer from the receipt of the call up to time for its payment, it is often quite difficult to prove manifest, certain and unchallengeable evidence of the beneficiary’s fraud.

Do Unconditional Bonds Really Reflect the Intention of the Main Obligor?
The main obligor’s focus is different from that of the bond issuer. While the issuer often accepts the solution required by the beneficiary, i.e. to restrict at most the possibilities to challenge the call of a bond, main obligors look for a solution which does not expose them to the risk to see the bond paid before they are able to prove that this is not correct.

Are There any Possible Improvements?
The authors of this article suggest that the way unconditional performance bonds are today structured is not sufficient because it allows abuses. While remaining within the framework of bonds on demand, other solutions allow to balance the intentions of the parties in a more satisfactory way:

• the desire of the beneficiary to collect quickly;
• the issuer’s wish not to find itself between two fires: the duty to pay and the duty of loyalty to its customer; and
• the main obligor’s need to avoid being exposed to the risk that the issuer pays under pressure - in the frequent cases when no evidence of manifest fraud by the beneficiary is promptly available – having then to commence, only after collection by the beneficiary, long and expensive proceedings to prove its performance.

Tips for the Negotiation of Bonds on demand During the COVID-19 Pandemic
The beneficiary of the bond, may wish to:

• ensure that the language of the bond is clear and is as little as possible tied to the underlying contract;
• make the agreed call process short and clear;

The main obligor may wish to: 

• instruct its advisors to check the law applicable to the main contract and to the bond, as well as any possible applicable international conventions;
• double check the forum to resolve disputes;
• negotiate the language of the bond in such a way as to have a say in the call;
• in the bond, provide for sufficient time to produce evidence of a manifest fraud by the beneficiary, between the call and the time for payment by the bond’s issuer;
• have evidence ready at hand to prove that the call by the other party is fraudulent;
• clarify, according to the applicable law of the contract, which circumstances amount to force majeure; 
• ensure a robust sanctions clause in its agreement with the issuer; and
• before entering into the main contract, secure an alternate plan in the event one or more of its suppliers fails to perform obligations toward the main obligor, causing the latter’s non-performance under the main contract.

By Mauro Rubino-Sammartano (email, Linkedin) and Ruggero Rubino-Sammartano (email, Linkedin), LawFed BRSA