Resolving Ambiguities in the Interpretation of Performance Bonds
Published 23 June 2016
Insurance policies and performance bonds underpin the financial performance of parties and the allocation of risk provisions of construction and engineering contracts. In the case of performance bonds, it is important that the meaning of these instruments is clear and that any formal requirements for making a valid call under the bond are defined with clarity so that, when the need arises, the party entitled to make a call under the bond understands precisely what formalities must be complied with in order to make a valid claim.
Two recent cases, Lukoil Mid-East Ltd v Barclays Bank Plc (2016) EWHC 166 (TCC) and the Scottish case of South Lanarkshire Council v Coface SA (2016) BLR 237, highlight the importance for parties to ditch ambiguous standard form wordings and stress the need for clear language to be used in setting out the requirements to make a valid call under an on-demand bond. When resolving disputes on what formalities must be complied with in order to make a valid demand for payment under a bond the court will have regard to the commercial purpose of the notice provisions and the need to have regard to the commercial realities of the underlying contract and commercial common sense in order to avoid any commercial absurdities that an interpretation may result in.
(a) Lukoil Mid-East Ltd v Barclays Bank Plc
Lukoil had entered into a contract with BH. Barclays provided an on-demand performance bond to Lukoil as security for BH's performance obligations. As a consequence of delay in BH's contractual performance Lukoil claimed the payment of LADs but BH failed to pay. Lukoil made a written demand for the payment of damages under the bond indicating as a consequence of BH's breach of contract.
The difficulty was that the bond contained what appeared to be inconsistent clauses. The bond provided by Barclays guaranteed the performance of BH's obligations under the contract. Barclays agreed to pay to Lukoil "at your first written request, without any disputes or objections…" and "without requiring from you to provide any proof or justification of your request…" an amount up to the sum guaranteed by the bond. Clause 5 went on to provide that no amendments to the contract between Lukoil and BH would relieve Barclays from liability under the bond and that Barclays waived the right to be notified of any such amendments.
However, clause 4 of the bond provided that Barclays' liability to pay under the bond was "on condition that no amendment has been made to the Contract between (Lukoil) and (BH) impacting on the timely performance of Works under the Contract". Barclays contended that it had no liability under the bond as Lukoil had failed to serve a valid demand under the bond and was out of time to rectify that defect. It contended that in order to make a valid demand it was necessary for Lukoil to state in the demand (in accordance with clause 4) that no amendment to the contract had been concluded that would impact the timely performance of the contract works.
The court rejected Barclays' contention, deciding:
- That the terms of a bond determine what, if any, formal requirements are required in order for a valid demand to be made.
- The purpose of the notice provisions was to enable the bondsman to determine from the demand that its obligation to pay had been triggered.
- The bond did not expressly state that any demand for payment had to state that no amendment had been made to the contract impacting on the timely performance of the contract works.
- That although there was a tension between clauses 4 and 5 it was necessary to interpret the bond as a whole. The court will not adopt a commercially absurd interpretation unless compelled to do so by clear words.
- Clause 5 clearly stated that no amendment would affect the validity of the bond. Barclays' contention was contrary to clause 5, in which Barclays waived the right to be advised of any amendments.
- Barclays' contention that clause 4 imposed an obligation to declare something that was under clause 5 irrelevant to Barclays' obligations under the bond was rejected.
- Commercially, it is inconceivable that in large construction contracts there would be no changes that would impact timely performance. Accordingly, it was inconceivable that Lukoil would ever be able to make such an assertion. Barclays' interpretation would have resulted in the bond being "virtually useless".
(b) South Lanarkshire Council v Coface SA
In this case, Coface issued to the council an on-demand performance bond in respect of contractual obligations owed by Scottish Coal to the council under a contract for the operation of a mine. The council's losses were guaranteed up to a stated maximum aggregate amount of £4,499,410.32, although the bond went on to provide for variable limits on liability reducing over time, which limits were index linked.
Scottish Coal indicated that it would be unable to carry out its contractual obligations under its contract with the council by reason of its insolvency. On 1 May 2013, the council informed Coface that it was likely that they would make a call under the bond. On 29 May 2013, the council made a demand for payment under the bond. In that letter the council stated that the cost of the remedial works would be £9,199,892 (being the sum identified in the bond as the estimated cost of carrying out the restoration works), but it did not state how much the restoration works would cost or what sum was actually being claimed under the bond. On 25 July 2014 the council sought payment of two amounts, including the sum of £4,499,410.32.
Clause 2.2 of the bond required Coface to, if called upon by the council to do so, pay "…the cost to the Council of the works required to carry out…" for the purposes of carrying out the required restoration works. Pursuant to clause 3.1 the council was required to provide notice in writing of any breach of contract by Scottish Coal and "the cost of Restoration Works to be carried out…". Clause 3.2 went on to provide that Coface was not obliged to investigate the authenticity of the claim; a written demand for payment from an authorised official of the council was sufficient.
Coface contended that the demand for payment was invalid because:
i. the bond required a two-stage procedure; first the council was required to give notice of the breach of contract complained of (pursuant to clause 3.1), whilst the second stage required the council to make a written demand for payment (pursuant to clause 3.2);
ii. the letter of 29 May 2013 was deficient in that it failed to provide the cost to the council of carrying out the restoration works and;
iii. the letter did not qualify as a demand as it did not use that term.
It was an important feature of performance bonds that they provided prompt and readily realisable security for breach of obligations. Provided that a demand conformed to the requirements of the bond, there should be no delay in making payment. The court held that the demand of 29 May 2013 complied with the requirements of the bond. Performance bonds had to be construed using commercial common sense having regard to the purpose of such bonds. Unduly technical interpretations will be avoided. The notice clearly stated that the demand was being made by reason of Scottish Power's breach of contract (it's anticipatory breach of contract to carry out restoration works by reason of its insolvency). The demand also gave an indication of the cost of the works to be carried out and thus strictly complied with the notice requirements of the bond. There was no commercial purpose in the two stage procedure contended for. Once the cost of the restoration works had been provided, calculation of the sum actually due under the bond was a straightforward calculation. The second stage was otiose.
Lessons From Both Cases
In order for liability under a performance bond to be triggered the court will look to the requirements of the bond. Usually these requirements will need to be strictly complied with, although in the South Lanarkshire Council case, the court acknowledged that some requirements may not (depending upon the circumstances) be conditions precedent to payment. Where there is ambiguity the court will adopt a commercial interpretation having regard to the underlying purpose of the bond, namely to provide prompt payment to reimburse the innocent party for losses suffered by reason of a breach of contract.
The purpose of the notice provisions to the bondsman is to make it clear that liability under the bond has crystalized and that damages are payable. Interpretations that place unnecessary conditions on the exercise of bonds will be rejected. In order to avoid disputes, the parties should (i) use clear and unambiguous language which precisely sets out the procedure that must be followed by a beneficiary in order to make a call under a bond, and (ii) take care to avoid using standard bond wording without giving proper thought to whether the conditions imposed are realistic or achievable having regard to the nature of the underlying contract and the manner in which it will be performed.
Chris Doran, Partner