The Do’s and Don’ts: Calling on a Performance Bond

Key Contacts: | Angelyn Rowan – Partner | Finola Igoe – Senior Associate

1. Introduction

A recent High Court case involving a call on a performance bond is a very useful overview of how the Irish Courts will interpret a typical performance bond and what the beneficiary of such a bond should do in order to ensure that its call on the bond does not encounter any unforeseen hindrances.

The case involved a residential housing development in Dublin 15 where Gembira Limited (“Gembira”) had engaged a contractor, MDY Construction Limited (“MDY”), to carry out the construction of the development. MDY had been required to provide a performance bond as performance security in favour of Gembira at the outset of the development, as would commonly be the case in construction projects. MDY ran into commercial difficulties and an interim examiner was initially appointed to the company followed by an examiner. Gembira terminated the Building Contract with MDY and appointed a replacement contractor to complete the development. Gembira then sought to call on the performance bond to recover the losses it had incurred as a result of the circumstances and issued proceedings seeking a summary judgment against the bond provider. The bond provider had refused to honour the bond claiming it had a bona fide defence with the main grounds being:

its obligations under the bond were conditional on Gembira establishing liability of MDY, which it said had not been done,
the bond was not an unconditional “on demand” bond such as would give rise to liability without Gembira establishing the debt due to it by MDY,
the Architect’s certificate relied upon to prove the expenses incurred by Gembira was not binding and effective for the purpose of Clause 33 of the Building Contract (being the clause that was referenced in the bond and related to how any loss would be calculated following termination for insolvency). It was no more than a statement of the “estimated value of the completed works” at best, and Gembira had not proven the amount of expenses incurred by it to demonstrate the excess over the contract amount as required by Clause 33.

2. Establishing MDY Liability

The performance bond set out that “If the Contractors obligation to complete the works was terminated under Clause 33 of the conditions the surety would, subject to this bond, pay the employer any amount for which the Contractor were liable under Clause 33(c)(iv) of the conditions.” If MDY breached the contract the surety would, subject to the bond, pay the employer any amount for which MDY was liable to the employer as damages for breach of contract.

The Court found that although the plaintiff need not first pursue, whether by arbitration or other proceedings, the contractor for the debt identified pursuant to Clause 33 and it may pursue the defendant directly under the bond, none of this means that the so-called “debt” does not have to first be established in accordance with the formula stipulated in Clause 33 of the Building Contract.

The Court concluded that under the terms of the Bond there was no requirement for Gembira to first pursue MDY for its claim before establishing the liability of MDY.

3. Bond was not an “On Demand” instrument

The Court considered various criteria when distinguishing between conditional and unconditional (on demand) bonds. Although bonds of this nature are often drafted in such a way that a party will be liable to pay on the mere demand of a beneficiary, any finding of a conditional bond will depend on the terms of the specific contractual terms, rather than the usual equities that apply to ordinary contracts of guarantee or indemnity.

In this case, the plain language of the bond was found to be that of a conditional instrument. Clauses 1 and 2 of the bond were found to be dependent on “if” certain things occur by reference to the contract. Clause 1 was to occur on the condition that the obligation to complete the works was terminated under Clause 33 of the Building Contract and the contractor was found to be liable for a debt under Clause 33(c)(iv) by the required calculation. This requirement for the Architect to verify the completion accounts and to certify the expenses incurred by the Employer in completing the works had not occurred, as the Employer’s claim was based on estimated rather than verified completion accounts.

Coulson J in Ziggurat¹ had rejected a submission that the employer claimant needed firstly to either obtain a judgment against the contractor or secure the contractor’s agreement of its liability for the debt before any claim could be made before the bond. The Court in this case adopted this reasoning, and thus held that neither the bond nor the contract even attempted to confer the status of conclusivity on the Architect’s certificate.

The Court found that the bond is a conditional bond, not an on-demand instrument, and did not relieve Gembira from establishing the amount of a debt due under Clause 33 of the contract. The Court rejected Gembira’s argument that the bond provider could not look behind the Architect’s certificate. The Court agreed with the bond provider that Gembira must instead demonstrate the debt due by MDY.

4. Validity of Architects Certificate

When determining if the Architect’s certificate was a valid certificate, the Court set out some noteworthy features of the certificate:

The Court stated “the certificate is required to certify that expenses properly incurred by the employer after termination of the MDY contract, which are then added to the amount previously paid to MDY. Clearly it should not certify the amounts paid to MDY”.

The certificate concludes by stating the “estimated value of the relevant part”. The Court held that by no description could this be characterised as a certificate of expenses properly incurred in exercise of the powers conferred by Clause 33. There are other circumstances in which a certificate of practical completion coupled with estimates of value may trigger interim or final payments. On its face, this was held not to be such a certificate.

Examining whether the certificate was “in form, substance or intent” the certificate prescribed by the Building Contract, the Court held that the Architect’s certificate did not comply with the contractual requirements and was not an effective certificate within the meaning of Clause 33. The function of a certificate for Clause 33(c)(iv) was to verify the amount of expenses incurred by the employer, such that the next step in the process, namely the calculation, can be performed.

The Court concluded that “The Architect’s certificate was found not to be a certificate which had binding effects for the purpose of Clause 33 of the Building Contract. Clause 33(c)(iv) of the contract requires a calculation to be made, of which the verified amount of expenses incurred after termination of the contract forms part of. It contained no provision conferring binding and conclusive status on an Architect’s certificate in any form.”

The “overarching certificate of practical completion” is an estimate and not a verification as required by Clause 33, as it did not meet the test of “Form, substance or intent”.

5. Courts Conclusion

As Gembira had originally relied on the Architect’s certificate, the Court held the considerations above sustained the argument that the bond provider had a real and bona fide defence and ought to be granted leave to defend. The conclusions regarding the Building Contract, the bond and the Architect’s certificate were sufficient to meet the requirement that the bond provider had demonstrated grounds of a bona fide defence, which it should be granted leave to advance at trial.

Under the terms of the bond there was no requirement for Gembira to pursue MDY for its claim. Therefore, Gembira was not closed out from establishing the liability of MDY pursuant to Clause 33 and accordingly the claim on the bond. The application for summary judgment was refused and leave was granted to defend the proceedings.

6. Key Take-Away Points

One must follow the terms of a bond and, where applicable, the underlying contractual mechanism to establish liability. Therefore, regard must be had to the specific wording of the bond in question. A beneficiary would be advised therefore to follow the precise contractual mechanism as stated in the bond, (which in turn may refer to the underlying contract), to establish its loss and ensure that it does not create issues for itself when seeking to enforce the bond.

Where the Architect is to “certify” the expenses incurred by the employer, there is no template form of certificate, however, it should be a certificate that references the relevant Building Contract, should preferably use the word “certify” and should set out in clear terms the assessment made which should strictly follow the method for the calculation of any monies owing to the employer or the Contractor, as the case may be, as per the terms of the relevant clause of the Building Contract.

The bond in question did not require Gembira to first pursue, whether by way of arbitration or other proceedings, the Contractor for the debt identified under Clause 33 – it did however first have to establish the debt under Clause 33.