Bonds – contract agreement or judicial intent?

“I may be allowed to remark that  it is difficult to understand why businessmen persist in  entering upon considerable obligations in old-fashioned forms of contract  which do not adequately express the true transaction.”

Lord Atkin in Trade Indemnity v Workington Harbour and Dock Board [1937] A.C. 1 HL at 17

Introduction

On 15 March 2024, the High Court in Auckland delivered its judgment in Hawkins v Elizabeth Properties [2024] NZHC 561 granting an interim inunction restraining the owner from making demand under the contractor’s performance bond.  This would appear to be another case judicial overreach, following last year’s decision of the High Court in Rau Paenga v CPB Contractors [2023] NZHC 2974.

Further clarity in drafting would seem to be required, if the expectations of the industry in relation to contractor’s performance bonds is to be maintained.

Bonds – purpose and intent

Bonds typically serve two purposes in the construction industry – (1) to secure money advanced, but not yet properly due under the contract (for example, with advanced payment for equipment, offshore payments and retentions); and (2) to secure performance (for example, default performance bonds).  Simplistically, the former would normally be “on-demand”, ie paid without proof of default or loss; whereas the second can be seen as security for default, which might require further proof.

In reality, all bonds and standby letters of credit are conditioned by an event, whether the passing of an agreed date, demand, certification by the engineer, default or loss.  

The first class of bonds enable the release of cash through the contract chain in circumstances where such payment is not yet properly due (eg, the owner has no security in the form of ownership of goods or materials or in the value of completed permanent work).  The second provide immediate access to cash in the event of default.  

The critical point for the second class of bonds is that they do not require proof of default or loss, enabling the owner to cover the immediate cost of replacing the contractor, at the contractor’s cost.  While the proceeds of demand will be included in any final accounting, the payment is made before any losses have been accrued (see Custom Street Hotel v Plus Construction [2017] NZCA 36).  Conversely, where a bond secures losses or amounts due under the contract, demand can only be made once the dispute has been resolved, either through arbitration or court proceedings, and all appeal rights exhausted (see Trafalgar House Construction v General Surety [1996] A.C. 199).

From a commercial perspective, it is for that reason that “on demand bonds” (payable without proof of default or loss or other conditions) typically secure "only" between 5% and 10% of the contract price.  For default bonds (requiring final proof of loss), the amount secured would need to be closer to the full contract price, plus a margin.  It is difficult to imagine 5% or 10% covering even the legal costs in completing the disputes procedure and exhausting any appeals.

The form of bond, how much is secured and the circumstances in which it may be called are all part of the commercial transaction agreed between the parties at award, and normally subject to the test of commercial sense (see both Vector Gas and Bathurst Resources).

Stopping payment

Allegations of default and termination are messy, almost without exception.  For most contractors, the first reaction is to try to stop the bond being called.

In the case of Edward Owen v Barclays Bank [1978] Q.B. 159 CA, an English contractor was engaged to erect glass houses in Libya.  On completion of the work, a 10% performance bond was called, without any evidence of default.  The bond was expressed to be paid “on-demand, without proof or conditions”.  The contractor issued proceedings against the bond issuer, Barclays Bank, to prevent payment.  

Lord Denning MR observed that the bond “bore the colour of a discount” and that they were “virtually promissory notes payable on demand.”  Such promissory notes and letters of credit were the basis upon which banks conducted business between themselves, sharing capital to ensure that their reserves were met.  Not to honour such bonds would have considerable consequences.

Where conditions, beyond demand, are imposed then it is clearly incumbent on the bond issuer to ensure that those conditions have been met before payment is made (see Trafalgar House Construction v General Surety referred to above).  In the case of Edward Owen, no such conditions were imposed.

The more fertile ground for contractors resisting the disruption of bonds being called is therefore to restrain the owner from making demand on the basis that it is not entitled to do so under the contract.

NZS3910

Under clause 3 of NZS3910 (both the 2013 and 2023 editions), the contractor’s performance bond may not be called if the contractor has complied with all its obligations under the contract; or it has paid the owner for any damages; or practical completion has been achieved.  The form of bond in Schedule 3 is not clearly “on-demand”, but in practice it has been treated that way – there are no preconditions to demand, but nor is demand specifically covered.  Most banks will require the bond to be modified to remove any doubt by adding the formula “on-demand, without proof or conditions” from the Edward Owen case.

The issue could be expressed more clearly, but in the overall commercial context of the amount secured by the bond, the expectation is that the bond provides cash up front in the event of default, despite any argument to the contrary.

In the Plus Construction case cited above (under the 2003 edition of NZS3910), the bond was expressly on demand.  The contract, however, was amended to provide that any demand had to be accompanied by a certificate from the engineer that the contractor was in default and that the amount demanded was “properly due” under the contract.  The bond in that case was for 25% of the contract price.

Ultimately, the Court of Appeal confirmed earlier findings that the contractor was not in default and that the amount demanded was not properly due under the contract.  The bond proceeds (in escrow) were returned to the contractor.  That position was materially different in the Hawkins case.

Hawkins Limited v Elizabeth Properties

In Hawkins v Elizabeth Properties, the $148 million project was significantly delayed and in dispute.  The issue of liability for $22 million in delay damages had been referred to adjudication under the Construction Contracts Act 2002.  While that process was underway, the owner gave notice of its intention to make demand under the contractor’s performance bond (securing $3 million).  The contractor issued proceedings seeking an interim injunction restraining the owner from making such demand.

The form of contract was NZS3910:2013, with special conditions requiring any demand under the bond to be accompanied by a certificate from the engineer (acting independently and impartially) that the contractor was in default and that the owner was entitled under the contract to call the bond.

After noting that the contract is between sophisticated commercial parties, and the purpose of the bond was to provide cash up front in the event of alleged default (alluding to the pay-now-argue-later ethos of the Construction Contracts Act) and confirming that it is not the place of the court to interfere in what has been agreed between the parties, the court granted the interim injunction.

Three grounds were given, variously questioning whether or not the engineer’s certificate was properly given.  The owner was then restrained from taking further action to call the bond until the adjudication had been concluded.  

While the decision was couched in the context of a serious question to be tried and balance of convenience required for interim injunctions, the end result is at best questionable, and certainly at variance with what appears too have been agreed between the parties at the time of award.  The bond secured a sum which was approximately 2% of the contract price, on the basis that it was “on-demand”, subject only to the engineer’s certification.  It was inevitable that the contractor, given prior notice, would challenge any attempt to call the bond.

In relation to the engineer’s certificate, the court noted that there was no suggestion but that he had acted in good faith.  It appears to have been the owner’s assertions that the bond should be called, and the ongoing adjudication proceedings, which tipped the balance.

The role of the engineer (which will cover the Independent Certifier under NZS3910:2023) has been the subject of much judicial consideration.  He or she is to act independently of the will of the parties and impartially when exercising any discretion or decision-making role under the contract.

How that role is to be exercised is, perhaps, not so clear.  It has become accepted, largely without question, that in exercising such roles the engineer is not acting as an arbitrator, required to comply with the rules of natural justice.  This obviates the need to consult with the parties, to give them the opportunity to be heard, or to give reasons for any decision (see AMEC Civil Engineering v Secretary of State for Transport [2005] EWCA Civ 291).  In the context where the decision of the engineer may be final, that assumption may need further consideration.

Conclusion

This is yet another case where the conditions of contract could have been drafted with more clarity and, as with last year’s decision in Rau Paenga v CPB Contractors [2023] NZHC 2974, where the courts have had insufficient regard to the commercial arrangements between the parties.

Following the Hawkins decision, the ability to call an on-demand bond for a significantly discounted amount joins the uncertainty over the ability to follow a default notice by terminating a contract after the decision in Rau Paenga.

As noted in the quote from Lord Atkin in Trade Indemnity above, the need for greater clarity in contract drafting is long overdue.