So when can you make demand under a bond?

In yesterday's High Court decision of Arrow International (NZ) Limited (in liq) & Ors v NZ Project 29 Limited & AAI Limited (formerly Vero) [2019] NZHC 1326, Justice Cooke discharged an interim injunction, issued on 15 May 2019, preventing Project 29 from making demand under a bond issued by Vero.  The decision is interesting for a number of reasons.

Under the standard conditions of the current NZS3910 suite of contracts, a standard which is widely used in NZ and is likely to be endorsed in the course of the Government's recently announced construction accord, the contractor will almost certainly be required to provide a bond for somewhere between 5% and 10% of the contract value.  The form of bond, attached as the Third Schedule to the general conditions, is what is styled a conditional bond, meaning that there are conditions which must be met before demand can be made.  

The standard form of bond in NZS3910 confirms that it is provided to ensure performance of the contractor's performance under the contract.  If the contractor performs, then it follows that demand cannot be made; inevitably, any threat of demand will be correctly challenged by the contractor that there needs to be proof of default and also proof of the amount demanded before the bond issuer can pay out.  Curiously, the form of bond does not actually deal with the mechanics of demand and payment, for some reason the contractor is a signatory of the bond and there is no provision for release on payment by either the bond issuer or the contractor of the amount of the amount secured by the bond.

This uncertainty is compounded by clause 3.1 of the general conditions which deals with the provision of the contractor's bond.  The clause is explicit that the owner cannot call the bond if the contractor meets its obligations under the contract and if it pays the damages due for breach of contract.  Under clause 3.1.8, where the owner wishes to make demand under the bond, the Engineer makes an estimate of the cost of remedial and other work outstanding under the contract, and any other sum due to the owner for breach.  Regrettably, the conditions go no further, particularly in relation to demand or what happens to the funds paid out by the bond issuer.

In practical terms, it is rare for demand to be made under a bond if the contract hasn't been, or is about to be, terminated.  The termination provisions of NZS3910 provide that the owner may step-in, with or without terminating the contract, and complete the work.  The owner then provides details of the cost of completing the work, and if the total cost (including all sums previously paid to the contractor and anything paid following termination) exceeds the original contract price, then such excess is to be paid by the contractor to the owner.

The critical point in this arrangement (despite the curious drafting of clause 3.1 and the form of bond in the Third Schedule) is that it is only once the owner has stepped in to complete the works, prepared the costings establishing its loss and established as a matter of finality that the contractor is liable for such losses and refused to pay them, that demand can be made under the standard form of bond attached to NZS3910.  That is the practical effect of such a conditional bond - it is inevitably little more than a guarantee for liquidated damages.

For most owners and financiers, this is an unattractive proposition.  Bonds are not cheap, they have a significant impact on contractors' working capital and the security they provide is inadequate if they can only be called on proof of liability and loss, typically after the disputes process has been exhausted (which may include adjudication, arbitration and appeals to the court).  Typically, financiers, if not owners, will require NZS3910 to be amended to provide for an on-demand bond, so that the amount secured can be called at the time of termination, when the funds are most useful.  This can be alarming for contractors, as such bonds require no proof of default or loss.

The compromise is to condition the bond with certification by the Engineer, as a notionally independent professional, prior to making demand.

In the case reported yesterday, Arrow had contracted with Project 29, a 100 share company controlled by John & Michael Chow, for the development of the property at 89 Courtenay Place.  The project was near completion when Arrow went in to voluntary administration earlier this year, followed by liquidation on 6 June, owing in the region of $40 million.  While there can be no doubt that Arrow was in breach of its contract, the quantum of its losses were perhaps less than clear.  On 15 May 2019, the liquidators of Arrow obtained an interim injunction (on an ex parte  basis) preventing Vero from paying out under the bond.  The case before Justice Cooke concerned either discharging the injunction or making it permanent.

The contract contained a special condition to the effect that on the owner terminating the contract or stepping in to complete the works, it could require the Engineer to certify the breach of the contract and to make a provisional assessment of all amounts that might become due to the owner as a result.  The owner could then make demand for that amount under the bond.

The bond secured the sum of $900,000 (5% of the contract price).

On 13 May 2019, Project 29 provided the Engineer with a speadsheet setting out its assessment of what it would cost Project 29 to complete the works amounting to $903,918 (plus GST).  A convenient sum, bearing in mind the amount secured by the bond, but in the event the Engineer issued the required certificate and demand was made.

While Justice Cooke acknowledged that there was an arguable case that the Engineer's certificate could be challenged, it was apparent from a subsequent quantity surveyor's assessment that the costs of completion could be greater than what was outlined on  Project 29's spreadsheet.  Notwithstanding the express requirement of an Engineer's certificate (which no doubt Arrow had relied upon), Justice Cooke appears to have accepted that the purpose of the bond was to provide cashflow at the time of breach, stating:

The commercial purpose of clause 14.2.7 is to avoid Project 29 being disadvantaged by not being able to have access to the Bond simply because Arrow, or a liquidator of Arrow, says the amounts are disputed.

While this is undoubtedly correct, it does rather overlook that the amount demanded needed to be assessed by the Engineer acting as required under the contract, and not the owner.  

This case needs to be contrasted with Custom Street Hotel Limited v Plus Construction Co Limited [2017] NZCA 36 in which the Court of Appeal appears to have come to a diametrically opposed conclusion. In that case, the Engineer was also to provide a certificate before the owner, a Pandey company, could make demand under an on demand bond.  This was a more critical issue for the contractor as the bond represented 25% of the contract price.  The Engineer was required to certify, in his independent capacity, both as to the default by the contractor and that the amount claimed was properly due under the contract.

The Engineer issued his certificate, based on an estimation by Beca (supported by WT Partnership) that the cost to complete was $42 million; considerably in excess of the $4.5 million secured by the bond.

On the more critical issue of termination, Kós P held that Plus was entitled to proceed to terminate the contract in terms of clause 14.3.3, despite the failure of the Engineer to suspend, stating:

It makes little sense that a contractor that wishes to exercise that cancellation right must first go through a charade of "suspending" and see its right to cancel mangled or misplaced if the engineer does not perform his or her duty to suspend.

That finding rather put the issue of default to rest.  Having validly terminated, there could be no question that the engineer had validly certified that Plus was in breach.

On the question of whether or not the amount demanded was properly due under the contract, the Court of Appeal held that under clauses 14.2.3 and 14.2.4 the cost of completion did not become due until the works were completed and the wash-up carried out.  It was not until that point that the amount that could be demanded was "properly due" under the contract.  It follows that the Engineer should not have relied on the Beca/WT Partnership estimation when issuing his certificate.

In the Arrow case, rather than relying on contract entitlement to payment, it had been agreed between the parties that a demand could be supported by the Engineer's assessment of "all amounts that may become owing" to Project 29.  That the Engineer relied on Project 29's own assessment, and subsequently a likely higher assessment by a quantity surveyor, is probably neither here nor there.  The certificate was clearly taken by the Court as being evidence that the Engineer had formed a view on the amounts likely to be owing, and therefore the demand has presumably been allowed.

The lesson is for drafters to take care in how they draft both the bond provisions and the corresponding provisions in the contract.  Both the Court of Appeal in Plus and the High Court in Arrow have made it clear that it is not their role, in the words of Justice Cooke, "to engage in a re-balancing of the risks and benefits that the parties have decided upon for themselves."