PRACTICAL SUGGESTIONS IN RESPECT OF ON-DEMAND GUARANTEES GOVERNED BY ITALIAN LAW AND USED IN INTERNATIONAL CONSTRUCTION PROJECTS
19.02.2015 - In mid-big size construction projects (both
international and domestic), it is standard practice that the
employer asks to the contractor a guarantee for the advance payment
received (advance payment bond), for the proper
performance of the works (usually known as performance
bond) and for the warranty period after the taking over of the
works (warranty bond). The contractor will therefore ask
(usually) to its own bank the issuance of such guarantees in favour
of the employer.
This note takes into consideration the case where an Italian contractor asks the issuance of the bond to an Italian bank and the bond is governed by Italian law.
DIFFERENT TYPES OF BOND IN INTERNATIONAL CONSTRUCTION PROJECTS
Generally speaking the employer requests a guarantee pursuant to which it will receive a certain amount of money upon default of the contractor. There are two main types of such guarantees:
- the so called 'default guarantee' or 'conditional guarantee', which is a bond pursuant to which the guarantor undertakes to pay a certain amount of money to the employer in case of contractor's default. This guarantee is intimately linked to the construction contracts in the sense that the employer, to receive the payment of the guarantee, shall prove the default of the underlying contract and the guarantor will be entitled usually to raise all the objections that the contractor could have raised on the basis of the construction contract. The main feature of a default guarantee is therefore that, if the contractor has valid grounds to refrain from performing the contract (on the basis of the construction contract), the same objections could be raised by the guarantor to refrain from paying the amount stated in the guarantee.
Example of default
"The guarantor X, with reference to the construction contract entered into between Employer and Contractor, guarantees the due performance of the works pursuant to all the terms and conditions of the construction contract."
- the so called 'on-demand bond' or 'unconditional bond' (or even simply 'first demand bond'), which is instead a guarantee, entirely autonomous from the construction contract (even if issued pursuant to a specific undertaking provided by the contract), pursuant to which the employer does not have the obligation and/or duty to prove the default of the contractor in order to receive the payment stated in the guarantee. The employer will be entitled to receive the payment simply 'stating' that the contractor is in default. In said guarantees neither the guarantor nor the contractor will be entitled to raise objections based on the construction contract and this is because such guarantees are 'autonomous and independent' from the underlying contract. With very few exceptions (see below), the guarantor shall have the obligation to pay the amount stated in the guarantee as called by the employer. The on-demand bond, therefore, allows the employer to cover the risk of the contractor's default without the need to start any legal proceeding and without the need to prove the actual default of the contractor.
Example of on-demand
"The guarantor, pursuant to the construction contract entered into between Employer and Contractor, undertakes to pay to the Employer the amount of € ___ upon simple request of the Employer, irrevocably and unconditionally, and notwithstanding any objection raised by the Contractor."
HOW TO IDENTIFY AN ON-DEMAND BOND
In order to ascertain whether the guarantee is an on-demand
bond, it is crucial to analyse carefully the entire text of the
guarantee and not to limit the analysis to the legal title given to
it by the parties (as said before, such guarantee being usually
called simply 'advance payment bond',
'performance bond' or 'warranty
bond'). As a consequence, if the intention of the parties
is to have a proper on-demand guarantee, it will not be sufficient
simply to call the bond as 'on-demand guarantee', but it
will be crucial to construe the entire text of the guarantee.
There are certain expressions which permit, generally, to identify an on-demand guarantee, such as:
- "on first demand";
- "without objections" or "unconditionally";
- "notwithstanding any objections from the contractor"
They are, if all included in the guarantee, indicative of an on-demand bond.
However, some of the expressions indicated above could, if used individually, create a conditional bond instead of an on-demand bond. For example, the expression "the guarantor shall pay upon first demand" is not considered by Italian courts sufficient to characterise the guarantee as an on-demand bond.
RISKS OF AN ON-DEMAND BOND
If, on the one side, an on-demand bond is for the employer a great tool to cover the risks arising out of the contractor's default, it can be, on the other side, the source of risks for both the contractor and the employer.
Risks for the contractor
With a truly on-demand bond, the guarantor shall be under the obligation to pay upon simple demand of the employer (i.e. without the need of any proof of the default) and the contractor shall be automatically debted the amount called from the guarantor. It is standard practice, in fact, that the guarantor issues the bond in favour of the employer in exchange of certain credit facilities granted by the bank to the contractor. Given the main feature of the on-demand bond (the payment of which can be obtained by the employer without any proof of the default and the obligation of the bank to honour the payment arises upon simple request from the employer), the risk for the contractor is that the employer will call the bond without having the right or fraudulently (the so called abusive or fraudulent calling).
Example of fraudulent
The employer calls the entire advance payment bond, even in the case where the contractor has already repaid (or partially repaid) the advance payment received at or before the notice to proceed (through the deduction on progress payment). The accounting of the contractor will demonstrate in a straight way that the advance payment has already been repaid.
In such case, the contractor will be entitled to obtain an injunction pursuant to which the competent court will order the guarantor to refrain from paying the amount called, but only in the case the contractor will be in the position to prove (on the basis of documentary evidence) the fraudulent and/or abusive calling of the employer. In the case the court will not issue such restraining order and the bank pays the amount stated in the guarantee, the contractor will have the right to start a legal proceeding against the employer (usually via an international arbitration) and eventually against the guarantor in the limited case in which the latter has not acted with due care and professionalism.
Practical suggestions for the contractor:
- Try to insert a clause providing that the employer will be entitled to call the bond only upon presentation of certain documents issued, for instance, by a third independent party who will ascertain the non-fulfilment of the contractual obligations.
- Provide, not only in the guarantee but also in the relevant underlying contract, the specific situations when the employer will be entitled to call the bond.
- Provide, both in the guarantee and in the underlying contract, a specific procedure for the calling of the bond (for example "the employer will be entitled to call the bond only in the case the contractor has failed to provide its justifications on the asserted default. The employer shall request the payment of the guarantee with written document stating in details the declared defaults").
Risks for the employer:
On the other side, the employer shall be at risk in the case it will call an on-demand bond whenever it is not in good faith and is aware that it is not entitled to receive the payment of the guarantee. In such cases, in fact, the contractor shall be entitled to obtain damages from the employer in case the calling will be found to be fraudulent.
Example of fraudulent
The default of the contractor is a consequence of an act of the employer who has consciously omitted to cooperate with the contractor in the settlement of certain technical issues or has even prevented the contractor from fulfilling the contractual obligations.
Practical suggestions for the employer:
- Expressly provide that the bond can be called unconditionally and notwithstanding any objection that the contractor can raise in respect of the construction contract;
- Provide a specific clause in the construction contract which will expressly specify that the bond is on-demand, autonomous and independent from the underlying contract and which will provide a specific procedure for the calling of the bond;
- Call the bond only in the case the contractor is honestly considered in default and refrain from using the bond as a tool to put some pressure on the contractor.
The drafting of an on-demand guarantee requires particular attention to avoid that it could be in case of dispute characterised as a conditional or default bond and therefore subject to the terms and conditions of the underlying construction contract. The substance will prevail on the legal title given to the guarantee (even in the case in which the title is simply advance payment bond, performance bond or warranty bond). The on-demand guarantee (if properly drafted) will allow the employer to obtain a prompt restoration of its losses arising out of the default of the contractor without the need to start any legal proceeding. It is, however, a tool that, from the contractor's perspective, can be a sensible risk in case of fraudulent calling. It is not unusual, in fact, that an on-demand bond (i.e. the threat of its calling) is improperly used by the employer as a weapon to put some pressure on the contractor.
The present note is based on the article written by Giuseppe Broccoli (and Lauren Adams, Barrister, for English law profiles) which title is " ON-DEMAND BONDS: A REVIEW OF ITALIAN AND ENGLISH DECISIONS ON FRAUDULENT OR ABUSIVE CALLING", published on International Construction Law Review – ICLR .
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.