One of the main frequent problems in international construction projects (and more generally in the international commerce) is represented by the issue of bonds or guarantees that the Employer requests to secure the performance of the contract.
The purpose of said bonds is to guarantee the Employer that he will recover any loss or damage that it might suffer as a consequence of the breach of the Contractor.
When dealing with such bonds, one of the first points to analyse is whether the guarantee is a conditional or instead of an on-demand bond.
Under certain jurisdictions (for instance under English Law) there is a difference even between the terms 'bond' and 'guarantee', while for the purpose of this note we will use the two terms as synonymous.
1. Differences between a conditional bond and an on-demand bond
As mentioned, the first point to analyse is whether the bond is a conditional or an on-demand bond since their main differences are that:
- the so-called conditional bond (also called 'default bond') is intimately linked to the underlying contract in the sense that the Employer will be entitled to receive the payment from the guarantor (either a bank or an insurance company) only after having proved the default of the Contractor to any of the specified obligations provided in the underlying contract. As such both the Contractor and the guarantor will be entitled to raise objections based on the underlying contract to prove that no default has occurred (or that the default was in some way justified). If the Contractor has grounds and reasons to justify its failure to comply with the obligations of the underlying contract then in principle the Employer is not entitled to call the bond;
Example of a conditional bond:
"The Guarantor, with reference to the contract no. [XXX] signed by and between [the Employer] and [the Contractor], guarantees due and timely performance of any and all the obligations of [the Contractor] pursuant to all the terms and conditions of the Contract and, upon default of [the Contractor] to any of such terms and conditions, undertakes to pay an amount up to $ ."
- the on-demand bond (sometimes called 'unconditional bond' or even 'first demand bond') is instead a guarantee autonomous and independent of the underlying contract (even if issued pursuant to a specific contractual provision) and which can be called by the Employer without the need to prove the default of the Contractor. Often the Employer will simply need to 'declare' that the Contractor has breached any of the obligations guaranteed. With an on-demand bond, neither the guarantor nor the Contractor will be entitled to raise any objection based on the underlying contract. Save for specific and limited cases (ie when the Employer acts in bad faith and calls the guarantee fraudulently), the guarantor (usually a bank) is under the obligation to pay the amount called by the Employer at its simple request. The on-demand bond allows the Employer to recover the losses or damages arising out of the (alleged) default without the need to start any litigation and without the need to prove the actual default of the Contractor.
Example of on-demand bond:
"The Guarantor, with reference to the contract no. [XXX] signed by and between [the Employer] and [the Contractor], undertakes to pay to you [the Employer] an amount up to $  upon your simple written request, without limitation and/or conditions and notwithstanding any objection raised by the Contractor."
It is pretty straightforward that the on-demand bond is particularly risky for the Contractor in the case the Employer will not act in good faith. On the other side, it is beneficial to the Employer in all those cases where the Contractor does perform the works with a certain degree of negligence or with willful misconduct.
2. How to identify an on-demand bond
It is almost unanimously accepted in many jurisdictions that the name given to the bond (on-demand bond vs default bond) is not conclusive as to its nature but there are certain expressions or words that, if used in the text, can qualify the bond as an on-demand or a conditional guarantee.
In the construction industry, the bonds are simply named ' advance payment bond', ' performance bond' or ' warranty bond' without any reference (at least in the name given by the parties) to its nature.
It is, therefore, crucial to read carefully and to understand the substance of the bond and the real and actual intent of the parties at the time of drafting the bond.
As mentioned there are certain words that, if used simultaneously, would be read as evidence of an on-demand nature of the bond and that the parties should be aware of.
Just as a way of example, expressions like:
- "on first demand";
- "without objections" or "unconditionally";
- "notwithstanding any objections from the Contractor".
are usually indicative of the on-demand nature of the bond since they usually grant the Employer the right to call the bond at its request, without the need to prove the actual default and notwithstanding any objection that the Contractor might raise on the basis of the contract pursuant to which the bond has been issued.
At the same time, certain of the above-mentioned expressions could be used in a way which does not prevent the bond from being a conditional guarantee. It is, in fact, the overall reading of the bond which will allow the parties to construe the bond as an actual on-demand guarantee.
For instance, in Italy, expressions like "the guarantor shall pay upon simple demand" or "at first request" are not considered as conclusive of an on-demand bond and can be found also in conditional bonds if used without any further specification.
A good test to see if the bond is an on-demand or instead a condition bond is to ascertain, from the entire wording used, if the Employer is entitled to call the guarantee without the need to prove the actual default of the Contractor and notwithstanding any objection that the Contractor might raise on the basis of the underlying contract.
If from one side, the on-demand bond represents a clear benefit for the Employer since it can be called without the need to start a legal action and to prove the default of the Contractor, on the other side it can be a dangerous weapon in the hand of an Employer who acts in bad faith or fraudulently.
In such case, in fact, the on-demand bond can be simply an instrument to put undue pressure on the Contractor and there are limited cases the Contractor can stop the payment of a bond if called fraudulently.
It is therefore crucial for both the Employer and the Contractor to read and draft carefully the bond so that it cannot be used to the detriment of one or the other party.
If you wish to read more, download the "Guide on bonds in international construction contracts"
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.