UK: Performance Bonds - UAE Perspective

Last Updated: 4 November 2014
Article by Heba Osman

Most, if not all, construction contracts, whether standard forms or bespoke contracts, require the Contractor to provide the Employer with a performance bond guaranteeing the Contractor's performance under the contract. The purpose of such performance bonds is to provide the Employer with an efficient and fast remedy should the Contractor default in carrying out its obligations under the construction contract.

The Employer's right to liquidate this performance bond is triggered upon the occurrence of a certain default on the part of the Contractor. It is not an absolute right to the Employer and the decision to liquidate a performance bond has to be exercised with caution.

It is accepted that an Employer has the right to liquidate the performance bond if the Contractor has clearly defaulted on its obligations, such as in the event of abandoning the works or refusing to proceed with the works for no reason.

However, when the relationship turns sour between the Employer and the Contractor, there appears to be a tendency by employers to liquidate the performance bond even without sufficient causation. In instances where the Contractor is not in default or its default is not sufficiently grave to warrant the liquidation of its performance bond, the Employer has no right to liquidate the performance bond.

During the Dubai financial crisis that started towards the end of 2008, many employers have relied on performance bonds as a quick method of receiving liquidity. These practices have caused great harm to many contractors who as well as not being paid at the time, were also being subjected to the liquidation of their bonds. This has also caused difficulty for many contractors to later obtain performance bonds from banks.

Performance bonds are essentially letters of guarantee issued by a bank on the request of the Contractor, by which that bank undertakes to make a payment to the Employer upon the Employer's demand.

The UAE Federal Commercial Law No. 18/1993 (the Commercial Code) regulates, inter alia, the issuance and use of letters of guarantee and defines them in Article 414 thereof as:

"an undertaking issued by the guaranteeing bank on the request of his client to pay a certain amount (or an amount that can be ascertained) to another person (the beneficiary) without restriction or condition, unless the letter of guarantee is conditional, if [the bank] is requested to do so within the period specified in the letter of guarantee. The letter of guarantee shall state the reason for which it is issued."

This means that a performance bond may be conditional or unconditional. However, the trend is that performance bonds issued by the Contractor are payable to the Employer "on demand" without any condition.

If the performance bond is unconditional and on-demand, the bank is obliged to make the payment in accordance with Article 417 (1) of the Commercial Code, which provides:

"The bank shall not be entitled to refuse payment to the beneficiary for reasons relating to the bank's relation with the client or the client's relation with the beneficiary."

This means that the bank cannot refuse liquidating the performance bond on the basis that there is a dispute between the Contractor and the Employer for example. The bank is obliged to make the payment to the Employer in accordance with the terms of the performance bond itself and has no interest in, and should not consider, the terms of the construction contract between the parties.

A Contractor who feels that the Employer intends to liquidate the performance bond on unjustifiable or fraudulent grounds can have recourse to the summary court seeking an order to stop the liquidation of the performance bond. This is also provided for in Article 417(2) of the Commercial Code:

"In exceptional circumstances, the court may on application of the client place an attachment on the amount of the guarantee with the bank provided that the client has serious and certain reasons for its request."

It is an established principle with the Dubai Court of Cassation that even though the issuing bank is obliged to liquidate the letter of guarantee upon the beneficiary's first demand without the need to obtain the permission of the client, the law still allows the client – who has a dispute with the beneficiary and fears that the latter may demand the bank to liquidate the letter of guarantee – to have recourse to the court to place an attachment order on the amount of the guarantee whenever this client has serious and certain reasons for doing so. The court would only order the bank not to liquidate the letter of guarantee in exceptional circumstances and provided that grounds for such stopping of liquidation are present and are clear and evident from the documents of the case.

Serious and certain grounds can include the fact that the project was completed and handed over, large pending payments are due to the Contractor, there are letters or documents showing that the Employer has no right to liquidate, etc.

In the event that the performance bond is liquidated, the remedy available to the Contractor is to file a case (or file for arbitration if the contract provides for arbitration) and seek the repayment of the amount of the performance bond, along with interest or damages, as the case may be.

International Quarterly is produced quartely by Fenwick Elliott LLP, the leading specialist construction law firm in the UK, working with clients in the building, engineering and energy sectors throughout the world.

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.

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