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What's in a name? The case of "on-demand" performance bonds

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Nettleton Sophie
Sophie Nettleton

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16 November 2015

A bank's attempt to characterise performance bonds as guarantees failed in a further example of the English Court's strict approach to construction of "on-demand" payment obligations. In a decision which provides some guidance for those drafting these agreements, Teare J in Caterpillar Motoren GmbH & Co KG v Mutual Benefits Assurance Co (Caterpillar) [2015] EWHC 2304, 31 July 2015 held that the application of "Paget's presumption" and the general principles of construction produced the same result: if the issuer of the performance bond is obliged to pay on demand by the beneficiary, then the bond is indeed "on-demand". Despite the use of terminology to the contrary, if to a reasonable person an agreement looks like an "on-demand" performance bond and acts like an "on-demand" performance bond, then it will be interpreted as such by the English court.

In 2013 Caterpillar Motoren GmbH & Co KG (Caterpillar), a German company which manufactures and provides industrial equipment and services, entered into contracts to deliver two power plants in Liberia. Caterpillar also entered into two sub-contracts with International Construction & Engineering Inc. (ICE)
under which ICE would provide construction services at the two Liberian sites. Each sub-contract required ICE to procure an Advance Payment Bond (APB) and a Performance Bond (PB) in favour of Caterpillar. The APB was to provide security to Caterpillar if ICE did not carry out the activities financed by Caterpillar via advance payment. The PBs were intended to provide security to Caterpillar if ICE failed to perform its other obligations under the sub-contracts.

The bonds were issued by Mutual Benefits Assurance Co (MBAC), a Liberian company with a licence from the Central Bank of Liberia to function as a "non‑bank financial institution".

Caterpillar made advance payments to ICE. When disputes arose between Caterpillar and ICE, Caterpillar purported to terminate the sub-contracts and demanded that ICE return the advance payments and pay a further sum by way of liquidated damages. Upon ICE disputing the claim, Caterpillar demanded payment from MBAC under the bonds. MBAC refused to make payment. Caterpillar issued proceedings to obtain payment and sought summary judgment against MBAC.

A question of construction

Caterpillar argued that the bonds were "on-demand" bonds and that MBAC's liability arose on Caterpillar's demand for payment. MBAC, on the contrary, maintained that the bonds were guarantees and that its liability arose only where it was established (by admission by ICE, concession by MBAC or by an arbitration award under the sub-contracts) that ICE was to liable to Caterpillar for the sums claimed.

Teare J construed the bonds by applying both: (i) the general principles of construction (ie identifying the meaning which the bond would convey to a reasonable person having all the background knowledge which would reasonably have been available to the parties in the situation in which they were at the time the bonds were entered into) (the approach advocated by Caterpillar); and (ii) "Paget's presumption" (the approach favoured by MBAC).

By way of reminder, "Paget's presumption", the analysis in Paget's Law of Banking (11th edition) applied by Longmore LJ in Wuhan Guoyu Logistics Group Co Ltd & anr v Emporiki Bank of Greece SA [2012] EWCA Civ 1629, provides that:

"Where an instrument (i) relates to an underlying transaction between the parties in different
jurisdictions, (ii) is issued by a bank, (iii) contains an undertaking to pay "on demand" (with or without the words "first" and/or "written") and (iv) does not contain clauses excluding or limiting the defences available to a guarantor, it will almost always be construed as a demand guarantee." 

Decision

Teare J held that the following terms of the APB established beyond doubt that MBAC was bound to pay on demand of Caterpillar, despite the use of the word "guarantee" in the title and opening section of the APB and the operative clause, and the reference made to a failure by ICE to perform its obligations:

(1)     MBAC's undertaking is to "pay forthwith on demand" and "without reference to the Contractor [ICE]";

(2)     what is to be paid is that which is "claimed by the Beneficiary [Caterpillar] to be due from the Contractor"; and

(3)     MBAC's agreement that the decision of Caterpillar "as to whether any money is payable by the Contractor to the Beneficiary or whether the Contractor has made any such default […] will be binding" and the fact that MBAC is not entitled to ask "the Beneficiary to establish its claims".

Although elements of the wording of the PB were suggestive of a true guarantee (ie that MBAC would be liable to pay when ICE fails to pay any lawful claims against it), this suggestion was undermined by the following wording:

(1)     MBAC is to pay once Caterpillar has "declared" that ICE is in default;

(2)     MBAC is to pay "unconditionally" and without demur "the amount of damages claimed by" Caterpillar;

(3)     any such "demand" shall be "conclusive" regarding the amount due and payment by MBAC; and

(4)     MBAC will be deemed to be in default 15 days after any additional notice from Caterpillar demanding payment.

 

For Teare J, this wording makes it clear that MBAC's liability is derived from Caterpillar's demand (an "on‑demand" obligation) rather than from proof that ICE is liable to Caterpillar.

Although the bonds failed to satisfy the fourth condition of Paget's presumption (ie the absence of clauses excluding or limiting the defences available to the guarantor), this was not fatal. Teare J found nothing in the background or in the wording of the bonds which was capable of rebutting Paget's presumption and held on the contrary that the elements listed above confirmed the bonds were indeed "on-demand" obligations.

Comment: This decision provides a useful example of the application of Paget's presumption and the rules of construction, which Teare J held not to be in conflict.
It also makes clear that the court is willing to apply Paget's presumption to non-bank financial institution issuers.

The court has provided a further reminder that dressing up an on-demand obligation as a guarantee offers little protection for issuers. If the intention is to draft a payment guarantee where the issuer's liability to pay arises only on proof of liability, care should be taken to avoid including terms which suggest any obligation to pay arises on demand by the beneficiary. The issuer's right to make enquiries should be expressly reserved.

Further information

This case summary is part of the Allen & Overy Litigation and Dispute Resolution Review, a monthly publication.  For more information please contact Sarah Garvey sarah.garvey@allenovery.com, or tel +44 20 3088 3710.