On-Demand Performance bonds: issues for issuers

Summary

In Power Projects Sanayi v Star Assurance, the court underlined the independence of a bond-issuer's obligation to make payment from the existence of any liability under the underlying contract, and the limited routes available to challenge valid demands for payment.

Background

On-demand bonds are a type of tripartite agreement that places a primary obligation on the bond-issuer, or primary obligor, to pay the beneficiary if the contract counterparty fails to fulfil a contractual obligation. For example, where an on-demand bond has been provided, if a contractor fails to perform its obligations to the project owner, the project owner can demand payment of the bond from the third-party bond-issuer.

Performance bonds, either on-demand or conditional, are frequently a requirement of construction contracts, offering a means of protection against the non-performance of the primary obligor's duties. 

The Power Projects dispute arose from a contract for the construction of a power-generation plant. Power Projects subcontracted the project works to Glotec entities, and the terms of the sub-contracts required Glotec to provide an on-demand performance bond in favour of Power Projects to secure Glotec's performance of their obligations. That performance bond was duly provided by Star Assurance (Star). The bond in question was an irrevocable, unconditional on-demand payment instrument in favour of Power Projects, with the obligation to make payments arising:

"upon receipt of a demand made in accordance with provisions of this Bond, without any further proof or condition and without any right of set-off or counterclaim, and [Star] shall not be required or permitted to make any other investigation or enquiry".

Following allegations by Power Projects of failures by Glotec (which were denied by Glotec), Power Projects issued a written demand for payment under the bond. This was disputed by Star, which argued that Power Projects had itself been in breach of the sub-contract terms. Power Projects then brought English Court proceedings under CPR Part 8, which provides a procedure appropriate to claims where there is no substantial factual dispute. The present decision arose from an application to convert the claim from a Part 8 to a Part 7 claim, on the basis that there was a substantial factual dispute which required fuller examination.

Decision

The court rejected Star's challenge to the use of the Part 8 procedure to resolve the issues (Power Projects Sanayi v Star Assurance). The bond was a classic on-demand performance bond, and the only defence available to Star was that Power Project's demand was fraudulent in some way. Otherwise, the clear obligation is to make payment, without any right of proof, investigation or enquiry. 

Considering the basic and well- established principles of the law relating to performance bonds, the court observed that, absent fraud, liability under the bond is separate from liability under the underlying contract. The court considered the decision in Edward Owen v Barclays Bank [1978] Q.B. 159, in which Lord Denning MR considered that the issuer of a "performance guarantee" is not concerned with whether the supplier has performed his contractual obligation, it must pay according to its guarantee, "on demand, if so stipulated, without proof or conditions.".

Star was not entitled to fail or refuse to pay pending investigation of the state of the underlying account or relationship between the project parties, nor on the basis of allegations made by Glotec, however confident or well-founded those may be.  

In reaching a decision on whether or not matters had passed the "substantial dispute" threshold, to make this an inappropriate dispute for determination under CPR Part 8, the court considered whether the disputed facts and arguments surmounted the summary judgment threshold under CPR Part 24, i.e. whether Star's arguments had a "real prospect of success. None of the facts identified by Star satisfied the court that there was a "real prospect of success” of arguing that the fraud exception was in play.

As a result, the court found that it was not open to Star to assert that Glotec had a strong case against Power Projects. Rather, their role was to pay the demand made, and allow Glotec to recover the sum from Power Projects.  As Star Assurance was unable to demonstrate that it had a real prospect of success on the relevant issues, the appropriate procedure for the claim remained CPR Part 8.

What this means

This case highlights the very narrow parameters within which a valid demand for payment under a classic on-demand performance bond might be successfully challenged. Bond-issuers/primary obligors and project owners/principals should, therefore, be aware of three key points:

(A) The courts have consistently held that the bond-issuer's obligation to make payment when validly demanded is completely independent of the position of the parties to the underlying contract.

(B) A valid demand might legitimately be challenged where there is a clear fraud, and the bond-issuer has notice of the fraud at the time of the demand.

(C) Where the payment is validly demanded, and there is no relevant fraudulent aspect, no defence will be available to a bond-issuer seeking to challenge payment. The correct procedure for disposing with any such dispute will be CPR Part 8, and the courts are prepared to require the bond-issuer to satisfy the summary judgment standard to convert the claim to a Part 7 claim.