Bonds v guarantees

What is in a name? Never is that question more relevant than in response to whether a document is a bond or guarantee. Does it matter and what is the difference between them?

These are all pertinent questions for contractors and consultants in these tough times when faced with the decision between giving either bonds or guarantees, or both.

Increasingly, employers, whether domestic or international, are demanding protection against default from contractors and consultants. Seldom were consultants ever required to give such protection to employers, but now particularly for international and public sector clients bonds and guarantees are featuring commonly in the menu of project requirements.

The first thing to bear in mind is that the name of the document can be misleading and does not necessarily accurately describe the nature of document. It is the content of the document that is key. Bonds and guarantees are forms of security that accompany contractual obligations (either building contracts or consultancy agreements), and are based on either primary or secondary obligations.

Examples of primary obligation bonds are simple or on-demand bonds or demand guarantees, where the bondsman pays an amount of money set out in the bond immediately on demand in writing without any preconditions, including the contractor’s liability. On-demand bonds tend to be common in international projects but are rarely seen in the UK. They are generally resisted where possible because of their draconian nature.

Secondary obligation instruments normally comprise guarantees, including parent company guarantees (PCG), or conditional bonds and the bondsman is only liable where a breach of contract has occurred, for example, the contractor is in breach of contract. Due to their nature they are more common in the domestic construction market, and contractors are more likely to provide such forms of security than the on-demand variety.

For employers deciding between the two, various considerations must be assessed including the cost of procuring them, where a bond has a direct impact on the tender price, but a parent company guarantee may not.

Recent cases have assisted in distinguishing between the two forms of security, but of course there are no guarantees the bondsman (or the surety) will meets its liability under the bond should it be called in. The Court of Appeal case of Aviva Insurance Limited v Hackney Empire Limited [2012] EWCA Civ 1716 provided useful guidance on the court’s approach to circumstances where a bondsman’s liability under the bond might be discharged.

In this case, Hackney Empire (‘Hackney’) had engaged a contractor under a JCT 1998 traditional building contract to undertake renovation works to the old Hackney Empire. The contractor obtained a performance bond from Aviva in favour of Hackney for £1.1m. The contractor fell into delay claiming extensions of time and loss and expense and Hackney faced with the dilemma as to whether to leave the contractor to struggle with financial difficulties and late completion, made advance payments to aid its cash flow and enable prompt completion. These payments were made under a separate side agreement between Hackney and the contractor. Unfortunately, the contractor went into administration and Hackney called in the bond.

Aviva resisted payment due to Hackney’s advance payments to the contractor which it claimed discharged it from liability under the bond. The matter reached the Court of Appeal where it was decided that Aviva’s liability as bondsman was not discharged by the advance payments and it remained liable to Hackney for the full amount of the bond. Interesting findings arose from the court’s decision as to circumstances where a surety may be discharged:

• (i) Where parties to a contract have varied the terms of that contract without the surety’s consent.
• (ii) Advance payments of the contract price paid by an employer to a contractor may discharge the surety, but additional payments (e.g. a gift/loan) to the contractor falling outside the terms of the original contract do not discharge the surety’s liability.
• (iii) The surety is not released from liability arising from contractual variations or advance payments if (a) he specifically consented to what was done or (b) the contract contained an indulgence clause.

The court’s reasoning fell within (ii) above in that the advance payments made to the contractor were outside the terms of the original contact and for extraneous reasons; the payments were not part of the original contract sum nor were they certified as due by the architect. Aviva’s liability as surety only related to the original building contract.

Practically, the safe course may be to ensure explicit consent is obtained from a surety if advance payments are considered and an appropriately drafted indulgence clause in the contract. Such clauses recognise potential variations to the contract and maintain the surety’s liability in these instances.

Alternatively, advance payments made via side agreements outside the contract could be considered, as any variation to the original contract itself could still discharge the surety.

This article was created by construction lawyer --Najma Dunnett as part of an ongoing series of legal articles written for Designing Buildings Wiki.

Follow Najma on Twitter to keep up to date with the latest changes in construction law @NDunnett_Cons.

NB

Resolution planning, guidance note, published by the Government Commercial Function in May 2021, states:

'Guarantees and bonds can be either performance or financial in nature or a combination of both. They only crystallise when a supplier has failed to perform or to pay a sum of money due to the Contracting Authority. As such, they provide a remedy once a supplier has failed to deliver the works or service, or make a payment, rather than pro-actively supporting performance of the contract.

'Bonds are typically provided by independent third parties (banks and insurance companies) and provide financial compensation in the event of supplier failure. They are generally used in construction contracts for which an active private market exists but are generally not appropriate for service contracts. They can also add significant cost. The availability and cost is not only affected by the type of bond (performance / conditional / on-demand) but also by the wider economic conditions at the time of application.

'Guarantees may be provided either by another member of the supplier’s group (usually a parent company) or an independent third party. Guarantees from group members are typically of limited use in the event of the insolvency of the supplier’s parent company. Guarantees from independent third parties should be unaffected by the insolvency of the supplier’s parent company but may be more expensive.'

[edit] Related articles on Designing Buildings

• Advance payment bond.
• Appointing consultants.
• Bid bond.
• Bonds.
• Breach of contract.
• Collateral warranties.
• Construction contract.
• Contractors' all-risk insurance.
• Guarantees.
• Modifying clauses in standard forms of contract.
• Parent company guarantee.
• Performance bonds.
• Professional consultant's certificate.
• Professional Indemnity Insurance clause in conditions of engagement
• Professional indemnity insurance.
• Retention.
• Retention bond.
• Surety.
• Warranty.
• What is a default?
• Wuhan Guoyu Logistics Group Co Ltd & Anr v Emporiki Bank of Greece SA (2013).

[edit] External references

• BAILII, Aviva Insurance Limited v Hackney Empire Limited.

Comments

With appreciation to the writer; the article did not provide any difference between Bond & Guarantee.

The point of the article is that you shouldn't focus on what it is called (a bond or a guarantee) but on the effect that it has - i.e. whether it is payable on demand or not.