STUART JORDAN* reminds readers that on-demand performance security instruments are powerful and should not be taken lightly.

A recent appeal court decision has given important guidance – and some timely reminders about the power of on-demand performance security instruments.

Performance bonds and similar security documents are requirements in almost all sizeable construction contracts in the Gulf region, and the on-demand versions are especially favoured by project owners here.

Unlike default bonds, which provide certainty of payment to the owner in the event of demonstrable failure by the contractor leading to identified losses to the owner, an on-demand bond is designed to pay out “without question or delay” just on the making of the demand. We have talked before about how this changes the dynamic of the owner-contractor relationship. 

Depending on where you stand, it is either an indispensable tool to force good performance of the contract or it grossly distorts the relationship, being used (or threatened) as a lever whenever things go wrong which have nothing to do with performance, especially when contractors make claims for compensation in delay and disruption. 

We should remember here that the effect of a call on performance security often goes way beyond the money claimed. Such a call can be devastating to the contractor’s business; especially its banking arrangements, its ability to obtain similar security on other projects, and having to declare the call on future tender questionnaires. Whatever your viewpoint, on-demand security is a big weapon which adds zest to any difficult situation!

It is important, therefore, to take note when we see court decisions that examine the essence of these instruments – where a party argues that the provider of the security should not pay out in response to a demand. We have a recent decision from the English Court of Appeal, which is even more interesting to us because it involves Fidic (Fédération Internationale Des Ingénieurs-Conseils – International Federation of Consulting Engineers) contract provisions. Fidic is not much used in the UK market (despite its being based originally on English civil engineering forms) and disputes tend to be resolved in arbitration, so it is a rare treat (for us lawyers anyway) when a court gets to consider Fidic conditions.

This case gathers together two important and related points in relation to on-demand security which we have looked at before, being:

• The potential for a disconnection between the construction contract (containing the bonded performance obligations) and the security instrument. The contract requires a bond (or other security) to be put in place and may expressly state its purpose but when issued, the bond has a life of its own and is primarily interpreted in its own terms; and

• The grounds on which a call on on-demand security might properly be refused.

In National Infrastructure Development Company (Nidco) v Banco Santander, the English Court of Appeal was asked to consider the terms of standby letters of credit (SLCs) which had been issued in favour of Nidco by the bank as security against the due performance of a contractor (OAS) under a contract for roads construction in Trinidad. There was no argument about the contractor having failed to perform its obligations. Indeed OAS was insolvent and the contract had been terminated by the time Nidco made a call on the SLCs and this dispute arose. 

The main argument put forward by the bank in support of its refusal to pay up was that it amounted to a fraudulent claim, which is the one universally accepted reason to refuse a call. Several grounds were put forward.

The most important argument was that the sums simply had not fallen due and owing. In this case, the bank stated that local law meant that such matters would end up in an arbitration but the same argument could apply to the post-termination provisions. This is a process which leads – eventually – to the employer calculating its additional cost to complete the works. It’s an interesting argument: What was before termination of a current cause of action against a failing contractor might be said to be removed and replaced at termination with a different process leading to a future cause of action. In support of this argument, the prescribed form for calling an SLC required Nidco to state that the sum called was “due and owing”.

It is clear that, at the time of making the call, the final accounting had not been done; all the losses which would go into that account had not been suffered and the eventual sum had not crystallised.

The bank made a separate argument that the amount claimed under the SLCs issued in lieu of retention, was more than the sum which Nidco was entitled to hold as retention under the contract.

The court on both counts rejected the bank’s case, stating that the deciding factor was Nidco’s actual belief in its entitlement. The court also decided that in any event there was contractual support for Nidco’s position. Here is where Fidic is helpful in at least making some effort to state the purpose of the security (so many don’t). That purpose includes, at clause 4.2 (d), circumstances entitling the employer to terminate. The court rejected the idea that this alleged dishonest belief or intent could be deduced from contractual analysis of Nidco’s actual entitlement.

Lord Justice Longmore said: “Even if there was…in fact no entitlement in law to make the demands which Nidco made under the letters of credit, there was nevertheless a strongly arguable case as to such entitlement and the question whether as to the facts, there is a real prospect of establishing [as the bank argued] ‘that the only realistic inference is that [Nidco] could not honestly have believed in the validity of its demands’ virtually answers itself”. 

Again the courts have reminded us that on-demand security means exactly that. Do not agree to these securities lightly and treat them with care!

* Stuart Jordan is a partner in the Global Projects group of Baker Botts, a leading international law firm. Jordan’s practice focuses on the oil, gas, power, transport, petrochemical, nuclear and construction industries. He has extensive experience in the Middle East, Russia and the UK.