No set-offs, counterclaim or investigations allowed - The autonomy of on-demand bonds

On-demand bonds have been described as the "life-blood of international commerce". While they provide performance security to the employer, lenders and contractors should be aware of the draconian consequences of their terms. The recent decision in Power Projects Sanayi Insaat Ticaret Ltd Sirketi v Star Assurance Company Ltd [2024] EWHC 2798 (Comm) serves as a cautionary tale.

Background

• In June 2017, Power Projects ("PP") were employed to construct an electrical power plant in Ghana.
• In May 2018, PP subcontracted part of its works to a Ghanaian Company, Glotec Engineering Limited ("G"). The parties entered into two subcontracts for that purpose.
• PP required G to provide an on-demand performance bond in their favour. G obtained this bond from Star Assurance Company Limited ("Star") (the "Bond"). The Bond was to be governed by English law, and included an irrevocable exclusive jurisdiction agreement in favour of the courts of England.
• Disputes arose between the parties towards the end of the works. PP asserted numerous failures on the part of G to complete their obligations under the subcontracts. G denied this to be the case. Instead, G claimed they were owed significant sums as PP failed to make the final payment of 2% of the contract price.
• PP then issued a written demand calling upon Star to pay $6.297 million under the Bond. Star refused to pay. PP began proceedings against them under Part 8 of the English court procedure rules – a procedure which is not appropriate where a substantial dispute of facts exist.

Star's position was that the procedure chosen by PP was inappropriate. In its view, the dispute did include a substantial dispute as to the facts because of the defence it wished to put forward. Essentially, Star wished to make a counterclaim by adopting G's position that it was PP (not G) that was in default of its obligations under the subcontracts. Star, therefore, requested the court to convert the claim to Part 7 proceedings where the facts of the dispute between PP and G could be considered.

Star's request was denied. The court decided that Star was not allowed to use G's defence against a demand made under the Bond. The decision was based on caselaw and the terms of the Bond.

Previous caselaw determined that on-demand bonds should be treated as autonomous contracts. Bonds deal with different obligations and are concluded by different parties than those to the contract. Here, the Bond was between PP (the beneficiary) and Star (the issuer of the bond). G was not party to this agreement. Therefore, any dispute in respect of entitlement under one contract does not affect the other.

The terms of the Bond confirmed this to be the case. Clause 3 of the Bond stated that no counterclaim, set off or further investigations were allowed upon receipt of a demand.

On this basis, authorities provided that the only defence that Star could raise to successfully challenge a call on the Bond was that PP committed fraud or had made a claim they knew they had no right to make. The court concluded that Star did not go "anywhere near satisfying those strict legal requirements".

Implications

On-demand bonds are commonplace in international projects. Importantly, in Power Projects, it was confirmed in on-demand bonds that defences which may be available to the contractor against the beneficiary of the bond will not be available to the issuer of the bond. As explained by Judge Millett K.C., the role of the issuer is not to act as the contractor's advocate in a dispute with the beneficiary, but to pay the beneficiary and allow the dispute under the contract to run separately. An issuer will only be able to successfully resist a call if it can satisfy the court that the call was fraudulent.

While it is the issuer of the bond who will need to pay the amount of the call, the issuer will then look to the contractor to recover that payment under the terms of its agreement with the contractor. It is therefore important that contractors understand how on-demand bonds operate where they could be faced with a liability to the issuer of the bond before it has resolved any dispute with the employer. From a contractor's perspective, a conditional bond is more advantageous. A demand can only be made under this type of bond if certain specified conditions are satisfied, most commonly that the contractor has breached the contract and that loss was suffered as a consequence.