REUTERS | David Mdzinarishvili

On demand bonds: do we feel fine?

R.E.M. felt fine, even though it was the end of the world as they knew it.

Leaving aside the raft of current problems facing the planet, the economy and our industry…

…and restricting our event horizon to the bubble that we construction lawyers inhabit, do we feel fine when we hear that the sanctity, purity and unassailable simplicity of the on demand bond has been cracked?

On demand bonds and the first gulf war

When the UN imposed sanctions on Iraq after the invasion of Kuwait, it became illegal to continue with a number of contracts being carried out in Iraq and Kuwait. Despite this, a number of on demand bonds were called against contractors who withdrew their services from those countries. There were even allegations that some on demand bonds had been called before contractors had the chance to say they were going to withdraw their services.

There was a great deal of discussion about whether you could call a contractor’s bond (under English law) where the reason for the call was that the contractor was refusing to do something which was in itself prohibited by English law, or where there was no reason for the call.

Some bondsmen (sureties) said that “a bond was a bond” and if an on-demand bond was not honoured the entire international bond market would collapse because of a lack of confidence. The underlying contract and the underlying circumstances were irrelevant. The bonds had to be paid.

This assertion reflected a common view (see, for example, RD Harbottle (Mercantile) Ltd v National Westminster Bank Ltd [1978]):

“Except possibly in clear cases of fraud of which the banks have notice, the court will leave the merchants to settle their disputes under the contract by litigation or arbitration… The courts are not concerned with their difficulties… these are risks which the merchants take. In this case the plaintiffs took the risk of the unconditional wording of the guarantees. The machinery and commitments of banks are on a different level. They must be allowed to be honoured, free from interference by the courts. Otherwise, trust in international commerce could be irreparably damaged.”

Government intervention

I remember calling up the DTI who said that they had received a series of phone calls asking for help. After not much time at all a further SI was passed which specifically prevented UK banks from paying.

Bonds were defined in the SI as:

“4. 4 (a) an agreement under which a person (“the obligor”) agrees that, if called upon to do so, or if a third party fails to fulfil contractual obligations owed to another, the obligor will make payment…”

The key word there is “or”. There were conditional bonds and on demand bonds and this was not a woolly distinction, it was a case of “either – or”.

Simon Carves Ltd v Ensus UK Ltd

And that seemed to be the law up until the Ensus case, which Geraldine Laing has also commented on.

I’m not sure that we can say that the walls protecting the on demand bond have now tumbled down. This judgment arose from an assertion that the bond was null and void, rather than whether the justification for calling the bond was meritorious by reference to a substantive claim and losses. The underlying contract was looked at to see whether the bond could be null and void…

…but the fact is the court did look at the underlying contract.

Another crack in the wall?

Of course, it remains to be seen whether this is a one-off or whether further cracks will appear.

But as the US Army Corps of Engineers have pointed out, once the water from the Mississippi River emerges from the spillway and starts to roll across the Atchafalaya River basin, it will in all likelihood carry on rolling.

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