The trials and tribulations of hybrid bonds

Caterpillar Motoren GmbH & Co KG v Mutual Benefits Assurance Company is the latest in a line of cases where the court had to decide whether a security instrument was an “on demand” bond or whether it was in the nature of a true guarantee.

The facts were relatively straightforward. The claimant, Caterpillar, entered into contracts to deliver two power plants in Liberia. It also entered into two sub-contracts with International Construction & Engineering Inc (ICE) for the provision of construction services for both power plants, which were in materially identical terms. Each required ICE to procure an advance payment bond (APB) and a performance bond (PB) in favour of Caterpillar, which it did. The APB was defined as “an instrument… that guarantees the due performance by [ICE] for an advance payment made by [Caterpillar] to [ICE] for sundry activities and/or task [sic].” The PB was defined as “an instrument… that guarantees the due performance of all Work by [ICE]”.

So far, so good. However, problems arose when Caterpillar demanded payment under the bonds and the defendant bond provider (MBAC) refused to pay on the basis that the bonds were in fact guarantees and it was only liable under them if it was established that ICE was liable to Caterpillar for the sums claimed.

What is a hybrid bond?

The bonds in question were all hybrid bonds. In other words they contained both “on demand” language and “guarantee” language. For example, the APB provided that MBAC “pay forthwith on demand”, “without reference to the contractor” and that “any such demand… shall be conclusive and binding notwithstanding any difference [between Caterpillar and ICE]”.

However, the APB was called a “guarantee” and this was referenced in various other clauses. The reference to a failure by ICE to perform its obligations suggested that the parties intended that MBAC would only pay where ICE had actually failed to perform. It also included a “saving” provision; that the guarantee would not be affected by any change in the constitution of the contractor or any extension or forbearance given to the contractor. This type of provision is only relevant to guarantees.

The PB was in a different form, but also contained language suggestive of both a true guarantee and an “on-demand” bond.

What is the problem?

Although in this case the court construed the bonds as on-demand instruments, their hybrid nature allowed MBAC to raise the “guarantee” argument and initially refuse to pay out under the bonds. This is the problem with hybrid bonds: they can be difficult to interpret, leading to uncertainty as to their effect – far from ideal for an instrument that is supposed to provide security to an employer if the contractor fails to carry out the works in accordance with the contract.

The courts recognise the problem. In Wuhan Guoyu Logistics Group Co Ltd and another v Emporiki Bank of Greece SA, the Court of Appeal gave guidance to “commercial men” about this type of bond and said that “while everything must in the end depend on the words actually used by the parties there is… a presumption that, if certain elements are present in the document, the document will be construed one way or another.” It set out “Paget’s presumption” (derived from Paget’s Law of Banking):

“Where an instrument (i) relates to an underlying transaction between parties in different jurisdictions, (ii) is issued by a bank, (iii) contains an undertaking to pay ‘on demand’ (with or without the words ‘first’ and/or ‘written’) and (iv) does not contain clauses excluding or limiting the defences available to a guarantor there will be a presumption that it will be construed as an ‘on demand’ bond or guarantee.”

The court in Caterpillar adopted this approach. While only two of the four of Paget’s presumptions were met, the court concluded that there was nothing in the background or the language of the instruments which was capable of rebutting Paget’s presumption and that, on balance, the language used showed that the instruments were intended to be “on-demand”.

Why do hybrid bonds still persist in the market?

Traditionally, parties regarded them as good thing and positively adopted a belt and braces approach following the Trafalgar House case in the mid-90s. What was often intended to be an on-demand security instrument also included a long list of matters that would not discharge a guarantor’s obligations under a guarantee, just in case a court construed the document as a guarantee rather than an on-demand bond. However, more recent cases make it clear that this type of provision can, in practice, have the opposite effect and result in an “on-demand” instrument being construed as a secondary security instrument precisely because a provision of this type is not required in an on-demand instrument.

There may be other reasons. The bond provider may only be willing to provide a bond on its “standard” terms, the parties may not understand the differences between primary and secondary security instruments (particularly if they are not based in the UK) or there may be an inequality of bargaining power between the parties.

Whatever the reasons, uncertainty over the true purpose and meaning of any performance security will almost always lead to disputes and legal proceedings that are time consuming and costly. In addition, the court’s interpretation can be difficult to predict.

While Caterpillar’s  claims under the bonds were ultimately successful, it was not achieved without a fight. If parties intend a security instrument to be on-demand, it should not contain any reference to “guarantees” or “guaranteeing performance”. It should not include “saving” provisions preserving the bond provider’s liability. For an example of this type of bond see our on demand performance bond. As ever, clear concise drafting is key.

Practical Law Jancyn Gardiner

One thought on “The trials and tribulations of hybrid bonds

  1. You’ve written it so well, and you have some really good ideas. This post is outstanding!

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