Adjudication bonds - an alternative to guarantees and on-demand bonds

Building and engineering contracts routinely rely on guarantees and on-demand bonds. Does an adjudication bond provide an equitable alternative?

Traditionally, there have been two distinct choices for an employer seeking security for its construction contract – a guarantee or an on-demand bond. Over time building contracts in England and Wales have come to use guarantees routinely whilst engineering contracts internationally have come to rely upon on-demand bonds. However, there may be a third way which could meet an employer's demand for quick and certain recovery under the security but still address the contractor's concern that the employer should only receive sums properly due to it.

Guarantees are inherently risky. These risks may be acceptable in the circumstances particularly since, where given by parent companies, they are generally perceived as a 'zero cost' form of security (on demand bonds meanwhile being relatively costly). However, in assessing the risks the project faces, it is important to be aware of the limitations of security documentation – guarantees are (to pardon the pun) no guarantee of recovery in the event the contractor fails to pay up.

The first thing to understand is the court's approach to guarantees – the guarantor is the guy in the white cowboy hat whilst the beneficiary is the one wearing the black. Historically, the court has viewed the guarantor as a magnanimous individual who, out of the goodness of his heart, has offered to answer for the debt, default or miscarriage of another. Whilst it is hoped that future cases concerning parent company guarantors will recognise the commercial realities of the parties' relationships and move away from this approach, much of the general law relating to guarantees was decided in this context. In consequence, where there is any ambiguity or inconsistency in the form of a guarantee or its scope, the court has come down on the side of the guarantor.

For example, if the building contract is varied or in any other way materially changed, the guarantor will be let off the hook. Of course, in drafting guarantees lawyers generally go to great pains (and often great length) to list all of the potential circumstances in which the guarantor might be relieved of its obligations and to state that the guarantor agrees that it will not be let off the hook should these circumstances arise. This often leads to guarantees which look archaic and unnecessarily lengthy, but leave these items out at your peril. You can bet your bottom dollar that the one item you decide is not really necessary is used by the guarantor as a silver bullet to shoot down the guarantee. On-demand bonds, however, are not subject to any of these restrictions. They are said to be a 'primary' (rather than secondary) obligation which will continue to be owed to the employer irrespective of what happens to the underlying construction contract to which it relates.

Further, there is a drafting trap which many guarantees can potentially fall into which is generally (but not always) avoided by on-demand bonds. An on-demand bond is at its simplest identified as a document by which the bondsman agrees to pay the beneficiary the amount claimed on first written demand without proof or conditions. There need be no reference to default or failure on the part of the contractor (as noted in the previous paragraph this is because the bond exists entirely separately from the construction contract). However, guarantees by their nature require the guarantor to promise to pay up in the event of some 'default' or 'breach' or other miscarriage by the contractor under the construction contract. It is this reference to 'default' which has left some employers high and dry. If asked which risk they were particularly keen to address in obtaining security, employers would unanimously shout 'the insolvency of the contractor'. However, there is case law stating that 'default' does not include administrative receivership (and arguably any other insolvency event) on the basis that the construction contract provides a code for what is to happen upon insolvency (typically termination). Accordingly, to protect the employer's ability to call on the security in the event of the contractor's insolvency, it is imperative that any guarantee (or bond) expressly states this and does not merely rely on references to 'default' or 'breach'.

A second difficulty with guarantees as compared with on-demand bonds is that before being able to recover any money, the employer must prove some default on the part of the contractor to an adjudicator / judge / arbitrator (contrast on-demand bonds which will generally merely require a statement by the employer that the contractor is in default). Worse still, the rule in Re Kitchen (a nineteenth century case which remains good law) means that it is not enough that the employer has obtained an adjudicator's award, judgment or arbitral award (Decision) against the contractor – the employer has to go back to square one and re-prove the entire case against the guarantor to be able to recover money from him. This process of course is without any certainty of success since the findings in the initial case against the contractor will not bind the guarantor. It is possible that in the case of adjudication at least there may be an expedited route for an employer if it can be said that the contractor's failure to pay an adjudicator's award constitutes a breach of contract (in which case, the proceedings against the guarantor would merely need to show failure to pay the adjudicator's award rather than re-prove the case forming the subject matter of the adjudication). However the cases are mixed as to the status of an adjudicator's award and so for risk assessment purposes it is safer to assume a need to re-prove the entirety of the original adjudication.

The rationale for the Re Kitchen principle has been that it would be unfair to bind the guarantor by proceedings in which it has had no involvement (back to the white hats). For example, the contractor could have effectively thrown in the towel or just been plain incompetent in defending its case. The guarantor has not had an opportunity to put its side of things. This may be true in circumstances where the guarantor is a financial institution. However, where the guarantor is the contractor's parent and accordingly has a significant degree of control over the contractor, it is harder to see why the guarantor should not be bound by the outcome of a dispute under the construction contract. Whilst there have been judicial remarks to this effect, these were not strictly relevant to the decision and so should not be relied upon as good law.

So, in the event that the employer is unable to recover money from the contractor following a dispute (most importantly because the consequence of the dispute is that the contractor has become insolvent), the employer effectively has to double its dispute resolution costs by re-proving the case against the guarantor.

This clearly is not a very satisfactory state of affairs for the employer. There are various solutions to this – one might be to include a clause in the guarantee stating that any Decision obtained under the construction contract is binding against the guarantor. This should not be objectionable to a parent company guarantor since, as noted above, in practice the parent company will have had an opportunity to be involved in its subsidiary's dispute resolution proceedings. However, this approach does not overcome the broader and inherent risk with guarantees, namely the many and various ways in which guarantor's can get themselves 'off the hook'.

An alternative solution might be to adopt (with some changes) the form of security often used in PFI projects and larger construction projects – the adjudication bond. This is essentially an on-demand bond. Accordingly, all that is necessary to make a call and receive the demanded sum is a notice which complies with the requirements of the bond. The law of guarantees does not apply and so the bondsman cannot argue that the construction contract has somehow been changed in such a way as to make its obligation to pay up invalid. This of course sounds great for the employer, but ominous to the contractor. However, the protection for the contractor is the requirement that the notice required by the bondsman prior to paying up includes a copy of a Decision. That is, the employer must have proven its case against the contractor and obtained a favourable outcome before it can make any kind of call under the bond. Further, it is suggested (though of course I am no accountant) that for accounting purposes such an adjudication bond is closer to a guarantee than an on demand bond in nature. After all, rather than a certain liability (as is the case with the usual form of on-demand bond) the obligation to pay out on an adjudication bond is merely a potential obligation which will only accrue upon the occurrence of uncertain future events not wholly within the bondsman's control (namely the employer obtaining a Decision). If this is so, then there should be no objection to using an adjudication bond from an accounting perspective.

In the context of larger projects, including PFIs, the adjudication bond is generally provided by a third party and accordingly is likely to be expensive. They also involve a large number of exclusions and limitations

(e.g. as to the types of loss recoverable, relatively short duration and can also include guarantee elements) which are arguably not appropriate for other (smaller) projects.

So, how would an adjudication bond look for such other projects? As noted above, the essence of it would be an on demand bond which provided that the bondsman would pay the employer the amount claimed (being the amount of the Decision) upon first written demand accompanied by such Decision. There would also need to be mechanisms dealing with the potential insolvency of the contractor leading to impossibility of proceedings against the contractor which could result in such a Decision. In such circumstances, there needs to be a mechanism in the adjudication bond which allows an adjudication to take place direct between the bondsman and employer since it will no longer be possible to fulfil the requirement that the demand be accompanied by a Decision. Similarly, given the temporary nature of adjudication awards, the bondsman is likely to require a mechanism by which it can recover any overpayment to the employer should a judgment or arbitral decision reduce the sums owed to the employer under the adjudication award. Crucially, and in contrast with bonds for PFI and larger projects, the bond would be from the parent company and would not expire until (as is often the case with guarantees) the lapse of 12 years from practical completion. In essence, what you would be left with is a document which operated much as a standard guarantee but without the risk of the guarantor being able to claim it had been let off the hook by a change to the underlying contract and without the need to re-prove a case proven against the contractor against the guarantor. Maybe a third way?

For further information please contact Alex Cunliffe on +44 (0)20 7367 2670 or at [email protected]