What is an "on-demand" bond?

In commercial transactions, bonds are frequently required as security for performance of contractual obligations. They are contracts which require the bondsman or surety to pay monies to the "buyer" under the underlying contract in the event of a default of the "seller" (or, in some sectors, vice versa). These bonds can be "conditional" or "on-demand", usually expiring on a certain date or on the occurrence of an event defined in the underlying contract.

In summary, the idea is that with conditional bonds, particular conditions, such as the seller's default, need to be established before payment is to be made, whereas, with on-demand bonds, payment has to be made if the demand is in compliance with the terms of the bond.

Two cases recently decided by the Technology and Construction Court emphasise that strict compliance with the terms of an on-demand bond is required and the underlying contract will not necessarily be ignored when deciding whether a demand should be restrained.

Satisfying the terms of an on-demand bond

In AES-3C Maritza East 1 EOOD v (1) Credit Agricole (2) Alstom Power Systems GmbH [2011] EWHC 123 (TCC), the court considered whether there had been a valid claim under an on-demand bond. AES engaged Alstom Power Systems and Alstom EOOD (Alstom) under an EPC (engineering, procurement and construction) contract in relation to the design and construction of a power plant in Bulgaria.

The facts of the case

Alstom was required to provide an on-demand bond, which was provided by a French bank. Alstom fell into delay on the project and AES made a demand on the bond in the sum of €93 million. Attached to the demand were letters and demands for late completion payments. Those letters attached invoices which totalled €27 million.

Following this demand, the bank stated that it had received correspondence from lawyers acting for Alstom disputing the validity of the demand. Alstom subsequently applied to a French court for an injunction preventing the bank from paying AES under the bond. The bank wrote to AES stating that the demand was defective because it was for €93 million, but only enclosed notices or claims against Alstom totalling €27 million. The bond, therefore, failed to observe one of its requirements, namely, that the "demand contains any notice to or claim against the Contractor relating to the respective breach of its obligations to which the demand refers". The French court granted the injunction.

In response, AES made a second demand on the bond in the sum of €96 million. On this occasion, the letters and invoices attached to this demand totalled the €96 million sum claimed. Although the bank acknowledged that this demand did appear to satisfy its formal requirements, it did not pay out as it remained bound by the French court's order. AES issued proceedings in the English court against the bank for summary judgment in relation to the sums claimed under the second demand. Alstom applied to be joined to the proceedings as a defendant.

The English court's decision

In assessing the validity of the first demand under the bond, the English court considered whether a claim for sums not yet alleged to be due and payable, and for which there was no notice to or claim against Alstom, could properly be demanded under the bond. The court found that there was a clear link between the documents to be supplied under the bond and the requirement for a statement that Alstom had failed to comply with its obligations under the EPC contract. The demand was, therefore, invalid as the notices or claims were in respect of €27 million, but the claim was made for €93 million.

In other words, the demand did not comply with the bond's requirements as it made a claim for which there was no notice or claim against Alstom. The court, however, found that the second demand was valid, in that it contained notices and invoices totalling the sums claimed which related to the breach of Alstom's obligations to which the demand referred.

Having found that the second call on the bond was valid, the court considered the order from the French court preventing the bank from making any payments under the bond. The court drew a distinction between a judgment which determined what, as a matter of contractual obligation, a party was obliged to do, and the enforcement of any payment obligation under that judgment. It held that the present case was a matter of contractual obligation, and did not interfere with the French court's order which prevented the bank from complying with its obligations under the bond. The court, therefore, made a declaration that the bank was obliged to pay to AES the sum of €96 million, but ordered that the judgment should not be enforced so long as the French court's order was in place.

What are the commercial implications?

This case illustrates the need to understand fully and comply with the exact requirements of a bond when making a demand. Ideally, the underlying contract should spell out not only that a bond is required, but also have the terms of the bond set out in an appendix. Additionally, the fact that a party has sought interim relief from the court in the country in which a bank is based is no bar to seeking summary judgment or declaratory relief from the English court. A distinction must be made between a judgment determining liability and one which enforces an obligation.

The terms of the underlying contract

In Simon Carves Ltd v Ensus UK Ltd [2011] EWHC 657 (TCC), the court considered the extent to which a party may be prevented from seeking payment under an on-demand bond by the terms of the underlying contract upon which the bond is provided.

The facts of the case

Ensus engaged Simon Carves Ltd (SCL) under the IChemE Red Book form of contract to carry out works in relation to a bio-ethanol process plant. SCL was required to provide an on-demand bond, which, once an acceptance certificate was issued, would become "null and void".

Disputes arose between the parties as a result of alleged defects at the plant. Although the acceptance certificate was subsequently issued, Ensus sought payment under the bond. SCL applied to the court for an injunction restraining Ensus from making any demand under the bond on the basis that it was null and void. Ensus did not appear at the first hearing and the court granted the injunction upon certain undertakings being given by SCL. In contrast to the AES case above, this was an injunction against the party to the underlying contract and not the bondsman.

The matter then came before the court for a full hearing of both parties' arguments. Ensus argued that a demand under the bond could only be restrained where clear evidence of fraud could be established. In response, SCL submitted there was no reason why the court could not restrain any breach of contract by way of injunction.

The court's decision

The court found that fraud is not the only ground upon which a demand could be restrained and there is no legal authority which permits a buyer from making a demand when it is expressly disentitled from doing so. The court further held that where an underlying contract clearly and expressly prevents the making of a demand, the buyer can be restrained from doing so.

The court found that, on the evidence, SCL established a good case that, as between it and Ensus, the bond is to be treated as null and void and is returnable. The court, therefore, ordered the continuance of the interim injunction preventing Ensus calling upon the bond.

What can we learn from these cases?

The message to buyers and sellers alike must be to ensure that, in the first instance, the wording of the on-demand bond and underlying contract accurately reflects the parties' intentions.

Where a party wishes to make a demand, the terms of the on-demand bond must be scrutinised and strictly followed. On-demand bonds are payable against a properly worded demand accompanied by such documents as are required by the bond without the need to prove default under the underlying contract.

Leaving aside non-compliance with the terms of the bond, if a party wishes to restrain the making of a demand, it will have to demonstrate, with evidence, either fraud on the part of the buyer or that the underlying contract clearly prevents the buyer from making a demand.

In many cases, buyers and sellers are able to resolve the underlying issues between them without either party having to make a demand. However, if a demand has been threatened or made, a party will need to marshal its evidence without delay and be ready to apply swiftly to the appropriate tribunal for injunctive relief, if it wishes to stop payment.

Finally, the fact that a party has sought interim relief from the court in the country in which a bank is based does not mean that the English court is debarred from expressing a judgment to determine what, as a matter of contractual obligation, a party is obliged to do.