PERFORMANCE BONDS REVISITED

The issue of bonds, whether performance bonds or advance payment bonds still remains a major cause of litigation in the insurance industry today. The terms and conditions of bonds are dictated by the insurer with little input from the contractor or principal, yet the current wordings of many bonds in the market today do not adequately protect the insurer. A bond may either be “on-demand” or “conditional”. However, in the interpretation of the type of bond, there is judicial authority that there is a presumption against a finding of an on-demand bond. In Marubeni Hong Kong v Govt of Mongolia (2005), the Court of Appeal in England held that, in the case of non-bank bonds, there is a very strong presumption against the existence of an on-demand bond and it would require clear words to the contrary to rebut the presumption.

Now, what are the defences available to an insurer who is sued for default under a bond and what conditions can be inserted to protect an insurer. Bonds are first and foremost contracts and therefore also subject to the principles of contract but oftentimes the common law principles are not invoked to defend claims by the principal. It is advisable to include some basic clauses on the principles of privity of contract, frustration and misrepresentation and so on. The importance of these clauses lies in the fact the insurer is not a party to the main contract and cannot invoke the terms and conditions of that contract. In African Insurance Dev. Corp. v Nig. Liquified Natural Gas Ltd (2000), the contractor failed to execute the contract within the stipulated time and the principal sued the insurer to enforce the performance bond. The insurer invoked the arbitration clause in the main contract and filed a motion for stay of proceedings. The Supreme Court held that on the principle of privity of contract the insurer was not a party to the main contract and therefore it could not invoke the arbitration clause.

In the case of a performance bond the main defence is of course that there was in fact no breach of contract by the contractor. In a recent performance bond claim handled by our firm the wordings of the bond were adequate to protect the insurer and therefore we were able to plead the following defences arising from the terms and conditions of the bond and argue that the legal action against the insurer was premature and inchoate;

  • that the value of the performance bond was gradually reduced by the amount of work done by the contractor which work must be ascertained before taking any legal action;
  • that the litigation against the insurer was time barred as the performance bond required any legal action under the bond to be brought within three months after the expiration of the bond;
  • that the insurer was not notified in writing by the surety of the contract variation within 14 days from the date of the variation;
  • that the default or breach of the contractor was not proved and liability under the bond was contingent upon the liability of the contractor;
  • that proof of the breach was not supported by an engineer’s or architect’s certificate or other relevant technical documentation;

The failure of the principal or contractor to notify the insurer of any variation of major contract terms is a valid ground for repudiation. Any such variation amounts to a change in the risk assumed by the insurer which requires full disclosure by the insured. See section 55 of the Insurance Act. One other matter is that some insurers undertake liability for damages rather than the value of the bond. This is dangerous as damages are wide enough to include sums awarded by the court over and above the value of the bond. Now even where the employer insists on an on-demand bond, it can still be worded to require that the demand should be accompanied by supporting documents, such as warning letters from the principal or letters of complaints from the architect or engineer, rather than a bare letter of demand.

We are still surprised to find bonds that do not adequately protect insurers and leave their lawyers with little room to raise viable defences. Therefore the underwriting and legal departments of insurance companies must co-operate and tighten policy wordings in this area.