Bonds And Guarantees Update: Distinguishing A Bond From A Guarantee And Bondsman's Obligations

In our sixth issue of Insight, we reported on the first instance decision in Hackney Empire Ltd v Aviva Insurance UK Ltd1 which considered the issue of whether conduct in agreeing payments outside of the building contract was prejudicial to the bondsman such that the bondsman was discharged from liability. That case has now been considered by the Court of Appeal.

Meanwhile, the question as to whether a security document is an on-demand bond or a guarantee continues to occupy the courts. The Court of Appeal has emphasised the need for a consistent approach by the courts. The court also noted that ultimately, the banks are concerned with the wording of the security document not about (i) the relationship between the supplier and customer, (ii) whether the supplier has performed his contractual obligations or (iii) whether the supplier is in fault unless there is clear evidence of both fraud and the bank's knowledge of that fraud. The Court of Appeal has therefore provided useful guidance on how to differentiate between on-demand bonds and guarantees.

A reminder of the key legal principles

Primary and secondary obligations

Bonds and guarantees are basically forms of informal security that support a contractual obligation (usually in the form of a separate security document) and are based on either primary or secondary obligations.

Bonds based on primary obligations are where the bondsman promises to pay a certain amount on receipt of a written demand immediately (absent very limited challenges such as fraud, or the bond having expired) without reference to the liability of the contractor or any other condition. There is no need to involve the original contracting party, which simplifies matters significantly if insolvency proceedings are in prospect or on foot.

Primary obligation bonds are variously referred to as single bonds, simple bonds, on-demand bonds, demand guarantees and documentary demand bonds and are common in international projects but are not seen as often in the UK market save for advance payment and retention bonds.

Bonds based on secondary obligations usually take the form of a guarantee and are referred to as conditional bonds, surety bonds and default bonds, and the bondsman's liability is dependant on there being a breach by the contractor of the underlying construction contract. They are much more commonly seen in the UK construction market because they are economic and they are usually readily available from most...