Performance Bond: introduction

 

The Performance Bond is a guarantee which ensures the prompt payment to the beneficiary (the Purchaser or the Owner) of a certain amount of money -from a Guarantor- in the case the Supplier or the Contractor is in breach of its contractual obligations. 

 

In international transactions, it is standard practice that the performance bond is in the form of an on-demand bond.

 

It is normally used in international construction contrasts, in international sale and purchase agreement or in international service contracts.  

 

 

Performance_Bond 

  

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Let's define some terms which will be used in this article:

 

(a) beneficiary: it is the subject in favour of which the bond is issued and who will be entitled to request the payment in case of default of the other party;

(b) applicant: it is the subject who asks the guarantor to issue the bond in favour of the beneficiary;

(c) guarantor: it is the subject who issues the bond and who, in case of request of payment, will actually pay the amount due under the performance bond;

(d) calling of the bond: it is the demand (a written demand) by way of which the beneficiary requests the payment of the bond to the guarantor;

(e) underlying contract: it is the contract between the beneficiary (as purchaser/owner) and the applicant (as supplier or contractor) which governs the transaction and, amongst the others, provides the issue of the bond from the applicant in favour of the beneficiary for the case of default of the applicant;

(f) mandate contract: it is the contract between the applicant and the guarantor  -usually a bank- upon which the latter issues the bond and undertakes to pay the agreed amount to the beneficiary upon the occurrence of the conditions established in the performance bond.

 

 

Content

 

In international contracts, the performance bond is usually issued in the form of an on-demand bond so that, upon occurrence of the default of the applicant, the beneficiary can obtain the payment at its first and simple demand without the need to prove the actual default.

 

The guarantor, upon receiving the request of payment (called the "demand") shall pay (except in very limited cases) the amount up to the maximum amount stated in the guarantee without the possibility to raise any exception or objection related to the underlying contract signed between the applicant and the beneficiary.

The performance bond is issued on the basis of a mandate contract between the applicant and the guarantor (see below to understand why this mandate contract is crucial for the protection of the interest of the applicant).

 

 

What an on-demand bond and at first demand is under Italian Law.

 

As mentioned above, in the international standard practice, the performance bond can be called upon simple demand and without the need to prove the actual default of the applicant.

Under Italian Law, however, there are certain additional aspects to be considered. In fact, for the sake of clarity, under Italian Law the on-demand bond should be defined and construed as 'an autonomous and at first demand bond' as opposed to a conditional bond.

 

What an 'autonomous' bond is. Under Italian Law an autonomous bond is a guarantee which is substantially independent from the underlying contract and which shall be paid without the possibility to raise any objection (neither from the applicant nor from the guarantor) related to the underlying contract.

It is correct to say that the on-demand bond has a connection with the underlying contract (the guarantee is issued because the contract provides such obligation) but neither the applicant nor the guarantor can suspend or stop the payment of the guarantee for reasons connected with the underlying contract. Under Italian Law this is the concept of an autonomous bond, i.e. a bond which is autonomous and independent from the underlying contract. This is the very same concept that applies in international standard contracts.

 

What a 'at first demand' bond is.  This is an aspect of the Italian legal system and it basically means that the guarantee might be called with a simple demand from the beneficiary. Such feature depends on how the guarantee is written and how the guarantee is meant to work in the intention of the parties. In other words, the guarantor shall be obliged to pay upon simple request sent (or better upon simple demand submitted) by the beneficiary. 

 

What a 'conditional bond' is. Here the guarantee is strictly linked to the underlying contract in the sense that the breach must be proved by the beneficiary and both the guarantor and the applicant are entitled to raise any objection based on the underlying contract itself to avoid the payment of the guarantee. As such, the guarantor will be able to refrain from paying because, for instance, the beneficiary has not timely performed its obligations. It is worth noting that, under Italian Law, even a conditional guarantee can be 'at first demand' in the sense that also a conditional bond can be paid upon simple request of the beneficiary provided that all the conditions are met.

 

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This is the reason why under Italian Law a 'first demand guarantee'  does not correspond necessarily to a 'on-demand guarantee' and therefore the real intention of the parties must be investigated and ascertained

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If you wish to deepen the topic read also our article Performance Bond: How it works under Italian Law .

 

 

 

2. The Performance Bond as an on-demand bond

 

As said an on-demand bond is generally a guarantee which should be paid upon simple demand from the beneficiary.

 

The beneficiary does not need to prove the default of the other party but

it simply needs to 'declare' that the default occurred.

 

However there are cases where the demand of payment must be served together with additional documents.

It is the case where the demand must be submitted, for example, together with a declaration issued by an engineer (which for instance declares that certain conditions stated in the bond occurred) or with a document listing in details the breaches attributed to the applicant.

Such additional documents do not in themselves change the nature of the bond from an on-demand to a conditional bond. It again depends on the real intention of the parties and how the text of the guarantee is written.

In other words, it has to be ascertain whether the simple submission of the documents is sufficient for the guarantor to pay or if instead the additional document is the basis for a detailed analysis of the good right of the beneficiary to obtain the payment.

 

Under Italian Law (as also in other jurisdictions) , in fact, it is crucial the distinction between bond 'at first demand', 'at justified demand' or 'at documented demand'. If you wish to deepen the topic please see our article on Performance Bond as an on demand bond

 

 

 

3. How and what to negotiate

 

Normally, the text of the performance bond is drafted by the beneficiary or directly by the guarantor on the basis of certain standard forms. 

In too many cases, the text of the performance bond is not accurately negotiated (especially for contracts of medium value).

On the one side the beneficiary will seek to protect itself to the maximum extent while the guarantor will try to conform the text to their own standard practice or, in the best cases, to the international practice.

If, on the one side, the performance bond should balance the interest of both parties, on the other side there are several clauses that should be carefully negotiated (except in those cases where standard text are adopted, such as those issue by the ICC - International Chamber of Commerce, Publication no. 758).

 

 

 

There are some precautions which may be adopted in order to protect the applicant from the risk of the payment of the guarantee without any ground

(i.e., to avoid an abusive calling of the bond).

 

The clauses that should be negotiated carefully refer mainly to:

 

(a) the reasons why the bond can be called;

(b) the automatic reduction of the guaranteed amount;

(c) the documents that must be eventually submitted with the demand;

(d) the payment terms of the amount stated in the bond;

(e) the expire date of the bond;

(f) the material return of the bond;

(g) the law governing the bond.

 

 

On how to negotiate a performance bond

click here.

 

 

(a) The reasons why the bond can be called.

 

The performance bond is issued on the basis of a specific clause contained in the underlying contract which requires the applicant to issue such guarantee in favour of the beneficiary. The underlying contract provides (or should provide) the detailed cases when then guarantee can be called.

 

The first suggestion is therefore to analyse carefully which are the reasons or the breaches (described in the underlying contract) that permit the beneficiary to call the bond.

The calling of the bond should be limited to the most material cases

which shall be considered carefully.

 

 

 

(b) The automatic reduction of the guaranteed amount.

When issued, the bond provides for the maximum amount that can be called.

Given that the performance bond aims at securing the full performance of the contract, it is crucial (for the protection of the applicant) that the guaranteed amount will be automatically reduced simultaneously with the proper progress of the performance of the contract from the applicant.

 

 

(c) The documents that must be eventually submitted with the demand.

As we said, it is not rare that the performance bond provides that the demand must be served together with certain documents. This could eventually reduce the risk of abusive calling. 

 

In the case of sale and purchase of goods, the purchaser could be entitled to call the bond if the delivered goods seem at first glance to be defective,

However, it is standard practice in international sale and purchase agreements, that the purchaser has to send a notice to the seller requiring to remedy the defects and if, not remedied, the purchaser will be entitled to call the bond.

In cases like this, it would be more than appropriate to provide that the demand could be served only with copy of the notice sent to the seller to remedy the defects with a declaration that the seller has not remedied.

In this case the bond still remains a on-demand guarantee but with 'documented demand'.

 

Read more on the difference amongst performance bond 'at first demand', 'at documented demand' and 'at justified demand'.

 

 

(d) The payment terms of the amount stated in the bond.

While the beneficiary of the bond is interested in obtaining a prompt payment after the calling if the bond (even 3 or 4 days after the demand), the supplier/contractor has, instead, a different interest simply because (if the demand can be abusive or fraudulent) it will not have enough time to challenge the demand and ask the guarantor to suspend the payment, which is normally possible only through a specific Court order.

 

Our suggestion is to insist for a term no shorter than 7 or 10 days (better if working days).

 

 

(e) The expire date of the bond.

As mentioned, the bond secures the proper and timely performance of the contract (delivery of goods, construction works or the like).

 

This means obviously that once the contract has been duly performed there is no longer need for the performance bond to be in force.

 

It is standard practice to provide that the performance bond will expire (and therefore the bond can no longer be called):

 

- after a fixed date, or

- upon the occurrence of a certain event (e.g. acceptance of the goods delivered).

 

It is also rather normal that the bond provides both dates, i.e. that the bond will expire upon the occurrence of the event and, in no cases, no later than a certain fixed date.

 

 

(f) The material return of the bond.

One additional clause that the beneficiary is very often keen to insert in the performance bond is the one that provides that 'the performance bond will not expire until the actual and material restitution of the original bond' or a similar one.

There is no need to insert such a clause other than rendering more difficult (in prejudice of the applicant) the automatic expire of te bond.

 

This is in fact in line with the most recent standard practice as well consolidated as stated by the Rules 758 della ICC.

 

So, in the case the beneficiary (or the guarantor) requires such clause, our suggestion is to firmly refuse to accept it.

 

 

(g) The law applicable to the bond.

As in the case of any other contract, a specific attention must be put on the law applicable to the bond.

 

It happens rather often that the beneficiary will require that the law applicable to the bond is a law different from the jurisdiction of the applicant. This is a logic decision provided that the parties agree to have as applicable law the one of a third jurisdiction.

 

It is also standard practice to have English law as applicable law to the bond.

 

Such decision must be carefully considered since the law applicable to the bond will govern any dispute strictly related to the bond.

 

Please note that in the case the bond does not specifically provide the applicable law, the bond will almost automatically be governed by the law of the bank which has issued the bond (and the jurisdiction will be the one of the place where the specific branch has issued the bond materially).

 

 

4. How to call a performance bond in Italy

 

Given that usually the performance bond is issued in the form of an 'on-demand' bond it can be called upon a simple demand from the beneficiary.

 

Usually the bond provides expressly:

 

  • who is entitled to sign the demand (e.g. the legal representative of the beneficiary);

 

  • the address where the demand must be delivered (e.g. the branch of the bank that actually issued the bond);

 

  • the date within which the demand can be lastly sent;

 

  • possible additional details that the demand should contain (e.g. that the applicant has breached its obligations);

 

  • possible additional documents that should be sent together with the demand.

 

Our suggestion is that the text of the bond contains at least the above mentioned information (unless the bond is drafted according to international standards such as those known as  ICC Rules n. 758).

 

This is to avoid any formal objection that the applicant (or the guarantor in certain cases) could eventually raise to suspend or even stop the payment of the guaranteed amount. 

 

 On this topic, you can read also the post on How to call a Performance Bond.

 

 

 

5. When a calling is abusive or fraudulent

 

As mentioned the performance bond is generally an on-demand guarantee and it is a such that can be called upon simple demand and be paid without the need to prove the actual breach of the applicant and without any right for the beneficiary or the guarantor to raise any objection related to the underlying contract.

 

However this doesn't mean that

the bond must be paid in any case.

 

There can be in fact certain circumstances where the demand is 'unlawful' in the sense that the beneficiary, upon payment of the guaranteed amount, would receive an unjust profit such as for example:

 

  1. because the contract has been duly performed (and the demand will be a 'fraudulent calling'); or
  2. because the formal conditions stated in the bond have not been fulfilled (and the demand will be an 'abusive calling').

 

In general terms, it can be said that the calling is unlawful every time the payment of the guaranteed amount would allow the beneficiary to reach a goal different from the one established with the bond and, therefore, to obtain an indemnity in cases where the beneficiary is not actually entitled to.

In the previous example of the sale and purchase agreement, a calling would be fraudulent if the contract has been fully and duly performed (the goods have been delivered, they are in good order and with no defects, the delivery has occurred in time).

 

The calling is unlawful either because the applicant has duly fulfilled its contractual obligations or

because the terms and conditions for the actual calling have not been complied with.

 

However it must be highlighted that:

 

The payment of a performance bond

(like any other on-demand guarantee) can be stopped when

the calling is abusive or fraudulent

 

which occurs not only when the payment would allow the beneficiary to obtain an unjust benefit but also when the beneficiary is itself aware that the payment would be unjust.

 

As in any contractual dispute, our suggestion is to keep records of the contractual relation so that the abusive or fraudulent calling can be proved with documentary evidence.

 

On this, you can also read our article  (The fraudulent Calling of the Performance Bond).

 

 

 

6. What to do in case of fraudulent calling of the performance bond in Italy

 

In all the cases where the calling might be abusive or fraudulent, it is possible to try to stop the payment:

  1. sending a warning letter to the guarantor requiring to refrain from the payment; and/or
  2. applying to the competent Court to seek an injunction ordering the guarantor to refrain from paying.  

 

In any event, the very first thing to do is to send a formal communication to the guarantor and submit any and all the

 

documents that can be useful to give

a prima facie evidence that

the calling is abusive or fraudulent.

 

(for example any necessary document to show that the goods sold have been duly and timely delivered and that they are free from any defect, or that all the works have been duly and timely completed). 

 

This is because, in addition to the liability of the beneficiary, in case of abusive or fraudulent calling, also the guarantor might be liable for having paid a bond which has been called fraudulently (see in this respect our article Performance Bond: obligations of the bank in case of calling). 

 

Please note that generally speaking the guarantor (especially if it is an international bank) would reluctantly refrain from paying to preserve their international standing but will pay at the same time the utmost attention for their potential liabilities.

 

So it is extremely important to act timely and to provide the guarantor all the evidence of the fraudulent calling. 

 

You can find more suggestions in our article What to do in case of fraudulent calling of the Performance Bond.

 

 

7. Obligation of the guarantor in case of fraudulent calling

 

As already mentioned, the performance bond is issued on the basis of a specific mandate contract signed between the applicant and the guarantor.

On the basis of such contract and in general of the Italian Law, the guarantor has specific obligations to protect the interest of the applicant, such as the obligation to

 

to ascertain that the calling is not

prima facie fraudulent or abusive. 

 

It must be stressed, however, that the guarantor does not have a specific obligation to analyse the reasons of the calling or the contractual reasons of the calling. The guarantor has in any event the duty to verify whether the calling seems prima facie abusive or, on the basis of the information received from the applicant, fraudulent.

It is therefore clear why the applicant must promptly inform the guarantor and provide to it any necessary supporting documents if the applicant believes that the calling is abusive or fraudulent. 

 

If it is true on the one side that the performance bond must be paid on-demand by the guarantor, it is also necessary to specify that the guarantor has a duty to ascertain that the relevant payment is not in prejudice of the rights of the applicant (for more details read Performance Bond: obligations of the bank in case of calling).