Free Legal Demand Letter for Payment to Contractors for Damages - DOC

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					                                       On Demand Bonds
                           A solution to the problem of an unfair call
                                      Giles Dixon, Solicitor
                              Georg Gößwein, LL.M., Attorney at law

We do not need to explain to the readers of this article the problems inherent in on demand bonds
– in particular the problem of an unfair call. In England, Germany and many other jurisdictions it
is not going to be easy for a contractor - or a bank – to get the courts to intervene if a call on a
bond is made unfairly: to achieve this, fraud will have to be shown and even if there is fraud, to
present a convincing case to the court in the short time available may prove to be impossible.

The international banking community could use their substantial influence to improve the
wording of on demand Bonds so as to reduce the risks of unfair calls being made. Unfortunately,
there is little sign of this. Indeed, in recent years, within the UK’s PFI industry there has been a
move towards on demand Bonds being required from project contractors, with support for this
from the banks, as funders.

In the current situation, without any constraints on the wording being exercised by the banks,
contractors who are required to provide bonds have to consider for themselves how best to
mitigate the risks. Perhaps the most satisfactory approach is to have an adjudication clause in the
bond itself and the authors of this article have been involved in such a case recently and this is
dealt with in more detail below.

Apart from incorporating a dispute resolution provision, there are ways of mitigating the risks
whilst still retaining the “on demand” character of the security. Examples are given below.

First, the beneficiary’s entitlement to make a call on the bond might be limited to circumstances
when the contractor has not only defaulted under the contract but has also failed to comply with
the award of an arbitrator or a court. It is not unknown for On Demand Bonds to contain a
provision that the payment will only be made upon production of a copy of an arbitrator’s award

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or a judgement of a court together with a statement that the award/judgement has not been
satisfied in full.

Since beneficiaries are unlikely to want to incur the time and cost of legal proceedings before
they can exercise their rights to recover the funds from the bondsmen, such a provision is unlikely
to be acceptable to many clients.

Wording which is more likely to be acceptable is that the call must be accompanied by a
statement signed by the beneficiary that the contractor has become insolvent or that the contractor
is in breach of the contract and has failed to remedy the breach within 28 days of being required
to do so under the contract. Sometimes such wording is accompanied by a requirement that a
copy of the notice of default issued by the engineer or some other evidence is submitted together
with the demand.

Other methods of trying to reduce the risks of a call include specifying precise wording to be used
on the call. On Demand Bonds are similar to documentary credits and banks are used to checking
the list of documentation and/or wording before honouring their commitment to pay, applying the
doctrine of strict compliance. By inserting specific language which must be used when the bond
is called could well give a contractor some comfort, since not every client is sufficiently well
organised to follow the bond requirements precisely. Especially when it is being called close to
the expiry date with the client’s objective being to have that expiry date extended, failure to
comply with the express requirements of a bond could result in the call being invalid and the
expiry date passing before the proper wording is used. In this circumstance it should be sufficient
simply to put the wording to be used for the call in quotation marks. It is a little insertion which
should make a big difference when the beneficiary deviates from the prescribed wording as he
makes an unlawful call.

It is also useful, for similar reasons, to require authentication of the signatures of those signing the
demand and/or certified copies of relevant documents which have to accompany the call. Unless
this procedure is strictly adhered to, the bank has no authority to pay.

Although the performance bond will be referred to in the contract to which it relates, that
reference is usually confined to no more than a statement that the contractor must provide a
performance bond in a pre-agreed form before or within so many days of contract signature.

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There is rarely any language in the contract which specifies the circumstances in which the bond
may be called or the consequences of an unfair call. This is another area to be addressed when
negotiating the contract. If the grounds on which the bond may be called are clearly specified in
the contract and the client makes a call when the circumstances do not justify it, the contractor
has a better chance of recovering his loss, if not actually preventing the call, than if the contract is
silent and the bond is in a simple “on demand” form.

Whether or not the contractor can negotiate acceptable terms for the performance bond, he also
has to consider the terms of the facility letter under which his bank will offer the bond. Banking
documents tend to be written to give the bank absolute control over his customer’s money
regardless of fault and with few obligations on the bank to behave responsibly. There is,
therefore, some scope for trying to persuade the bank to moderate its terms and, for example, to
give notice to the contractor if a call is made and to consult with a contractor if the beneficiary of
a bond seeks to have the expiry date extended. At the very least, a contractor should carefully
study the terms on which he is offered bonding facilities since he may otherwise find that he has
difficulties with the bank as well as the beneficiary when a call is made and his funds are applied
to cover their bank’s risk.

While it is important to try to narrow the grounds upon which a call under an On Demand Bond
may be made by having appropriate wording in the bond, incorporation of a dispute resolution
mechanism into the bond itself is recommended. This will impose a contractual obligation on the
bondsman to comply with the dispute resolution process if required to do so, thereby avoiding the
risk of payment pending the resolution of the dispute. Provided that the dispute resolution
mechanism allows for a decision within a short period of time, there should not be any real reason
for the client to object to such proposal. A fair minded client will, in any event, hesitate before
calling a bond, using this only as a weapon of last resort and an adjudication provision which
allows for a decision within, say, 28 days of a reference, would not prejudice the client to any
serious extent.

In a recent case with which the authors were concerned, an adjudication provision was
incorporated in an on-demand performance guarantee to secure warranty obligations issued by an
Austrian bondsman at the request of a German contractor that had entered into a major
infrastructure project with a client in the Middle East.

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The contract between the parties provided for ICC arbitration in Geneva. When the performance
bond was negotiated, it was agreed that if a call was made under the performance guarantee and
the contractor objected, either party could require that the matter be referred to adjudication under
the CEDR (Centre for Effective Dispute Resolution) rules. The request for payment would then
be suspended until the adjudicator decided how much would be paid. A certified copy of this
award was to be sent to the bondsman.

30 days before the performance guarantee was due to expire the employer made a demand for the
full value of the guarantee – a phenomenon not unknown to those who work in the Middle East!
The contractor gave notice of objection and applied to CEDR for the appointment of an

CEDR nominated an individual, who required approval by both parties.               In this case, the
adjudicator selected by CEDR was a leading QC in England with wide international project
experience who was duly appointed. Under the CEDR Rules there is 28 day period for the
adjudicator to reach a decision from the date of referral. This is defined as the date upon which
the referring party’s statement of case is submitted to the adjudicator and the other parties. In this
case the referring party had a problem in preparing its statement of case: the contractor was not,
as is usual with a claim, seeking money from the employer but, instead, it was seeking to prevent
the client from getting money from the bondsman.

No reasons had been given for the call. The referring party’s statement of case was therefore
succinct and, in effect, concentrated on the fact that no complaints concerning the contractor’s
activity had been made under the contractual procedures and, therefore, there was no justification
for a call under the bond.

The contractor and the adjudicator had to wait for the employer’s response before seeing the
reasons for the call. That response was voluminous in its reference to technical details. Because
of the extent of the documentation, the adjudicator proposed, and the parties agreed, to extend the
period of 28 days for the decision.

There was no hearing, the adjudication being conducted entirely by an exchange of documents
with the adjudicator raising questions for response by the parties where he needed clarification.

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The CEDR Rules allow the adjudicator to determine the procedure and he may require a hearing
if he feels that this is desirable.

The adjudicator’s decision was issued 8 weeks after his appointment and concluded that an
adequate case for payment under the bond had not been made.

Under the CEDR rules, both parties are jointly and severally responsible for the payment of the
adjudicator’s fees and expenses but each party has to bear its own costs of the adjudication. The
adjudicator’s only discretion in respect of costs is apportionment of liability with regard to his
own fees and expenses. In this case no such discretion was exercised.

CEDR’s adjudication rules allow for considerable flexibility, including the possibility of
mediation, in which case the adjudication process will be suspended whilst mediation is
undertaken. In this case there was no such proposal.

Although the employer did not receive the funds that it had expected from the bondsman, it
nonetheless still had a right of recourse:    it was free to commence arbitration against the
contractor for breach of contract under the arbitration clause in the contract. And the contractor
was not relieved of any of its contractual obligations to perform its remaining duties under the

Adjudication has become a mainstream activity in the UK as a result of the Housing Grants
Construction and Regeneration Act 1995 (HGCRA). Under this legislation, either party to a
construction contract in England can require that any dispute which arises between the employer
and contractor must first be referred to adjudication. The decision of the adjudicator must be
issued within 28 days from the date of the referral, but the law provides for this period to be
extended by the referring party unilaterally increasing the period to 42 days or further by
agreement of both sides. The adjudicator’s decision will be binding on the parties and must be
implemented; it can only be overturned by subsequent proceedings in arbitration or the courts.
The CEDR adjudication rules were prepared with the HGCRA in mind but they are capable of
use in any jurisdiction and CEDR is an organisation with substantial international experience.

Introduction of an adjudication clause into international performance bonds can achieve an
equitable solution: the demand for payment, if challenged, will only be delayed for a short period,

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the costs involved in the reference to adjudication will be very much less than those of arbitration
and the likelihood of unfair calls which fall short of fraud can be reduced. And, even if a call is
not allowed by the adjudication, the employer may still recover damages if he is successful in
subsequent proceedings against the contractor under the contract.

For the employer, there is also an advantage: by having a fairer process, the project cost will be
reduced: contractors will be less inclined to add in the value of the bond when submitting their
tender. Last but not least the parties to the dispute are always free to utilize the event of
adjudication to “stop and settle” the dispute immediately thereby saving precious time and cost.

As for the banks that issue performance bonds, they too can benefit – it is not really in their
interests or, more important, the interests of their customers, for unfair calls to be made.
Moreover, although the bank       will usually have sufficient security to protect itself, a call,
especially if it is challenged, can at the very least be time consuming for those involved. If the
banking community were to take the lead – and insert an adjudication clause in their standard
form of bond wording, the unfair practices of some international clients would be curbed and
international contractors could sleep more easily at night.

Giles Dixon, solicitor– The author is a sole practitioner specialising in
non-contentious construction and infrastructure contracts. He is also a consultant with Shadbolt &
Co., solicitors, London.

Georg Gößwein, LL.M., attorney at law. The author is the general counsel of a German
engineering company.

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