Calls of Performance Bond or Bank Guarantee in Construction Contract: Interpretation and Demands
Introduction
(1) Performance bonds and bank guarantees are commonplace in the Malaysian construction industry. Construction contracts often require a contractor to take out a performance bond, typically in the form of a bank guarantee which can be called upon by the employer to a specified maximum limit in the event of the contractor’s breach of the construction contract.
(2) Performance bonds are typically given prior to the commencement of the contract, when the relationship between parties is positive. In contrast, calls on performance bonds are usually made after negotiations fail and communication has broken down. It is little wonder that demands on performance bonds are frequently opposed and challenged.
(3) In deciding disputes on performance bonds, the courts ought to undertake a straightforward exercise of interpretation of the performance bond and defer to the intention of the parties. The parties here refer to the principal (usually the contractor), the guarantor (usually a bank) and the beneficiary (usually the employer). This article examines the various interpretations of performance bonds and the requirements of a valid demand, with reference to Malaysian case law and examples of valid and invalid demands.
Interpretation of performance bonds
(4) In the interpretation of performance bonds, the Malaysian courts have generally come to three different constructions based on the varying words used in performance bonds. These three possible constructions were first considered by the English Court of Appeal inEsal (Commodities) Ltd & Anor v. Oriental Credit Ltd & Anor [1985] Lloyds’ Rep 546 at 550 and have been adopted by the Federal Court in China Airlines Ltd v. Maltran Air Corp Sdn Bhd & Another Appeal [1996] 2 MLJ 517 at 534-536 and Kerajaan Malaysia v. South East Asia Insurance Bhd [2000] 3 CLJ 705 at 711.
(5) The three possible constructions of a performance bond are summarised by the Federal Court in SEA Insurance:
“There are three possible meanings which can be given to the [performance bond].
First, no more than a mere written demand is required.
Secondly, the demand must assert a failure to perform the contract.
Thirdly, because of the word “damages”, proof thereof and not mere assertion is required before liability under the bond arises.”
Firstly, “A mere written demand”
(6) The words of certain performance bonds do not require anything more than a mere written demand to call on the performance bond. The Court of Appeal in Teknik Cekap Sendirian Berhad v. Public Bank Berhad [1995] 4 CLJ 697 at 702 affirmed by the Federal Court in [1998] 3 MLJ XXV cited two such examples:
“There is no doubt that some performance bonds must be paid merely on a demand being made, and whether this is so must depend on the wordings of the bond itself.
In Kirames Sdn. Bhd. v. Federal Land Development Authority [1991] 2 MLJ 198 the guarantee provides that the guarantor shall “irrevocably and absolutely guarantee payment on demand without having to assign any reason whatsoever for such demand.” In the light of these clear and unambiguous wordings it can be said that this is an unconditional and a pure “on demand” bond. What is required to trigger payment in such bonds is the demand simpliciter.
In Esso Petroleum Malaysia Inc. v. Kago Petroleum Sdn. Bhd [1995] 1 AMR 189 the then Supreme Court on examination of the performance bond in that case held that it was a pure on demand guarantee and therefore a mere demand would trigger off the guarantees without asserting any reasons thereto. In that case the guarantor “unconditionally and irrevocably guaranteed payment …”
(7) Traditionally, such performance bonds have been branded as “unconditional” or “on-demand”. However as disussed below, there is little utility in classifying the bond as such, especially if it distracts from a plain interpretation of the words of the bond.
Examples of a mere written demand
Kirames Sdn. Bhd. v. Federal Land Development Authority [1991] 3CLJ (Rep) 27 (High Court)
(8) The words of the security guarantee in Kirames read:
“(a) the said sum of Ringgit RM117,535 shall be paid by us forthwith on demand by you in writing without your having to assign any reason whatsoever for such demand.
(b) the said sum of Ringgit RM117,535 shall, be paid by us forthwith to you irrespective of whether or not there is any disputebetween the said contract and yourselves (the authority) in respect of or relating to the said contract or in respect of any other matter and irrespective of whether or not such said dispute, if any, has been settled, resolved, litigated or adjudicated upon or otherwise howsoever.”
(9) Accordingly, it was not necessary for the Court to consider whether the demand had stated the basis for calling on the guarantee. This guarantee has been described by the Court of Appeal in Teknik Cekap as a “pure on demand bond” requiring merely a “demand simpliciter” to trigger payment.
Esso Petroleum Malaysia Inc. v. Kago Petroleum Sdn. Bhd [1995] 1 CLJ 283 (Supreme Court)
(10) Likewise, the words of the bank guarantee in Esso Petroleum did not require the demand to state the grounds or basis for such a demand. The bank guarantee read:
“In consideration of Esso Production Malaysia Inc. (EPMI) agreeing to release to Perbadanan Ladang-Ladang Tabung Haji Sdn. Bhd. (PLLTH) the sum of DM466,562 (Four hundred sixty six five hundred sixty two only) being the amount of liquidated damages (L/D) presently withheld by EPMI pursuant to several purchase Orders made between EPMI and PLLTH, we hereby Unconditionally and Irrevocably guarantee the payment to EPMI, the Ringgit equivalent of the sum of DM466.562 (Four hundred sixty six five hundred two only).”
(11) The Supreme Court described this bank guarantee as a “pure on-demand guarantee” not requiring any declaration or documentation by the beneficiary or inquiry by the bank into any breach between the parties.
Secondly, “Demand must assert a failure”
(12) The words of some performance bonds require that the beneficiary expressly state in the demand its basis for calling on the performance bond. In Esal Commodities, the English Court of Appeal adopted this interpretation of the performance bond and held:
“… in addition to the beneficiary making the demand, he must also inform the bank that he does so on the basis provided for in the performance bond itself.”
(13) In such circumstances, the failure by the beneficiary to meet this requirement in its demand will render the call invalid and unenforceable. When faced with such an invalid demand, the principal (contractor) can challenge the call in court. If the principal has sufficient notice of the demand, he may even take out an injunction to restrain the beneficiary (employer) from receiving monies from the guarantor (bank) pursuant to the invalid call.
Examples of demands required to assert a failure
Esal (Commodities) Ltd And Relto Ltd v. Oriental Credit Ltd And Wells Fargo Bank NA [1985] Lloyd’s Law Reports Vol. 2, 546(English Court of Appeal)
(14) The performance bond in Esal Commodities stated:
“we undertake to pay the said amount on your written demand in the event that the supplier fails to execute the contract in perfect performance…”
(15) In interpreting the words of the bond, the English Court of Appeal held that:
“… in addition to the beneficiary making the demand, he must also inform the bank that he does so on the basis provided for in the performance bond itself. This interpretation not only gives meaning and effect to the words “in the event that the supplier fails …” which otherwise would be mere surplusage, but it in no way imposes an extravagant demand upon the bank.”
(16) The Court of Appeal there found that when making the demands the beneficiary did not assert that there was a failure to perform the contract. The Court then came to the conclusion the condition had not been complied with and that the call was invalid.
Teknik Cekap Sendirian Berhad v. Public Bank Berhad [1995] 4 CLJ 697 (Court of Appeal)
(17) In Teknik Cekap, the bond began with the words:
“If the sub-contractor shall in any respect fail to execute the contract or commit any breach of his obligations there under then the guarantor shall pay …”
(18) The Court of Appeal held that “the very wordings of the bond itself is clear and unequivocal that” in addition to the beneficiary making the demand he must also inform the bank that he did so on the bases provided for in the performance bond. However, the letter of demand in Teknik Cekap merely stated:
“We… hereby give you notice that we wish to make a claim for the full amount against the abovesaid performance bond.”
(19) Accordingly, the Court of Appeal held that the demand was invalid and that any payment pursuant thereto was also invalid and ought to be returned:
“Nothing in the demand is mentioned either expressly or at least in substance that the contractor had failed to perform the sub-contract or that it had committed a breach thereof. Having given this matter my serious consideration and applying the proposition inEsal’s case (supra) which proposition I agree and accept, I hold that the appellant had failed to assert the very basis of the demand as required by the bond and, therefore, the letter of demand made pursuant to the performance bond in this case is invalid and consequently any payment made thereunder by PBB is also invalid and ought to be returned.”
China Airlines Ltd v. Maltran Air Corp Sdn Bhd & Another Appeal [1996] 3 CLJ 163 (Federal Court)
(20) In China Airlines, the letter of guarantee provided:
“The said sum shall become payable by us in the event of the said Messrs Maltran Air Corporation Sdn. Bhd.’s failure to perform the said covenants.”
(21) In interpreting the letter of guarantee, the Federal Court applied the principles in b and agreed that the beneficiary making the demand had to inform the bank of his basis for doing so. However, in China Airlines, the Federal Court held that the demand was valid because the qualifying words in the letter of guarantee had been compiled with:
“Here, to comply with the terms of the said Guarantee, the solicitors’ letter to the Bank dated 14 November 1989 specifically demanded payment of RM400,000 under the said Guarantee giving the reason that the agent had failed to perform its part of the covenants under the GSA agreement. In addition to making this demand, the letter asserted that it was so made because under Article VII of the agreement, the agent had the unconditional responsibility for the due payment to the Airline of monies in respect of tickets sold which it had continuously failed to settle. The solicitors also enclosed in the demand letter the correspondence exchanged by the parties. In our view, the reference to the breach under Article VII of the GSA agreement in the letter of demand does give meaning and effect to the qualifying words in the Guarantee, i.e. in the event of the agent’s failure to perform the covenants in the agreement. Thus, on the above grounds, we are satisfied – as was the qualifying words in the latter part of the guarantee had been fulfilled”
Kerajaan Malaysia v. South East Asia Insurance Bhd [2000] 3 CLJ 705 (Federal Court)
(22) In SEA Insurance, the performance guarantee stated:
“The guarantor shall pay damages to the Government a sum not exceeding RM420,645.00 within three months upon receipt of a written notice demanding that the guarantor pays the Government for any breach of the contract’s obligations under the contract…”
(23) In interpreting the words of the performance guarantee, the Federal Court stated that “the demand must assert a failure to perform the contract.” On the facts of this case, the Federal Court found that the notice of demand was valid because it had a clear assertion of the contractor’s breach of the contract. The notice of demand read:
“I am directed to inform you that the Contractor had defaulted in completing the works stated above. Please see our notice of termination to the Contractor ref (76) dlm. PPS.07/4T/2/50 dated 30.11.1992 which we served on you earlier. Following the above notice of termination, we hereby demand from you payment under the following guarantees…”
HSH Engineering & Construction Sdn Bhd v. Belton Properties Sdn Bhd & Anor [2001] 2 CLJ 186 (High Court)
(24) The High Court in HSH Engineering properly applied the principles of interpretation adopted by the Federal Court in China Airlinesand SEA Insurance. In HSH Engineering, the performance bond read:
“If the Contractor … shall in any respect fail to execute the contract or commit any breach of his obligations thereunder then the Guarantor will indemnify…”
(25) The Court held that the letter of demand “had fulfilled the necessary requirement and there is a clear assertion that the Respondent had failed to execute the contract and committed breaches of its obligation under the contract.” The operative words letter of demand read as follows:
“The contractor has failed to execute the contract and committed breaches of his obligations under the said contract and the Contractor … and in the circumstances you will indemnify…”
Konajaya Sdn Bhd v Perbadanan Urus Air Selangor Bhd [2009] 9 CLJ 640 (High Court)
(26) Konajaya is another case where the High Court held that the bank guarantee required the beneficiary to state the basis for its claim, and the failure to do so rendered the demand invalid. In that case, the principal obtained an injunction to restrain the beneficiary from calling on the guarantee. The High Court’s decision allowing the injunction and declaring the demand invalid was confirmed on appeal to the Court of Appeal and by the Federal Court.*
(27) The terms of the bank guarantee in Konajaya read as follows:
“In accordance with the terms and conditions of Contract No. … (herein referred to as “the Works”), WE, Maybank Berhad, of Nos 28-30, JalanTukang, 4300 Kajang, Selangor Darul Ehsan at the request of the Contractor ie. Konajaya Sdn Bhd irrevocably undertake and guarantee to the Government against any defect or damage which may arise due to any defect, fault or insufficiency in the design, material or otherwise of the said Works/portion of the Works which the Contractor is responsible for the design, in the manner hereinafter appearing.
Now the Guarantor hereby agrees with the Government as follow:
1) If any defect or damage shall occur to the Works/portion of the Works or any part thereof as a result of any defect, fault or insufficiency in the design, workmanship, materials or otherwise, on the Government first written demand, we shall pay to the Government the amount specified in such demands notwithstanding any contestation or protest by the Contractor or any other third party and without proof or conditions. …”
(28) The beneficiary’s written demand dated 27.6.2003 was worded as follows:
“We refer to the above matter and to the Bank Guarantee for Design Guarantee No: BG(P) 99/33 dated 8th July 1999 (hereinafter referred herewith as the said Bank Guarantee). Please find enclosed herewith a copy of the said Bank Guarantee for your perusal.
We PERBADANAN URUS AIR SELANGOR BERHAD (572635-A) (formerly known as “Jabatan Bekalan Air Selangor” which was corporatised on 15th March 2002) or PUAS BHD in short, having our business address at IBU PEJABAT PERBADANAN URUS AIR SELANGOR BERHAD, JALAN PANTAI BAHARU, 59990 KUAL LUMPUR hereby demand from your goodselves under the above Bank Guarantee a sum of RM4,895,160.00 (Ringgit Malaysia Four Million Eight Hundred Ninety Five Thousand One Hundred Sixty only) (hereinafter referred to as the said sum) notwithstanding any contestation or protest by the contractor or any other third party and without proof or conditions. [Emphasis added]
Please remit all payment of the said sum by cheque or bank draft made payable to PERBADANAN URUS AIR SELANGOR BERHAD within twenty one (21) days from the date hereof.”
(29) The High Court accepted the beneficiary’s arguments that the demand was invalid and held:
“It is evident from the defendant’s written demand that the defendant had failed and omitted to state any “damage or defect” to the works or any breach of the plaintiff’s obligation under the contract. This omission is fatal and renders the defendant’s written demand invalid and ineffective because it does not comply with the condition of the bank guarantee as interpreted by the Federal Court. Accordingly, the defendant is not entitled to any payment under the bank guarantee.”
Meaning of words “without proof or conditions”
(30) The High Court in Konajaya further held that the words “without proof or conditions” in the bank duarantee do not mean “without having to assign any reason whatsoever”.
(31) The words “without proof” simply mean that the benefiiary is not required to prove an actual default by the principal in the performance of the contract. This was the first possible construction of performance bonds as explained in Esal Commodities. Even though proof of an actual default is not required, the beneficiary must state in its written demand the basis upon which the demand is made (which is the second possible construction of performance bonds as explained in Esal Commodities).
(32) The words “without proof or conditions” mean that upon receipt of a valid demand, the guarantor ought to pay the beneficiary the sum of the bank guarantee without imposing any conditions. In this case, however, the beneficiary’s written demand was invalid for failing to state the basis for its demand.
Meaning of words “notwithstanding any contestation or protest”
(33) High Court in Konajaya also held that the words “notwithstanding any contestation or protest by the Contractor” is consistent with the above interpretation of the bank guarantee. Similar words “notwithstanding any contestation or protest” were used in the performance bond in Teknik Cekap and the Court of Appeal there nevertheless held that the bond required the beneficiary to inform the bank of the basis of the demand. That interpretation was affirmed by the Federal Court on appeal.
(34) The words “notwithstanding any contestation or protest by the Contractor” were also used in the performance bond in Cygal Bhd v. Bandar Subang Sdn Bhd [2004] 3 CLJ 67 (Court of Appeal); [1998] 1 LNS 414 (unreported) (High Court). In Cygal, the High Court held and the Court of Appeal accepted that “the Appellant in making a claim on the bond merely has to state in the notice to the bank that the Respondent has breached the contract and the claim has to be made good or honoured.”
Words “under the above guarantee” insufficient
(35) In Konajaya, the words “under the above guarantee” in the beneficiary’s demand was insufficient to comply with the conditions of the bank guarantee. This is because the words “under the above guarantee” do not assert any defect, damage or failure and do not state the basis for the demand on the bank guarantee.
(36) The letter of demand in Teknik Cekap stated “we wish to make a claim for the full amount against the abovesaid performance bond.” Notwithstanding the reference to the performance bond, the Court of Appeal held that the letter of demand was invalid because “nothing in the demand is mentioned either expressly or at least in substance that the contractor had failed to perform the sub-contract or that it had committed a breach thereof”.
Thirdly, “Proof and not mere assertion”
(37) The words of other performance bonds may make the bond conditional upon proof or inquiry of the breach of the terms of the contract by the principal. The Supreme Court in Esso Petroleum held that such conditions may include:
(37.1) The production of a document, e.g. a certificate from some nominated independent person like an architect; or
(37.2) An inquiry by the guarantor into the existence or otherwise of any breach of the contractual obligation between the principal and the beneficiary.
Traditional categorisation of performance bonds
(38) It is useful to understand that traditionally, performance bonds have been classified either as (1) a conditional bond or (2) an unconditional or on-demand bond.
(39) This traditional categorisation was explained by the Federal Court in China Airlines Ltd v. Maltran Air Corp Sdn Bhd & Another Appeal [1996] 2 MLJ 517 at 534 per YA Mohamed Dzaiddin Abdullah FCJ:
“A bank guarantee is a performance bond. There are two types of performance bond.
The first type is a conditional bond whereby the guarantor becomes liable upon proof of a breach of the terms of the principal contract by the principal and the beneficiary sustaining loss as a result of such breach. The guarantor’s liability will therefore arise as a result of the principal’s default.
The second type is an unconditional or “on demand” performance bond which is so drafted that the guarantor will become liable merely when demand is made upon him by the beneficiary with no necessity for the beneficiary to prove any default by the principal in performance of the principal contract.”
(40) Notwithstanding this traditional categorisation of performance bonds, the Malaysian courts have preferred a straightforward exercise of construction, or interpretation of the bond to discover the intention of the parties. This development away from the traditional categorisation was the thesis of Professor Vincent Powell-Smith in his article entitled “Calls on Performance Bonds in Malaysia – The Current Law” [1992] 2 MLJ i where he wrote:
“…There has been considerable confusion as to exactly what those principles are, but the fairly recent decision of the English Court of Appeal in IE Contractors Ltd v Lloyds Bank plc and Rafidain Bank (1991) 51 Build LR 1 has cleared the air by restating the principles to be applied in the construction of performance bonds. The correct approach, the court said, is not to categorize performance bonds as being ‘on demand’ or ‘unconditional’ – as seems to have been the past practice – but simply to treat them as contracts and to interpret them as such.”
“Performance bonds are after all, merely collateral contracts and they should be treated and construed as contracts. No useful purpose is served by categorizing performance bonds in a priori manner, whether as ‘on demand’, conditional or anything else or confusing them with letters of credit.”
(41) The Professor’s view has been adopted and applied by the Supreme Court in Esso Petroleum where YA Peh Swee Chin SCJ emphasised the importance of a “straight forward exercise of construction” and held:
“We endorse fully however the view of an eminent local academic that the said description could have served to cloud the real issue – which is one of contractual interpretation of a performance bond and not of the nature of transaction “Calls on Performance Bonds in Malaysia – The Current Law” by Professor Vincent Powell-Smith [1992] 2 MLJ 1.
That the real issue of a performance bond is one of contractual interpretation was the unanimous view of three Judges in the Court of Appeal in IE Contractors Ltd. v. Llyods Bank plc and Rafidain Bank [1991] 51 Build LR 1 [1990] 2 Llyod’s Rep 496. It is not our intention to write an essay on performance bonds, in the instant appeal, except to repeat that it “involves a straightforwardexercise of construction, or interpretation of the bond to discover the intention of the parties“- per Sir Deny Buckley in IE Contractors at page 503, ibid”
(42) The problem with the traditional classification of performance bonds as conditional and unconditional, is that it distracts the parties from a closer scrutiny of the words of the performance bond in question, which may as discussed above, require the “demand to assert a failure”.
Conclusion
(43) A beneficiary that fails to comply with the strict requirements of the bond or guarantee risks having his demand challenged and declared invalid. A principal that is aware of such failings has the opportunity to challenge the call. It is thus important that parties to a performance bond or bank guarantee understand their rights and liabilities under the words of the bond or guarantee.
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