Bond or guarantee? It’s all in the words

A recent Court of Appeal decision has again highlighted critical differences between guarantees and on demand performance bonds.

The key question that had to be addressed in the case of Meritz Fire & Marine Insurance Co Ltd v Jan de Nul N.V. & another was where C provides an on demand performance bond to guarantee A’s performance of a contract with B, will C remain liable to B even if the contract is transferred by A to a third party, releasing A from any liabilities to B (in legal jargon, “novated”)?

As we have written previously (“My word is my bond – unless it is my guarantee” 4 February 2011), the law distinguishes between on demand performance bonds and guarantees. With a guarantee, the guarantor’s liability is usually secondary to the party for whom security is being provided. So if the guaranteed party can avoid liability on the underlying contract, so can the guarantor. An on demand performance bond, in contrast, imposes independent primary liability on the guarantor.

In Meritz Fire & Marine, the appellant insurance company had provided on demand bonds to secure the performance of a Korean shipbuilding company under contracts it had entered into with two Dutch ship owning companies. Under the terms of the on demand bonds, Meritz was required to pay to the Dutch ship owners the advance payments that had been made to the Korean shipbuilder if the latter breached the contracts and then failed to return the advance payments when demanded.

The contracts were novated by the original Korean shipbuilder to another company and the original contracting company was dissolved. The work then fell into delay and the Dutch ship owners demanded the return of the advance payments. The advance payments were not returned and the Dutch companies demanded the monies from Meritz.

Meritz’s argument in the Court of Appeal was that it should not be liable because the on demand bond had been provided only for the benefit of the original contracting company, not the company to which the contract had been novated.

The Court of Appeal rejected Meritz’s appeal, making the following key points:

• Meritz had been notified of the novation of the shipbuilding contract and had raised no objections.
• The wording of Meritz’s bond meant that its liability to the Dutch shipbuilders was triggered by the documents, without regard to the underlying contract. The Dutch shipbuilders had served their demand on Meritz entirely in accordance with the terms of the bond. They were entitled to do so because the bond provided that their right to serve notice arose when a refund had not been made by the original shipbuilder. No refund had been made.
• Meritz had sought to rely on the 19th Century case of Commercial Bank of Tasmania v Jones, to support its assertion that its liability lapsed once the original contract was novated to a third party. The Court of Appeal found this case irrelevant, as it concerned a traditional guarantee, not an on-demand performance bond.

The lesson for those providing surety is to keep track of what is happening to the underlying contract. Meanwhile, businesses to whom security is provided must take care to consider carefully the wording of the security on offer to ensure that it will operate as anticipated.

If you have any queries about the issues raised by this article please contact Julia Dodds or Jim Sharkey.