Tuesday, October 7, 2008

Contract interpretation: Clough Engineering -v- Oil and Natural Gas

The basis on which a call on an 'on demand' performance bond may be resisted.

Summing upThe case: Clough Engineering Limited-v-Oil and Natural Gas Corporation Limited [2008] FCA FC 136 (22 July 2008).The issue: The basis on which a call on an 'on demand' performance bond may be resisted.The implication: Normally courts will interpret 'on demand' bonds as the equivalent of cash in hand. 'On demand' bonds can be resisted only if it can be shown that the employer had acted fraudulently by calling in the bond. It is sufficient for the employer to show that it had a 'bona fide belief' that the contractor was in breach of contract or had failed to perform.

For some employers, performance bonds can play an important role in construction projects by providing financial security in the event of a contractor's failure to perform.
Performance bonds can be characterised as either conditional or unconditional. Conditional bonds may be 'called in' only if and when the contractor is shown to be in breach of contract or has failed to perform. Unconditional bonds, sometimes better known as 'on demand' bonds, can be 'called in' irrespective of the employer having to prove any failing on the part of the contractor.

The law in England relating to 'on demand' bonds was clarified in the 1999 case of Balfour Beatty -v- Technical and General Guarantee Company, where it was held that an 'on demand' bond would be the equivalent of a letter of credit or cash-in-hand unless the surety had clear evidence of fraud on the part of the employer in calling in the bond.

A similar case has recently come before the Federal Court of Australia. In this case, an Australian contractor, Clough Engineering, undertook to provide services to an Indian energy exploration company, Oil and Natural Gas Corporation Limited (ONGC), in connection with the development of oil and gas fields off the coast of India.

Disputes arose between Clough and ONGC over extensions of time for the performance of the contract and the resultant failure of Clough to extend the validity of the performance bond and insurance cover required by the contract. On the day that ONGC terminated the contract, it also made a demand on the banks under the performance bond provided by them.

Clough sought injunctive relief from the Courts restraining ONGC from calling in the performance bond and preventing the banks from paying out against the guarantees issued by them. The issues to be decided by the Court at first instance concerned the interpretation and interaction of the wording of the performance bond and the underlying provisions in the parties' contract.

The contract obliged Clough to furnish ONGC with an unconditional and irrevocable performance bond within two weeks of signing of the contract. Of some importance was clause 3.3.3, which stated that ONGC would have the right under the bond to claim up to the amount of 10% of the value of the contract "in the event of the contractor failing to honour any of the commitments entered into under this contract".

Bond guarantee

The wording of the performance bond guarantee was not unusual. It required the guaranteeing bank(s) to pay immediately on first demand in writing the moneys demanded to the extent of the limit of the bond "on breach of contract by the contractor without any demur, reservation, contest or protest or without reference to the contractor".

Clough argued that the contract wording, properly construed, prohibited a demand being made on the bond. It contended that the wording of clause 3.3.3 placed an onus on ONGC to show that Clough was in breach of contract before the bond could be called in.

The judge at first instance held that upon the proper construction of the provisions of the contract, ONGC was entitled to call upon the performance bond where it had a 'bona fide belief' in its claim that Clough was in breach of the contract.

Judge's reasoning

The judge reasoned that the contract, as well as the wording of the performance bond, should be considered in totality. He found that there were powerful indicators in the wording to show that a mere claimed breach of contract, not fraudulently asserted, was sufficient to trigger an entitlement to call on the guarantees provided by the bond.

The judge also stated that the commercial objective of a performance bond under a contract was to allocate the risk of a party being out of pocket pending the resolution of a dispute and that ONGC was entitled to call upon the bond even where a genuine dispute existed as to whether or not Clough was in breach and whether or not damage had been suffered by ONGC.

Clough obtained leave to appeal this decision. The Appeal Court agreed with the Court at first instance and, in doing so, stated that if the commercial purpose of unconditional 'on demand' bonds was that they were the equivalent of cash, the introduction of a qualification on the entitlement of ONGC to call upon the performance bond "would be to deprive them of the quality which gives them commercial currency".