76 BUILD 115 December 2009/January 2010

LEGAL

Bonds that stand up in insolvencyInsolvency may not automatically be a breach of contract, so if it doesn’t factor in the performance bond, there could be a high price to pay. By Lisa Curran, Simpson Grierson, Auckland

is a performance bond worth more than the price of the paper it is written on? If a contractor becomes insolvent part way through a project, can the principal automatically call on the performance bond? The answer to these questions will be important to many

principals with projects on the go where the contractor is on the brink of insolvency.

Focus on performance bonds

This article looks specifically at performance bonds – where the surety’s obligation to pay is conditional on the principal proving that the contractor has breached its obligations to carry out the works under the construction contract and that it has suffered a loss as a result of the contractor’s breach.

The issues do not apply to on-demand bonds, which can be called on by simply making a demand in accordance with the requirements of the bond. No proof of default or the damages sustained needs to be provided to the surety at the time of calling on the bond.

Make sure insolvency is covered

Two cases in England highlighted significant problems in the language common in many bonds, including those used in New Zealand. In the first case, Prerar BV v General Surety and Guarantee Co Ltd, the contractor became insolvent, and under the terms of the contract, this was grounds for automatic termination.

The contract provided for termination due to various listed acts of default and then dealt separately with automatic termination where the contractor became insolvent. Termination for insolvency was not specifically stated to be an act of default of the contractor but rather simply entitled the principal to terminate the contract automatically. This distinction was important. The bond was a performance bond that could be called on to ‘satisfy damages sustained by the principal’ due to the contractor’s ‘default’.

The Court held that, as the insolvency of the contractor was not specifically stated to be an act of default under the contract, the principal could not call on the bond at all, so the bond was worthless.

The lesson from this case is to make sure that your bond clearly allows you to call on it if the contractor becomes insolvent. This can be achieved by either specifically stating in the bond itself that it can be called on in the event of insolvency or ensuring that the construction contract provides that, where the contractor becomes insolvent, they are in default.

Funding replacement contractorThe second case, Paddington Churches Housing Association v Technical General Guarantee Co Ltd, concerned whether the principal can call on a bond to fund the cost of engaging a replacement contractor to complete unfinished works where the original contractor becomes insolvent.

Where a contractor becomes insolvent, the principal will want to convert the bond to cash to fund the cost of engaging a replacement contractor to complete the works. In this case, the contractor became insolvent part way through the project. A performance bond had been provided, which the principal called on to fund the remaining work undertaken by an alternative contractor.

The performance bond in that case specifically allowed the principal to call on the bond where the contractor became insolvent, so the problem posed by Prerar (discussed above) was not an issue.

However, the next hurdle was whether the principal could call on the bond to fund the cost of the remaining works. The bond, in this case, stated that the surety had to pay the ‘net established and ascertained damages sustained by the principal’. The question before the Court was, did these words actually prevent the principal calling on the bond before the cost of the work undertaken by the replacement contractor was completed and the final cost determined?

The Court held that the principal’s call on the bond was premature and that it had to wait until the final account of the replacement contractor was determined before it could make a claim, so the principal had to fund the cost of completing the work itself and could only call on the bond after the works were completed and the final account determined.

Be cautious with NZS 3910:2003

How does the standard form of bond under NZS 3910:2003 Conditions of contract for building and civil engineering construction stand up? Will it allow a principal to call on it in the event of insolvency? When can it be called on?

The bond under NZS 3910:2003 can be called on where the contractor is in default. But is the contractor becoming insolvent an act of default under NZS 3910:2003?

Arguably insolvency is not a default under the general conditions of contract of NZS 3910:2003 as it is not one of the events of default permitting the principal to terminate the contract under subclause 14.2.1. Similar to Prerar, insolvency is dealt with separately. Under subclause 14.2.2, where the contractor becomes insolvent and no satisfactory arrangements have

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been made with the liquidator for the execution of the works, the principal can terminate the contract or resume possession of the site.

Nowhere in subclause 14.2.2 is insolvency stated to be an act of default by the contractor. Although we are not aware of any surety refusing to pay out on a bond under NZS 3910:2003 by arguing that insolvency is not a default under NZS 3910:2003, it may be a potential issue in the future.

Damages paid on completion of work

The next question is, when can the principal call on the bond? Under the form of bond under NZS 3910:2003, the surety is liable for the ‘damages sustained by the principal in respect of all defaults by the contractor’. The calculation of the damages sustained by the principal where the contractor becomes insolvent can only really be calculated once the works have been completed by the replacement contractor.

Under subclause 14.2.4 of the general conditions, the engineer certifi es the cost of the principal completing the works where the principal has either terminated the contract or resumed possession of the site due to the default of the contractor.

The eff ect of the wording of the bond under NZS 3910:2003 is that the principal can only call on the surety to pay damages upon completion of the works and certifi cation by the engineer of the costs to complete. The employer will not be able to convert the value of the bond into cash to fund the completion of the works.

This article is not intended as legal advice. For further information, please contact Lisa Curran at Simpson Grierson on (09) 977 5143 or email lisa.curran@simpsongrierson.com.

What to look forWhen reviewing bonds provided by contractors:

Check that the bond can be called on where the contractor becomes ❚

insolvent. For a performance bond, either: expressly state in the form of bond itself that it can be called on •

where the contractor becomes insolvent, orensure the construction contract states that the insolvency of the •

contractor is a default under the contract.If you want to be able to convert the bond to cash quickly, you require ❚

an on demand bond.