When is On-Demand not On-Demand?

Introduction

Since the decision in Edward Owen Engineering Ltd. v Barclays Bank International Ltd. and Another [1] was handed down in 1978, practitioners and those in the construction industry have appreciated that an on-demand bond was payable immediately upon the presentation of a valid demand to the bondsman unless there was clear evidence of fraud.

Justice Morison in Cargill International S.A. v. Bangladesh Sugar & Food Industries Corp[2] expressed the “pay now, argue later” nature of on-demand bonds in the following terms:

“The concept that money must be paid without question, and the rights and wrongs argued about later, is a familiar one in international trade, and substantial building contracts.”

The Hong Kong Courts have traditionally adopted a similar view. However, as explained below, two recent cases, namely WKCDA v AIG and W v Contractor, could signal a change in the Courts’ attitude, introducing additional hurdles and/or challenges to those hoping to obtain swift payment under on-demand bonds.

A Brief History of On-Demand Bonds in Hong Kong

In Hong Kong, drafters of on-demand bonds have been influenced by a series of authorities, emanating from construction of  Chek Lap Kok airport in the late 1990s, which reinforced the “pay now, argue later” nature of on-demand bonds. As a result, many bonds in effect today in Hong Kong still follow similar operative wording, in the expectation that this should preserve the beneficiary’s right to swift payment.

The first of these authorities is UDL Kenworth Engineering Ltd v Airport Authority and Another[3]. There, the sub-contractor attempted to prevent the beneficiary from receiving the bonded sum by arguing that the demand was invalid as the beneficiary was “unable to point out any or any quantifiable damages sustained by the [Employer] as a result of the alleged default of the [Sub-contractor].”[4]

The operative provision of the bond was as follows:

“…if the Sub-Contractor shall be in default in respect of any of his obligations under the Sub-Contract the Bondsman shall upon demand made by the Employer in writing and without proof of the said default or conditions satisfy and discharge the amount identified in the demand of any damages, losses, charges, costs or expenses sustained by the Employer by reason of the default up to the amount of the Bonded Sum.”

Upon consideration of the terms of the bond, the Court of First Instance held that a demand for payment under the bond was valid as long as it:

(a)     was in writing;

(b)    stated that the sub-contractor was in default of his obligations under the sub-contract; and

(c)     set out an amount not exceeding the bonded sum as being the losses or damages sustained by beneficiary by reason of the default.

Importantly, the Court did not require the beneficiary to prove the default relied upon in the demand at the time of the demand and further noted that the beneficiary “would undoubtedly suffer loss expense or damage if the sub-contractor defaulted in completing his sub-contracted works within the scheduled time frame. It does not follow that the [beneficiary] has suffered no loss or damage simply by reason that such loss or damage has not quantified at this point in time”.[5]

In other words, quantification of the actual losses flowing from the alleged default should be a matter for determination down the line.

A year later, in 1999, the Court grappled with a similar issue in Nishimatsu Construction Co Ltd v American Home Assurance[6]. There, the beneficiary made a demand under a bond but the bondsman refused to pay. The bondsman argued that the demand was invalid, and argued that the bond required the beneficiary to:

(a)     state that there has or have been defaults and to identify the default relied upon;

(b)    give some detail of the monetary loss which flows from each default, and indicate how it has arrived at the sum; and

(c)     indicate the causal link between the default relied upon and the monetary loss which is claimed to have been sustained.

The Court disagreed with the bondsman, preferring the UDL approach. It held that the demand made by the beneficiary was valid, and stated the following:

“In my judgment, in this case the demand conformed with the wording of the bond and the Defendant has to pay. The demand stated that there had been a default and identified the amount of damages, losses, charges, costs or expenses sustained by the Plaintiff by reason of the default; the demand restricted the call to the amount of the bonded sum. The bond does not require more than this. The relevant provision in the bond states that the payment is to be made “without proof of the said default or conditions”. Specifying a particular breach or particularising the damages sustained is not required when making a formal demand on the bond.”[7]

As can be seen from the above, the Hong Kong Courts have traditionally upheld the “pay now, argue later” nature of on-demand bonds. However, two recent cases give pause for reconsideration.

WKCDA v AIG

In WKCDA v AIG[8], the Court of Appeal in Hong Kong took a stricter approach when construing the validity of demands.

Despite the passage of some 20-odd years, the operative provision of the bond in WKCDA v AIG remains remarkably similar to those in UDL and Nishimatsu:

“If, in the [WKCDA’s] opinion, the Contractor is or has been in default in respect of any of its obligations under the Contract, [AIG] shall upon demand made by the [WKCDA] in writing and without conditions or proof of the said default or amount demanded, pay the amount identified in the demand in respect of the damages, losses, charges, costs or expenses sustained by the [WKCDA] by reason of the default, up to the amount of the Bonded Sum.”

In its written demand to AIG, WKCDA stated that the contractor had been failing to perform its obligations under the contract, and by reason of which WKCDA has “suffered and sustained and will continue to suffer and sustain, damages, losses, charges, costs and expenses” (emphasis added).

The first instance judge held that the demand was valid[9]. Given the similarities in the operative provision of the bond, the judge cited UDL and held that “it was not a requirement under Clause 2 for the plaintiff to specify the particular breach/default by the contractor, or to particularize the amount of damages, losses, etc sustained…”[10].

However, AIG appealed, asserting that the sum demanded not only included damages and losses WKCDA had already suffered by the time of the demand but also future damages and losses.

The appeal was allowed. The Court of Appeal rejected WKCDA’s argument that the demand was valid in spite of the submission that the words “will continue to suffer and sustain” were “redundant and surplusage”.[11] It held that by adding the words in question to the demand, “there is nothing before the court which would show and support the position that at the time of the 1^st Demand, [and] there was an objective context or basis to say that the quantified damages were already well beyond the Bonded Sum”.[12]

Of wider significance, however, is the Court’s view that the operative provision of the bond required WKCDA to make a demand “by reference to damages, losses etc which have already been suffered and quantified, but not unquantified sums arising from or by reason of by the Contractor’s default”.[13] This appears to be a departure from the previous authorities cited above, in particular Nishimatsu, where the Court expressly stated that “specifying a particular breach or particularising the damages sustained is not required when making a formal demand on the bond.”

This significant departure from earlier authorities means that parties on the receiving end of a demand will be more prepared to “take a chance” and challenge what would otherwise be legitimate demands, based on whether the sum demanded has been quantified and/or whether there are any (minor or other) deficiencies in the wording of the demand.

W v Contractor

Against the backdrop of WKCDA v AIG, the recent case of W v Contractor[14] shows that a beneficiary may face hurdles in obtaining the bonded sum even if a bona fide valid demand has been submitted.

Under the contract between W and the Contractor, the Contractor provided an on-demand bond issued by a bank in favour of W. The bond was governed by Hong Kong law and contained an exclusive jurisdiction clause in favour of the Hong Kong Courts for disputes arising under the bond.

Disputes concerning the underlying contract between W and the Contractor arose, which led to the Contractor commencing arbitration against W. Subsequently, W made a demand under the bond.

Upon becoming aware of W’s demand, the Contractor­­ applied to the arbitrator for interim measures pursuant to Articles 17 and 17A of the Model Law (given effect by Sections 35 and 36 of the Arbitration Ordinance, Cap. 609), to restrain W from making any application, demand or call to the bond for payment under the bond, on the grounds that the status quo of the arbitration should be preserved.

Despite the fact that the bond was an independent instrument containing an exclusive jurisdiction clause, the tribunal held that it did have jurisdiction under Articles 17 and 17A of the Model Law to grant the interim measures sought by the Contractor. The Court noted the following:

“The arbitrator pointed out that he was not determining any dispute as to the validity of a demand made on the Bond, which dispute would be covered by the exclusive jurisdiction clause in the Bond and should be referred to the Hong Kong Court. Instead, the arbitrator explained that what he was asked to decide was the request for interim measures to maintain or restore the status quo until the disputes in the Arbitration have been determined. In the arbitrator’s view, where the tribunal has undoubted jurisdiction to decide the underlying disputes and the Arbitration, Article 17 presupposes that the tribunal has jurisdiction to grant or refuse interim measures.” [15]

W sought to appeal against the arbitrator’s decision, but its application for leave to appeal was dismissed on the grounds that the interim measures award was not an “award” that was capable of appeal under the Arbitration Ordinance due to its interim nature. The Court stated the following:

“the issue or matter dealt with in the Award and for which leave to appeal is now sought is the grant to an interim measure, pending the determination of the substantive issues in the Arbitration. Such an order can be varied, and is subject to any other or further order which can be made by the arbitrator, and is not final in relation to the matters considered and decided in the Award.

…

Having carefully considered: the nature and substance of the issues decided in the Award; the form of the Award; the fact that the injunction granted in the Award is interim in nature, pending the conclusion of the resolution of the substantive dispute in the Arbitration, or until any further order from the tribunal, I do not consider that it is an “award” within the meaning of the Section 5 of the Schedule, from which the Employer can seek leave to appeal to the Court…” [16]

The practical effect of W v Contractor is that a demand on a bond could be restrained, if there is an underlying arbitration between the beneficiary (in this case W), and the party procuring the bond (the Contractor), as payment under the bond by the bondsman to the beneficiary would disturb the status quo of the arbitration.

What Now?

The combined effect of WKCDA v AIG and W v Contractor puts beneficiaries in an unenviable position. Instead of being able to make a swift demand upon breach (as per UDL and Nishimatsu), it now has to satisfy itself that there is some objective or quantifiable basis for making a demand under a bond. This will no doubt take additional time, as the quantum of a breach may not be immediately apparent or indeed ascertainable.

Against the above, given the Court’s apparent endorsement of the wide reach of Article 17 of the Model Law, a beneficiary will also be under pressure to issue a demand before an arbitration is commenced against it.

Meanwhile, those on the paying end of an on-demand bond may be incentivised to commence arbitration as early as possible in an attempt to prevent the beneficiary from making a call.

There thus appear now to arise increased uncertainties for beneficiaries, bondsmen as well as those procuring on-demand bonds. Those considering making a call on an on-demand bond, or are anticipating a call to be made, will now need to consider their position in light of the cases discussed above.