When trust breaks down

Trying to keep faith with a customer's demands can be a legal minefield for suppliers, says Jeremy Sharman

In large commercial contracts, it is not uncommon for the customer to require the supplier to provide some form of performance guarantee.

Such a guarantee or bond may be required, for example, to guarantee the supplier's performance, particularly where the customer agrees to make payments to the supplier before work actually being performed.

In many cases, the bond will be a performance bond or a demand bond issued by the supplier's bank in favour of the customer which must be honoured in accordance with its terms, after a demand, without proof of loss.

On demand bonds can be distinguished from 'see to it' bonds that are dependent on, or have as a precondition, the need by the beneficiary to establish loss or an entitlement under the underlying contract to recovery or damages.

While the contract between the supplier and its customer will refer to the bond and may provide, for example, the circumstances in which it is to be exercised, the supplier will not be a party to the bond.

Nonetheless, the supplier will, of course, be vitally interested in any demand made on the bond because if its bank pays out, then the supplier's account will be immediately debited.

In addition to having to fund the payment, the supplier's credit facilities and commercial standing might also be adversely affected.

What then is the position when the parties are in a dispute over whether or not the supplier has performed its obligations under the contract and the customer makes a call on the bond before that dispute is resolved? Can the supplier obtain an interim injunction restraining the customer from making the call and, if so, in what circumstances?

The principles that will be applied by the court in such circumstances were considered by Judge Anthony Thornton QC in TTI Team Telecom International and another v Hutchinson 3G UK Ltd [2003] All ER (D) 83 (Apr).

Briefly, the facts of the case are as follows:

Hutchinson contracted with TTI for the provision of a customised software system to enable Hutchinson to manage and monitor its third generation (3G) mobile services network in the UK.

Hutchinson agreed to make payments against the achievement of certain defined milestones, including a substantial advance payment before TTI had performed any services or delivered any software.

The contract provided that TTI would procure a bond, which effectively guaranteed payment to Hutchinson for the same sum as the advance payment.

The work by TTI was delayed for a variety of reasons which were in dispute.

Hutchinson gave notice terminating the agreement and stated that it intended to call the bond.

TTI maintained that a call on the bond would constitute a breach of contract and sought an interim injunction restraining the call pending the full trial of the action.

The Technology and Construction Court had to rule on what test to apply when deciding whether to grant interim relief.

Was it the traditional balance of convenience test set out in American Cyanamid Co v Ethicon Ltd [1975] AC 396, HL, or did TTI have to demonstrate something more onerous - for example, that payment of the call would amount to fraud, dishonesty, or bad faith on the part of Hutchinson?

The court rejected TTI's application for an injunction.

When reaching its decision the court identified the following principles:

- A third party (in this case TTI) seeking to restrain a beneficiary from calling a bond must show that its application is supported by an underlying claim based on a breach by the beneficiary of the underlying contract or on some other cause of action such as fraud, restitution or a breach of faith.

- A call will normally only be restrained where there has been fraud in setting up or calling the bond or where there is a breach of faith by the beneficiary in threatening a call.

- The basis for a contention of a breach of faith must be established by clear evidence even for the purposes of interim relief.

A breach of faith can arise in various circumstances - for example, a failure by the beneficiary to provide an essential element of the underlying contract on which the bond depends; misuse by the beneficiary of the guarantee by failing to act according to the purpose for which it was given; and a threatened call by the beneficiary for an unconscionable ulterior motive.

- In addition, where it appears that the call would be a nullity, a court will intervene to restrain that invalid call - for example, where a condition precedent to a call has not yet been fulfilled; where the bond is a 'see to it' bond requiring prior proof of loss by the beneficiary or poor performance by the third party which has not yet been established; or where the demand does not meet the requirements imposed by the bond for a valid demand.

- If none of the above factors exists, then a threatened call will not be restrained.

In particular, the calling of a bond will not be restrained merely because the factual basis of the call arising out of the underlying contract is disputed.

Disputes as to whether, for example, a breach of contract actually occurred or the contract was determined for cause, will not be allowed to found an application to restrain a call unless these disputes reveal a breach of faith by the beneficiary.

- If interim relief is being sought, the court will not intervene unless the third party has a real prospect of succeeding in both the entitlement to restrain the call and in its underlying claim which ought to be tried before the call is made.

Central to the decision reached by Judge Thornton was his conclusion that the bond in question was a performance bond (subject to ISP98, a set of rules that govern international standby practices including documentary standby letters of credit) rather than a 'see to it' bond.

He stressed the importance to international commercial activity of the integrity of standby payments and the non-interventionalist approach taken by the English courts.

The fact that the courts will not, as a general rule, interfere to prevent a beneficiary from calling a performance bond may appear unduly harsh so far as the supplier is concerned, particularly if it has a legitimate grievance under the underlying contract.

However, as Judge Thornton made clear (citing Cargill International SA v Bangladesh Sugar and Food Industries Corp [1996] 4 ALL ER 563) the matter does not end there as there will need to be an 'accounting' exercise at some future date finally to determine the rights and obligations between the parties.

A payment which over-compensates the customer may be recouped by the supplier in subsequent litigation under the underlying contract.

The TTI v Hutchinson case again highlights the non-interventionist approach that the courts take towards performance bonds and other standby payments.

The decision emphasises the need to consider carefully when negotiating such arrangements the wording of the bond and the circumstances in which it may be called.

Jeremy Sharman is a partner in the international dispute resolution group at City-based law firm Bird & Bird