Performance Bond Workshop Exercise

11 December 2009

© Francis Ho, 2009

Workshop Session

On demand Performance Bonds

Scenario

You are an in-house lawyer for Fields Developments plc (“Fields”), a UK developer of
IWPPs (integrated water and power plants). Fields is developing an IWPP project in the
Emirate of Dubai in the United Arab Emirates which will be constructed under an
Engineer, Procure and Construct (“EPC”) contract. The EPC contract is governed by
English law and is subject to arbitration in the Dubai International Arbitration Centre.

Nova Construction SA (“Nova”), a Spanish contractor, was awarded the EPC contract by
Fields in October 2006. Under the EPC contract, the Time for Completion for the plant
was 24 August 2009. Clause 4.2 of the EPC contract required Nova to provide Fields
with a bank performance bond.

It is now 11 December 2009. Construction of the plant is almost complete but it is
substantially behind the scheduled Time for Completion of 24 August 2009.

Your colleagues in Fields’ project management team have established that Nova is
responsible so far for 12 weeks of this delay and wish to levy 12 weeks of liquidated
damages against it. There are currently strong rumours circulating that Nova’s group of
companies (including the contractor and its parent company) is close to insolvency.

Given the concerns as to Nova’s solvency, your colleagues have specifically asked
whether the 12 weeks of liquidated damages could be claimed against the Performance
Bond. The aggregate value of liquidated damages for 12 weeks is €12,480,000.

What you need to do

Working in groups of four people, review Clause 4.2 (set out in Appendix 1) and the
Performance Bond (set out in Appendix 2) and:

(a) Consider whether there are any weaknesses in the drafting of (i) Clause 4.2
and (ii) the Bond, and whether these affect Fields’ ability to claim under the Bond.
Consider what improvements you might have made to Clause 4.2 and the Bond;

(b) Decide what procedural steps Fields will need to take to claim (assume here that
it is entitled to claim for liquidated damages under the Bond).

Note: for the purposes of this exercise, you should assume that Fields is entitled to claim for the 12 weeks
of liquidated damages under the EPC contract.

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APPENDIX 1

(Clause 4.2 of the EPC contract)

4.2 PERFORMANCE BOND

4.2.1 The Contractor shall obtain (at his cost) a Performance Bond for proper
performance, in an amount equivalent to ten per cent of the Contract
Price, i.e. a bond amount of seventeen million, five hundred and ninety-
eight thousand and one hundred euros (€17,598,100).

4.2.2 The Contractor shall deliver the Performance Bond to the Employer within
5 days after both Parties have signed the Contract. The Performance Bond
shall be issued by a financial institution and from within a country (or
other jurisdiction) approved by the Employer.

4.2.3 The Contractor shall ensure that the Performance Bond is valid and
enforceable until issue of the Taking-Over Certificate of the Works in
accordance with Clause 10.1. If the terms of the Performance Bond specify
its expiry date, and the Contractor has not become entitled to receive
the Taking-Over Certificate by the date 21 days prior to the expiry date,
the Contractor shall extend the validity of the Performance Bond until
the Works have been completed.

4.2.4 The Employer shall not make a claim under the Performance Bond, except
for amounts to which the Employer is entitled under the Contract in the
event of:

(a) failure by the Contractor to extend the validity of the
Performance Bond as described in the preceding paragraph, in which
event the Employer may claim the full amount of the Performance
Bond,

(b) failure by the Contractor to pay the Employer an amount due, as
either agreed by the Contractor or determined under Clause 2.5
[Employer’s Claims] or Clause 20 [Claims, Disputes and
Arbitration], within 21 days after this agreement or
determination,

(c) failure by the Contractor to remedy a default within 21 days after
receiving the Employer’s notice requiring the default to be
remedied, or

(d) circumstances which entitle the Employer to termination under
Clause 15.2 [Termination by Employer], irrespective of whether
notice of termination has been given.

4.2.5 The Employer shall indemnify and hold the Contractor harmless against and
from all damages, losses and expenses (including legal fees and expenses)
resulting from a claim under the Performance Bond to the extent to
which the Employer was not entitled to make the claim.

4.2.6 The Employer shall return the Performance Bond to the Contractor within 7
days after the Contractor has become entitled to receive the Taking-Over
Certificate.

NB: You do not need to consider Clauses 2.5, 10.1, 15.2 or 20 of the EPC contract to
answer the questions.

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APPENDIX 2

(Performance Bond)

BANCO NACIONAL DEL RÍO
To:
Fields Developments plc
Fields House
Forest Road
London E8 3BH
Date: 11 October 2006
Subject: Performance Bank Guarantee
Applicant: Nova Construction SA, Floor 18, Casa Río, C/ Rosa
76, 13426 Madrid, Spain
Amount: €17,598,100
Project: Design, construction, completion, commissioning and
testing of an IWPP project in Dubai, U.A.E.
Issuing Bank: Banco Nacional del Río SA, 22/F, Casa Río, C/ Rosa
76, 13426 Madrid, Spain
Beneficiary: Fields Developments plc
Dear Sirs:
WHEREAS, Fields Developments plc (“Employer”) has entered into that
certain contract (“Contract”) with our client, Nova Construction SA
(“Contractor”), for the construction and completion by the Contractor
of an integrated water and power plant in Dubai, United Arab Emirates
as further described in the Contract; and
WHEREAS, the Contractor is required under Clause 4.2 of the Contract to
procure a bank guarantee in favour of the Employer in support of the
due and proper performance of the obligations undertaken by the
Contractor in respect of the Contract;

NOW, THEREFORE, in consideration of the above we, Banco Nacional del
Río, hereby irrevocably and unconditionally undertake that, forthwith
upon our receiving written notice from you stating that in your sole
and absolute judgment the Contractor has failed to observe or perform
any of the terms, conditions or provisions of the Contract on its part
to be observed or performed, we will (within two working days) pay to
you or as you may direct in euros such an amount as you may in such
notice require not exceeding (when aggregated with any such amount(s)
previously so paid) the amount for which this Bond is for the time
being valid.
This Bond shall be valid from the date hereof in its full amount,
namely seventeen million, five hundred and ninety-eight thousand and
one hundred euros (€17,598,100), and shall continue to be so valid with
respect to any such written notice to us referred to above as is
received by us not later than 4.30 p.m. (Madrid time) on either 24
February 2010 or the date of the Taking-Over Certificate, whichever
occurs earlier. This Bond shall not be valid with respect to any
written notice received by us after the latter date and shall after

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that date be null and void. When the validity of this Bond has expired
it must be returned to us for cancellation but we shall be released
from any obligation hereunder even if, in breach of this provision,
such return has not taken place.
Any payment by us hereunder shall be in immediately available and
freely transferable euros free and clear of and without any deduction
for or on account of any present or future taxes, levies, imposts,
duties, charges, fees, deductions or withholdings of any nature
whatsoever and by whomsoever imposed.
Our obligations hereunder are of a continuing nature, constitute direct
primary irrevocable and unconditional obligations, shall not require
any previous notice to or claim against the Contractor or any other
person, and shall not be discharged or otherwise prejudiced or
adversely affected by any time, indulgence or forbearance which you may
grant to the Contractor, any unenforceability or invalidity of, or any
amendment, modification or extension which may be made to, the Contract
or the work to be performed thereunder, any intermediate payment or
other satisfaction made by us, any change in the constitution or
organisation of the Contractor, or any other matter or thing which in
the absence of this provision would or might have that effect except a
discharge or amendment hereof expressly made or agreed to by you in
writing.
Yours faithfully,

Julio Escobar
-------------------------------- B.N.D.R.
Authorised Signatory

Name: J.P. Escobar
Title: Finance Director Company Stamp

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Workshop Session

On demand Performance Bonds - Solution

(a) Consider whether there are any weaknesses in the drafting of (i) Clause 4.2
and (ii) the Bond, and whether these affect Fields’ ability to claim under the
Bond. Consider what improvements you might have made to Clause 4.2
and the Bond.

The drafting examples of Clause 4.2 and the Bond are based on forms which would not
be considered unusual.

This does not mean, however, that an employer or project financier would consider them
to be acceptable. One of the aims of this workshop is to demonstrate that legal disputes
concerning bonds are frequently complex and often the question of successful
enforcement boils down to ensuring that they are carefully worded.

Analysis of Clause 4.2

This is the contractual provision within the EPC contract requiring the Contractor to
provide the performance bond.

In Clause 4.2.4 it lays out the four sets of circumstances under which Fields can claim
under the Bond. The circumstances are quite specific.

The main concerns with the drafting of Clause 4.2 are as follows:

(i) Concern 1: Does the clause permit Fields to claim for liquidated damages under
the Bond?

Yes, although the drafting of Clause 4.2.4 is not ideal. Complications arise from
the fact that the drafting of the clause does not specifically cater for a claim for
liquidated damages arising from late completion. 1

Fields could argue that it is able to claim for such delay liquidated damages under
Sub-Clause 4.2.4(c). However, it is not certain whether this argument would
succeed in arbitration, as different arbitrators may have different views on it (see
our analysis below). On the other hand, Fields should be able to rely on Sub-
Clause 4.2.4(b) to claim liquidated damages although, as discussed below, that
sub-clause has its own limitations.

1
This is an issue employers need to watch out for when drafting such clauses. It would have been preferable for Clause 4.2 to have
explicitly stated that the Employer is entitled to claim for liquidated damages under the Bond.

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Both sub-clauses are examined below.

Sub-Clause 4.2.4(c)

Under Sub-Clause 4.2.4(c), Fields can claim under the Bond where there has
been a breach of contract by Nova which it has not been remedied within 21
days, following Fields notifying Nova of the breach.

We know that Nova’s failure to achieve completion 2 by the required Time for
Completion is a default because your colleagues have ascertained that Nova is
responsible for 12 weeks of delay. However, for Fields to apply Sub-Clause
4.2.4(c) requires notice to be given by Fields to Nova of the default and then for
Nova to be given 21 days to rectify the default (a period lawyers generally call a
“cure period”).

The requirement for a cure period gives the impression that the sub-clause was
not intended to cover a situation where the default in question is a failure to
complete in time because such a default only occurs once the Time for
Completion has been missed. As a consequence, Fields would only be able to
give notice after that date has been missed. Although Nova must be given a cure
period before the Bond can be called, the default (i.e. missing a deadline) cannot
be remedied (unless the arbitrator considers payment of liquidated damages to be
a suitable remedy).

If Fields makes a claim under Sub-Clause 4.2.4(c) and the bank pays out, Nova
may claim against Fields alleging a wrongful call on the Bond. An arbitrator
assessing such a claim by Nova may interpret Sub-Clause 4.2.4(c) in one of two
ways:

(i) he or she may decide that Fields was entitled to claim under Sub-Clause
4.2.4(c) and ignore the requirement for a cure period; or

(ii) he or she may decide that, because of the requirement of a cure period,
Sub-Clause 4.2.4(c) was not intended by the parties to cover a recovery of
delay liquidated damages and thus Fields cannot rely on Sub-Clause
4.2.4(c) to recover under the Bond. The arbitrator is then likely to require
that Fields compensates Nova accordingly (by virtue of Clause 4.2.5).

As indicated above, it cannot be predicted with great certainty which
interpretation an arbitrator would take.

2
Technically, completion would be “Substantial Completion” under a FIDIC-based contract.

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Sub-Clause 4.2.4(b)

Sub-Clause 4.2.4(b) provides that if Nova fails to pay Fields an amount due
(including where such failure is due to insolvency), Fields is then entitled to claim
under the Bond for that very amount. 3 This sub-clause would therefore allow a
claim for liquidated damages but Fields would have needed to have claimed for
the liquidated damages against Nova first (and Nova would then have needed to
fail to pay).

Although this gives Fields an avenue through which to claim under the Bond,
it undermines one of the principal reasons for having a performance bond which
is that the bank is a primary obligor. This means that the beneficiary can claim
directly from the bank without pursuing the Contractor first.

(ii) Concern 2: What is the significance of Clause 4.2.5?

In agreeing to provide Nova with an on demand bond in favour of Fields, the bank
(in line with standard practice) will likely have required Nova to provide it with a
counter-indemnity. This is an agreement that it will be reimbursed by Nova
should it be required to pay out any monies to Fields under the Bond.

Therefore, Clause 4.2.5 is for Nova’s benefit. Its purpose is to prevent Fields from
making a claim under the Bond where it has no entitlement to do so under Clause
4.2. 4

Whilst in principle such a provision should not be objectionable to employers,
many prefer not to include it in order to avoid complications in circumstances
where the Contractor and the Employer cannot agree whether or not the Employer
was entitled to make a claim under the Bond.

Even without Clause 4.2.5, the Contractor should still have a claim against the
Employer where the Employer has made a claim under the Bond which is not
permitted under Clause 4.2.4 - this would be a simple breach of contract claim.

(iii) Concern 3: Is Nova required to ensure that that Bond is valid and enforceable at
the time Fields is contemplating making the claim?

We are told that the Works are close to completion but have not yet been
completed. This means that the Bond should still be valid and enforceable; Nova

3
As mentioned in the instructions for the exercise, it should be assumed that Fields is entitled to levy the 12 weeks of liquidated
damages.
4
One of the primary concerns for banks (and contractors) with on demand bonds is employers making fraudulent claims under them
because, under a properly-drafted on demand bond, the bank should have no right to refuse a claim - unless they have reason to
suspect the claim is fraudulent.

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is obliged to ensure that the Bond is valid and enforceable until the Taking-Over
Certificate has been issued under Clause 4.2.3. 5

To be safe, Fields should claim under the Bond before the Taking-Over
Certificate has been issued.

Analysis of the Performance Bond

Any bond provided by the Contractor’s bank should always be carefully reviewed before
being accepted by an employer. Banks often prefer to use their own wording rather than
the Employer’s. However, it is invariably the case that the bank’s preferred form of bond
is drafted on terms which are beneficial to the bank. It may therefore not comply with
what is required under the EPC contract.

The following issues should be considered in relation to the Bond:

(i) Issue 1: Expiry of the Bond

Clause 4.2.3 requires the Contractor to ensure that the Bond remains valid and
enforceable until the Taking-Over Certificate has been issued. Clause 4.2.3 also
provides that if the Bond contains an expiry date 6 and Nova is not in a position to
receive the Taking-Over Certificate within 21 days of that expiry date being
reached, it must extend the validity of the Bond until the Works have been
completed.

The Bond from Banco Nacional del Río does contain an expiry date (24 February
2010). Although Nova is contractually required to extend the Bond should the
circumstances described above arise, from an employer’s point of view it would
be preferable if there was a mechanism for automatic extension within the Bond
itself. This would give Fields comfort that the Bond will remain valid in the event
that Nova fails to renew the Bond if the expiry date is reached before the Taking-
Over Certificate has been issued (for example, because it has become insolvent).

According to the fourth paragraph of the Bond, if the Works are not completed
by 24 February 2010, the Bond will expire. While it is usual practice to draft a
long-stop date to work in such a manner (as banks wish to avoid a potentially
open-ended liability), Fields should make sure that any long-stop date it agrees to
is sufficiently far in the future not to cause problems if the date of the Taking-
Over Certificate is delayed substantially beyond the expected date due to delays to
the Works.

5
An exception to this would be where Fields decided to issue the Taking-Over Certificate early (i.e. prior to the Works achieving
completion) which it might have done this if it wished to take early possession of the IWPP.
6
An expiry (or “long-stop” date) is a specific date when the Bond will expire, if it has not previously done so.

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(ii) Issue 2: Is there a sufficient amount of the Bond value remaining for Fields to
claim for the full value of the liquidated damages sought?

From the facts we are given, it is not clear whether previous amounts have been
paid out under the Bond. However, if no amounts have previously been paid out,
the bond amount (€17,598,100) should be sufficient to meet the current
aggregated value of delay liquidated damages claimed (€12,480,000).

(iii) Issue 3: Is the Bond an on demand bond?

Yes, although the wording of the Bond is weaker than what we would prefer to
see. For example, there is no mention of the bank paying on the beneficiary’s
“first written demand” nor drafting obliging the bank to ignore any objections
from the Contractor which relate to Fields claiming under the Bond.

However, the Bond does state that the bank cannot revoke the bond and must
perform its obligations unconditionally and pay Fields “forthwith”. If Fields
provides a notice in line with the requirements of the Bond, the drafting requires
the bank to honour it. This would indicate that it is an on demand bond.

What improvements might you have made to Clause 4.2 and the Performance
Bond?

Aside from the suggestions made above, the following amendments could be considered:

1. Clause 4.2 should specify that the performance bond required should be an on
demand bond

Clause 4.2 does not specify that the Performance Bond required should be an on
demand bond although the market expectation for international projects such as
this is to have an on demand bond. Consequently, Nova’s obligations under the
clause might have been satisfied if it had supplied a default bond instead of the on
demand bond it has provided (a default or conditional bond is typically one which
allows the surety to challenge any claim if it believes that the Contactor is not in
default). Clause 4.2 should state that an on demand bond is required.

In addition, it is recommended that the form of Bond required by the Employer is
specified and attached to the EPC contract. This reduces the scope for the
Contractor or its bank to suggest a form of bond which may not meet with the
Employer’s intentions.

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2. Include a provision that the bond amount will increase if the Contract Price
increases

On most projects, it is likely that the final Contract Price will be higher than the
initial Contract Price stated in the EPC contract. If the bond amount remains the
same as the Contract Price rises, then the usefulness of the Bond to the Employer
will eventually decrease.

Clause 4.2.1 states that the bond amount of €17,598,100 is 10% of the original
Contract Price. The Employer can consider including an obligation in Clause 4.2
requiring the bond amount to be increased proportionately to reflect increases in
the Contract Price and for the Contractor to notify the bank promptly of such
increases in the Contract Price and to pay the bank any additional premium as
necessary.

In turn, the Bond should include a mechanism providing for the bond amount to
increase automatically to reflect increases in the Contract Price.

3. Specifically state that the Employer can claim for performance liquidated
damages under the Bond

Just as it is strongly advisable to specify in Clause 4.2 that delay liquidated
damages may be recovered under the Bond, similar consideration should be
given to the recovery of performance liquidated damages (should the EPC
contract allow for such liquidated damages to be levied).

4. Include governing law and jurisdiction clauses

The Bond is itself a contract and therefore should include specifying governing
law and jurisdiction. Otherwise - and particularly in an international project such
as this one where the parties involved are from different countries with the project
itself in another country - a party may receive an unintended benefit depending on
which law and jurisdiction are established to govern the Bond and the
enforceability of some of the parties’ rights and obligations under it may be in
doubt.

Generally, the Employer and the Contractor would, for consistency, want the law
and jurisdiction of the Bond to match that of the EPC contract. We are told that
the EPC contract is governed by English law and is subject to arbitration in the
Dubai International Arbitration Centre.

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5. Consider extending the Bond to cover the defects rectification period

Aside from the issue discussed above regarding the long-stop date, the Employer
may wish to consider whether it wishes the Bond to expire upon issue of the
Taking-Over Certificate or upon the end of the defects rectification period. 7
The latter will provide more longer security to the Employer although it will also
attract a further premium on the cost of the Bond which will ultimately be met by
the Employer through an increase in the Contract Price.

6. Include a provision in Clause 4.2 preventing the Contractor from seeking to
obstruct a call on the Bond

The purpose of including such a provision would be for Fields to reinforce the
fact it should be able to call on the Bond at any time. The provision would prevent
Nova from taking action to prevent Fields from making a call (for instance by
seeking an injunction). The inclusion of such a provision is likely to be strongly
resisted by most contractors on the basis it may leave the Contractor vulnerable to
a wrongful call by the Employer (see comments above in relation to the counter-
indemnity between the Contractor and the bank).

However, the Contractor may be amenable to a watered-down provision being
included - for example, a provision providing that the Contractor shall not seek to
prevent the Employer calling from the Bond for liquidated damages if there is, at
the time, an unresolved dispute between the Contractor and the Employer as to
whether the liquidated damages are payable.

7. Include clearer identification of the project and the contract within the Bond

Neither the project nor the EPC contract are identified with clarity in the Bond.
The project is simply described as “…an IWPP project in Dubai, U.A.E.” If the
parties have entered into more than one contract or are working together on more
than one project in Dubai there could be confusion as to which contract this Bond
relates to.

Choice of surety

There is one further issue to be aware of, although it does not directly affect the drafting
of Clause 4.2 or the Bond. Clause 4.2.2 states that the surety shall be a financial
institution from a country (or other jurisdiction) approved by the Employer.

The surety here is Banco Nacional del Río, a Spanish bank, whose identity and
nationality were presumably approved by Fields. Generally, on international projects

7
Known as the “Defects Notification Period” under the FIDIC Silver Book.

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employers prefer for the Bond to be provided by a bank in the Employer’s home country
(the UK in this case) which the Employer knows has a good reputation and satisfactory
creditworthiness. This avoids the Employer having to pursue a foreign bank and also
means the Employer can be sure that it will not be obstructed by legal uncertainties in the
bank’s country.

Employers should also be wary of the risk that Contractor and surety may wrongly
collude in an attempt not to honour calls on the Bond made by the Employer. In our
experience, this risk is higher where Contractor and surety have an unusually close
relationship. Although it represents only circumstantial evidence, it can be noted from the
Bond, for instance, that both Contractor and the bank appear to have their offices in the
same building in Madrid. This may hint at a close relationship.

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(b) Decide what procedural steps Fields will need to take to claim (assume
here that it is entitled to claim for liquidated damages under the Bond).

The procedure is largely set out in the third paragraph of the Bond.

It is important to follow any notice requirements as close to the letter as possible since
any material deviation from these may give the bank a reason to refuse an Employer’s
call on the bond until a conforming notice has been provided.

To call on the Bond, Fields must produce a written notice or letter addressed to Banco
Nacional del Río SA stating that, in Fields’ sole and absolute judgment, Nova
Construction SA has failed to observe or perform any demands or provisions of the
Contract on its part to be observed or performed. 8

As well as stating the amount claimed, the notice or letter should specify how and where
the funds should be remitted by the bank. It is recommended that the notice or letter also
clearly identifies the Bond, project and EPC contract in question.

The Bond does not specify whether notice can be given by facsimile or e-mail (indeed no
fax number or e-mail address for the bank are provided on the Bond). Therefore, it should
be assumed that such electronic forms of notice should not be used. Notice should
therefore be given by post, courier or hand delivery to the bank’s address as stated in the
Bond (unless, of course, the bank has moved offices in the interim in which case its new
Madrid address should be used). If post is used, it is advisable that a recorded, signed-for
method of delivery is used so the Employer can ascertain that the notice has been
successfully received by the bank.

The Bond does not require details to be given of Nova’s breach so these should not be
provided.

8
The requirement under the Bond to make such a statement is generally a standard requirement of on demand performance bonds. As
mentioned previously, banks and contractors are concerned about the risk of employers making claims under on demand bonds where
they have no entitlement to claim. The main circumstance under which a bank can refuse to honour a call on an on demand bond is
where the bank has good reason to suspect the claim as being fraudulent. If the bank knows that the statement made by the Employer
in the notice or letter is false it can refuse to pay out.

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Performance Bond Workshop Exercise

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