Performance bonds: the UAE Perspective

Most, if not all, construction contracts, whether standard forms or bespoke contracts, require the contractor to provide the employer with a performance bond guaranteeing the contractor’s performance under the contract. The purpose of such performance bonds is to provide the employer with an efficient and fast remedy should the contractor default in carrying out its obligations under the construction contract. This is fairly universal. Here, Heba Osman, one of our friends and colleagues, who works out of Dubai, takes a look at how performance bonds are treated in the UAE.

As a starting point it is always important to distinguish between performance bonds and guarantees. A guarantee will only be paid once the loss under the primary contract has been proved. The employer’s right to liquidate this performance bond is triggered upon the occurrence of a certain default on the part of the contractor. It is not an absolute right to the employer and the decision to liquidate a performance bond has to be exercised with caution.

On the other hand a true “on-demand” bond is really a stand alone agreement meaning that a bondsman will pay immediately on the first written call by the beneficiary. Remember that the use of the words “on demand” will not in every case suggest that a bond is in fact “on demand” in nature, if it is clear that on a proper construction the parties intended it to be “conditional” in the sense that there are preconditions to the issuer’s liability. With a performance bond, it is accepted that an employer has the right to liquidate the performance bond if the contractor has clearly defaulted on its obligations, such as in the event of abandoning the works or refusing to proceed with the works for no reason.

However, when the relationship turns sour between the employer and the contractor, there appears to be a tendency by employers to liquidate the performance bond even without sufficient causation. In instances where the contractor is not in default or its default is not sufficiently grave to warrant the liquidation of its performance bond, the employer has no right to liquidate the performance bond.

During the Dubai financial crisis that started towards the end of 2008, many employers caused great harm to many contractors who as well as not being paid at the time, were also being subjected to the liquidation of their bonds. This has also caused difficulty for these contractors when they later went to obtain performance bonds from banks.

Performance bonds are essentially letters of guarantee issued by a bank on the request of the contractor, by which that bank undertakes to make a payment to the employer upon the employer’s demand.

The UAE Commercial Code

The UAE Federal Commercial Law No. 18/1993 (the Commercial Code) regulates, inter alia, the issuance and use of letters of guarantee and defines them in Article 414 thereof as:

“an undertaking issued by the guaranteeing bank on the request of his client to pay a certain amount (or an amount that can be ascertained) to another person (the beneficiary) without restriction or condition, unless the letter of guarantee is conditional, if [the bank] is requested to do so within the period specified in the letter of guarantee. The letter of guarantee shall state the reason for which it is issued.”

This means that a performance bond may be conditional or unconditional. However, the trend is that performance bonds issued by the contractor are payable to the employer “on demand” without any condition.

If the performance bond is unconditional and on-demand, the bank is obliged to make the payment in accordance with Article 417 (1) of the Commercial Code, which provides: “The bank shall not be entitled to refuse payment to the beneficiary for reasons relating to the bank’s relation with the client or the client’s relation with the beneficiary.” This means that the bank cannot refuse liquidating the performance bond on the basis that there is a dispute between the contractor and the employer for example. The bank is obliged to make the payment to the employer in accordance with the terms of the performance bond itself and has no interest in, and should not consider, the terms of the construction contract between the parties.

The contractor’s remedy

A contractor who feels that the employer intends to liquidate the performance bond on unjustifiable or fraudulent grounds can have recourse to the summary court seeking an order to stop the liquidation of the performance bond. This is also provided for in Article 417(2) of the Commercial Code:

“In exceptional circumstances, the court may on application of the client place an attachment on the amount of the guarantee with the bank provided that the client has serious and certain reasons for its request.”

It is an established principle with the Dubai Court of Cassation that even though the issuing bank is obliged to liquidate the letter of guarantee upon the beneficiary’s first demand without the need to obtain the permission of the client, the law still allows the client – who has a dispute with the beneficiary and fears that the latter may demand the bank to liquidate the letter of guarantee – to have recourse to the court to place an attachment order on the amount of the guarantee whenever this client has serious and certain reasons for doing so. The court would only order the bank not to liquidate the letter of guarantee in exceptional circumstances and provided that grounds for such stopping of liquidation are present and are clear and evident from the documents of the case.

Serious and certain grounds can include the fact that the project was completed and handed over, large pending payments are due to the contractor or, there are letters or documents showing that the employer has no right to liquidate, etc.

In the event that the performance bond is liquidated, the remedy available to the contractor is to file a case (or file for arbitration if the contract provides for arbitration) and seek the repayment of the amount of the performance bond, along with interest or damages, as the case may be.

A comparison with the UK

In this there is little difference with the approach of the UK courts. The basic premise behind the general UK approach can be found in the well-known case of Edward Owen Engineering Ltd v Barclays Bank International Ltd,1 where the bond stated that it should be paid “on-demand bond without proof or conditions”. Barclays Bank had provided the bond to an English supplier, Edward Owen Engineering. They in turn had contracted to supply goods to a Libyan customer. The Libyan customer made a call on the bond when he himself was in default. Edwards Owen Engineering sought an injunction against Barclays Bank in order to restrain payment of the bond. Lord Denning concluded that the bank must pay on first demand and without proof default or conditions. The bond could, therefore, be called upon even if the breaches were non-existent. The basic exceptions to this rule are where there is fraud or where the bond had expired by virtue of the underlying contract.

From a UAE perspective, that is certainly a similar starting point, although the “serious and certain” reasons test, does provide a small measure of comfort to contractors, provided it is understood that it is a small measure only and that the hurdle that must be climbed to prevent a call on the bond is a high one.

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• 1. [1978] 1 QB 159