PerformanceBondsinITProjects

20 May 2003

Edward Alder

In large commercial projects a heavyweight customer dealing with a new supplier for the first time will often require some form of performance guarantee or ‘bond’ from a trusted third party such as bank. Under these bonds the bank irrevocably commits to make a fixed payment to the customer on a project failure simply upon the customer presenting certain documents and certificates.

Performance bonds put up by suppliers’ banks have been a way of life in the Hong Kong construction industry for many years, but they are increasingly found in high value IT projects.

Bonds enable the customer to make upfront project stage payments to the supplier, which help the supplier’s cashflow, safe in the knowledge that if the supplier fails to perform the customer can obtain repayment of some or all of the payments on demand, without having to having to wait for lengthy disputes with the supplier to be resolved.

The supplier is not a party to the bond itself, which is between the bank and the customer direct. But the supplier will be vitally concerned if the customer makes a call on the bond because if the supplier’s bank meets the call the supplier’s account will be immediately debited with the paid out amount. What if the parties are in dispute over whether the supplier has breached its project obligations and the customer calls on the bond before that dispute is resolved? Can the supplier stop the call from being made?

Hutchison 3G UK Limited, the pioneering British telecoms arm of Hong Kong’s Hutchison Whampoa group, has recently had a brush with the English courts in a performance bond dispute with Israeli software house TTI Team Telecom International.

TTI had contracted with Hutchison to provide software to manage Hutchison’s new 3G network in the UK. As usual, the agreement required Hutchison to make payments to TTI at certain specified project ‘milestones’, starting with an advance payment of over £1m. Under this structure until the project was completed Hutchison would always have paid for more than they had received from TTI. Hutchison therefore required TTI to arrange a performance bond in case TTI failed to perform leaving Hutchison out of pocket.

The work by TTI was delayed for reasons which were in dispute. Hutchison terminated the project agreement and told TTI that they were going to call the bond. TTI regarded this as a breach of the project agreement by Hutchison.

Knowing the implications of a pay out on their cashflow, TTI prepared to file a writ against Hutchison and rushed to court for an interim injunction to restrain Hutchison from making the call while the case went to trial.

English and Hong Kong courts normally grant interim injunctions to preserve the status quo in the run up to trial on well established tests. The applicant must usually show that it will suffer irreparable harm if the injunction is not granted prior to trial, whereas if the restrained party later wins the case, so that the applicant was never entitled to an injunction, that party can be compensated in money terms. If one or other party is bound to suffer some irreparable harm whichever way the court rules pending trial, the court considers the overall ‘balance of convenience’ in deciding what to do.

However, the courts recognise that reliance upon financial arrangements like bonds, letters of credit and standby payments is vital for much of the economy to function. The court in the Hutchison case applied a series of English, Australian and Singapore rulings on bonds from construction and international trade cases and confirmed that an applicant in TTI’s position can only restrain a call if it can meet the much stricter test of showing by ‘clear evidence’ that the call amounted to ‘fraud or bad faith’ on the customer’s part.

While TTI might have been able to show that they would suffer harm if the call proceeded, they could not show fraud or bad faith on Hutchison’s part and the court rejected TTI’s application.

The fact that the supplier simply disputes that it breached the project agreement is not sufficient for the court to restrain a call unless these disputes reveal a breach of faith by the beneficiary. If payment under the bond over-compensates the customer the balance has to be recouped in subsequent litigation by the supplier under the project agreement.

The Hutchison case is a strong indicator that the courts only rarely interfere with performance bonds and other standby payments. Suppliers need to proceed carefully when negotiating performance bonds and specifying the circumstances when the customer is entitled to payment. Once a bond is in place it will be very difficult to restrain a call whatever the nature of the dispute between the parties under the main agreement.
Important - The information in this article is provided subject to the disclaimer. The law may have changed since first publication and the reader is cautioned accordingly.