Performance Bond: Introduction & How to Restrain a Demand (Part 1)

When a party engages another party to carry out certain works, the former would certainly expect the latter to perform its duties and obligations under the contract accordingly. In the construction industry, in ensuring that this is the case here, there would usually be a requirement for the Sub-Contractor to provide the Main Contractor with what is known as the Performance Bond. It is to be issued by a Bank in favour of the beneficiary (i.e. the Main Contractor) and is usually given in the form of a Bank Guarantee.

Performance Bonds are important as they are a form of security in ensuring the due observance and performance of the Sub-Contractor. In the event of any non-compliance with the contractual obligations by the Sub-Contractor, the beneficiary would be entitled to make a demand on the Bank Guarantee and demand the issuer of the Bank Guarantee (i.e. the Bank) to make payment on the Bank Guarantee. In this article, we will examine the circumstances in which the Bank is obliged to make payment out on the Bank Guarantee to the beneficiary.

A. Types of Performance Bond: Conditional and On-Demand

Generally, there are two (2) types of Performance Bonds. The first is the on-demand and unconditional Performance Bond and the second is the conditional Performance Bond. Performance Bonds are usually provided in the form of on-demand and unconditional due to their practicality. In dealing with contracts which provide for Performance Bonds, it is important to note that there are in fact two (2) separate contracts that are in existence. As clearly explained by Zainun Ali JCA in the Court of Appeal case of Kejuruteraan Bintai Kindenko Sdn Bhd v Nam Fatt Construction Sdn Bhd & Anot [2011] 7 CLJ 442 (“Kejuruteraan Bintai Kindenko Sdn Bhd”): -

“[68] In short, matters relating to the requirement, issuance, calling and payment out of a performance bond involves two separate sets of transactions under two separate sets of contracts or agreements, namely:

1. a call or demand made by the beneficiary under the underlying contract between the beneficiary and the other party; and

2. payment made by the issuer or bank upon the demand made by beneficiary under performance bond or guarantee agreement.”

When it comes to an on-demand and unconditional Performance Bond, all it takes to trigger the Bank to pay out on the Performance Bond is to make a valid demand in writing. Performance Bonds of such a nature would mean that upon receipt of a valid written demand, it is mandatory on the Bank to make payment forthwith to the beneficiary regardless of whether the demand is being disputed and contested. The position of the law on this has been clearly illustrated in Kejuruteraan Bintai Kindenko Sdn Bhd: -

“[71] The law on this issue is well-settled, locally as well as overseas: ie, if the performance bond is on demand and unconditional in nature, it is independent of any underlying contract between the parties; it is not open to the court to inquire into any breach of such underlying contract; and the bank/issuer is obliged to pay the beneficiary without any proof or condition and notwithstanding any contestation or protest from any party … The only exception to this rule is on the ground of fraud which the banker/issuer has notice. The fraud must be on the performance bond itself and not the other documents … The question of “unconscionability” does not arise and should not be an exception to the rule.”

Similarly, in the Court of Appeal case of LEC Contractors (M) Sdn Bhd (formerly known as Lotteworld Engineering & Construction Sdn Bhd) v Castle Inn Sdn Bhd & Anor [2000] 3 MLJ 339 (“LEC Contractors”), Mokhtar Sidin JCA held as follows on the law on performance bond at page 358, paragraph G: -

“That is the position of an on demand performance bond. It is clear to us that the bank guarantee in the present appeal is a performance bond. From the wordings of the guarantee it is clear to us that it is ‘on demand’ performance bond …the guarantor will become liable merely when demand is made upon by the beneficiary with no necessity for the beneficiary to prove any default by the principal in performance of the principal contract.”

It was further held at page 359, paragraph C as follows: -

“…A proper demand had been made and as such the bank (second defendant) is obliged to pay the first defendant the amount stated in the bond. As to whether the plaintiff or the first defendant was at fault is not the concern of the bank. That dispute is for the parties to the contract to settle either by arbitration or by litigation in court. The bank has no choice but to pay the amount demanded. The first defendant is entitled to that sum not under the contract but under the performance bond.”

B. Restraining demand on Performance Bond

This general rule above however is not absolute and is subject to exceptions. The applicability of the exceptions will however depend on whether the Sub-Contractor is seeking to either restrain the beneficiary from calling on the Performance Bond or to restrain the issuer from making payment out on the Performance Bond to the beneficiary. If it is the latter, the only exception to prevent the issuer from paying up on the Performance Bond is fraud. The element of unconscionability however does not serve as an exception to the general rule here. As held by the Court of Appeal in LEC Contractors at page 361, paragraph D: -

“… in order to justify any injunction to stop payment there must be clear evidence of fraud on the part of the first defendant which comes to the knowledge of the second defendant. Bad faith or unconscionable conduct by itself is not fraud…”

C. Restraining demand on Performance Bond: Unconscionability

When dealing with the former however, in addition to the exception of fraud, the Court over the years has shown great inclination in accepting unconscionability as a factor to prevent the beneficiary from calling on the Performance Bond. As held by Abdull Hamid Embong FCJ in the Federal Court case of Sumatec Engineering and Construction Sdn Bhd v Malaysian Refining Company Sdn Bhd [2012] 3 CLJ 401: -

“[36] We are also in agreement with Mohamad Ariff bin Md Yusof JC in the case of Focal Asia Sdn Bhd when he expressed this opinion on these two exceptions and the test to be applied-

If there is clear evidence of fraud in the underlying contract, or unconscionability, the Court can interfere. In these two situations, the integrity and autonomy of the document will not be compromised, since the paying bank will not be directly prevented from acting on the document. It is the beneficiary that is prevented from making a call on the document on these grounds. Nonetheless, the evidence allowing intervention by the Court must be clear. I accept the test of “seriously arguable that the only realistic inference is fraud” as good law in an interlocutory application such as the present.”

Unconscionability is a doctrine which allows the Court to deny enforcement of a contract on the ground of abuse arising out of the contract. The underlying principle of this doctrine is to prevent oppression and unfair conduct. There is no specific definition for unconscionability and therefore the question of whether unconscionability is present in a particular case would largely depend on the material facts of that case. Generally, it would involve some unfairness or some form of conduct that appears to be done in bad faith. The test for “unconscionability” has been laid down by the Court in Kejuruteraan Bintai Kindenko Sdn Bhd: -

“[94] …there must be placed before the court manifest or strong evidence of some degree in respect of the alleged unconscionable conduct complained of, not a bare statement…“hence, the plaintiff has to satisfy the threshold of a seriously arguable case that the only realistic inference is the existence of fraud or unconscionability which would basically mean establishing a strong prima facie case…” …This additional ground should only be allowed with circumspect where events or conduct are of such degree such as to prick the conscience of a reasonable and sensible man.”

D. Case Laws where Courts have found conduct amounting to unconscionability

Moving on, we will discuss on the circumstances in which the Court has held that the element of unconscionability is present, thereby rendering the call of the Performance Bond by the beneficiary invalid and unenforceable. In the case of Kejuruteraan Bintai Kindenko Sdn Bhd, the First Respondent (i.e. the beneficiary) called on the Performance Bond due to the failure of the Appellant in obtaining an extension of the Performance Bond. The Appellant applied to the Court to restrain the First Respondent from making the call. The parties subsequently reached a settlement whereby the Appellant would extend the validity period of the Performance Bond and the First Respondent would withdraw the demands made earlier.

The Appellant honoured his side of the bargain but not the First Respondent. Instead, the First Respondent issued further demands based on the fact that there was a breach of contractual obligations. The Court held that there was unconscionability on the part of the First Respondent when it proceeded to make the second demand after the Appellant extended the Performance Bond in accordance with the terms of the settlement.

Similarly, in the High Court case of Bauer (M) Sdn Bhd v Hundred Vision Construction Sdn Bhd [2015] MLJU 2320, Mary Lim J, as she then was, held that there was unconscionability on the part of the Defendant (i.e. the beneficiary) in making a call on the Performance Bond based on the ground that there was no real default being committed by the Plaintiff and the actual reason behind the call was because the Performance Bond was close to expiration. The Plaintiff was the nominated sub-contractor appointed by the Defendant to carry out earthworks. Later, a neighbour complained about defects to its premise arising from the works and brought an action against the Employer, the Plaintiff and the Defendant. The suit was eventually settled. Twelve (12) days later, the Defendant called on the Performance Bond on three (3) grounds, namely, the Plaintiff’s failure to complete the works within the timeline, to remedy damage and to submit warranties in respect of materials and to use Form G. However, the Plaintiff argued that the Architect had issued the Certificate of Practical Completion thereby evidencing that the Plaintiff had in fact completed its works. Further, there was never any Certificate of Non-Completion being issued and the Defendant never had any complaints previously about the works carried out by the Plaintiff. All in all, the Court held as follows: -

“[64] From all these submissions, I am hard-pressed not to agree with the plaintiff’s submission. When all three grounds relied on by the defendant are examined, the entire basis for defendant’s call is questionable. Given that the plaintiff has completed the subcontract works with the issuance of the CPC held up as testament of its successful completion of the subcontract works; that there were no CNC issued; that there were no complaints from the defendant; that remedial works have been done and are ongoing during the DLP; that Wagner Piano’s action has been withdrawn without any of the parties reserving their right to claim from the plaintiff; that the warranties and Form G were not required at this point in time; the only reasonable inference that can be drawn of a call made two weeks before it expires; is one of unconscionability. The plaintiff has added that “only reason as to why the defendant issued the demand on the said performance bond at this juncture … is because of the plaintiff’s refusal to share the costs of rectification of Wagner Piano’s premises as requested by the Employer”. There is every basis for such a suggestion.”

In the Court of Appeal case of Target Resources Sdn Bhd v Thp Bina Sdn Bhd [2019] MLJU 266, Hasnah binti Mohammed Hashim J held the Defendant in calling on the Performance Bond has acted unconscionably and therefore barred the call. The Defendant engaged the Plaintiff as the contractor to carry out works for the construction of a building and in return, a Performance Bond was provided by the Plaintiff. Parties had a dispute which led to the termination of the contract but nevertheless, the Defendant requested for the Plaintiff to renew the Bank Guarantee.

The Defendant agreed that it would not make a demand on the Bank Guarantee provided that the Plaintiff renews the Bank Guarantee. However, the Defendant decided to go back on its words and made a demand despite the validity period of the Bank Guarantee being successfully extended. The Court held as follows: -

“[32] The Defendant through its letter dated 27.11.2017 had made it clear that it was prepared to grant indulgence whilst waiting for the Plaintiff to renew the Bank Guarantee. Despite having given such assurance the Defendant proceeded to make a demand even after the Bank Guarantee was extended to 5.1.2019. The Plaintiff had no notice of the deadline of 28.11.2017 for the renewed Bank Guarantee to be procured as they were not given a copy of the letter to MBB nor were they notified by the Defendant. The Defendant on 27.12.2017 had written to MBB complaining that the renewed Bank Guarantee did not comply with the requirements of the Defendant as it was not on the same terms as the first Bank Guarantee. This letter was, however, also not copied to the Plaintiff.

[33] The Defendant had made the demand after the Plaintiff had extended the Bank Guarantee clearly illustrates the lack of bona fide on the part of the Defendant. The call on the Bank Guarantee when the Defendant had given indulgence to the Plaintiff can be construed as unconscionable. We are of the view that any discussions or negotiations on the terms of the Bank Guarantee should necessarily involves the Plaintiff. The lack of notice to the Plaintiff calls into question the conduct and the conscionability of the call by the Defendant.”

To conclude, Performance Bonds that are on-demand and unconditional in nature afford wide discretion and latitude to the beneficiary in making a call on the Performance Bond. Even so, the willingness of the Court in recognising “unconscionability” as a ground, in addition to fraud, to prevent beneficiaries from calling on the Performance Bond shows the attempt of the Court in ensuring that such freedom is not to be abused by the beneficiary. Be that as it may, it is important for parties to be aware that the exception of unconscionability is only relevant in cases where the party is seeking to refrain the beneficiary from making a demand on the Performance Bond. The exception does not stretch to include situations to restrain the Bank from making payment out on a Performance Bond to the beneficiary.

In the next article, we will examine the circumstances in which the Court has held that certain conducts of the beneficiary in calling the Performance Bond do not constitute unconscionable.