Stopping the Call on Performance Bonds

A performance bond serves as a guarantee to a beneficiary for the performance of contractual obligations owed by a third-party. Performance bonds are widely adopted in the construction industry, whereby the third-party subcontractor (a person hired to do the work) provides a performance bond (typically in a bank guarantee) to guarantee their performance. The performance bond gives financial security to the beneficiary main contractor if the subcontractor’s non-performance occurs. If default occurs or breach of contract by the subcontractor, the main contractor may claim the money from the bank guarantee. This claim is known as a “call” on the performance bond.

A main contractor may sometimes threaten to call on the performance bond for reasons disputed. The subcontractor may get a court order to restrain the main contractor from making a call on performance bond. An injunction may be granted if the applicant can demonstrate either fraud or unconscionability.

Fraud

In the past, fraud was viewed as the only ground in which one could obtain an injunction to restrain a call on a performance bond.

In 2000, the Court of Appeal in LEC Contractors (M) Sdn Bhd (Formerly Known As Lotteworld Engineering & Construction Sdn Bhd) v Castle Inn Sdn Bhd & Anor [2000] 3 MLJ 339 refused to grant an injunction against the bank to make payment on an on-demand performance bond as “all that was required to trigger them (on demand performance bond) was a demand in writing”. It was found that a proper demand had been made and the bank had to pay the main contractor the amount stated in the bond. Injunction was refused as fraud was not pleaded.  The court was adamant that to justify any injunction to stop payment, there must be clear evidence of fraud by the defendant which came to the knowledge of the bank.  Bad faith or unconscionable conduct is not fraud.

(NB: LEC Contractors must be viewed in light of its facts – it involved an application to restrain the bank/issuer from making payment on an on-demand bond. It did not involve an injunction to restrain the beneficiary from making a demand on the bond.)

Unconscionability

In recent years, Federal Court case Sumatec Engineering and Construction Sdn Bhd v Malaysian Refining Co Sdn Bhd [2012] 4 MLJ 1 recognized unconscionability as a valid ground for courts to grant an injunction. Even though clear guidelines on what constitutes unconscionability in relation to calls on performance bond have not yet been forthcoming, the court provided that ‘the concept of unconscionability involves unfairness, as distinct from dishonesty or fraud, or conduct so reprehensible or lacking in good faith that a court of conscience would either restrain the party or refuse to assist the party’.

A lack of good faith (bona fide) will also play into the court’s consideration in such matters, although the court clarified that it is determined case-by-case in that “what kind of situation would constitute ‘unconscionability’ would have to depend on the facts of each case”.

Besides lack of good faith and moral reprehension, the Court of Appeal in Kejuruteraan Bintai Kindenko Sdn Bhd V. Nam Fatt Construction Sdn Bhd & Anor [2011] 7 CLJ 442 added that the pre-requisite is the plaintiff must have a strong prima facie case of unconscionability against the defendant. Unconscionability may be proven if a defendant sought to obtain unjust enrichment through unconscionable conduct.

Recently, another Court of Appeal case KNM Process Systems Sdn Bhd v Lukoil Uzbekistan Operating Company LLC [2020] MLJU 85 applied the test of unconscionability. Based on the facts, various reasons were cited as “unconscionable” by the respondent. The court granted an injunction to restrain the call of the performance bonds pending arbitration. The allegations made by the appellant against the respondent included:

  1. The respondent issued simultaneous demands on 3 guarantees, one of which was a conditional demand bond;
  2. The calls did not comply with the terms of the main contract;
  3. The call was only available upon termination, which did not arise in the case;
  4. The respondent showed there was no objective entitlement on its part to make a call on the guarantees and that the respondent knew that it could not make the call;
  5. The respondent had agreed that following multiple extensions of the Warranty Guarantee, there would be no further extensions and the Warranty Guarantee would be returned to the appellant;
  6. The simultaneous calls on the guarantees issued were made under 2 unrelated and independent contracts.

The Court held:

“Absence or “lack of good faith” has long been accepted as a basis to restrain a beneficiary from calling a bond or guarantee… We are of the view that the above circumstances display a seriously arguable and realistic inference case of want of good faith on the part of the respondent such that an interim injunction restraining the respondent’s substantive rights is warranted.”


Key takeaways

The position of Malaysian courts in restraining a main contractor’s right to call on performance bonds has shifted over the years. The criteria has been extended to include unconscionability of the defendant, thus giving the courts more flexibility to inspect the “unconscionable behaviour” of the defendants. There is no concrete delineation of what constitutes unconscionable acts, which turns this into a question of fact which requires the court to look into the facts of each case individually.

Before calling on a performance bond, there should be a proper examination on the performance bond and the main contract between the parties. If contractual conditions must be met before a bond can be called, the party seeking to call on the bond must meet all those conditions, failing which their call may be considered unconscionable. A party seeking to call on the bond should also know how its behaviour may be construed – for example, pressuring or threatening the other party to extend the bond.

Material facts of the case may be significant to the court’s deliberation in granting an injunction, although the plaintiff must first prove that they have a strong case against the defendant and that the action of the defendant lacked good faith.

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This article was written by Donovan Cheah with assistance from Tiffany Chin (Intern). Donovan is an Advocate and Solicitor of the High Court of Malaya. He is a Fellow at the Singapore Institute of Arbitrators and the Malaysian Institute of Arbitrators. He is also a registered foreign lawyer with the Singapore International Commercial Court.  

 Donovan & Ho is a law firm in Malaysia. Our practice areas include employment law, dispute resolution, tax advisory and corporate advisory.  Have a question? Please contact us.

 

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