Italy: Performance Bond: How And To What Negotiate

In international commercial transactions, it is very common for the importer/owner to request the supplier/contractor to issue a Performance Bond (i.e., almost always an autonomous and on-demand guarantee) to be called in the event of breach of some of the contractual obligations, as agreed in the underlying contract.

In other articles we have already examined the risks associated with this type of guarantee and those deriving from the fact that it is often  /en/performance-bond-as-on-demand-guarantee" target="_blank" >an autonomous on-demand guarantee.

In this article we want to give you some practical advice on the riskiest clauses and how to negotiate them.

Usually in contracts of a certain value, the performance bond is drawn up by the purchaser or by the owner (the beneficiary of the guarantee).

In contracts of a minor value, the beneficiary often simply requests the supplier/contractor (the applicant) to have a performance bond issued by its bank.

In this case, the bond is usually drawn up directly by the bank which will almost always make use of commonly accepted international standards.

There is a standard drawn up by the International Chamber of Commerce with Publication number 758 which, except for the adjustments required for the specific case, represents a widespread standard which maintains a substantial balance between the interests of the beneficiary and the applicant.

Our suggestion is to add a clause that expressly provides that:

provided that you are familiar with how this standard works.

Pay also attention to not include clauses which may be in contrast with the above mentioned Rules (unless this is done voluntarily and any relevant practical implication has been duly considered).

The application of Rules number 758 ensures substantial security that the bond will be regulated in compliance with international standards, even if the parties omitted to include some details in their own text.

Unfortunately, in our experience, even the bonds drawn up by the banks (sometimes even those that explicitly refer to Publication number 758) may be incomplete or very generic and require careful analysis to avoid their non-conformity with the specific case.

But let's go in order and begin to see the main clauses to be considered and how to negotiate them:

• the grounds of the calling;
• the total value and any automatic reduction of the amount;
• the ways of the bond calling;
• eventual documents to be attached to the calling letter;
• the time for the payment;
• the expiry date and the deadline of the calling;
• the law applicable to the bond.

Let's see each of them and explain how they can be negotiated.

• The grounds for the calling.

As already explained in a different article, the performance bond is issued by virtue of a specific clause contained into the underlying contract (for example, supply or works contract) to allow the importer/owner to receive a certain amount of money in case of the counterparty's default.

Needless to say, if the contract provided that:

not only there would be some doubts on the validity of the clause, but also it would give almost total power to the purchaser/owner.

Especially in the international works contracts, the parties often state that the performance bond will secure not just the good performance of works but also that, once completed, it will remain in force for a certain period to secure the owner from any defects which may arise during the warranty period.

On the basis of our experience, despite this is a normal practice, it would be appropriate to avoid such provision for two following reasons:

1. first of all, because if the performance bond secures eventual defects too, the relevant clause and the performance bond itself must be drafted with particular care to reflect such change of its 'function';
2. second, it goes without saying that the guaranteed amount must be reduced for such eventual defects and this must be reflected into the draft of the performance bond.

As mentioned, based on our experience, it is advisable to state that, upon delivery of works, the performance bond would be 'replaced' by a different guarantee covering only and exclusively the defects that may arise during the warranty period (click here to discover more about the  /en/how-to-negotiate-a-warranty-bond" target="_blank" >Warranty Bond).

• The total value and the automatic reduction of the amount.

The value of performance bond represents another issue to be considered.

At the moment of issue (usually immediately after the signature of the contract), the bond must cover the risks of default for the full amount stated in the performance bond.

By way of example, we refer to a supply contract:

• of value equal to $ 100 million;
• according to which the supplier must deliver the goods in 6 months (one batch per month);
• the parties agree that the performance bond will cover up to maximum amount of 30% of the contract's value (in our example, the performance bond will be issued for an amount of $ 30 million).

In such case (but it is applicable to the works contract too) it would be reasonable to negotiate the reduction of the performance bond value proportionally and automatically upon delivery of each batch.

This is not a benefit that the purchaser/owner grants to the supplier/contractor but a legal consequence of the performance bond purpose.

A standard clause such as:

would protect the supplier from the risk that the beneficiary enforces the performance bond in its entirety even though a part of the contract has already been fulfilled.

Therefore, it is essential to state that the value of the bond will be reduced proportionally in the light the contractual performances not fulfilled yet.

• The ways of the bond calling.

It was already said that the performance bond, in its standard form, represents an autonomous on-demand guarantee.

This means that it can be called by means of a simple request that the beneficiary submits to the bank.

However, there are two aspects to be considered:

1. the form of calling (i.e. the so called 'demand');
2. the means of transmission of the calling to the bank.

1. THE FORM OF CALLING.

During the negotiations, it is advisable (after having examined the events entitling to call the bond under the contract) to state that the demand must include at least the indication of the defaults asserted by the beneficiary.

Such provision would be in favour of both beneficiary (the purchaser/owner) and applicant (the supplier/contractor).

Indeed, the obligation to indicate the asserted defaults during the calling process considerably reduces the risk of disputes because it would be immediately clear if:

• the calling is unfounded and, therefore, the beneficiary made untrue statements (and the applicant would be able to easily prove that the payment is undue); or
• the calling is well-founded and, therefore, the indication of the defaults should avoid (to the applicant in good faith) useless disputes.

We do not suggest to indicate a simple reference to the contractual clauses which the beneficiary deems have been violated but the factual circumstances representing for beneficiary a breach of the contract.

This allows, among other things, to verify if the defaults asserted by the beneficiary correspond to those indicated into the underlying contract on the basis of which he is entitled to call the bond.

2. THE MEANS OF TRANSMISSION OF THE CALLING TO THE GUARANTOR-BANK

It is useful to verify if the performance bond states the mean of delivery of the demand.

There are substantially two ways:

• delivery in electronic form (for example, SWIFT or e-mail); and
• delivery in paper form.

We advise to use the way which can ensure certainty of actual delivery and delivery date.

This is because the guarantee must be paid within a certain deadline (often few days) and it is essential to be sure at least about the delivery date to the guarantor.

Based on our experience and the most recent practice, the delivery via SWIFT message is the best way.

From our point of view, the calling delivered by the Court bailiff could be particularly difficult, but it is a valid system to ensure greater certainties in case of a possible dispute (especially if the bond does not specify the means of delivery).

For other recommendations see our article on  /en/how-to-call-a-performance-bond-under-italian-law" target="_blank" >How to call a Performance Bond in Italy.

• Possible documents to be attached to the demand.

While it is true that the performance bond is typically an on-demand guarantee that can be called on the basis of a simple request, this does not exclude that the demand must be accompanied by additional and specific documents.

For example, consider the case of the seller who has delivered goods which, upon an initial assessment, are found not to comply with the conditions of the contract or which are apparently damaged.

Therefore, it is clear that the supplier has not properly fulfilled its obligations and this would entitle the purchaser to terminate the contract and to call the performance bond.

In practice, the sales or works contracts almost always provide that, if the supplier/contractor does not correctly fulfil his own obligations, the purchaser/owner will be entitled to send a formal warning letter requiring the supplier/contractor to replace the goods (or to fix defects) within a certain period of time.

In our example, if the supplied goods are not complied with the conditions of the contract, the purchaser will send a warning letter to the supplier requiring the replacement of the goods within a certain number of days. If the supplier does not replace them, the buyer will be entitled to call the performance bond.

In this case, it is suggested to state that the beneficiary of the performance bond must attach to the demand a copy of the warning letter sent to the supplier and a declaration stating that the deadline set out therein have expired without any remediation work.

In international works contracts, it is standard practice to attach to the demand a declaration drafted by an independent party (for example, an engineer) declaring the occurrence of the default.

Let's imagine, for example, an owner who calls the bond because the erected plant is not functioning or is not able to achieve the guaranteed performances. In such cases, an independent party would not have serious difficulties in assessing that the plant is not functioning (correctly) or that the guaranteed performances are not achieved.

• The time for the payment.

The performance bond must be paid by the bank within a certain number of days.

It is clear that the beneficiary of the bond prefers to obtain the guarantee payment quickly (even in 3 or 4 days from the receipt of the calling).

The applicant, instead, has an opposite interest for the simple reason that, if there are grounds  entitling the bank to refrain from paying, he would gain more time to start all the activities necessary to prevent the payment (including the  /en/what-to-do-in-case-of-fraudulent-calling-of-the-performance-bond" target="_blank" >drafting of an eventual Court application).

Our suggestion is to state that the bank will be obliged to pay within (at least) 10 days from the date of the calling letter of the beneficiary.

However, it is also acceptable a term of not less than 5 (at least working) days.

• The expiry date and the deadline for the demand.

If, as mentioned, the performance bond secures the correct fulfilment of the obligations set out in the contract (delivery of goods, execution of a work), it is obvious that the bond will no longer have reason to exist when the supply has been delivered or the work has been completed completed.

It is standard practice to state in the bond that:

Less frequently (because it would ensure to the beneficiary an extremely strong position) it is stated that the bond will expire upon the issue of a document that the same beneficiary must issue (for example, the certificate of works completion).

Our suggestion is to state that:

It must be avoided to state that the payment of the performance bond may be required within a certain number of days after the expiry of the guarantee.

It is obvious that the beneficiary of the bond has every interest to include such clause since it would allow him to verify without haste the occurrence of eventual contractual breaches which, would allow the beneficiary "to keep in check" the applicant for more time.

• The law applicable to the bond.

In the performance bond, as well as in any other contract, particular attention must be paid to the clause governing the law applicable to the guarantee.

Usually, the beneficiary prefers that the guarantee is governed by a different law from that of the applicant. English law is often chosen (actually, it is a law which particularly suites with international commercial relationships).

It is also a standard practice that the bank issuing the performance bond chooses the applicable law.

Please also note that, if the performance bond does not provide anything in this regard, the law of the branch that issued the guarantee will apply almost automatically.

We suggest referring to a well-known law which is usually used in international trade.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.