The Performance Bond is called with a demand served by the beneficiary to the guarantor in order to receive the payment of the amount stated in the demand itself and within the cap set by the bond. On the one hand, it is true that such guarantee, if used fairly, represents a good protection for the beneficiary, on the other hand, there are various situations where the bond is used unlawfully.

In particular, we refer to all those cases in which the calling is considered as 'abusive' or 'fraudulent'.

Let's try to understand when a calling is unlawful and in which circumstances the payment of the Performance Bond can be stopped with specific reference to Italian Law.

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In its standard form, the Performance Bond is an autonomous on-demand guarantee and its features allow the beneficiary (for example, the purchaser/owner) to have an almost immediate remedy against the defaults of the applicant (for example, the seller/contractor) because:

  • its payment can be requested to the guarantor without having to prove the actual default of the applicant; and
  • its payment can be obtained notwithstanding any objection based on the underlying contract which the applicant itself or the guarantor may raise (for example, the sales contract or the works contract).

However, this does not mean, that the performance bond

can be called in any case and

at the sole discretion of the beneficiary.

There are some cases in which the payment demand is 'unlawful' and the beneficiary is not entitled to receive the payment of the bond or, to be more accurate, the payment of the performance bond would allow the beneficiary to obtain an unfair benefit.

In particular, there are the cases in which:

  1. the conditions of the bond calling as stated by the text of the performance bond were not met; or
  2. the contract has been correctly fulfilled.

In general terms and as mentioned above, it can be said that the calling is unlawful when the payment of the bond would allow the beneficiary to obtain an unfair benefit, but it is necessary to understand when a calling can be considered as abusive and fraudulent.

  1. Failure to comply with the conditions of the bond calling

We have seen that, even if the performance bond is usually an autonomous on-demand guarantee, its text set out some conditions to be complied with for the calling (for example, the means by way of which the bond is called such as SWIFT message or authenticated signature).

At the same time, there are performance bonds which, despite being in the form of an autonomous guarantee, provides for a 'documented demand' clause or a 'justified demand' clause.

We have dedicated a specific article to the differences between an on-demand bond, a documented demand bond and a justified demand bond.

By way of example, the bank may reject the payment:

  • when the performance bond states that the demand must be submitted following a warning letter to be sent to the applicant which requires fulfilment of the obligations, but de facto  this warning letter has not been sent or has not been attached to the calling letter;
  • when the performance bond states that the demand must indicate in detail the defaults that justify the request of payment, but de facto  the calling letter does not contain any indication in this regard;
  • when the performance bond states that the demand must be accompanied by the declaration of an independent third party who 'certifies' the occurrence of defects and such declaration has not been attached;
  • when the demand is served after the expiry date of the performance bond.

In nutshell, these are all cases of the calling made in breach of the performance bond's provisions (and exactly, in breach of the terms and conditions of the performance bond itself).

In these cases, we talk about the abusive calling.

  1. The underlying contract was correctly fulfilled

If it is true that the performance bond secures the beneficiary from the default of the counterpart, it is correct to say that, in case of the correct fulfilment of the contract, the performance bond has no longer reasons to exist or, in any case, completes its function.

In such case, the demand for payment must be rejected.

At the same time, the payment may be rejected if the default is due to force majeure or to a fact attributable to the beneficiary itself.

In these cases, we talk about the fraudulent calling (by referring to the bad faith of the beneficiary of the bond which called it knowing that it was entitled to it).

However, a clarification is necessary: in all those circumstances in which the exact fulfilment of the contract is objected on genuine basis (and based on documentary evidence), unlikely the payment of the bond can be rejected.

Let's give some examples:

  • in a sales contract, the seller states that the goods have been delivered on time and in compliance with all contractual conditions, but the purchaser objects that the goods are defective; or
  • in a works contract, the owner has notified to the contractor the default as the built plant does not achieve the guaranteed performances (the plant has been completed but not in full compliance with the contractual conditions).

And so, in these circumstances, the bank will unlikely refrain from paying precisely because the correct fulfilment of the contract is not sufficiently clear (but, indeed, it is genuinely disputed).

It is often difficult to identify whether a calling was fraudulent or not, because in international contracts (think about the works contract for construction of plants), it is often difficult to clearly identify whether the fulfilment was carried out correctly or not, on time and in full compliance with the contractual conditions.

  1. Consequences

Hence:

  • on the one hand, there are circumstances entitling the bank to reject the payment for issues that are strictly related to the performance bond,
  • on the other hand, there are circumstances entitling the bank to reject the payment for issues that can be related to the underlying contract.

However, this does not mean at all that the performance bond is linked to the underlying contract (we are talking about an autonomous guarantee) but only that in serious circumstances, the bank may reject the payment on the basis of events deriving from the underlying contract which have been duly documented by the applicant (the supplier/contractor).

For better understanding of such difference, it is useful to clarify that:

  • in cases of the calling which is in breach of formal requirements as stated in the performance bond, it will be the bank itself (in total autonomy) to reject the payment;
  • in cases of the calling based on fulfilment of the contract, the bank may reject the payment only upon instructions of the applicant (i.e. the party who has materially fulfilled the contract) as only the applicant is able to provide the bank with such facts.

A further consideration is necessary: it is often believed that the performance bond calling (as well as any other autonomous guarantee) is a matter only between the purchaser/owner and the supplier/contractor.

However, we must always remember that during the calling process the bank-guarantor has certain obligations to comply with too and, in particular, the obligation not to pay (without any need for instructions from the applicant) if the calling is manifestly unlawful.

If the calling is manifestly abusive or fraudulent, the payment of the performance bond should be rejected by the bank without any previous action by the applicant.

  1. Conclusion

The sole fact that the performance bond is an autonomous on-demand guarantee does not mean that it must always be paid under any circumstances.

There are circumstances upon occurrence of which the bank itself (without any need for instructions from the applicant) must reject the payment but also other circumstances upon occurrence of which the applicant can obtain that the bank rejects it.

It is always the matter of detailed analysis regarding the factual circumstances related to both the underlying contract as well as its fulfilment and the calling (or threat of the calling) of the performance bond.

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.