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Performance bond issues

Jonathan Brown examines the decision in Aviva Insurance Limited v Hackney Empire Limited which concerned the effect and extent of a performance bond issued by Aviva to guarantee obligations of the contractor on the Hackney Empire theatre refurbishment.

Aviva Insurance Limited v Hackney Empire Limited

Performance bonds are an essential part of the construction industry. Yet their operation and the law in relation to them remains unclear to many, not least because of the dearth of case law on them. The case of Aviva Insurance Limited v Hackney Empire Limited therefore throws some welcome light on this important feature of the construction world.

The case involved the renovation of the Hackney Empire theatre, which fell into substantial delay during the course of the works. The Employer, Hackney Empire Ltd (“HEL”), blamed the contractor, Sunley Turriff Construction Ltd (“STC”), for the delays. STC blamed HEL, citing the number of variations. As the delays increased, and in an effort to “park” who was responsible for the delays until the works were complete, HEL and STC entered into a side agreement whereby HEL would pay to STC the sum of £1m in instalments on account of STC’s contended delay costs, albeit on the understanding that this sum would be repaid if STC were subsequently unable to establish such delay costs.

STC failed to finish the works by the completion date, and went into administration. By that stage, HEL had paid £750,000 to STC.

HEL engaged another contractor to complete the works, which increased the project costs substantially. HEL therefore made a claim against STC’s bondsman, Aviva, for the full bond amount of £1.1m. Aviva refused to pay, saying that it had been discharged from liability under the bond by reason of HEL’s extra-contractual payments of £750,000.

The Court of Appeal affirmed the principle that if an Employer pays sums under a building contract before they fall due then, absent consent from the surety or an “indulgence clause” in the bond permitting the Employer to act accordingly, those advance payments could discharge the surety from liability. This is on the basis that, whilst such advance payments might be made to a contractor to assist and encourage them to complete the project, they can ultimately lead to the surety being prejudiced. First, the incentive on the contractor to complete is reduced because less of the contract sum remains to be earned. Second, the Employer will hold less retention money for the purpose of paying another contractor to complete the works if the first contractor defaults. Accordingly, it becomes more likely that the Employer will suffer a loss and call on the bond.

However, the significant point to the Court of Appeal was that, in this instance, no advance payments had been made under the building contract. The sum of £750,000 had been paid under the side agreement instead. The Court said that Aviva had no liability in relation to the £750,000 because it concerned a separate contract entered into after the bond had been agreed. However, Aviva’s obligations in relation to the building contract had not been prejudiced by the side agreement, and therefore remained. Accordingly, Aviva was not discharged from liability under the bond.

This case raises the perennial problems faced by an Employer when a contractor is experiencing financial difficulties. Should the Employer prop up the contractor’s ailing finances with advance payments under the building contract in the hope that the contractor can reach the end of the project? Or should the Employer let the contractor go under and engage an alternative contractor, with all the risks and problems that that entails? Neither is an attractive option. The bottom line is that an Employer must always remember that if it decides to make advance payments under a building contract, it is running a risk that any surety will be able to avoid liability if the gamble does not pay off.

Contact

For further information please contact Jonathan Brown, Senior Associate on +44 (0)20 7220 5218 or email jonathan.brown@dwffishburns.co.uk

By Jonathan Brown

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This information is intended as a general discussion surrounding the topics covered and is for guidance purposes only. It does not constitute legal advice and should not be regarded as a substitute for taking legal advice. DWF is not responsible for any activity undertaken based on this information.

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