Making Demands on Advance Payment Guarantees and Performance Bonds – the “fraud exception”

by Karen Gough

The general principle is that subject only to the “fraud exception” claims for payment under Advance Payment Guarantees (“APGs”) and Performance Guarantees or Bonds (“PGs”) should be met on demand. The Courts have not been kind to those resisting payment, even when the claims are doubtful, potentially dishonest and/or clearly overstated.

The case of R.D. Harbottle (Mercantile) Limited v National Westminster Bank Limited and Others [1977] 1 WLR 752 concerned guarantees by sellers, confirmed by banks, in favour of buyers. The amount secured was payable on the buyers’ demand. The sellers had provided cross indemnities in very wide terms to the banks, enabling the banks to deduct any payments made from their account; the bank’s demand being conclusive evidence of the sum due.

The buyers demanded payment from the banks (Nat West and others) but the sellers contended that there was no justification for the demands and made an application to the court seeking declaratory relief to that effect and also applied for injunctions restraining the banks from paying, and the buyers from demanding payment, under the guarantees. On an interim basis, the Plaintiffs secured ex parte injunctions against the banks.

Nat West applied successfully to have the injunction against them discharged. Kerr J (as he then was) explained the rationale behind the Court’s approach to such cases:

“It is only in exceptional cases that the courts will interfere with the machinery of irrevocable obligations assumed by banks. They are the life blood of international commerce… Except possibly in clear cases of fraud of which the banks have notice, the courts will leave merchants to settle their disputes under the contracts by litigation or arbitration as available to them or stipulated in the contracts. The courts are not concerned with their difficulties to enforce such claims; these are risks which the merchants take.” [at p.761]

Kerr J was also the judge at first instance in the Edward Owen Engineering case . In the Edward Owen case the Court of Appeal approved Kerr J’s decision in Harbottle and held that a performance bond stood on a similar footing to a letter of credit and that a bank giving such a guarantee must honour it according to its terms unless it had notice of clear fraud. (see Denning MR at p.169 and 171)

In Edward Owen, Denning LJ referred to the authorities concerning letters of credit and cited the American case of Sztein v J. Henry Schroder Banking Corporation (1941) 31 NYS 2d 631 heard in the New York Court of Appeals. In that case the Court had upheld a challenge on the basis that the bank had knowledge of the fraud prior to the presentation of the documents for payment. Shientag J said:

“…where the seller’s fraud has been called to the bank’s attention before the drafts and documents have been presented for payment, the principle of the independence of the bank’s obligation under the letter of credit should not be extended to protect the unscrupulous seller.”

In his judgment in Edward Owen Lord Denning described a performance bond as a “new creature” (ibid at p.169A), and he concluded that:

“the performance guarantee stands on a similar footing to a letter of credit. A bank which gives a performance guarantee must honour that guarantee according to its terms… The only exception is when there is a clear fraud of which the bank has notice.” (ibid at p. 171)

As far as fraud was concerned, Lord Denning confirmed that it was not enough simply to allege fraud, it had to be established. In fact it had to be, “very clearly established.”

These cases, decided thirty years ago, established the “fraud exception” as a principle in English law. Lord Denning’s statement that any fraud must be “very clearly established” for the exception to operate has been recognised and applied consistently since that time as recognised in the case of Enka Insaat ve Sanayi AS v Banco Popolaire Dell’Alto Adige SPA; Enka Insaat ve Sanayi AS v Cassa Di Risparmio Di Bolzano SPA [2009] EWHC. Teare J noted the consistency of tribunals post “Edward Owen” when faced with this issue:

In Turkiye Is Bankasi AS v Bank of China [1996 2LLR 611, Waller J held (and was approved by the Court of Appeal):

“That passage identifies the difficulty that a plaintiff has in succeeding in stopping payment on a performance bond. He may show an arguable case that the demand is not honest, but that it not sufficient. He must also establish that: “the only realistic inference is that the demands were fraudulent.”” (P.616)

Rix J looked at the same issue in another way in the case of Czarnikov-Rionda v Standard Bank [1999] 2LLR 187:

“However the fact that the claimant gets the benefit of a lower standard of proof for the purposes of a pre-trial hearing, places on the Court, as I believe the cases demonstrate, an additional requirement to be careful in its discretion not to upset what is in effect a strong presumption in favour of the fulfilment of the independent banking commitments.” (p.202)

In Solo Industries v Canara Bank [2001] 1WLR 1800, Mance LJ cautioned the court against allowing any dilution of the presumption in favour of upholding independent banking obligations. Equally in Banque Saudi Fransi [2007] 2LLR 47, Pill LJ noted that the task of demonstrating a “real prospect” that at trial it could be proved that the beneficiary calling the bond could not honestly have believed in the validity of the demands was “a high hurdle, as the authorities in my judgment recognise.” (p.55)

In Enka the Court had little difficulty in concluding that the “fraud exception” while alleged, had come nowhere close to being proved sufficiently even to meet the “real prospect” test necessary to obtain leave to defend an application for summary judgment. The case is of course decided on its own facts but it is interesting to note that the Court required only that the beneficiary should have held the belief that there had been breaches of the contractual obligations of the sub-contractor. The Court held that upon the true construction of the APG and PG there was no necessity for there to be any causal connection between the allegation of breach against the sub-contractor and the amount of the sums claimed.

In arriving at his construction of the guarantees Teare J was keen to emphasise that it was necessary to bear in mind the nature of performance guarantees or bonds as explained in the authorities. In particular, in Cargill International v Bangladesh Sugar and Food Industries Corporation [1996] 2 LLR 524, Morison J said, when considering an application for an injunction to restrain a call on a bond;

“However, it seems to me to be implicit in the nature of a bond, and in the approach of the Court to injunction applications, that, in the absence of some clear words to a different effect, when the bond is called, there will, at some stage in the future, be an “accounting” between the parties in the sense that their rights and obligations will be finally determined at some future date. The bond is not intended to represent an estimate of the amount of damages to which the beneficiary may be entitled for the breach alleged to give rise to the right to call.” (p.528)

When read in that context the Court had no hesitation is dismissing the claim of fraud on the basis that when the calls on the guarantees were made there was no obligation on Enka to state that it had an honest belief that it had suffered damage in the amount claimed under the PG, or that it was entitled to payment equal to the sums demanded under the APG. On a true construction of the guarantees, there needed only to be an honest belief in the allegation of a failure on the part of the sub-contractor to fulfil its obligations under the sub-contract. The fact that the loss was not as much as the value of the guarantees, or indeed even if it could be shown there was no loss, was immaterial to the bank’s obligation to pay . In order to avoid the obligation to pay, the banks had to show that the only realistic inference was that when the demands were made, Enka could not honestly have believed in the validity of their demands.

What the authorities here demonstrate is that while the fraud exception is an established part of English jurisprudence, which in principle gives rise to a right to avoid payment of a demand on a performance bond, in practice it seldom operates successfully so to do.

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