At its heart, a surety bond is a simple thing: a promise to pay money on demand, usually issued by a major insurer. But, especially when millions of dollars are at stake, even such a simple promise can be the subject of a dispute.

Surety bonds are especially common in the construction industry. Where a contractor is required to provide cash security under a contract, they may instead offer a surety bond, which the principal can convert into cash if the need ever arises. This keeps cash flow free for the contractor, while giving the principal the right to immediate cash in the event of default (in which case, invariably, the contractor will be under an obligation to immediately reimburse the bond issuer).

Sometimes, a contractor will dispute their principal’s right to convert surety bonds into cash and may seek court orders restraining the principal from calling on those surety bonds.

However, by way of two recent judgments the Courts have confirmed their unwillingness to block calls upon surety bonds, thereby preserving their commercial value as a near-equivalent to cash security.

Duro Felguera Australia Pty Ltd v Samsung C&T Corporation [2016] WASC 119

In this case, Duro contracted to perform work for Samsung at a mine in Western Australia. As security for the performance of Duro’s work, Samsung was given surety bonds totalling (to the extent relevant) approximately $76million.

A dispute then broke out between Duro and Samsung. Samsung claimed Duro was liable to pay it over $100 million as damages for delays and defective works, while Duro denied Samsung’s claim and instead claimed that Samsung had failed to pay for work performed by Duro.

The dispute was initially referred to adjudication, which resulted in awards in Duro’s favour totalling about $70million. Samsung challenged those awards and also gave notice of its intention to call on Duro’s surety bonds.

Duro applied to restrain those bond calls, arguing that the calls should not be allowed in circumstances where Duro had a prima facie right to be paid $70 million. However, the Supreme Court of Western Australia refused to intervene, finding that any interference with the bond calls would be inconsistent with their purpose, which was to put the cash flow risk during any dispute upon Duro rather than Samsung.

Simic v New South Wales Land and Housing Corporation [2016] HCA 47

In this case, a contractor (Nebax Constructions) contracted to perform work for the New South Wales Land and Housing Corporation (the Corporation). The performance of that work was to be secured by surety bonds, though in a mix-up the bonds actually obtained were made out to a differently-named non-existent entity.

When Nebax ran into financial difficulty and the Corporation made calls upon the surety bonds given to it, Nebax’s directors (who had given guarantees in respect of the bonds) argued that the Corporation could not call upon the bonds because it was not the beneficiary named on them.

The High Court, after noting that the commercial purpose of a surety bond is to "provide an equivalent to cash", decided that even if the Corporation had no right to call upon the bonds as they were drafted, as the intention of all parties was to provide security to Nebax Constructions’ principal (being the Corporation) the bonds could be "rectified" by order so as to read as if the Corporation had always been the named beneficiary. The Court made such an order and the Corporation was entitled to its payment.

As good as cash (almost)

Both of these cases further confirm the worth of surety bonds, in that a bond call will not be prevented except in the most extreme circumstances.

That is not to say that principals and contractors should not obtain advice regarding anticipated calls upon surety bonds. Principals can be prevented from making calls upon bonds in some circumstances (for example, if they have entered into a contract that puts conditions on their right to make such calls) and must ensure that any call they do make strictly complies with the terms of the bond.

For more information, please contact Stephen Polczynski or Dajana Malnersic on 02 9234 1500.