In ‘Performance Guarantee Bond on Demand’: Underlying Contract Shall Not Affect the Guarantor’s Duty to Comply
On-Demand Guarantees Must Be Paid, Fraud the Only Exception- SC
Reinforcing the autonomy of on-demand guarantees, the Supreme Court held that such performance bonds must be honoured by guarantors—typically banks or insurance companies—without reference to the underlying contractual disputes, save in exceptional cases such as fraud. This judgment reaffirmed that these instruments are crucial to international and commercial transactions, and to protect commercial confidence.
While acknowledging the general rule of autonomy, the Court also considered the narrow exceptions where such obligations may be refused, notably in instances of fraudulent claims.
The case before the Court involved an insurance company that had issued a performance guarantee bond on demand, securing the obligations of a contractor undertaking a fuel tank farm project. When the contractor defaulted, the beneficiary of the bond submitted several written demands under the guarantee. The insurer refused payment, triggering litigation.
One of the central issues was whether the demand made by the beneficiary complied with the formal requirements of the bond. The insurer argued that the initial demand was invalid as it was a faxed copy without a signature. However, the Court noted that the insurer had acknowledged receipt of the document and engaged in correspondence regarding it. This, the Court held, rendered the question of authenticity moot. Subsequent written demands were also valid and unambiguous, further confirming the beneficiary’s entitlement to claim.
Another major contention raised by the insurer was that the contractor named in the written contract differed from the one named in the performance bond. The insurance company argued it had guaranteed one entity’s performance, but the contract was executed with a related entity. The Supreme Court, consistent with the High Court’s findings, rejected this argument. It accepted that while the written agreement was with one company, the actual project work was performed by the company named in the bond—a fact acknowledged by both entities in related legal proceedings.
The Court also highlighted a crucial clause in the performance bond that significantly undermined the insurer’s position. The bond explicitly permitted changes or modifications to the underlying contract—including who performed the work—without requiring notification to or consent from the insurer. This clause, the Court ruled, prevented the insurer from arguing that its liability was discharged due to changes in the contractual arrangement.
In deciding whether the insurer was liable under the on-demand performance guarantee, the Supreme Court emphasized that two key requirements must be satisfied: first, that the beneficiary has made a valid demand in accordance with the terms of the guarantee; and second, that the guarantor (in this case, the insurer) has a clear obligation to pay. The Court noted that while the insurer initially disputed the validity of the demand—citing issues such as the signature on the letter—the fact that the demand was acknowledged and not challenged for authenticity removed that objection.
The Court also affirmed that the insurer could not escape liability by pointing to the absence of a direct contract between the beneficiary and the named contractor, as the guarantee itself did not require a written contract and even expressly waived the necessity for the insurer to be notified of any changes or modifications in the underlying agreement.
“…It is well established that if the beneficiary seeks payment in accordance with the terms of an on-demand payable performance bond, the bank must pay regardless of how “unfair” such claim might be to the principal at whose request the bond was issued. As a general rule the bank will not be concerned with the rights or wrongs of any underlying dispute between the beneficiary and the principal, or with the factual accuracy of the statement made by the beneficiary or the genuineness of any document presented in order to obtain payment…”
“…The position therefore is that where the bank has clearly undertaken to pay on demand, and where the claim is in conformity with the requirements of the bond, it must do so without demur. While it is not open for the bank to refer to any underlying dispute between the beneficiary and the principal, the bank must also not go in search of reasons to justify any refusal to pay. After all, it is an instrument that the bank has willingly issued and it must honour its word. However, Courts do recognise that banks can refuse to honour a demand where such a demand is fraudulent. In the absence of fraud on the part of the beneficiary who is making the claim which may include any misrepresentation on the part of the principal that induced the bank to issue the guarantee in the first place, the bank’s obligation to pay under the guarantee against presentation of the demand and where stipulated, any documents, is absolute….”
“…an on-demand performance guarantee is similar to letters of credit and thus, must be accorded the same sanctity afforded to letters of credit, as they are the lifeblood of international commerce. I have also stated that any dispute between the parties to the underlying contract shall not affect the obligation of the bank to honour a claim under such a guarantee, and that probably the only exception is where the bank is able to establish that a demand is fraudulent….” – Justice Arjuna Obeyesekere
Case No: SC/CHC/Appeal No: 52/2007 (Decided on 25.02.2025)
Before: Murdu N. B. Fernando, PC, CJ E.A.G.R. Amarasekera, J Arjuna Obeyesekere, J
