The Performance Bond is a guarantee by means of which the purchaser or the owner secure the risk of the default of the counter-party (the supplier or the contractor). In case of default, the purchaser will obtain a sort of indemnity from the subject who issued the bond (usually a bank, called also the ‘guarantor’).

***

Let's see first how a Performance Bond works in practice.

In an international sales contract, the purchaser (for example, an English company) undertakes to purchase a certain quantity of goods to be manufactured and supplied by a supplier (for example, an Italian company). The purchaser will ask the supplier to have a performance bond issued by a bank, i.e. a guarantee of good performance of the contract, so that, in case of the supplier's default, the purchaser, instead of starting a long and costly dispute to obtain the compensation for the suffered damages, will obtain a prompt payment from the guarantor without the need to prove the actual default of the supplier.

This is the basic structure which, in normal conditions, will allow the buyer to obtain a fair and quick compensation for damages suffered due to the default of the supplier.

In other words, the performance bond itself represents a mechanism created to simplify commercial transactions (especially, international transactions) so that the purchaser can have an instrument that allows him to quickly recover the suffered losses. With the coverage of the performance bond, the purchaser will be incentivised to buy goods from a supplier who lives in a different country.

It is important, however, that the Performance Bond is not used unlawfully by the purchaser.

***

If, based on what we have said so far, everything seems very simple, in reality the Performance Bond may have some risks since it can be potentially used improperly.

***

It must be kept in mind that basically there are two types of guarantees in international trade:

• the autonomous guarantee; and
• the conditional guarantee (well-known in Italy as surety).

The autonomous guarantee is a guarantee (usually issued by a bank) which is independent from the underlying contract (in our example, the guarantee is independent from the sales contract), and which will be paid without the guarantor or the supplier being able to raise any objections related to the underlying contract. It can be said that, in a certain sense, the autonomous guarantee has its own life and, generally, is not affected by the events relating the underlying contract.

Read our detailed study on how to recognise an autonomous guarantee.

Even if the supplier has valid reasons based on the sales contract for not having carried out its supply, these reasons will not affect the bank's obligation to pay and cannot be used to prevent the bank from paying the amount of the guarantee.

When dealing with autonomous guarantee, it is necessary to make an effort to understand that the sales contract and the guarantee follow two different paths.

The conditional guarantee or surety is, instead, a guarantee intimately linked to the underlying contract (in our example, the sales contract) and follows all its events. Unlike what happens in the autonomous guarantee, the bank will be able to use any objection based on the underlying contract to reject the requested payment.

In this case, the guarantor only undertakes to execute the ‘same’ performance that the supplier did not perform (even if in the form of the payment of a certain amount of money).

The guarantor will have almost the same rights of the guaranteed party and, therefore, will be entitled to reject the payment in all those cases where the supplier was entitled not to carry out the supply.

In our example, the guarantor will be entitled to refrain from paying the sum by claiming that the supplier’s default was caused by the buyer's failure to comply with certain obligations under the sales contract.

Consequently, it is clear that what needs to be checked first is whether the Performance Bond was issued in the form of an autonomous guarantee or, instead, of a conditional guarantee. The differences are substantial and remarkable.

Especially under Italian Law, we often talk about an ‘first demand bond’ but to be precise we should talk, under Italian Law, about a guarantee with an ‘first demand’ clause. This is because the first demand clause does not characterise a particular type of guarantee but instead establishes only the  terms and conditions for calling it.

Indeed, regardless of whether the guarantee is autonomous or conditional, the first demand clause allows the beneficiary of the bond (in our example, the importer or the purchaser) to request payment with a

simple demand sent to the bank and without the need to prove -before the payment- the actual breach of the supplier.

Indeed, the purchaser can limit himself to request the payment to trigger the bank's obligation to pay.

In such case, the 'first-demand' clause works in the same way a clause 'pay now, litigate later' works.

Substantially, this means that the beneficiary can request the payment of the guarantee and the bank must pay it but has the right and is entitled to raise objections based on the underlying contract.

Read also our article on Performance bond as an on-demand guarantee.

Therefore, if the main distinction is between an autonomous guarantee and a conditional guarantee, ‘at first demand’ clause can be contained in both types of bonds.

***

This is the reason why when the importer or the owner requests the issue of an on-demand bond, it is necessary to check whether it is an autonomous or conditional guarantee and not limit yourself to the name of the bond.

***

In international practice, the Performance Bond is almost always issued in the form of an autonomous on-demand guarantee by virtue of which the beneficiary, upon the occurrence of the default, is entitled to request the payment by providing the bank with a simple request (the calling), without need to prove the default of the other party and without the possibility to raise objections relating to the underlying contract.

Upon receipt of the calling letter and subject to obligations of good faith, the bank has no duty to verify whether the alleged and declared breach has actually occurred or not and, therefore, will have only to pay (except in specific cases).

***

However, the fact, that the guarantee is autonomous (from the underlying contract) does not mean that it has no relationship with the underlying contract.

This is because, as in our example of an international sales contract, the purchaser and the supplier will be in the process of entering into (or have already stipulated) a sales contract which will contain:

• a clause that provides for the supplier's obligation to issue the performance bond;
• one or more clauses providing for the events upon the occurrence of which the performance bond can be called by the purchaser.

Both clauses must be analyzed and negotiated with the utmost care.

The clause providing for the obligation to issue the performance bond usually establishes the features that the bond must have (for example, autonomous, on-demand, issued by a bank of international standing, etc.).

The clause providing for the cases when the guarantee can be called lists the defaults entitling the purchaser to call the performance bond. It is clear how important is the careful analysis of this clause before signature of the contract.

Read here how to negotiate a performance bond.

The biggest problems arise when the sales are made on the basis of simple purchase orders (usually of one or two pages) that often regulate only the sale of goods, delivery terms and eventual INCOTERMS).

In such cases it is very rare that the purchase order establishes the events entitling the purchaser to call the bond. This grants the purchaser a wide power that could hardly be objected (in case of a ruthless purchaser).

Conclusions

Therefore, in case of the performance bond calling it is essential to:

• check whether it is an autonomous guarantee or a conditional guarantee;
• check whether it is a on-demand or documented-demand guarantee;
• carefully check what the underlying contract provides at least in relation to the events entitling the purchaser to call the performance bond.

Discover how to negotiate a Performance Bond