In our March 2012 Legal Update, we reported on the English case of Hackney Empire Ltd v Aviva Insurance Ltd, in which the surety disputed liability under a bond when the contractor defaulted, because the side agreement under which liability arose, had been entered into by the employer and contractor without the surety’s knowledge.
The court held that the side agreement did not involve any material variation of the building contract and was, in any event, within the scope of an indulgence clause and that the bond was therefore still enforceable. However, it found that the obligations under the side agreement (to make advance payments on account of the contractor’s claims for extensions of time and associated loss and expense) fell outside the scope of the bond and that the employer could therefore only recover liquidated and ascertained damages under the bond, but not advance payments.
The surety subsequently appealed to the Court of Appeal on the grounds that the judge had applied the wrong test for determining whether liability of a surety under a bond should be discharged. The surety argued that on the basis of the correct test, it should be discharged from its liability. The employer accepted that the wrong test had been applied, but contended that, by reference to the correct legal principles, it was still entitled to recover under the bond. The Court of Appeal dismissed the appeal holding that:
- For the rule in Holme v Brunskill to apply (see our March 2012 Legal Update for details of the rule), there had to be a variation of the original contract without the surety’s consent.
- Advance payments of the contract price made by an employer to a contractor might have the effect of discharging a surety’s liability. On the other hand, additional payments (whether by gift or loan) made by the employer to the contractor outside the terms of the original contract did not have that effect.
- A surety will not be released from liability by reason of contractual variations or advance payments if (a) he has specifically consented to what was done or (b) there is an indulgence clause which covers what was done.
Applying the above principles, the Court of Appeal held that:
- The parties had not varied the construction contract, save in two immaterial respects and it therefore followed that the rule in Holme v Brunskill did not apply.
- The effect of the side agreement was that the advance payments made by the employer to the contractor were a loan. If the contractor subsequently substantiated a loss and expense claim, then the money paid by the employer would be retained by the contractor as payment, or part payment, of the loss and expense. If the contractor failed to establish any loss and expense claim, then it would repay the advance payments to the employer.
- The advance payments made by the employer to the contractor in this case did not therefore have the effect of releasing the surety from liability under the bond. However, the surety’s liability only related to the original construction contract and it therefore had no liability in respect of the contractor’s failure to repay the advance payments which it owed to the employer under the side agreement. The surety was however, liable for the ₤205,000 liquidated and ascertained damages due under the construction contract.