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The Facts

Hackney Empire Limited (鈥淗EL鈥�) owns the Hackney Empire Theatre in East London. It engaged Sunley Turriff Construction Limited (鈥淪TC鈥�) to carry out extensive refurbishment to the theatre.

Aviva Insurance UK Limited (鈥淎viva鈥�) issued a bond in favour of HEL for 拢1,106,852 to secure STC鈥檚 performance under the building contract.

The refurbishment work did not progress well and fell into delay which STC alleged was a result of the architect鈥檚 instructions. STC then submitted a loss and expense claim which the quantity surveyor maintained was unsupported.

However, at a meeting between the parties it was agreed that HEL would pay 拢1m (in instalments against a revised programme) 鈥渙n account鈥� of STC鈥檚 claims pending the provision of proper particulars.

A side agreement was entered into in this respect which expressly provided that the payments were to be 鈥渙n account鈥� of STC鈥檚 claims. Some 拢750,000 was paid to STC but before the final instalment was paid STC went into administration. HEL then determined STC鈥檚 employment under the building contract and demanded repayment of the 鈥渙n account鈥� payment. HEL then engaged other contractors to complete the work.

HEL made a claim against Aviva for the full amount of the bond.

The Issues

The issue was whether HEL鈥檚 agreement to make payments to STC 鈥渙n account鈥� effectively varied the building contract was prejudicial to Aviva鈥檚 position such that Aviva was discharged from the bond.

The Decision

This is an appeal from Mr Justice Edward-Stuart鈥檚 first instance decision in the TCC of 21 September 2011. In that decision the judge held that the payments to STC were made under a separate free standing agreement that did not vary the building contract, except in two immaterial respects. Aviva sought to rely on the rule in Holme vs Brunskill under which a surety may be discharged from liability where variations are made to the underlying contract without the consent of the surety. The judge then considered whether HEL鈥檚 conduct was prejudicial to Aviva such that it would discharge Aviva from liability under the bond. He held that it was not (but did so the basis of a test he had formulated himself).

Aviva appealed on grounds that the judge had applied the wrong legal test and that, on the basis of the correct test, Aviva should be discharged from any liability. Aviva acknowledged that there had been no variation of the building contract and so the rule in Holme vs Brunskill did not apply.

Having reviewed the authorities, Lord Justice Jackson held that the correct principles to be applied are:

• The rule in Holme vs Brunskill only applies where the parties to the underlying contract have varied the terms of that contract without the consent of the surety
• Advance payments of the contract price made by an employer to a contractor may have the effect of discharging the liability of the surety. On the other hand, additional payments (whether by gift or loan) made by the employer to a contractor outside the terms of the original contract do 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 these principles, Lord Justice Jackson held that the 拢750,000 was a loan to STC. The basis of the agreement between HEL and STC was that if STC could substantiate a loss and expense claim then it would retain the value of that claim from the 拢750,000. Equally, if STC could not substantiate its claim then the money would be repaid to HEL. Lord Justice Jackson noted that the 拢750,000 did not form part of the original contract sum and was not a sum certified by the architect. Aviva was therefore not discharged from the bond but Aviva鈥檚 liability did not extend to cover any failure by STC to repay the 拢750,000. It followed that Aviva鈥檚 liability was limited to losses caused by STC under the building contract).

Comment

It is not uncommon for payments to be made to contractors 鈥渙n account鈥� pending full substantiation of a claim. In this case the parties documented the position by way of the side agreement and this was a key element in the judge鈥檚 finding that that the money was not an advance made under the contract but an arrangement outside of the main contract. But how often do the parties document the arrangement? In light of this case employers and contractors finding themselves in similar circumstances should try to obtain the express consent of the surety and/or document the arrangement such that there can be no doubt that any payment is made outside of the main contract. This should not be necessary if the bond includes an indulgence clause that expressly covers 鈥渙n account鈥� payments.