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20 March 2013
Once again, the English courts have delivered a significant decision on guarantees and the all-important distinction under English law between guarantees and indemnities or on-demand bonds.
Under a guarantee, the promise given by the guarantor is that the debtor will perform its obligations under the secured contract. If the debtor fails to do so, the guarantor is liable to the same extent as the debtor under the contract. Conversely, where security is given by way of an on-demand bond, the guarantor is obliged to pay if the debtor does not, irrespective of any dispute under the contract.
The English courts have repeatedly attempted to explain the distinction between these two forms of security. In a recent decision the Court of Appeal attempted a more simple solution by seeking to cut – or perhaps unravel – this Gordian knot.
In Wuhan Guoyu Logistics Group v Emporiki Bank,(1) Greek owners had contracted with a shipyard in Wuhan, China for the construction of two handymax bulk carriers. The contract price was payable in instalments. At the time that the dispute arose, the first instalment had been paid and the second instalment was due. The shipyard had provided a refund guarantee for each of the buyers' instalments, and the buyers' financing bank was required to provide a payment guarantee in advance in respect of each instalment to be paid by the buyers. A payment guarantee had been issued by the buyers' bank approximately four months before the shipyard demanded payment of the second instalment.
Under the shipbuilding contract, the second instalment was due upon steel cutting. When the shipyard demanded payment of the second instalment, it provided a certificate of steel cutting, but the certificate was not countersigned by the buyers' representative, as required. The buyers argued that the second instalment was not due, as there was no proof that the steel had been cut. This dispute was referred to arbitration, with the buyers contending that the shipyard must await an award in its favour before enforcing its claim for the second instalment.
The shipyard made a demand under the payment guarantee and commenced court proceedings seeking an immediate judgment. The bank tried to avoid payment by claiming that its payment guarantee was a guarantee and not an on-demand bond. The bank argued that until the buyers were held liable for payment of the second instalment, it had no liability to pay under the payment guarantee.
The shipyard argued that the payment guarantee was an on-demand bond and that the bank was liable irrespective of the arbitration proceedings. As guarantor, the bank's obligations under an on-demand bond were not dependent on the outcome of the underlying arbitration.
The challenge in this case was that the payment guarantee used language that was consistent with both guarantees and on-demand bonds. The High Court judge found the payment guarantee to be a guarantee, not an on-demand bond. Hence, the judge ruled that the shipyard had to await resolution of the dispute with the buyers in the arbitration.
The shipyard appealed and received a favourable judgment. The Court of Appeal dispensed with much of the legal analysis that had occupied the lower court and referred to the guidance given in Paget's Law of Banking, which is considered to be an authoritative textbook in this area of law.(2) In particular, the Court of Appeal drew attention to following passage:
"Where an instrument (i) relates to an underlying transaction between the parties in different jurisdictions, (ii) is issued by a bank, (iii) contains an undertaking to pay "on demand" (with or without the words "first" and/or "written") and (iv) does not contain clauses excluding or limiting the defences available to a guarantor, it will almost always be construed as a demand guarantee."
The Court of Appeal held that this guidance should be applied or treated as strongly presumptive where the obligation to pay is expressed to be 'on-demand', and added that the presumption should apply even in circumstances where the security document does not contain clauses excluding or limiting the defences available to a guarantor. Having followed Paget, the Court of Appeal did not hesitate in deciding that the payment guarantee was indeed an on-demand bond and that the buyer's bank was liable.
As the Court of Appeal held, a "bank guarantor is not and should not be concerned in any way with the rights and wrongs of the underlying transaction". Guarantees, such as the payment guarantee in this case, "are almost worthless if the Bank can resist payment on the basis that a foreign buyer is disputing whether a payment is due".
This decision throws up nothing new, but it does make an important point – that when construing the language of a guarantee or on-demand bond, it is important to have regard to previous case law and textbooks. Further, the commercial purpose of security being provided for a payment obligation should not be underestimated. This decision reinforces the point that where such security is being provided by a bank, the presumption is that the bank's obligation is to pay when called on to do so.
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