The difference between a guarantee and an on-demand bond - and how to get it right (Commercial contracts newsletter, August 2012)

Summary: Bonds and guarantees are a commonly-used means of protecting a party against non-performance of a contractual obligation. True guarantees and on-demand bonds are often confused, but there is a key distinction between the two: the liability of the issuer to pay under an on-demand bond does not depend on breach of the underlying contract, whereas a guarantee cannot be enforced until a breach has occurred. In Wuhan Guoyu Logistics Group Co Ltd Anor -v- Emporiki Bank of Greece SA [2012] EWHC 1715 (Comm) an instrument described as a "Payment Guarantee" was held to be a guarantee, rather than an on-demand bond, with the result that the bank's liability to pay was a secondary obligation.

Primary or secondary liability? Under a shipbuilding contract, the buyer was required to procure that its bank issue a Payment Guarantee in respect of the payment by the buyer of the second instalment of the price. The contract provided that the second instalment was payable within five New York banking days of receipt by the buyer of a refund guarantee issued by the seller's bank, together with a certificate as to the cutting of the first steel plate of the vessel. The buyer's bank (the respondent in the case) provided the payment guarantee to the seller's bank. The buyer disputed its liability to pay the second instalment, which dispute was the subject of an arbitration.

The question for the court was whether the instrument called a "Payment Guarantee" was in fact a guarantee or an on-demand bond.

The seller argued that the payment guarantee was in the nature of an on-demand or performance bond and that payment was due upon a written demand under that bond, whether or not the payment which the bond guaranteed was actually due by the buyer. The demand for payment had been made and the seller claimed summary judgment for the principal and interest.

Christopher Clarke J held that the Payment Guarantee was a guarantee and not an on-demand bond for the following reasons:

  • The instrument continually referred to itself as a "guarantee". While that was "far from conclusive", it was a "pointer".
  • Although payment was to be made upon "first written demand", which was an indicator of an on-demand bond, that obligation followed on from clauses 1-3 of the instrument. Clause 1 expressed the core obligation and was in the classic language of a guarantee.(1) Clause 2 required the buyer's countersigned approval of the steel cutting certificate (which requirement would be a "dead letter" if the instrument was a bond). Clause 3 contemplated payment of interest only after the buyer's default.
  • The words "in the event that the BUYER fails to punctually pay….then" were an indication that the obligation to pay on demand arose when, but not before, the event specified had occurred. Thus the demand and a written notice of default were a necessary, but not a sufficient, condition of recovery.
  • While the undertaking was given "irrevocably, absolutely and unconditionally", what the bank had undertaken to do was to guarantee the due and punctual payment of the second instalment. It was not a guarantee of what was not due.
  • The existence of an "as primary obligor and not merely as surety" provision did not automatically mean that the instrument was not a guarantee (relying on Carey Value Added -v- Grope Urvasco(2)). In this case the undertaking given as "primary obligor and not merely as surety" was an undertaking to guarantee the payment of the second instalment.

The judge undertook a detailed analysis of the phraseology and the structure of the payment guarantee. Although he acknowledged that reference in a security instrument to the contractual default to which that instrument relates does not necessarily mean that the beneficiary has to show that default has occurred, the wording in the particular guarantee went well beyond what was needed for the purpose of identifying the obligation for which the security was being given. The language used confirmed the conditionality of the event.

If the instrument in question had done no more than provide that the bank would pay on first written demand stating the second instalment was not paid, the basis for saying that the instrument was an on-demand bond would have been very strong. However, the context of the "first written demand" obligation was important, particularly the clauses that preceded it in the instrument.

The key difference: whether liability arises from the instrument or the underlying contract. The case includes a detailed discussion of the differences between a guarantee proper and an on-demand bond, noting that the essential characteristic of a guarantee is that the liability of the guarantor is a secondary one. The effect of this is that, if the debtor has no liability, the guarantor has none either. Under an on-demand instrument, liability arises from the instrument itself rather than the underlying contractual arrangement. In practice, the beneficiary of an on-demand bond is likely to be able to obtain summary judgment if he is not paid on presentation of the conforming documents even if there is a bona fide dispute between the main parties to the contract as to whether the sum in question is due.

The judge looked in detail at the authorities on this question, including a number of recent authorities. He noted that the authorities and the legal textbooks had identified particular criteria - or combinations thereof - as having a certain effect but the answer to the question of whether a given instrument is a guarantee or bond cannot be given by a "tick box approach". The same factor may have a different significance from case-to-case and few factors, with the exception of a conclusive evidence clause are, on their own, likely to be decisive.

Less is more. The message was clear: if the seller had wanted the security of an on-demand bond, it should not have used a document which was described as, took the form of, and used the language of a guarantee and included provisions habitually found in a guarantee. Instead, it should have used the appropriate, "terser" language, of an on-demand bond.

Notes:
(1) "We, EMPORIKI BANK OF GREECE SA, hereby IRREVOCABLY, ABSOLUTELY and UNCONDITIONALLY guarantee, as the primary obligor and not merely as the surety, the due and punctual payment by the BUYER of the 2nd installment of the Contract Price..."
(2) [2011] 2 All ER (Comm) 149. 

 

Please click on the links below for the other articles in the August 2012 commercial contracts newsletter:

 

Contacts

If you would like further information on any of the matters discussed in this newsletter, please contact:

Mark Lubbock
Partner, London
T: +44 (0)20 7859 1762
E: mark.lubbock@ashurst.com

Dominic Batchelor
Partner, London
T: +44 (0)20 7859 1279
E: dominic.batchelor@ashurst.com

 

This newsletter is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to. Readers should take legal advice before applying the information contained in this publication to specific issues or transactions.

 

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