Guarantees

Bank Guarantees

A bank guarantee may be required in an export sale. The buyer may be required to obtain a guarantee in favour of the seller under the sale contract. It may be provided that the guarantee is to take effect if no letter of credit or equivalent assurance of payment is provided within a stated time period.

The requirement is usually for an undertaking by a financial institution or insurer to pay the stated or defined sum if the relevant conditions apply.  As the bank has a contingent liability to pay on the guarantee, it will enter a facility agreement on the basis of having to meet the guarantee. It will be assessed and underwritten on a basis similar to that for a loan in the guaranteed amount.

The bank guarantees the performance by the buyer. The general principles in relation to guarantees apply. In contrast to an indemnity, a guarantee is essentially an undertaking in favour of the beneficiary to meet the liability of the third-party in defined circumstances.

There are a range of common law and other rights that apply, if and when the guarantee is triggered. They include rights of subrogation and indemnity for the guarantor against the guaranteed party. See the principles on guarantees, which are set out in the section on finance.

Trigger / Default

A key issue is the trigger; the basis on which the guarantee may be demanded by its beneficiary. This will be defined by the terms of the guarantee. The general principle is that there should be a default.

In practice, due to the potential for a dispute in proving a default, demand guarantees are used in international trade. They are conditional on demand only. They are payable on demand by the beneficiary of the guarantee. The bank does not inquire into the question of default. The fact of demand suffices.

A demand guarantee differs from a conditional guarantee. A conditional guarantee is triggered by the default and requires the bank to consider the circumstances of the alleged default.

The guarantor is obliged to pay the guaranteed sum on demand in much the same way as a letter of credit. Many of the principles that apply to letters of credit, also apply to demand guarantees. The requirement for triggering the guarantee must be strictly complied with.

The guarantee is triggered on demand unless there is evidence that the demand is fraudulent and that the beneficiary is aware of the fraud. The possibility of interpleader arises in circumstances where there appears to be fraud or a question as to the obligation to pay. In this case, the monies must be paid into court, and the parties can be required to litigate the matter.

Uniform International Rules

The Uniform Rules for Demand Guarantees deal with guarantees given on behalf of a seller or supplier in international trade. The Uniform Rules seek to regulate guarantees (typically given in international trade) by financial institutions and insurance companies. The Rules provide for international practice on the triggering of a demand guarantee. They apply when the guarantee is stated to be subject to the Uniform Rules. These rules are not widely used in practice.

A demand guarantee for the purpose of the rules is any guarantee, bond or other payment undertaking however named or described by a bank, insurance company or other body of persons given in writing for the payment of money on presentation in conformity with the terms of the undertaking of a written demand for payment and such other documents (including for example a certificate, a judgment or an arbitral award) as may be specified in the guarantee.

Such undertaking is given at the request, the instruction or under the liability of a party (the principal) or at the request or on the instructions and under the liability of a bank, insurance company or other body of persons. The instructing party acting on behalf of the principal or another party is described as the beneficiary.

The Uniform Rules provide that guarantees by their nature are separate transactions from the contract or tender conditions upon which they may be made. The guarantors are not concerned with or bound by such contracts or tender conditions, despite any indication or reference to them in the guarantee.

The Demand

The duty of the guarantor under the guarantee is to pay the sum or sums stated on presentation of a written demand for payment and other documents specified in the guarantee which appear on their face to be in accordance with the terms of the guarantee.

The demand must be made in writing and transmitted to the principal without delay. It must be presented at a place at which the guarantee is issued and before its expiry.

The rules provide that any demand for payment under the guarantee shall be in writing and shall be supported by a written statement whether in the demand itself or in a separate document or guarantee accompanying the demand. It should refer to it, stating that the principal is in breach of its obligation under the underlying contracts or in the case of a tender guarantee, the tender conditions and the way in which the principal is in breach.

Any demand under a counter guarantee against the applicant/ primarily liable party) must be supported by a written statement that the guarantor has received a demand for the payment under the guarantee in accordance with its terms and with the rules.

Rationale for Fine Trigger I

Because of the fine trigger conditions; the mere making of a demand, which may be based on an alleged breach, the principal carries the risk that the beneficiary will unfairly trigger the demand. The only exception is in respect of fraud to the knowledge of the beneficiary. It is possible in principle in some cases to obtain export insurance against this possibility.

The courts are reluctant to interfere with the practice in international trade and will tend to allow the bank to make payment on the guarantee in the absence of evidence of the presence of fraud. Their rationale is that the unique value of such a letter, bond or guarantee is that the beneficiary can be completely satisfied that, whatever disputes may arise between him and the bank’s customer in relation to the performance or indeed the existence of the underlying contract, the bank is itself undertaking to pay him provided that the specified conditions are met.

In requesting a bank to issue such a letter, bond or guarantee, the customer is seeking to take advantage of this unique characteristic. If save in the most exceptional cases, he is to be allowed to derogate from the bank’s irrevocable undertaking, by restraining the bank from honouring that undertaking, it would undermine the bank’s reputation for financial and contractual probity. If this happened frequently, the value of all irrevocable letters of credit and performance bonds and guarantees would be undermined.

Exceptional Case of Fraud

The wholly exceptional case where the bank may be restrained from making payment is where it is proved that the bank knows that the demand for payment already made or which may thereafter be made is or will be clearly fraudulent. The evidence must be clear both as to the fact of fraud and to the bank’s knowledge.

It is not normally sufficient that this rest upon the uncorroborated statement of the customer. Otherwise, irreparable damage could be done to a bank’s credit in a relatively brief time which elapsed between the granting of an injunction and the application by the bank to have it discharged.

Judges ask whether there is any challenge to the validity of the letter, bond or guarantee itself. If there is not or if the challenge is not substantial, prima facie, no injunction should be granted, and the bank should be left free to honour its contractual obligation although restrictions may well be imposed upon the freedom of the beneficiary to deal with the money after he has received it.

The evidence of fraud must be clear both as to the fact of the fraud and the bank’s knowledge. The mere assertion or an allegation of fraud is not sufficient. The court requires strong corroborative evidence of the allegation usually in the form of contemporary documents, particularly those emanating from the buyer.

In general, for the evidence of fraud to be clear, the buyer should be given an opportunity to answer the allegation and to have failed to provide any or any adequate answer in circumstances where one can properly be expected. If the court considers that on the material before it, the only realistic inference to draw is that of fraud, then the seller would have made out a sufficient case.

UNCITRAL Convention I

The United Nations Conference on International Trade (UNCITRAL) has published the UN Convention on Independent Guarantees and Stand-By Letters of Credit.

The Convention is designed to facilitate the use of independent guarantees and standby letters of credit where only one or the other of those instruments is traditionally in use. The Convention also solidifies recognition of common basic principles and characteristics shared by the independent guarantee and the standby letter of credit.

The Convention gives support to the autonomy of the parties to apply agreed rules of practice such as the Uniform Customs and Practice for Documentary Credits (UCP), formulated by the International Chamber of Commerce (ICC), or other rules that may evolve to deal specifically with standby letters of credit, and the Uniform Rules for Demand Guarantees (URDG, also formulated by ICC).

In addition to being consistent with the solutions found in rules of practice, the Convention supplements their operation by dealing with issues beyond the scope of such rules. It does so in particular in relation to the question of fraudulent or abusive demands for payment and judicial remedies in such instances.

The deference of the Convention to the specific terms of independent guarantees and standby letters of credit, including any rules of practice incorporated therein, enables the Convention to work in tandem with rules of practice such as UCP and URDG.

UNCITRAL Convention II

An independent guarantee or standby letter of credit is an undertaking given to a beneficiary. Accordingly, the focus of the Convention is on the relationship between the guarantor (in the case of an independent guarantee) or the issuer (in the case of a standby letter of credit) and the beneficiary.

The relationship between the guarantor/issuer and its customer the principal, in the case of an independent guarantee, or the applicant, in the case of a standby letter of credit, largely falls outside the scope of the Convention.

The same may be said of the relationship between a guarantor/issuer and its instructing party (the instructing party being, for example, a bank, requesting, on behalf of its customer, the guarantor/issuer to issue an independent guarantee).