GUARANTEES – further guidance on cutting a Gordian knot

February 2013

Once again English courts have delivered an important 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 then the obligation of the guarantor is 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 has attempted a more simple solution by seeking to cut or perhaps untie this Gordian knot.

Wuhan Guoyu Logistics v Emporiki Bank

In Wuhan Guoyu Logistics Group v Emporiki Bank[1] (the buyers) Greek owners had contracted with a shipyard in Wuhan, China, for the construction of two handymax bulk carriers. The con-tract price was payable in instalments. At the time the dispute arose, the first instalment had been
paid, and the second instalment had arguably fallen 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 about four months prior to the shipyard calling for 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 was indeed cut. This dispute was taken 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 Decision

The challenge in this case was that the payment guarantee used language that was consistent with both guarantees and on-demand bonds. To the relief of the bank,the High Court judge found the payment guarantee to be a guarantee, not an on-demand bond. Hence, the judge decided that the shipyard had to await resolution of the dispute with the buyers in the arbitration.

The shipyard appealed and the judgment was this time in favour of the shipyard. The Court of appeal dispensed with much of the legal analysis that had occupied the High 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 in Paget's: “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 even apply in circumstances where the security document does not contain clauses excluding or limiting the defences available to a guarantor. Having followed Paget's, the Court of appeal had little hesitation in deciding that the payment guarantee was indeed an
on-demand bond and 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”.

Comment

This decision perhaps tells us nothing new, but it makes 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 text books such as Paget's Law of Banking. 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 upon to do so.

Postscript from Norway

A recent Norwegian Supreme Court judgment (Norsk Tillitsmann aSa v Silvercoin Industries 
AS, Rt. 2012 p. 1267) deals with a similar distinction under Norwegian law; the distinction between an ordinary guarantee triggered by the default of the principal debtor  selvskyldnergaranti) and an on-demand guarantee (påkravsgaranti).

In the judgment, the Supreme Court confirms the long held view that the main rule under Norwegian law is that the guarantor’s liability is triggered by the default of the principal debtor (selvskyldnergaranti) unless there is a reasonably clear basis for a different interpretation. Another important distinction under Norwegian law, not discussed here, is between guarantees
triggered by default and guarantees triggered by insolvency). With that starting point, the Supreme Court scrutinised the wording of the various guarantee clauses, and concluded that the Silvercoin guarantee was indeed an ordinary guarantee triggered by the default of the principal debtor (selvskyld-nergaranti) and not an on-demand guarantee (påkravsgaranti).

Taken at face value, the Supreme Court’s reasoning and conclusion may be seen as expressing the complete opposite view as that held by the English Court of appeal. In our view, that is not the case. The Silvercoin guarantee was not a bank guarantee as in the Wuhan Guoyu
Logistics Group v Emporiki Bank, and the Norwegian Supreme Court clearly distinguishes the case at hand from guarantees issued by banks or other financial institutions. Analysing the Supreme Court’s arguments, it is possible that the Supreme Court could have arrived at a different conclusion if the guarantee had been issued by a bank or other financial institution. As noted from the above, the fact that the issuer was a bank was also mentioned by the Court of appeal. However, in the matter at hand there was also other evidence (outside the guarantee itself) pointing towards the conclusion the Supreme Court arrived at. Hence it may be that the final conclusion would have been the same even if the guarantee was issued by a bank or other financial institution. 
[1] Wuhan Guoyu Logistics Group Co Ltd, Yangzhou Guoyu Shipbuilding Co Ltd v Emporiki Bank of Greece SA, [2012] eWCa
Civ 1629 (judgment on 7 December 2012).