Interpreting see-to-it and on-demand guarantees30 September 2021

INTRODUCTION

A see-to-it guarantee is an undertaking by an entity to be answerable for the debt or obligation of another if the other party defaults. The essential feature is that liability under the guarantee depends on the defaulting party’s liability under the underlying contract. The liability of the guarantor is therefore only secondary. In contrast, a demand guarantee (also sometimes known as a demand bond or performance bond) is payable simply when a demand is made which complies with the requirements of the contract. The defaulting party’s liability is irrelevant and payment can normally only be refused in circumstances of clear fraud. The guarantor does not have the benefit of suretyship defences which can apply to a see-to-it guarantee. A demand guarantee is also not subject to the requirements of the Statute of Frauds on execution.

While both types of guarantee are aimed at decreasing risk and providing security to the beneficiary, demand guarantees serve an additional purpose which is to increase cashflow – a particularly significant benefit for manufacturers, builders and shipyards whose ability to fund a project may depend upon receiving quick payment.

The classification of these instruments has been the subject of extensive judicial consideration by the English courts, which have previously held that, where an instrument is given by a financial institution, then it will be presumed to be an on-demand guarantee. However, in Shanghai Shipyard the Court of Appeal has now rejected arguments that the starting point is to identify the nature of the institution providing the instrument, holding that instead the focus should remain on the words used by the parties in the commercial context.

BACKGROUND

Reignwood (the “Guarantor”) was a Hong Kong company which offered investment services. In 2011 it entered into a shipbuilding contract with Shanghai Shipyard (the “Shipyard”) for the construction of a US$200m offshore drillship as part of a financing arrangement with OOL. The shipbuilding contract was novated to Opus Tiger (the “Buyer”), an SPV owned by OOL, and the Guarantor acquired a majority shareholding in OOL.

The price of the vessel was to be paid in three instalments, with the final instalment of US$170m to be paid upon delivery. The Guarantor provided the Shipyard with an “irrevocable and unconditional Letter of Guarantee” to secure the payment of the final instalment.

The Letter of Guarantee provided that in the event of default, the Shipyard could demand the final instalment from the Guarantor, who was obliged to pay immediately on receipt of the demand. However, the Letter of Guarantee also provided that if there was a dispute between the Buyer and the Shipyard over the instalments and the dispute was referred to arbitration, the Guarantor could withhold payment until the outcome of the arbitration.

The Buyer refused to take delivery of the vessel or to pay the final instalment. A dispute ensued over whether the final instalment was payable and the Shipyard proceeded to make a demand under the Letter of Guarantee. However, the Guarantor refused payment pending the outcome of arbitration between the Shipyard and the Buyer.

At first instance the High Court² held that the Letter of Guarantee was a see-to-it guarantee and so payment could be withheld pending the determination of the arbitration, even though the arbitration had not in fact commenced until after the date of the demand. The Shipyard appealed.

PAGET’S PRESUMPTION

Paget’s Law of Banking sets out four criteria which, if present, will normally lead to the conclusion that the relevant instrument is an on-demand guarantee. They are that the instrument:

1. relates to an underlying transaction between the parties in different jurisdictions;
2. is issued by a bank;
3. contains an undertaking to pay ‘on demand’ (with or without the words ‘first’ and/or ‘written’); and
4. does not contain clauses excluding or limiting the defences available to a guarantor.

This presumption, known as “Paget’s presumption”, was endorsed by the Court of Appeal in Wuhan Guoyu Logistics Group Co Ltd v Emporiki Bank of Greece SA³, where it was concluded that even though not all of the criteria were present, the instrument in question was a demand guarantee.

In Shanghai Shipyard, the Guarantor sought to rely on Paget’s presumption in support of its argument that the Letter of Guarantee was a see-to-it guarantee, pointing in particular to the fact that it was not issued by a bank or other financial institution. However, noting that the purpose of the guarantee was to eliminate or reduce counterparty risk, in Lord Justice Popplewell’s view it was not the nature of the business that was carried on by the Guarantor which was of relevance, but rather the Guarantor’s commercial and financial strength. Therefore, at least in the shipbuilding context, it should not make a difference if the guarantor is a bank or parent company.

The judge added that in the context of a shipbuilding contract it has long been established that payment and refund guarantees may be demand guarantees and if a non-bank gives a guarantee adopting wording which, if given by a bank would be a demand guarantee, he did not see how it could mean something different. Indeed, such an approach would be uncommercial. Lord Justice Popplewell went on to conclude that Paget’s presumption did not assist in “promoting certainty” and that the “primary focus must always remain on the words used by the parties in their context”. If resort was to be had to the presumption at all, it should only be where all the stated conditions were fulfilled.

WORDING OF THE LETTER OF GUARANTEE

Lord Justice Popplewell emphasised that it was necessary to look at the wording of the document as a whole and not place undue focus on particular provisions to the exclusion of others. Focussing, therefore, on the wording of the entire Letter of Guarantee, Lord Justice Popplewell concluded that the critical language pointed strongly towards the instrument being a demand guarantee:

• The Guarantor’s obligation to pay used the capitalised words “ABSOLUTELY and UNCONDITIONALLY”, which conveyed that the obligations were not conditional on the liability of the Buyer;
• The Letter of Guarantee also stated that the Guarantor’s obligation to pay was “[as primary obligor] and not merely as the surety” and the obligation to pay “immediately” was triggered “upon receipt by us of your first written demand”, which were all clear indications of an on-demand guarantee; and
• It was also relevant that the effect of any contractual dispute between the Shipyard and the Buyer was excluded from the Guarantor’s obligation to pay.

Although the Guarantor sought to rely on a proviso in the Letter of Guarantee entitling it to withhold and defer payment in the event of a dispute and the submission of that dispute to arbitration, the Shipyard submitted that in order for the proviso to be triggered, there had to be both a dispute and the commencement of arbitration prior to a valid demand being made. Lord Justice Popplewell agreed, holding that, if triggered, the clause would only render the obligation to pay conditional on the issuance of the award, rather than on any underlying liability. He went on to reject arguments that the clause had been triggered, finding that, on the wording, the Guarantor could only withhold and defer payment if the arbitration had been commenced before the demand was made. The fact that a demand could be made within just fifteen days of the Buyer’s failure to pay was not uncommercial in circumstances where the purposes of the Letter of Guarantee was to protect cashflow.

Therefore, the Court of Appeal allowed the appeal, holding that the Letter of Guarantee was in fact an on-demand guarantee.

COMMENT