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Guarantees in Shipbuilding Agreement

On-Demand or Conditional Guarantees? David Seah LLB London It has been said that the law of guarantee and indemnities is a difficult branch of English law, and in respect of performance bond they are not true guarantees but a contractual commitments by the Bank to pay money in a specified event [1]. One of the key issues during shipbuilding contract negotiations will be the provision of guarantees; namely refund or performance bond. The nature of such instrument can either be conditional or on-demand, depending on the terms upon which it may be invoked. An ondemand bond is payable without proof or condition independent of the underlying contract. Its purpose is to provide a security which is to be readily, promptly and assuredly realizable when the prescribed event occurs. In the context of international sale, such instruments have been likened to a letter of credit. In the case of Edward Owen Engineering Ltd v Barclays Bank International Ltd & Umma Bank [2], it was held by Lord Denning that: So long as the Libyan customers make an honest demand, the banks are bound to pay; and the banks will rarely, if ever, be in a position to learn whether the demand is honest or notthe performance guarantee stand on similar footing to a letter of creditA bank which gives the performance guarantee must honour that guarantee according to its terms. It is not concerned in the least with the relations between the supplier and the customer; nor with the question whether the supplier has performed his contracted obligations or not; nor with the question whether the supplier is in default or not. The bank must pay according to its guarantee, on demand, if so stipulated, without proof or conditions. The only exception is when there is a clear fraud of which the bank has notice. [Facts: a contract has been made between English suppliers and Libyan customers to erect greenhouses in Libya. Payment was by way of an irrevocable confirmed letter of credit payable in installments. The customers had required a performance bond for 10% of the contract price, payable on demand without proof or conditions. This was issued by Umma to the customers and Barclays gave a bond in similar terms to Umma. The suppliers gave a counter-guarantee to Barclays irrevocably authorizing them to comply with any demands under the guarantee. The customer did not open the correct confirmed letter of credit under the contract, and the suppliers then said that their guarantee had no effect. The suppliers were not in default. The customer responded by making a call on the performance bond and Umma paid. Umma then claimed payment from Barclays, who in turn claimed from the suppliers on the counter-guarantee. The suppliers sought to restrain Barclays and Umma from paying on the guarantees by an action for an injunction [3]. ] In contrast, the House of Lords allowed an appeal from the Court of Appeal decision that the instrument in question was not a see to it guarantee. In Trafalgar House Construction Ltd. v General Surety and Guarantee Co. Ltd [4], the instrument was a so called double bond issued by the appellants to the respondent main contractors to secure the performance of sub-contractors who had gone into liquidation. The obligation to pay was on default by the sub-contractors the surety shall satisfy and discharge the damages sustained by the main contractor. In deciding that this was a true guarantee, Lord Jauncey said at page 205 : Bonds in similar form have existed for more than 150 years and have been treated by the parties thereto and by the courts as guarantees In the first place the bond itself contains indications that it was intended to be a guarantee. The Appellants are described as the surety. There is a provision to the effect that no alteration in the terms of the sub-contract should release the surety from liability. In the absence of such provision a surety would normally be released from his obligation by any subsequent material alteration to the contractual provisions agreed between the contractor and the sub-contractor.

When the case of Gold Coast Ltd v Caja De Ahorros Del Mediterraneo & Others [5], came before the Court of Appeal, the issue was whether the guarantees were so called on demand guarantees independent of the shipbuilding contract or true guarantees where the guarantors liability is dependent upon the liability of the principal debtor. It was in regard to the interpretation of a refund guarantee issued by a bank pursuant to an obligation in a shipbuilding contract. Payment of specified amounts was to be made on your first written demand, subject (under condition 1) to receipt of a certificate issued by Lloyds Bank that the refund had become due. The Court of Appeal [6] held that the instrument in question had all the hallmarks of a first demand guarantee: It describes itself as a guarantee, but this is simply a label; it does not use the language of guarantee. Rather, the obligation, which is expressed to be an irrevocable and unconditional undertaking, is that the banks will pay on a first written demand. The only express condition of payment is contained in condition 1. This requires a certificate but makes no reference to arbitration or underlying liability under the shipbuilding contract. The instrument contains its own dispute resolution provisions. In Marubeni Hongkong and South China Ltd v The Mongolian Government acting through the Ministry of Finance Mongolia [7], the Court of Appeal had to decide whether a letter issue by the Ministry of Finance Mongolia was an unconditional independent promise by the Mongolian Government to pay on demand all amounts payable under the sales contract, i.e. a demand bond, or was a secondary or conditional promise to act as a surety. In the former case, the obligation to pay arises upon a simple demand or demand supported by a specified document. In the latter case, not only must the claimant prove the actual indebtedness of the debtor, but the guarantor has all the defences available to the debtor, and is discharged automatically if there is any variation of the arrangements with the principal debtor without his consent which might prejudice his interests. The material parts of the letter are in the following terms: the undersigned Ministry of Finance of Mongolia unconditionally pledges to pay to you upon your simple demand all amounts payable under the Agreement if not paid when the same becomes due (whether at stated maturity, by acceleration or otherwise) and further pledges the full and timely performance and observance by the Buyer of all the terms and conditions of the AgreementThe Ministry of Finance hereby waives any right to require you to proceed against the Buyer or against any security received from the Buyer or any third party or to pursue any other remedy available to you ". Counsel for the appellant argued inter alia, that the obligation of the Mongolian Government is expressed to be unconditional, and the trigger is a "simple demand". However the Court were of the view that these words are qualified by the following words, which indicate that the obligation only arises if the amounts payable under the agreement (are) not paid when the same becomes duewere appropriate to a secondary obligation, that is one conditional upon default by the buyer. It was held that the letter was a conditional guarantee to answer for a debt and subjected to proof of default. Finale: In international transactions, where a bond or guarantee issued by a bank is expressed to be payable upon demand, in the absence of clear words indicating that liability under it is conditional upon the existence of liability on the part of the account party in connection with the underlying transaction, it will be treated as an on-demand bond. Relevant factors in consideration will include its factual and contractual context having regard to its commercial purpose and whether its intent was to provide security which was readily and easily realisable. In cases where banks are not the issuers of such guarantees, the courts will be reluctant, in the absence of clear words, to interpret the instrument as an

on-demand bond. The way I see it, cases of this sort will be recurringwill be interesting to see the next one. Footnotes: [1] Lingard on Bank Security Documents at 13.81 [2] (1978) Lloyd's Rep 166, (1978) QB 159, 1 ALL ER 976, see also Chitty Law on Contracts 29th Edition Vol 2 para 44-014 [3] Injunction: In order to secure an injunction, a Claimant has to show that (a) there exists a serious issue to be tried on his claim, (b) damages would not be an adequate remedy, and the balance of convenience favors restraint. In cases of urgency, the application may be made unilaterally (legalese = ex-parte) by way of an interlocutory application, usually upon undertaking to pay costs and damages. American Cyanamid v Ethicon [1975] AC 396 [4] (1995) 73 BLR [5] (2001) EWCA Civ 1806 [6] In the process, reviewing Edwards Owen Engineering Ltd v Barclays Bank International Ltd & Umma Bank, I.E Contractors v Lloyd's Bank [1990] 2 Lloyd's Rep 496, 500, Paget's Law of Banking (11th Edition), Esal (Commodities Ltd v Oriental and Trafalgar House Construction Ltd v General Surety and Guarantee Co Ltd [7] (2005) EWCA Civ 395 Caveat: This article is for general reading only...please do not rely or act upon it in any given circumstances.