As a financial services attorney in the United States (US) for nearly 50 years, I still have a lot to learn about the way the reweird west of the world uses so-called demand or bank guarantees and argues about whether they are independent or accessory undertakings.

For historical reasons and regulatory concerns, US banks seldom issue bank guarantees.

The regulations have been modernised to allow US banks to issue bank guarantees, but they must be payable against the presentation of documents under a recognised regime such as the UCC Article 5, the ISP, the UCP, the eUCP, or the UNCITRAL Convention.

US banks are not to issue undertakings based on non-documentary conditions or the resolution of facts or legal disputes between the applicant and the beneficiary.

The rest of the world does not have the same bank regulatory regime as does the US when it comes to banks issuing guarantees.

James Barnes, dean of the US letter of credit bar, authored an article in 2013 citing the problems of the French and the British determining whether an undertaking is independent or accessory. 

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Independent or accessory undertakings

“Is it a demand guarantee?” was the title of a December 2004 DC Insight article by Georges Affaki, in which he noted then that in France there had been over 300 decisions dealing solely with whether an undertaking should be characterised as independent (suretyship or independent guarantee). 

The article describes this type of litigation as a European “sport” inducing drafters of guarantee texts to burden and lengthen them with meticulous details as to their character. 

It concludes with recommendations to incorporate the URDG and to use published URDG templates (then ICC publication no. 503). 

The English courts have been asked repeatedly to characterise undertakings that are ambiguous as to their intended independence. 

I deduce from the many English cases that, among other factors, incorporation of ICC rules (ISP, UCP, or URDG) is very helpful in establishing independence, that the identity of the obligor as a bank is critical and that the inclusion somewhere of an undertaking to pay against a demand is also critical. 

The Barnes article points to a failure in drafting where banks and other issuers of guarantees fail to incorporate a set of rules in their guarantees intended to be used for independent undertakings. 

Affaki’s comment about litigating over whether a guarantee is independent or accessory was made almost 20 years ago. 

However, the same issue is still recurring – witness the recently decided Shanghai Shipyard and Bank Audi cases — reminding me of the saying that those who ignore the lessons of the past are forced to repeat them. 

Much of the problem about arguing over whether a guarantee is an independent or accessory obligation was solved, or at least is solvable, by the advent of the URDG and the ISP. 

When incorporated as the rules governing a guarantee, and following their drafting rules (e.g. no nondocumentary conditions), in most cases there should be no real argument that a guarantee is documentary and independent, especially if the guarantor issuer is a bank. 

If the guarantee is independent, the guarantor can be called upon to pay with a demand and statement of default as specified in the undertaking without the guarantor or the applicant has the right, before paying, to litigate a claim of breach of the underlying agreement the guarantee supports. 

As is sometimes stated in US letter of credit cases, once a timely confirming documentary demand is presented, the rule is that where a “demand guarantee provides that where there is a dispute, the guarantor must “pay now and argue later.”

What is a Bank Guarantee?

Corporate guarantees in the US

In the US, corporate guarantees are normally drafted very one-sidedly – with payment being unconditional, absolute, irrevocable, primary, and immediate upon the assertion of default, with waivers of all conceivable suretyship defences. 

They serve their purpose in cases of insolvency of the primary obligor, waive suretyship defences, and in most cases overcome procedural defences that the guarantor may raise. 

Yet, most sophisticated beneficiaries understand that such guarantees, no matter how well-drafted, are not letters of credit.

This means that the meaningful assertion of substantive defences that the obligation guaranteed is not owed by the primary obligor may slow down or defeat the immediate enforcement of the guarantee until their judicial resolution. 

The beneficiary’s demand on a typical corporate guarantee in the US would not normally be treated in court as would a demand on a letter of credit or other independent undertakings. 

That is apparently not the rule in the rest of the world where the ISP or URDG are frequently not incorporated into what is intended to be independent, first demand, or bank guarantees. 

These guarantees vary as to language and conditions. 

There are different criteria used and applied differently by different courts in different jurisdictions with different legal systems based on different contexts, issuers, and wording to determine whether a guarantee is independent or accessory. 

Although the result was the same in both Bank Audi and Shanghai Shipyard, the courts used factor analysis to make the determination of independence. 

Especially in the Shanghai Shipyard case, the court considered not only various factors in the way the guarantee was worded and in what context it operated, including that it provided for arbitration if timely invoked but also the varying views of numerous prior English court decisions on the subject. 

Independent guarantees

Professor James Byrne in his book Standby & Demand Guarantee Practice listed several factors used to determine whether a guarantee is independent: 

  1. Is the undertaking documentary; 
  2. Is the terminology used consistent with and contains the earmarks of an independent undertaking; 
  3. What is the name of the undertaking; 
  4. Are practice rules such as the URDG or ISP incorporated into the undertaking; 
  5. Does the relevant jurisdiction’s laws (such as U.S. UCC Article 5), support the independence of the undertaking, and 
  6. What kind or type of entity is making the promise to pay – such as a bank vs. natural person.
cargo ship Trade Finance Global

The Shanghai Shipyard case

The English court in the Shanghai Shipyard case recited Paget’s Law of Banking (11th ed.) under the heading of “Contract of Suretyship v. Demand Guarantee”: 

“Where an 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, it will almost always be construed as a demand guarantee.” 

Some of these factors were not present in the case. 

The guarantor was previously the purchaser and created or sponsored an SPV to take title – making it more like a corporate relationship rather than an independent bank issuer. 

Defences were allowed if arbitration was timely demanded. 

That is a major exception to the pay now, litigate later principle that should be present to characterise independent undertakings. 

The wording of the guarantee read in many respects like a US corporate guarantee would read. 

The decision of the lower court was overturned, indicating that the case is a closed case. 

The case is on appeal to the Supreme Court of England. 

The Bank Audi case

In Bank Audi, as noted in Thomas Song’s article on the case, even though it did not incorporate any set of rules, the guarantee was issued by a bank, secured an advance payment in an international equipment purchase order where advance pay letters of credits or bank guarantees are typically used, and contained wording without reference to arbitration or court resolution, of payment on demand, and declaration of default. 

The takeaway from both cases and from the articles by Prof. Byrne, Jim Barnes, and Georges Affaki on the issue of independent vs. accessory guarantees, is that to better assure that the issuer’s guarantee is independent, incorporate a set of rules into the undertaking that is designed for and supports it as an independent obligation.

This article was published on Documentary Credit World.