Guarantees and Performance Bonds

Payment obligations under commercial contracts are often secured by means of guarantees issued by banks, which guarantee the performance of the payment obligation by the buyer. For instance, if A and B enter into a contract whereby A agrees to sell B a ship for the price of $50 million, B’s bank may issue to a payment guarantee to A to secure the payment of this amount from B. In the alternative, the contractual arrangements between A, B and the bank may be such that the bank issues a performance bond to A. However, there is a fundamental difference in the nature of the obligation assumed by the bank in the two cases.

If the bank issues a guarantee, the contractual arrangement between the parties is trilateral, whereby the bank undertakes a secondary obligation to guarantee that B will perform its contractual obligations to A. Therefore, any defences available to B are also available to the bank, and A must prove that B has invalidly failed to perform its contractual obligations. In such a case, depending on the nature of the guarantee, A can have recourse against the bank: (a) in damages, for a breach of the bank’s obligation to ensure B’s performance; or (b) requiring it to step into B’s shoes and pay the amount owed by B on the satisfaction of any notice or demand requirements contained in the guarantee.

To the contrary, when the bank issues a performance bond, there are two independent bilateral arrangements in place: one between A and B, and the other between A and the bank. By virtue of the performance bond, the bank is obliged to pay A the secured amount if certain notice/demand conditions are satisfied, irrespective of whether any payment is due from B to A under the primary contractual arrangement.

Therefore, whether a given transaction involves a guarantee or a performance bond depends on the relative bargaining strengths of the parties, and the difference assumes great significance in cases where there is a dispute between A and B as to the existence of the primary payment obligation. It was one such case which was recently considered by the English High Court in Wuhan Guoyu v Emporiki Bank of Greece [2012] EWHC 1715 (Comm).

The facts of the case involved a shipbuilding contract, under which the buyer was to pay the consideration amount in instalments on the completion of certain activities in relation to the ship. The payment of these instalments was secured by means of a ‘Payment Guarantee’ which was Exhibit B to the primary contract, and was issued by the buyer’s financing bank. The seller’s bank had also issued a ‘Refund Guarantee’ to the buyer (Exhibit A), to secure repayment of the consideration amounts if the contract was rescinded or cancelled in accordance with its terms. Both these documents were referred to in the contract as ‘irrevocable letters of guarantee’.

The buyer paid the first instalment, following which there was a dispute between the buyer and the seller as to whether the second instalment was due. The seller sought payment of the instalment from the bank notwithstanding this underlying dispute, thus calling upon the High Court to decide whether the ‘Payment Guarantee’ was a guarantee in the true sense, or in fact a performance a bond.

The Court began by clarifying that the question is one of construing the contract, and while previous cases could provide guidance as to the relevance of several factors, the identity of each document depended on its particular language and context. Based on a very useful survey of authorities (contained in paragraphs 32-54 of the report), the Court culled out the following principles which are relevant to determining the identity of a particular document:

  • The labelling of the document as a ‘guarantee’ is not determinative, and neither is an elaboration of the commercial purpose of the document (e.g. ‘to indemnify …’)
  • An undertaking to pay the on ‘first written demand’ and a provision that such demand is the only condition for payment indicates that the document is a performance bond
  • The reasoning must start with the wording of the contract and the Court must not bring any pre-conceived notions to interpreting the document
  • A key question is whether the condition for payment is the presentation of documents which assert certain facts, or the actual existence of the facts asserted
  • A clause stating that the presentation of certain documents shall be ‘conclusive evidence’ indicates that the document may be a performance bond
  • The issuance of the document in a banking context is material. In non-banking contexts, there is a strong presumption against it being a performance bond
  • If the transaction is cross-jurisdictional, it may suggest that the parties would prefer to avoid a detailed proving of the merits of the underlying claim (and hence provide a performance bond)

On a detailed consideration of these factors, the Court concluded that the document in question was a guarantee and not a performance bond. While a detailed discussion of the conclusions would be out of place here, some interesting points emerging from the reasoning are:

  • The fact that both the Payment Guarantee and the Refund Guarantee were referred to as ‘irrevocable letters of guarantee’ suggested that they had the same legal effect. The Refund Guarantee was undoubtedly a guarantee in legal terms (the contrary view would be commercially unreasonable), and therefore the Payment Guarantee was also likely a guarantee.
  • The reference to the bank as the ‘primary obligor’ was not conclusive, since it begged the question of what the bank’s primary obligation was. If the effect of the document was to create an obligation to guarantee and not to pay, then the reference to ‘primary obligor’ was not material.
  • The bank’s obligation arose if the buyer breached its obligations and then the seller issued a demand, which suggested that the breach a necessary precondition to payment. Although there is authority indicating that the use of such language (‘if … when’; ‘then’) was not conclusive, when read in the context, the language here suggested that payment was condition on more than just the presentation of a demand notice.
  • The fact that the bank was financing the buyer provided some commercial context to the bank’s likely obligations. It was not a pure banking relationship, and the bank, in its capacity as the buyer’s financer, was also likely to have an interest in the performance of the primary contract. While this was not a “particularly sure guide to the correct interpretation”, it nevertheless refuted the seller’s argument that the bank had no interest in the merits of the underlying transaction.

In sum, the decision provides a useful summary of the applicable principles in distinguishing between guarantees and performance bonds, and also is an example of their application to an interesting but not unusual set of facts.

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