Guarantees are frequently used in connection with commercial and shipping transactions. A recent decision of the English Court of Appeal1 has revisited the important distinction between guarantees and demand bonds under English law.
What is a guarantee under English law?
Under what is properly called a guarantee the guarantor or surety (“A”) undertakes responsibility for the due performance of the legal obligations of another person, the principal, (“B”) towards a third person (“C”) who is the beneficiary of the guarantee. Typically this may involve guaranteeing performance by B of a contract (known as the “principal contract”) or payment of a debt to C. The guarantor undertakes to “see to it” that B performs its obligations towards C and if B fails to do so the guarantor A will be liable to C.
Guarantees may be in many different forms and the liability of the guarantor may vary. However to be valid under English law a guarantee must be in writing and signed by the guarantor.
The essential characteristic of a true guarantee is that the liability of the guarantor is secondary to that of the principal party being guaranteed (B in the example above). It is B who has the primary liability. The guarantor A is only liable to the extent that B has a liability to C. It legal language the liability of the guarantor A is said to be co-extensive with the liability of the principal B.
Any claim by C under the guarantee is likely to involve consideration of:
- the legal obligations of B to C under the contract or other relationship that is being guaranteed;
- any defences available to B that may reduce or eliminate such legal obligations;
- whether B has failed to discharge its obligations to C and thus whether the liability of A under the guarantee has been triggered.
What is a demand bond?
Demand bonds (or on demand bonds) are intended to overcome the uncertainties involved in claiming under a true guarantee. A demand bond is an instrument usually issued by a bank or other institution under which the issuer / guarantor undertakes to pay a certain sum on demand. The terms of the bond may specify that the demand will be supported by certain documentation such as a certificate that a particular event has arisen, e.g. that a payment from B to C has not been made to use the example above.
The essential characteristic of a demand bond is that the issuer / guarantor has a primary liability to the beneficiary. Whilst the demand bond may be issued in connection with an underlying principal contract it is independent of it. If a demand is made on the bond that is in conformity with its terms then the issuer is obliged to pay unless it has notice of fraud. The issuer is not concerned with the underlying principal contract or whether any payment is actually due under it.
As stated by one judge2:
“All this leads to the conclusion that the performance (bond) stands on a similar footing to a letter of credit. A bank which gives the performance (bond) must honour that (bond) 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 (bond), 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.”
Implications for users
The difference between a true guarantee and a demand bond may be crucial.
- For a beneficiary a demand bond enables a speedy payment of the sum covered without any need to consider issues arising under the underlying principal contract. The guarantor is primarily liable and thus the beneficiary can claim immediately without regard to the liability of the principal.
- For principal being guaranteed and for the guarantor a true guarantee ensures that payment will only be made if correctly due under the underlying principal contract. As the guarantor has only secondary liability a claim under the guarantee can only be made once the primary liability of the principal has been established.
What is in a name?
The clear difference in concept between a guarantee and a demand bond may be obscured by the different names that may be used. Demand bonds may also be referred to as demand guarantees, performance bonds or performance guarantees. Indeed name of the ICC Uniform Rules for Demand Guarantees (URDG 758) is an example of this. It is the concept and not the name that is critical.
The courts have frequently been confronted with cases where the language of a given document gives rise to uncertainty whether it is a true guarantee or a demand bond. Any clients considering issuing or receiving security are recommended to give careful consideration to whether a guarantee or demand bond is needed and to ensure that the correct concept is clearly expressed in the language of the document.
Some guidance may be had from the latest decision the Court of Appeal3 where it approved the view that where an instrument:
- relates to an underlying transaction between the parties in different jurisdictions,
- is issued by a bank,
- contains an undertaking to pay “on demand” (with or without the words “first” and/or “written”) and
- does not contain clauses excluding or limiting the defences available to a guarantor,
it will almost always be construed as a demand bond.
A further indication is that guarantees usually respond to facts e.g. that the principal is in breach of the underlying principal contract whereas demand bonds tend to respond to documents and are not concerned with the underlying facts.
1 Wuhan Guoyu Logistics Group Co Ltd & another v Emporiki Bank of Greece SA  EWCA Civ 1629
2 Edward Owen Engineering Ltd. v Barclays Bank International Ltd.  1 QB 159