Demand guarantee
Encyclopedia
In English writings, traditionally the term “guarantee” denotes an accessory
(secondary) or “conditional
” type of obligation
. The essence of the instrument is the promise
to answer for the duty of another should the other default
. The beneficiary
of such a promise will not be entitled to payment
unless it can adduce evidence
of the occurrence of the event, which the guarantee secures. Thus the issuer’s liability
to pay arises only in cases of actual default of the principal and not by a mere demand. In addition the issuer in cases of litigation can raise any defences available for the principal. Thus if it later appears that the contract
between the principal and the beneficiary was void, the guarantor may raise this defence to avoid paying the beneficiary. In addition the surety
could raise defences which are not available to the principal, these include (i) materially increasing the risk
of the issuer without consent of the issuer by contract changes (ii) alterations (iii) improper payments. For further analysis on the defences available to the issuer.
Major differences distinguish this instrument from “demand guarantees”; in the latter instrument the obligation to pay is conditioned within the terms of the bank’s promise, therefore if the demand guarantee is payable upon the beneficiary’s written first demand he is assured payment notwithstanding any defence related to any other underlying transactions. Proof of default is not needed and issuers are not concerned with the underlying contract nor can they raise any defence available to the underlying contracting party.
This type of guarantee is usually used in a wide range of different and often complex transactions
. These transactions include: payment upon the seller’s default in a sale of goods transaction; security
for service contracts or construction contracts; paying the fee of a solicitor
in case he secures a divorce
for a client; underwriting
the liability
of partners in joint venture
agreements; and they have even been used to secure the payment of a ransom
. Each type of business or transaction may require the issuance of a certain type of guarantee. The typical demand guarantee is simply used to provide financial security
against default in performance of a non-money obligation, in which case the guarantee is usually given by the seller/contractor (the account party) to the buyer/employer (the beneficiary).
There is much terminological confusion when distinguishing between demand guarantees and accessory guarantees. Indeed the issue has been disputed in some recent cases. No precise term has yet been adopted to distinguish between the two types of instruments. English courts
, however, have agreed that the decisive factor in determining the type of the guarantee is to be found in the terms of the guarantee itself and not in how the guarantee is referred to in a particular transaction.
In the United States
and Canada
, a demand guarantee is referred to as a standby letter of credit (SBLC) and English courts give standby credits the same legal status that is given to demand guarantees.
The account party might not trust the beneficiary enough to agree to provide him with a cash deposit
; similarly the beneficiary might doubt the account party’s solvency
and therefore ability to fulfil the underlying contract or its ability to rectify defaults in performance. The demand guarantee bridges the “gap of distrust” that exists between the parties. When the bank issues the demand guarantee, the beneficiary deals with a party whose financial strength he can trust and a party which would pay upon first demand regardless of an existing dispute between the parties on the performance of the underlying contract. More importantly, however, the demand guarantee is also used to reallocate the risks between the parties. In this regard, the demand guarantee is used to avoid three types of risk: judgment risks, execution risks and jurisdictional risks. Judgment risks include, inter alia, risks involved in taking the dispute to court, losing on a procedural issue, the risk of an unfriendly court, evidentiary problems and the threat of political uncertainty that could prevent an action being brought against a party. Execution risks include the risk that a plaintiff could not execute a judgment against the defendant. This is often due to defendant insolvency or due to the unenforceability of one country’s court judgments in another country. Finally jurisdictional risks are part of both the above risks: they revolve mainly around the costs and difficulty that a party would endure when bringing an action against the defendant who is usually located in another jurisdiction. Where the beneficiary is issued a demand guarantee by a bank in his own locality, the guarantee aims “to shifting of risks and the cost of bearing them from [the beneficiary to the account party]”. Should the beneficiary find the contractor in default, he can immediately seek compensation by demanding on the guarantee and it is the account party who is forced to bring an action to recover any disputed amount. The premise in such transactions is that by agreeing to provide a demand guarantee both the account party and the beneficiary agree that the latter should not be deprived of his money (money due under the guarantee) by litigation against him at the suit of the account party.
Accessory
Accessory may refer to:* Accessory , a person who assists a criminal but is not present at the crime* Accessory , with members Dirk Steyer and Ivo Lottig* Fashion accessory, i.e...
(secondary) or “conditional
Conditional
Conditional may refer to:*Causal conditional, if X then Y, where X is a cause of Y*Conditional mood , a verb form in many languages*Conditional probability, the probability of an event A given that another event B has occurred...
” type of obligation
Obligation
An obligation is a requirement to take some course of action, whether legal or moral. There are also obligations in other normative contexts, such as obligations of etiquette, social obligations, and possibly...
. The essence of the instrument is the promise
Promise
A promise is a commitment by someone to do or not do something.In the law of contract, an exchange of promises is usually held to be legally enforceable, according to the Latin maxim pacta sunt servanda.- Types :...
to answer for the duty of another should the other default
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
. The beneficiary
Beneficiary
A beneficiary in the broadest sense is a natural person or other legal entity who receives money or other benefits from a benefactor. For example: The beneficiary of a life insurance policy, is the person who receives the payment of the amount of insurance after the death of the insured...
of such a promise will not be entitled to payment
Payment
A payment is the transfer of wealth from one party to another. A payment is usually made in exchange for the provision of goods, services or both, or to fulfill a legal obligation....
unless it can adduce evidence
Evidence (law)
The law of evidence encompasses the rules and legal principles that govern the proof of facts in a legal proceeding. These rules determine what evidence can be considered by the trier of fact in reaching its decision and, sometimes, the weight that may be given to that evidence...
of the occurrence of the event, which the guarantee secures. Thus the issuer’s liability
Legal liability
Legal liability is the legal bound obligation to pay debts.* In law a person is said to be legally liable when they are financially and legally responsible for something. Legal liability concerns both civil law and criminal law. See Strict liability. Under English law, with the passing of the Theft...
to pay arises only in cases of actual default of the principal and not by a mere demand. In addition the issuer in cases of litigation can raise any defences available for the principal. Thus if it later appears that the contract
Contract
A contract is an agreement entered into by two parties or more with the intention of creating a legal obligation, which may have elements in writing. Contracts can be made orally. The remedy for breach of contract can be "damages" or compensation of money. In equity, the remedy can be specific...
between the principal and the beneficiary was void, the guarantor may raise this defence to avoid paying the beneficiary. In addition the surety
Surety
A surety or guarantee, in finance, is a promise by one party to assume responsibility for the debt obligation of a borrower if that borrower defaults...
could raise defences which are not available to the principal, these include (i) materially increasing the risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
of the issuer without consent of the issuer by contract changes (ii) alterations (iii) improper payments. For further analysis on the defences available to the issuer.
Major differences distinguish this instrument from “demand guarantees”; in the latter instrument the obligation to pay is conditioned within the terms of the bank’s promise, therefore if the demand guarantee is payable upon the beneficiary’s written first demand he is assured payment notwithstanding any defence related to any other underlying transactions. Proof of default is not needed and issuers are not concerned with the underlying contract nor can they raise any defence available to the underlying contracting party.
This type of guarantee is usually used in a wide range of different and often complex transactions
Financial transaction
A financial transaction is an event or condition under the contract between a buyer and a seller to exchange an asset for payment. It involves a change in the status of the finances of two or more businesses or individuals.-History:...
. These transactions include: payment upon the seller’s default in a sale of goods transaction; security
Security
Security is the degree of protection against danger, damage, loss, and crime. Security as a form of protection are structures and processes that provide or improve security as a condition. The Institute for Security and Open Methodologies in the OSSTMM 3 defines security as "a form of protection...
for service contracts or construction contracts; paying the fee of a solicitor
Solicitor
Solicitors are lawyers who traditionally deal with any legal matter including conducting proceedings in courts. In the United Kingdom, a few Australian states and the Republic of Ireland, the legal profession is split between solicitors and barristers , and a lawyer will usually only hold one title...
in case he secures a divorce
Divorce
Divorce is the final termination of a marital union, canceling the legal duties and responsibilities of marriage and dissolving the bonds of matrimony between the parties...
for a client; underwriting
Underwriting
Underwriting refers to the process that a large financial service provider uses to assess the eligibility of a customer to receive their products . The name derives from the Lloyd's of London insurance market...
the liability
Legal liability
Legal liability is the legal bound obligation to pay debts.* In law a person is said to be legally liable when they are financially and legally responsible for something. Legal liability concerns both civil law and criminal law. See Strict liability. Under English law, with the passing of the Theft...
of partners in joint venture
Joint venture
A joint venture is a business agreement in which parties agree to develop, for a finite time, a new entity and new assets by contributing equity. They exercise control over the enterprise and consequently share revenues, expenses and assets...
agreements; and they have even been used to secure the payment of a ransom
Ransom
Ransom is the practice of holding a prisoner or item to extort money or property to secure their release, or it can refer to the sum of money involved.In an early German law, a similar concept was called bad influence...
. Each type of business or transaction may require the issuance of a certain type of guarantee. The typical demand guarantee is simply used to provide financial security
Security (finance)
A security is generally a fungible, negotiable financial instrument representing financial value. Securities are broadly categorized into:* debt securities ,* equity securities, e.g., common stocks; and,...
against default in performance of a non-money obligation, in which case the guarantee is usually given by the seller/contractor (the account party) to the buyer/employer (the beneficiary).
There is much terminological confusion when distinguishing between demand guarantees and accessory guarantees. Indeed the issue has been disputed in some recent cases. No precise term has yet been adopted to distinguish between the two types of instruments. English courts
English law
English law is the legal system of England and Wales, and is the basis of common law legal systems used in most Commonwealth countries and the United States except Louisiana...
, however, have agreed that the decisive factor in determining the type of the guarantee is to be found in the terms of the guarantee itself and not in how the guarantee is referred to in a particular transaction.
In the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
and Canada
Canada
Canada is a North American country consisting of ten provinces and three territories. Located in the northern part of the continent, it extends from the Atlantic Ocean in the east to the Pacific Ocean in the west, and northward into the Arctic Ocean...
, a demand guarantee is referred to as a standby letter of credit (SBLC) and English courts give standby credits the same legal status that is given to demand guarantees.
Role of demand guarantees in international trade
Demand guarantees developed to replace money deposits, which sellers had to provide to buyers in order to secure the latter against the former’s default under the contract. The substitution of money deposits by demand guarantees helped account parties to maintain their liquidity: they were no more forced to tie up their money for a considerable period of time pending completion of the underlying contracts, and where the account party had no sufficient money to pay an upfront deposit it was relieved from the expense of borrowing cash from a banker and paying interest on the loan during its life. The account party also benefits from the low cost of demand guarantees compared to other instruments such as accessory guarantees.The account party might not trust the beneficiary enough to agree to provide him with a cash deposit
Deposit account
A deposit account is a current account, savings account, or other type of bank account, at a banking institution that allows money to be deposited and withdrawn by the account holder. These transactions are recorded on the bank's books, and the resulting balance is recorded as a liability for the...
; similarly the beneficiary might doubt the account party’s solvency
Solvency
Solvency, in finance or business, is the degree to which the current assets of an individual or entity exceed the current liabilities of that individual or entity. Solvency can also be described as the ability of a corporation to meet its long-term fixed expenses and to accomplish long-term...
and therefore ability to fulfil the underlying contract or its ability to rectify defaults in performance. The demand guarantee bridges the “gap of distrust” that exists between the parties. When the bank issues the demand guarantee, the beneficiary deals with a party whose financial strength he can trust and a party which would pay upon first demand regardless of an existing dispute between the parties on the performance of the underlying contract. More importantly, however, the demand guarantee is also used to reallocate the risks between the parties. In this regard, the demand guarantee is used to avoid three types of risk: judgment risks, execution risks and jurisdictional risks. Judgment risks include, inter alia, risks involved in taking the dispute to court, losing on a procedural issue, the risk of an unfriendly court, evidentiary problems and the threat of political uncertainty that could prevent an action being brought against a party. Execution risks include the risk that a plaintiff could not execute a judgment against the defendant. This is often due to defendant insolvency or due to the unenforceability of one country’s court judgments in another country. Finally jurisdictional risks are part of both the above risks: they revolve mainly around the costs and difficulty that a party would endure when bringing an action against the defendant who is usually located in another jurisdiction. Where the beneficiary is issued a demand guarantee by a bank in his own locality, the guarantee aims “to shifting of risks and the cost of bearing them from [the beneficiary to the account party]”. Should the beneficiary find the contractor in default, he can immediately seek compensation by demanding on the guarantee and it is the account party who is forced to bring an action to recover any disputed amount. The premise in such transactions is that by agreeing to provide a demand guarantee both the account party and the beneficiary agree that the latter should not be deprived of his money (money due under the guarantee) by litigation against him at the suit of the account party.