(d) URDG: demand guarantees
General. An adequate alternative to a ‘confirmed L/C’ is a (bank) guarantee.[1] A guarantee provides a higher level of certainty as regards the other party’s performance. It can be procured by both parties. If a buyer procures the bank guarantee, its aim is to secure the payment of the contract price (that would normally be paid by the buyer itself). If a supplier procures the bank guarantee, its aim is to secure repayment of any paid contract price, or of any damages caused by non-conformity or delayed performance.
Usage. Guarantees are used in various types of risky, often complex transactions. Such transactions include:
- in a sale of goods transaction, payment upon a seller’s default (e.g. non-conformity or delayed delivery);
- in a service contract or construction contract, security for due performance; or
- in joint venture agreements, underwriting the liability of the partners by their respective parent companies.
Terminology. A demand guarantee (when issued by a bank, a “bank guarantee”) is also referred to as a “first demand guarantee”, an “independent guarantee” or an “abstract guarantee”. These are all designations of the same concept, emphasising the essential characteristic of a guarantee: a separate undertaking by the guarantor to answer for the duty of another, should the other default. The trigger for a (demand) guarantee is contractual non-performance (or poor or delayed performance). To what extent the breach of contract must be proven vis-à-vis the guarantor is a matter of negotiation: a less abstract guarantee that requires a more comprehensive inquiry into the validity of the documents submitted by the beneficiary, or into compliance with the underlying contract, is sometimes also called an “accessory guarantee”.
First pay then talk. A bank guarantee ensures that the harmed customer must start court proceedings to recover damages (it cannot withhold payment). The effect of a bank guarantee is “first pay then talk”. If the customer procures the bank guarantee, the effect of calling under the bank guarantee is that the contract price is paid by operation of the bank guarantee. If the supplier procures the bank guarantee, any damages suffered by the customer are compensated by operation of the bank guarantee. When there is discussion whether or not a claim under the bank guarantee is justified, such discussion would take place after payment under the bank guarantee. Accordingly, a bank guarantee diminishes the risks that either party would otherwise assume.
Abstract (or independent) character. Normally, a guarantee is an ‘absolute’ (‘primary and independent’) undertaking by a bank – the guarantor – to pay if the conditions of the guarantee are satisfied. The issuing bank is not concerned as to whether there has been any actual default by the applicant. Obviously, a bank issuing a guarantee will require that the applicant (or a third party, such as an affiliated or parent company) “counter-guarantee” due performance vis-à-vis the bank.
The conditions of a guarantee are stipulated in a separate agreement with the guarantor, which is called “the guarantee”. The applicant should ascertain that the underlying contract and the guarantee match: the underlying contract should not require a guarantee that is hardly obtainable (or excessively expensive); and the guarantee should not require documents or evidence that will never exist in the framework of the underlying contract. If any documents or evidence must be submitted to the guarantor, the guarantor will examine the required documents and evidence “on their face”, i.e. by interpreting the context of the presented document, the guarantee and the applicable rules. If they reasonably appear to meet the requirements, the bank (or guarantor) will pay.
If the guarantee does not require any document or evidence, a mere statement that there is a breach of contract is sufficient for the guaranteeing bank to pay. The guarantee may expressly stipulate that no such statement is required at all.[2]
Bank guarantees vs. L/C’s. In practice, demand guarantees, performance guarantees, performance bonds and standby L/C’s have a similar legal character and resemble documentary credits: they are ‘primary’ (independent or abstract) and typically conditional only upon a written demand for payment, accompanied by any stipulated documents or evidence. The principle of autonomy of the bank´s undertaking and the doctrine of strict compliance apply to bank guarantees just as they do to L/C’s. Moreover, the fraud exception may be invoked in respect of a guarantee.
Regulatory framework: URDG. The international standard practice for use of demand guarantees is reflected in the Uniform Rules for Demand Guarantees published by the ICC (URDG; current version URDG 758).[3] URDG 758 applies to any demand guarantee or counter-guarantee (whatever name is given to it), provided that this is expressly indicated in the provisions of the guarantee (and the counter-guarantee). A guarantee is irrevocable even if it does not state that this is so.
[1] See the ITC Model Contract for the international commercial sale of goods (standard and short versions), Article 4.3; the ITC Model Contract for the international long-term supply of goods, Article 4.3; and the ITC Model Contract for the international distribution of goods, Article 5.3.
[2] URDG Article 15(a) and (c).
[3] URDG 758 is a complete revision of URDG 458, and effective as of 1 July 2010.