In an alert last year, we looked at payment obligations under English law and how payment instruments commonly referred to as ‘guarantees’ may be misleading. This is despite their being crucial components to security in a commercial context.
The recent decision of the English Commercial court, Shanghai Shipyard Co Ltd. v. Reignwood International Investment (Group) Company  EWHC 803 (Comm), is the latest example of the type of dispute that can arise when the terms of the guarantee are not clearly drafted.
The Shanghai Shipyard case
The dispute was whether an “Irrevocable Payment Guarantee” given to a shipyard to secure a final instalment payment of US$170 million from a buyer of a drill ship created a primary or secondary obligation.
Under English law, the difference between a primary and secondary obligation is:
- A primary obligation requires the guarantor to pay if a compliant demand is made. This is often referred to as creating an obligation on the guarantor to pay ‘on demand’.
- A secondary obligation means the guarantor is ‘seeing to it’ that the underlying contract is performed. Therefore, in contrast to a primary obligation, the rights and obligations in the underlying contract determine whether the guarantor has to pay.
Thus in Shanghai Shipyard, if the guarantee was not an ‘on demand’ guarantee, the shipyard would have to show that the final payment of US$170 million was due under the terms of the shipbuilding contract. However if the guarantee created a primary obligation, the position under the shipbuilding contract was not relevant as between the guarantor and the shipyard, and the guarantor would have to pay.
Why does it matter?
The issue is one of practicality.
The (significant) advantage of an ‘on demand’ guarantee is that the beneficiary should ordinarily be able to get paid (assuming the guarantor is good for the money) relatively quickly and can then fight any dispute with money in its pocket.
By contrast, a ‘see to it’ guarantee means that in the event the guarantor refuses to pay, the beneficiary will have to obtain an arbitration award (or court judgment) establishing liability in relation to the underlying contract. This could take the beneficiary a great deal of time and could cost a great deal of money. The beneficiary may also then face enforcement issues.