The Shanghai Shipyard case
The dispute concerned a document the parties had called an “Irrevocable Payment Guarantee” (the Guarantee), governed by English law. The Guarantee was given by Reignwood (the Guarantor) to Shanghai Shipyard (the Builder) to secure a final instalment payment of US$170 million from a buyer of a drillship (the Buyer) under a shipbuilding contract (the Contract). Underlying the dispute under the Guarantee was an arbitration between the Buyer and the Builder under the Contract after the Buyer did not take delivery of the drillship, alleging it was not in a deliverable condition.
The issue before the Court was how to classify the Guarantee and, in particular, whether:
(a) The Guarantee was a traditional surety guarantee such that the Guarantor was only liable to honour the Builder’s demand under the Guarantee if the Buyer was itself liable to pay the Builder the final instalment under the Contract. Guarantees of this type are sometimes known as “see to it” guarantees, because the guarantor must “see to it” that the debtor performs its obligations to the creditor; or
(b) The Guarantee was an “on demand” guarantee such that the Guarantor’s liability under the Guarantee arose simply by reason of the Builder’s demand ‒ and irrespective of whether or not the Buyer was liable to pay the final instalment to the Builder under the Contract. Under an “on demand” guarantee, the guarantor’s liability is triggered not by the debtor’s liability but by an event – typically the making of the demand itself. Indeed, the word “guarantee” is scarcely suitable for instruments of this type, although it is still widely used, often resulting in considerable confusion.
Whilst both traditional “see to it” guarantees and “on demand” guarantees protect the beneficiary against the risk of counterparty default or insolvency, an “on demand” guarantee additionally preserves the beneficiary’s cash flow. If a guarantee is an “on demand” guarantee, then it is unlikely that the guarantor (assuming it is solvent) will be able to resist payment provided that the demand was made in good faith, and even if the underlying debt is disputed by the debtor. If, however, a guarantee is a “see to it” guarantee, the guarantor is likely to be able to dispute liability to pay insofar as there is an unresolved dispute as to the validity of the beneficiary’s claim under the underlying contract. (In Shanghai Shipyard, there was an ongoing arbitration between the Builder and Buyer as to whether the drillship was in a deliverable condition as required by the Contract and therefore whether the final instalment was due.)
The common theme in many of the reported cases in this area is ambiguity as to how a guarantee should be classified. Despite attempts by the courts to clarify the law, in many cases, it remains difficult to predict how a court or arbitration tribunal will classify a particular guarantee ‒ and of course, such determinations take time, potentially undermining the very cash flow benefits that the beneficiary hoped to receive from an “on demand” guarantee.
The Guarantee
The Guarantee in the Shanghai Shipyard case included the following wording:
“1. [...] [The Guarantor] hereby IRREVOCABLY, ABSOLUTELY and UNCONDITIONALLY guarantee[s] in accordance with the terms hereof, as the primary obligor and not merely as the surety [...]
4. In the event that the [Buyer] fails to punctually pay the Final instalment guaranteed hereunder in accordance with the Contract or the [Buyer] fails to pay any interest thereon, and any such default continues for a period of fifteen (15) days, then, upon receipt by us of your first written demand, [the Guarantor] shall immediately pay [...]
In the event that there exists dispute between the [Buyer] and Builder as to whether:
(i) the [Buyer] is liable to pay to the Builder the Final Instalment; and
(ii) the Builder is entitled to claim the Final Instalment from the [Buyer],
and such dispute is submitted either by the [Buyer] or by you for arbitration in accordance with Clause 17 of the Contract, we shall be entitled to withhold and defer payment until the arbitration award is published. [...]
7. Our obligations under this guarantee shall not be affected or prejudiced by:
(a) any dispute between you as the Builder and the [Buyer] under the Contract;
[...]”
The Commercial Court decision
As explained in our previous client alert, under English law, there is a strong presumption that a guarantee given outside a banking context (i.e., by a guarantor that is not a bank or financial institution) will be a traditional “see to it” guarantee and not an “on demand” guarantee (Marubeni Hong Kong and South China Ltd v. Government of Mongolia [2005] 1 WLR 2497).
As is so often the case, the uncertainty in this case arose because, whilst the Guarantee was not given to the Builder by a bank or financial institution, the Guarantee contained commonly found wording which, as a matter of language, tended to suggest an intention to create an “on demand” payment obligation on the part of the Guarantor.
At first instance, the Commercial Court found in favour of the Guarantor, holding that the wording of the Guarantee was insufficiently clear to create an “on demand” obligation, and the Guarantor’s obligation to pay the Builder was held to be conditional on the outcome of the ongoing arbitration between the Buyer and the Builder.
The Court of Appeal decision
The Court of Appeal unanimously overturned the first instance decision and found that the Guarantee should properly be characterised as an “on demand” guarantee, with the result that the Builder had a right to immediate payment notwithstanding that the Builder’s underlying claim was still the subject of the arbitration.
The decision was made on the basis of the words used in the Guarantee and, in particular, the following words:
- The words “ABSOLUTELY and UNCONDITIONALLY” would convey to a businessman that the Guarantor’s obligations were not conditional on the liability of the Buyer.
- The words “[as a primary obligor] and not merely as the surety” were a clear indication that the document was not a surety guarantee.
- The words stating that the Guarantor’s payment obligation would be triggered “upon receipt by us of your first written demand” were a hallmark of an “on demand” guarantee.
- “Immediate payment” was inconsistent with the nature of a “see to it” guarantee.
- The Guarantee expressly provided that the Guarantor’s obligations were unaffected by any disputes under the underlying Contract, which put beyond it any argument that this could be a “see to it” guarantee.
- The proviso in clause 4 that if a dispute between the Builder and Buyer as to whether the final instalment was due was submitted to arbitration, no sum was payable under the Guarantee until an arbitral award was made ordering the Buyer to pay the final instalment, in fact, supported the construction of the Guarantee as an “on demand” guarantee. This was because, where such an arbitration was commenced, the Guarantor’s liability was triggered by an event ‒ the making of an award ‒ and not the underlying liability of the Buyer to the Builder.
The Court of Appeal rejected as a matter of principle the submission that the starting point for classifying the nature of the Guarantee was to first identify the nature of the Guarantor. The Court of Appeal did not, therefore, begin the exercise of interpretation from a presumption (consistent with authorities such as Marubeni) that where the guarantor was not a bank or financial institution, the guarantee was likely to be a “see to it” guarantee. The court was particularly influenced by prior cases in the shipbuilding context in which guarantees, including guarantees given by parties other than banks, were held to be “on demand” guarantees.
The effect of the arbitration
There was a second issue before the Court of Appeal, namely whether the proviso in clause 4 could be engaged notwithstanding that the Builder’s demand had been made before the arbitration between the Builder and the Buyer had been commenced. If the proviso could be engaged in such circumstances, the Builder would have to wait for publication of a favourable award before legitimately expecting payment on demand from the Guarantor. However, the Court of Appeal ruled that the Builder accrued a right to payment under the Guarantee at the time it made the demand, and therefore only clear language could subsequently divest the Builder of that right. There was no such language in this Guarantee, and the proviso was not engaged.
Practical implications
It remains to be seen whether the dispute will be considered by the Supreme Court (the highest court in the English legal system) to give the final word.
The Court of Appeal’s decision will undoubtedly be welcomed by the Builder. However, it should not be forgotten that the Builder first made the demand under the Guarantee in 2017. It has taken more than four years of litigation for it to be found that this demand for immediate payment was valid. This is exactly the sort of issue that “on demand” guarantees are meant to avoid, and the case shows the problems that can arise when guarantees lack clarity.
Drawing principles from the Court of Appeal’s decision is also difficult as decisions on these issues (as the court itself noted) invariably turn on the wording used, and similar wording to that relied upon by the Court of Appeal in this case has, in other cases, been found to be insufficient to create an “on demand” obligation. However, the decision does show that the presumption that guarantees given outside a banking context ‒ such as for example parent company guarantees ‒ will tend to be classified as guarantees of suretyship rather than “on demand” guarantees has been displaced. The wording used in the guarantee itself will henceforth be the primary area of focus.
Also of particular note is the Court of Appeal’s interpretation of the wording at clause 4 of the Guarantee that no sum would be payable if arbitration had been commenced under the Contract, absent a favourable arbitration award for the Builder. The Court of Appeal rejected the Guarantor’s argument that this wording was inconsistent with an obligation to pay “on demand”. Instead, it held that it could still apply, in the words of the Court of Appeal, to “convert” the on-demand obligation into a “conditional bond”. Although the judgment stresses that if clause 4 were triggered, it would not make the Guarantor’s obligation to pay under the Guarantee conditional on the Buyer’s liability to the Builder being established, to all intents and purposes that is the practical effect. Therefore, as a matter of practicality, a beneficiary with similar wording in their guarantee would be well advised to make a formal demand as soon as possible to ensure that such a provision cannot be triggered by the guarantor to create a “conditional bond” and thereby delay the obligation to pay.
In-depth 2021-212
