In an alert last year, we looked at the English Commercial Court’s decision in Shanghai Shipyard Co Ltd. v. Reignwood International Investment (Group) Company  EWHC 803 (Comm), a case concerning whether a guarantee should be classified as an “on demand” guarantee or a traditional surety or “see to it” guarantee. The Court of Appeal (the second-highest court in the English legal system) has now overturned the decision of the Commercial Court.
The Court of Appeal’s judgment provides important guidance on the question of when a guarantee is likely to be classified being as payable “on demand”. The judgment will therefore be of interest to those responsible for drafting guarantees, especially as (as the court observed) disputes of this nature are common.
The Court of Appeal’s judgment suggests that, when deciding whether a guarantee should be classified as an “on demand” guarantee, the words the parties have chosen to use in the guarantee itself should be the court’s primary focus – and that the identity of the guarantor (and, in particular, whether or not it is a bank) will be less relevant to this issue than has previously been supposed.
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 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;