Demand Bonds: In the UK, Less Is More
A recent case has opened a debate as to the drafting required to create a demand bond as opposed to a guarantee. If you are involved with issuing demand bonds or are a beneficiary under a document that purports to constitute a demand bond, you will need to look closely at the language used in such document to ensure a court will interpret it as such.
It is often a requirement of commercial arrangements that a third party agrees to stand behind a party to the main contract. This support can take many forms—an agreement to ensure that the party to the main contract duly performs or an entirely separate obligation to make good the failure to perform. The former is an example of a guarantee and the latter an example of a demand bond.
Demand bonds provide comfort to the beneficiary that if its counterparty under a contract breaches that agreement, it need only inform the provider of the demand bond (usually a bank) in writing of the default, and the provider will pay out a specified sum. The beneficiary is entitled to payment simply on submitting a statement (or certificate) that the counterparty is in default of the contract.
Under English law, demand bonds create a primary liability that is wholly independent of the main contact, whereas guarantees create a secondary liability that is contingent upon the obligation under the main contract being enforceable. The distinction can therefore be crucial if there is dispute as to the validity of the terms of the main contract.
In a recent case (Wuhan Guoyu Logistics Group Co Ltd and others v Emporiki Bank of Greece SA  EWHC 1715 (Comm) (22 June 2012)), the High Court in England found that even though a bank had agreed to "irrevocably, absolutely and unconditionally guarantee, as primary obligor and not merely as surety, the due and punctual payment by the buyer" and that "upon receipt by us of your first written demand stating that the [Buyer] has been in default of the payment obligation for twenty (20) days, we shall immediately pay to you…," this was nevertheless a guarantee, not a demand bond. Such wording (particularly if given by a bank) had previously been viewed as a strong indicator of a demand bond, but the court held that the primary obligation assumed by the bank was the obligation to pay the sum actually due under the underlying contract.
The seller entered into shipbuilding contracts with the buyer. The contract price was to be paid in installments, and the bank issued what was described as a guarantee (the "Guarantee") of the second installment, which was due to be paid under the main contract after completion of the cutting of the first 300 meters of steel plate.
The seller sent the buyer an invoice for the second installment, together with a certificate that the steel cutting had been done, but the second installment was not paid. The seller made a claim under the Guarantee saying that it was a demand bond, due on written demand, irrespective of any dispute around whether or not the underlying payment was due.
The bank refused payment, arguing that the Guarantee was not a demand bond but a guarantee and that there was a dispute as to whether or not the underlying payment was due, which meant that it was not liable. The seller applied to court for summary judgment against the bank.
The judge refused summary judgment, deciding that the Guarantee was a guarantee, not a demand bond.
The judge held that the bank agreeing to be a "primary obligor" and to "pay on first written demand" did not override the fact that the main obligation was to guarantee "payment by the Buyer." Further, the fact that the Guarantee elaborated on the circumstances in which the bank was liable, particularly the inclusion of a requirement that notice of the cutting of the steel (which constituted a condition precedent to payment under the main contract) be given and was referred to as a "guarantee" throughout the document, led the judge to hold that the primary obligation undertaken by the bank was the obligation to pay the sum actually due under the main contract. As a consequence, if the underlying sum was not due, no claim could be made under the Guarantee.
The Guarantee was confusing in that it used the language of primary obligation but applied it in the context of a guarantee relationship. However, it is not unusual for such documents to combine both primary and secondary obligations, and similar wording had previously been found to constitute a demand bond.
The judge said that "appropriate (and terser) language" should have been used to create a demand bond. As a consequence, going forward, drafting for demand bonds should be kept as simple as possible—ideally along the lines of:
"We irrevocably and unconditionally promise to pay, as primary obligor, to you on your first written demand an amount of [ ]."
The bond should also set out any requirements for the form of the written demand. Attempting to clarify in greater detail the exact nature of the obligation may open a debate as to whether the legal nature of the obligation created is a guarantee.
For documents already issued, you might want to revisit the language used to check whether it would be held to be a demand bond or a guarantee.
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