01 Sep 2021

Surety guarantee or delayed demand?

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The recent decision of the Court of Appeal in Shanghai Shipyard Co Ltd v Reignwood International Investment (Group) Company Ltd [2021] EWCA Civ 1147 has demonstrated neatly the importance of the parties to a shipbuilding contract having a clear understanding of the legal nature of English law guarantees. The key issue is often whether the guarantor is obliged to pay a claim regardless of whether the validity of that claim has first been established by agreement between the parties to the shipbuilding contract or, in the absence of agreement, through litigation or arbitration proceedings.

If the document is drafted as a demand guarantee, the guarantor is obliged to pay regardless of any dispute under the shipbuilding contract. Demand guarantees are usually issued by a bank, for example, a refund guarantee by which a bank guarantees the shipyard's obligation to refund instalments. The bank has no interest in the underlying dispute, and will usually hold security from the shipyard to cover its liability under the guarantee. In contrast, if a guarantee is to be issued by a parent company, for example to secure the buyer's obligation to pay instalments, this is usually a "see-to-it" guarantee: the parent company does have an interest in the outcome of the underlying dispute and would not wish to pay a disputed claim until it had been proven in litigation or arbitration proceedings.

To protect a shipyard from the consequences of its refund guarantor being obliged to pay a disputed claim, it is usual for the refund guarantee to provide that the guarantor's obligation to pay may be deferred, in the event of arbitration proceedings having been commenced, until the issue of an arbitration award. At first sight (and in the opinion of the first instance judge in this case) this may appear to convert a demand guarantee into a see-to-it guarantee, by making the document subject to the outcome of an arbitration award, and thereby dependent upon the underlying dispute. However, the Court of Appeal has confirmed this is incorrect, and therefore a dangerous assumption for a buyer to make. 

The consequence is that if the parties to a shipbuilding contract were to agree the provision of reciprocal guarantees, whereby the parent company guarantee mirrors the wording of the refund guarantee, the parent company then exposes itself to the same potential liability as the refund guarantor, i.e. may be obliged to pay a claim, even if it is invalid. It may be thought that the consequences are not severe, as the parent company would still have the protection of being able to defer payment until following the outcome of an arbitration. However, in order to obtain the right to defer the payment obligation under a demand guarantee, the wording of the guarantee which provides that protection must be strictly followed. If it is not, as occurred in this case, the protection is lost, and the demand must be satisfied immediately, regardless of its validity. 

Background

Shanghai was the builder of a drillship for Opus (under a contract based on the CMAC Standard Newbuilding Contract (Shanghai Form)). Reignwood was the guarantor of Opus's obligations. Opus refused to take delivery of the completed vessel asserting that it had a number of significant defects and was not in a deliverable state. Shanghai rejected the assertions that the vessel was not in a deliverable state and claimed the final instalment from Opus on 11 January 2017. When Opus failed to pay, it made a demand of Reignwood under the guarantee on 23 May 2017. 

Shanghai commenced proceedings against Reignwood under the guarantee in September 2018. Reignwood commenced arbitration, on behalf of Opus, against Shanghai on 3 June 2019 under the shipbuilding contract.

Decision

At first instance, the High Court judge held that the guarantee was a 'see to it' guarantee so liability under the guarantee only arose if the buyer was liable to pay the first instalment. Reignwood could refuse to pay under the guarantee until the dispute as to whether the final instalment was payable had been resolved. It did not matter that the arbitration was not commenced until after the demand under the guarantee. 

Appeal

The Court of Appeal reversed the judge's decision, concluding that it was a demand guarantee and Reignwood was therefore liable to pay following the demand. It could not invoke the contractual clause to delay payment because the arbitration had not been commenced before the demand was made. 

The Court said that there should be no preconceptions about the nature of the instrument solely from the identity of the guarantor, i.e. just because Reignwood was not a bank, it could not be said that the guarantee was more likely to be a 'see to it' guarantee. The wording of the contract is the key factor. The commercial context of the guarantee was neutral as to the nature of the guarantee, but certain items of language indicated strongly that it was a demand guarantee. 

The first of these was the use of "ABSOLUTELY and UNCONDITIONALLY", which indicated that the guarantor's obligations were not conditional on the liability of the buyer. Further, clause 1, which set out the main guarantee obligation, said that Reignwood contracted "as primary obligor and not merely as surety".

The obligation on the guarantor to pay was triggered "immediately" on "receipt by us [the guarantor] of your [the yard's] first written demand". Payment against demand is a classic hallmark of a demand guarantee. In addition, it would not be appropriate for a surety guarantee to require immediate payment, because the guarantor would need time to assess whether there was an underlying liability to pay the final instalment. Another clause expressly provided that obligations on the guarantor were not to be affected by any dispute under the Building Contract. 

Clause 4 of the guarantee caused some of the confusion as to the type of guarantee this was. It allowed Reignwood to defer payment where there was a dispute between the buyer and the builder, until an arbitration award was produced. The Court of Appeal considered that, contrary to the judge's view, this supported the position that it was an on demand guarantee. The deferral of the payment did not convert the guarantor's obligation from primary to secondary. With the secondary obligation in a surety guarantee, the guarantor would not be bound by any arbitration award and could challenge a conclusion by the Tribunal that the buyer was liable. Clause 4 did not permit that; the guarantor remained obliged to pay on the issue of a document but changed that from the written demand to the arbitration award.

The final issue was whether clause 4 required the dispute to be submitted to arbitration before the obligation to pay on demand was suspended. The Court of Appeal held that it did. To provide otherwise would be to remove Shanghai's accrued right to payment on a valid demand, and clearer language would be required to remove such an accrued right.

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