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The difference between suretyship guarantees and demand guarantees

Author
Philip Carstairs

Senior PSL

London

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02 August 2021

A guarantee is essentially a promise by a third party to ensure that an obligor meets its liabilities to another. There are two main types of guarantee that we meet in finance transactions: suretyship guarantees and demand guarantees. The differences between the two are important and yet identifying into which category a particular guarantee falls is something that even judges find difficult, despite a significant body of case law.

A demand guarantee is a type of guarantee usually, but not always, provided by a bank on behalf of a customer (for a fee) in which the bank agrees to pay a specified sum on receipt of a demand from a specified third party (usually its customer's contractual counterparty). A suretyship guarantee is a promise by one party to be answerable for the obligation or liability of another.
 
The differences between the two are important. With a suretyship guarantee, equity will intervene to protect a guarantor in some circumstances (for example, if the underlying contractual obligations which it has guaranteed have been increased without the guarantor's consent). A surety's obligations are also secondary: the beneficiary of the guarantee must first establish the main obligor's liability and default. With a demand guarantee payment is only conditional on the beneficiary serving a demand in the required form (although this can be made conditional on an event happening). Normally, demand guarantees are not subject to the equitable defences that a suretyship guarantee is. A demand guarantee is not quite as good as cash or a letter of credit, but it is a lot closer to cash than a suretyship guarantee is, and there is far less scope for litigation about whether payment is due from the guarantor. 
 
You often encounter demand guarantees in a shipbuilding context: the shipyard might get its bank to guarantee the shipyard's obligation to refund stage payments for the construction of a ship if it defaults on the shipbuilding contract, or the buyer may provide the shipyard with a guarantee of its obligations to make stage payments during construction. A suretyship guarantee might be encountered when a parent company guarantee's the obligations of a subsidiary. 
 
The problem for parties relying on guarantees is that there is not a clear cut distinction between the two types, rather they are at different ends of a spectrum and many cases fall between the two ends. Suretyship guarantees tend to be drafted with wording that makes the guarantor "primary obligor" and liable to "pay on first demand" (ie gives the guarantor a primary obligation to perform the primary debtor's obligations once the debtor defaults); there is also a tendency for demand guarantees to contain waivers by the guarantor of its equitable defences (even if these are generally unnecessary). 
 
Shanghai Shipyard agreed to build an offshore drillship for Reignwood. Reignwood had provided letters of credit to cover the first two stage payments and a guarantee to cover the last (Reignwood novated the shipbuilding contract to an special purpose company which was to take title to the vessel on delivery). A dispute developed about whether the vessel was in deliverable condition. Shanghai Shipyard sought payment under the guarantee, which it said was a demand guarantee. Reignwood resisted on the grounds that it was a suretyship guarantee and no liability had yet arisen.
 
The courts frequently refer to the leading text Paget's Law of Banking which identifies four key characteristics of a demand guarantee, namely: a cross-border transaction, the guarantee being issued by a bank, an undertaking to pay on demand and an absence of clauses excluding or limiting the equitable defences normally available to a guarantor.
 
The guarantee stated that "we [Reignwood] IRREVOCABLY, ABSOLUTELY and UNCONDITIONALLY guarantee… as primary obligor and not merely as the surety, the due and punctual payment by the Owner [i.e. the SPV] of the final instalment. … In the event that the Owner fails to punctually pay… upon receipt by us of your first written demand we shall immediately pay all unpaid final instalment…" Later in the guarantee, a clause excluded the equitable defences available to a surety.
 
The guarantee therefore met only two of Paget's four criteria. However, Paget's criteria are not consistently applied by the courts or always helpful (for example, you do not need to be a bank to issue a demand guarantee). In this case the Court of Appeal rejected using these criteria and reviewing the many conflicting authorities which looked at many differently worded guarantees, in order to arrive at a presumption of which type of guarantee it was. The court preferred to rely solely on the language of the document, the words actually used by the parties in "the document taken as a whole" and the assumption that because the commercial context involved a shipbuilding contract, it was more likely to be a demand guarantee than a suretyship guarantee. The wording which convinced the court that this was a demand guarantee were the "ABSOLUTELY and UNCONDITIONALLY", "as primary obligor and not merely as the surety", the fact that payment was triggered by a demand and to be immediate, and that the obligation to pay was unaffected by any dispute under the shipbuilding contract, unless arbitration was actually underway at the time of demand in which case payment was deferred until the arbitrator had made an award.
 
The case illustrates the problems with drafting guarantees and the risks in relying on abstract criteria rather than the actual wording of the document and its intended effect. Demand guarantees are more onerous for guarantors as they have far less room for argument about whether payment is due and generally no access to the equitable defences, so these points are worth bearing in mind; likewise if a party wants a demand guarantee it is better to be absolutely clear that this is what is being given.

Judgment: Shanghai Shipyard v Reignwood
 
 

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