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When is a payment guarantee in fact a performance bond?

05 March 2013

In the case of Wuhan Guoyu Logistics Group Co Ltd & anr v Emporiki Bank of Greece SA [2012] EWCA Civ 1629, 7 December 2012, the Court of Appeal has expressed concern about the extensive and complex case law on whether an instrument is a performance bond or a guarantee, and expressly approved the analysis in Paget’s Law of Banking which provides that where an instrument contains an undertaking to "pay on demand" there should be a strong presumption that the instrument is a performance bond. In unanimously reversing a first instance decision that an instrument described as a "Payment Guarantee" was a guarantee rather than a performance bond, the Court of Appeal found that it was incorrect to treat the language of the instrument in question with "reverence" and to conduct an exhaustive line-by-line analysis of it.

The distinction between guarantees and performance bonds
There is an important distinction between guarantees and performance bonds, particularly in circumstances where there is a dispute as to whether the underlying debtor is in default. The essential characteristic of a guarantee is that primary liability rests with the debtor. The guarantor’s liability is secondary, and he will have no liability until breach of the primary contract has been demonstrated, and the related loss has properly crystallised but not been settled by the debtor. In any dispute as to whether the debtor is liable, the guarantee will be unenforceable until such liability is established.
 
By contrast, a performance bond can be called on immediately: the bank agrees to make a payment upon the beneficiary’s written demand and/or the production of documents certifying that certain events have occurred. Upon demand, the bank is obliged to make the payment, even if there is a dispute as to whether the events giving rise to the payment have occurred. If the bank refuses, it is normally possible for the beneficiary of a performance bond to obtain summary judgment, whereas such an application by the beneficiary of a guarantee would be unlikely to succeed.
 
Background
Pursuant to the terms of a shipbuilding contract, the two Chinese shipbuilder claimants agreed to construct two ships for the buyer. The buyer was obliged to make payment to the claimants in five instalments as construction of the ships progressed, the second of which was to be payable upon receipt by the buyer of a refund guarantee, together with a certificate confirming that the first steel plates of the vessel had been cut by the claimants. The buyer’s payment obligation was supported by an instrument described as a "Payment Guarantee" entered into between, among others, the claimants and the defendant, pursuant to which the defendant guaranteed the buyer’s payment obligations.
Clause 1 of the instrument provided that "…we, Emporiki Bank of Greece SA, hereby irrevocably, absolutely and unconditionally guarantee, as the primary obligor and not merely as the surety, the due and punctual payment by the Buyer of the 2nd instalment of the Contract Price". Clause 4 of the instrument then provided that "In the event that the Buyer fails to punctually pay the second Instalment guaranteed…then, upon receipt by us of your first written [notice]…we shall immediately pay to you or your assignee the unpaid 2nd Instalment".
 
In due course, the claimants issued an invoice for the second instalment, together with the relevant certificate stating that the steel had been cut. The buyer disputed whether the steel cutting had in fact taken place. The claimants made a demand for payment under the "letter of guarantee". The buyer disputed that the payment was due and the guarantor defendant accordingly refused to make payment. The claimants applied for summary judgment. The key question was whether the instrument was a performance bond, in which case summary judgment ought to be granted, or a guarantee, in which case the proceedings could not be determined summarily because of the underlying dispute as to whether payment was actually due.
At first instance the High Court found that the instrument was a guarantee and refused to grant summary judgment. The claimants appealed.
The Court of Appeal’s decision
Longmore LJ noted that, as in many such cases, the problem in construing this instrument was that its language included pointers in both directions. For example, the instrument was described as a guarantee but conversely provided for payment to be on the claimants’ first written demand.
In criticising the extensive authorities on similar matters of construction, which he felt had unnecessarily complicated this area of law, Longmore LJ emphasised the importance of adopting a consistent approach. He noted that the presence of certain elements in an instrument would give rise to a presumption that it be interpreted in one way or another. In this regard, Longmore LJ expressly cited and approved of the analysis in Paget’s Law of Banking (11th edition) which provides that:
"where an instrument (i) relates to an underlying transaction between the parties in different jurisdictions, (ii) is issued by a bank, (iii) contains an undertaking to pay "on demand" (with or without the words "first" and/or "written") and (iv) does not contain clauses excluding or limiting the defences available to a guarantor, it will almost always be construed as a demand guarantee."
Longmore LJ found that where an instrument contained elements consistent with Paget’s description, there should be a presumption that that instrument was a performance bond rather than a guarantee, especially in circumstances where the obligation to pay is expressed to be "on demand". Support for this approach was seen in Caja de Ahorros del Mediterraneo v Gold Coast Ltd [2001] EWCA Civ 1806, which also cited Paget with approval.
 
Further, Longmore LJ expressed concern that, had the first instance judgment been permitted to stand, guarantees of the kind before the Court would be almost worthless if, as here for example, a bank could resist payment on the basis that a foreign buyer was disputing whether a payment was due.
 
The Court of Appeal found that the judge at first instance had erred in failing to give sufficient regard to the presumption in Paget, and on this basis concluded that the instrument was in fact a performance bond.
 
Comment: In expressly approving Paget’s presumption, the Court of Appeal has given an important indication that, when distinguishing between a guarantee or a performance bond, the focus should be on the commercial context rather than the minutiae of the instrument’s language. The support for this presumption is likely to lead to a more consistent approach by the courts to similar questions of construction, promoting greater certainty for commercial parties as to the precise nature of the document they are entering into.
Further information
 
This case summary is part of the Allen & Overy Litigation Review, a monthly update on interesting new cases and legislation in commercial dispute resolution.  For more information please contact Sarah Garvey sarah.garvey@allenovery.com, or tel +44 (0)20 3088 3710.