Guarantees of performance are often required in commercial transactions. A crucial distinction must be made between guarantees which enable a claim to be rejected on the basis of defences to the underlying liability ("true guarantees", which provide protection against insolvency of the contracting party or other difficulties of enforcement of the liability once established) and those which do not ("demand bonds") where the guarantor is liable regardless of whether there is such a defence and which provide in addition a cash flow protection which can be a crucial element of the financing of a complex transaction.

Distinguishing between these two forms of indemnity has been troubling first instance and appellate courts regularly for over forty years.  In Wuhan Guoyu Logistics Group Co Ltd  & another v Emporiki Bank of Greece SA [2012] EWCA Civ 1629 the English Court of Appeal firmly rejected an approach to this question involving either "reverence" for the words used in the instrument or a detailed analysis of authority.  Instead, the Court decided that "if certain elements are present in the document, the document will be construed in one way or the other".

At first instance ([2012] EWHC 1715 (Comm)), Christopher Clarke J. held that the instrument was not a demand bond because it guaranteed "due and punctual payment by the buyer of the 2nd instalment of the Contract Price", "it is not a guarantee of what is not due" and, accordingly, a defence to the claim for payment of the 2nd instalment was also a defence to the claim on the instrument.  When we commented on that [please click here], we noted that "the [High] Court's focus on the wording of the core guarantee obligation is logical and persuasive. It remains to be seen whether subsequent judges (including the Court of Appeal) will conclude that it represents too radical a departure from earlier decisions".

That has in fact proved to be the case but the approach adopted by the Court of Appeal may itself also be seen as something of a departure from the modern approach to contract interpretation, favouring a presumption based analysis rather than the words actually used by the parties.

As we noted, "the courts have strongly favoured interpreting performance guarantees given by banks as demand bonds. Indeed, a passage in a leading textbook repeatedly referred to with approval (albeit often qualified) in judgments concluded that a bank guarantee given in connection with an international transaction "will almost always be construed as demand guarantee" if it contains an undertaking to pay on demand and does not contain clauses excluding or limiting the defences available to a guarantor." 

The Court of Appeal has elevated that statement in Paget's Law of Banking to the level of a strong presumption which will apply even where the final criterion specified is not satisfied, that is, where the document does contain clauses excluding limiting the defences available to a guarantor. The presumption applies wherever the obligation to pay is expressed to be "on demand". In reaching this conclusion the Court of Appeal relied upon its earlier decision, Gold Coast Ltd v Caja de Ahorros [2002] 1 LlR 617 as approving Paget's statement as a presumption even in the absence of one of its criteria. In fact, the passage was only one factor in the Court of Appeal's decision and a closer analysis of the judgment suggests that the decisive point was that the instrument required the payment of an amount specified in a conclusive certificate.

The Court of Appeal in Wuhan appears to have been decisively influenced by its stated concern that "guarantees of the kind… in this case are almost worthless if the Bank can resist payment on the basis that a foreign buyer is disputing whether a payment is due".

With respect, that begs the question as it fails to take proper account of the fact that in international sale transactions bonds can perform either of the roles described above. The Court of Appeal describes only the cash flow function. If the payment is not received pursuant to the underlying contract when it was expected, the receiving party can look to the Bank to provide it with the money immediately to meet its third-party obligations.

However, a bond also protects the beneficiary against the risk that it may be difficult or impossible to enforce contractual payment obligations, for example, if the paying party becomes insolvent. Once the payment obligation under the underlying contract has been established the beneficiary need not be concerned with enforcement against its contracting party but can instead look to the bank for immediate payment.

It is a matter of negotiation at the time of contracting whether the beneficiary is only given a bond which will protect against difficulties of enforcement or whether it is also given a bond which will give it the cash flow protection described by the Court of Appeal. If it is to protect only against an enforcement risk, the parties' bargain would be frustrated if the Bank were obliged to pay where there was  a genuine dispute about liability on the underlying contract.

Although the Court of Appeal in Wuhan qualified its decision by noting that "everything must be dependent on the words actually used by the parties", it did not consider it necessary to review in detail the wording of the core guarantee obligation (which, as the judge at first instance explained, said that it guaranteed sums due under the contract not sums that were not due) or to analyse the commercial background against which the bond was given. It relied instead on its simple assertion of the cash flow protection objective described above and applied a presumption that in an international transaction an instrument "will almost always be construed as demand guarantee" if it contains an undertaking to pay "on demand".

As in a number of previous decisions, the Court of Appeal in Wuhan drew an analogy between performance guarantees and letters of credit. It is clearly established that a bank giving a letter of credit is not concerned with the underlying transaction but must pay on presentation of the listed documents. The analogy is questionable: in most cases, the documents listed in the letter of credit will provide strong prima facie evidence of compliance with the underlying contract and in any event reflect the clear agreement that on presentation of those documents payment will be made. The position in a performance guarantee is less clear. Where, as in Gold Coast, the instrument states that the bank must pay on presentation of a certificate, the analogy with letters of credit is fair. Where, however, the only document referred to is a demand, it is less convincing.

The Court of Appeal gave no guidance concerning the language which might rebut the very strong presumption it held applies. 

It would appear that, unless and until this decision is reviewed by the Supreme Court, a Bank instructed to give a performance guarantee intended to protect only against difficulties of enforcement should ensure that the instrument sets out very clearly that the Bank's payment obligation is only triggered upon proof of breach of the payment obligation under the underlying contract.