It is common for a parent to be asked to guarantee an obligation of a subsidiary. However, it may be dangerous to judge a proposed parent company guarantee (PCG) by its cover.

Although it may be described as a “guarantee” it may also actually contain a number of indemnities, the implications of which are very different. If a PCG is not carefully reviewed to ensure that it does not contain both indemnity and guarantee provisions, this will create uncertainty and could result in costly litigation. The recent case of Vossloh Aktiengesellschaft v Alpha Trains (UK) Limited (2010) serves as a cautionary tale.

Spot the difference

What is the difference between an indemnity and a guarantee? Broadly, under a traditional PCG the guarantor parent is liable to the beneficiary only if its subsidiary, is in breach of the underlying contract between the beneficiary and the subsidiary. This form of guarantee is sometimes referred to as a conditional guarantee. A conditional guarantee is better for the parent company because its liability is triggered only if the beneficiary demonstrates that the subsidiary has failed to perform its obligations.

An indemnity is a different animal. Under an indemnity the parent company’s liability may be triggered as soon as the beneficiary serves a compliant demand. One key difference of this type of indemnity is that the beneficiary does not have to prove that there has been a breach of the underlying contract. This type of agreement is also known as a demand guarantee and because it is far more onerous than a conditional guarantee, parent companies should, where possible, avoid entering into this form.  

Conflicting provisions

As the effects of these two forms of guarantee are different, parties should use precise terminology so that it is clear at the outset which type of guarantee they are entering into, because, as the Vossloh case illustrates, a guarantee which contains conflicting provisions can be difficult to interpret and may require litigation to resolve. This is because the beneficiary may be tempted to isolate the indemnities and use them to “bully” the parent company to settle its claim “on demand”. However, the parent company will want to rely on the conflicting guarantee provisions to argue that the beneficiary must prove that there has been a breach of the underlying contract. In the case of litigation which approach is likely to succeed?

The courts’ rule of thumb

The good news is that if the PCG is unclear and contains conflicting guarantee and indemnity wording the courts will generally assume that it is a conditional guarantee. However, companies should not rest on their laurels as the rule of thumb does not apply where the wording of the guarantee clearly states that it is intended to be construed as a demand guarantee. Accordingly, companies requested to provide guarantees must carefully review the language used to make sure that they do not unwittingly enter into a demand guarantee.

Terms to avoid

Is it obvious which terms create a demand guarantee? In the Vossloh case the parent company agreed that it would act as “a principal debtor and not merely as a surety”. The parent company also agreed that it would pay any sums to the beneficiary “on demand”. Used alone (see “Mix and Match” below), the courts have decided that similar language is clear enough to create a demand guarantee. Such language should, therefore be requested to be deleted.

“Mix and Match”

In Vossloh, the PCG contained clauses that actually contradicted the indemnities. For example, the guarantee assumed that the parent company would be liable only if the subsidiary was in default of the underlying agreements; there was also a clause that allowed the parent company to rely on defences available to its subsidiary. How might the courts deal with this “mix and match” approach? In Vossloh the judge said that the “mix and match” approach was confusing. He also confirmed that clear words are required to create a demand guarantee. Consequently, he decided that the PCG was not clear enough to create a demand guarantee and he held that the PCG was a conditional guarantee.  

Do “labels” help?

Some parties mistakenly believe that the name given to a PCG can be persuasive. This is not true. In Vossloh the court confirmed that parties should not confuse the PCG’s “label” with its substance. Although the label may sometimes indicate the parties’ intentions, the court will always look beyond the label and consider the substance of the document to make its decision.

Conclusion

It is important to make sure that any guarantee is clear and unambiguous, otherwise it may obscure the parties’ intentions and ultimately could lead to costly and time consuming litigation. In addition the parties need to remember that labels can be misleading and therefore they should never judge a PCG by its cover!