A recent Commercial Court decision has provided clarity and guidance on the question of what constitutes an 'on demand' bond, as opposed to a 'see to it' guarantee.

Whilst there are fundamental differences between each type of contract and their consequences, it is not uncommon to see features of both in the same instrument. Mixed terms may seem appropriate at the drafting stage - or may simply be overlooked - but can lead to considerable confusion and cost when the beneficiary looks to rely on the protection it believes it has been afforded.

Project

The dispute before the Court arose out of a significant engineering project for the widening of the Panama Canal. As part of the project in 2009 the claimant Panamanian public corporation (ACP) engaged with a consortium of mostly European construction contractors, who then set up and in 2010 assigned their contract with ACP (the Contract) to a new Panamanian company (GUPC). The consortium also jointly and severally guaranteed GUPC's obligations to ACP (the Guarantee). Both the Contract and Guarantee were subject to Panamanian law and provided for a dispute resolution process culminating in arbitration in Miami.

Between 2012 and 2016 GUPC requested various advance payments from ACP to facilitate the ongoing works in view of GUPC's own cash flow problems. Each time the repayment date for existing advance payments was extended. Initially the advance payments were supported by guarantees (APGs) given by the consortium which were, like the Contract and Guarantee, subject to Panamanian law and arbitration in Miami.

Upon the final advance payment, however, a fresh APG was entered into providing for English law and exclusive jurisdiction of the Courts of England and Wales. Subsequently APGs in respect of advance payments were entered into on similar terms. The parties also confirmed the Guarantee remained applicable to GUPC's obligations under the Contract, including to repay the advance payments to ACP, the final extended deadline for which was 31 December 2016.

Fallout

The deadline for repayment went unmet. ACP notified GUPC of its default under the Contract and, at the same time, demanded payment from the consortium under the APGs. Again this went unmet and ACP issued proceedings in the Commercial Court, then applied for summary judgment on the basis the APGs were 'on demand' bonds.

In the meantime, the consortium had commenced arbitration proceedings under the Contract seeking declarations that repayment of the advance payments was not yet due under the Panamanian law Contract given unresolved disputes over the contract price. The consortium argued the English proceedings should be stayed pending the outcome of the arbitration.

The Court disagreed on the basis that the matter referred to arbitration was distinct from the specific matter before it, namely liability under the APGs, which fell in its exclusive jurisdiction.

Key principles

Before considering the construction of the subject APGs, the Court assimilated 7 key principles from the extensive body of case law in this area, which can be summarised as follows:

  1. A first demand bond is autonomous of the underlying contract (and to that extent can be likened to a letter of credit) whereas a 'see to it' guarantee inherently is an ancillary contract;
  2. The key question is whether the substance of an instrument is truly 'on demand'; how it is labelled, the incorporation of a 'principal debtor' clause or similar may be indicative but certainly not determinative;
  3. The Court must approach the document as a whole and without any preconception;
  4. The nature of the party giving the guarantee is, however, relevant; there is the Marubeni presumption against construing an instrument issued by a non-financial institution as an on demand bond;
  5. The absence of 'protective clauses' excluding or limiting the defences available to a guarantor is suggestive of an on demand bond;
  6. 'Conclusive evidence clauses' requiring payment against certification by the beneficiary will tend to sit more consistently with an on demand construction (although note any ambiguity in such clauses will be resolved in favour of the guarantor);
  7. If incorporated into the instrument, the ICC Uniform Rules for Demand Guarantees will likely be conclusive.

Analysis

Inevitably different terms of the APGs were held up as supporting and militating against ACP's argument that the consortium's obligations to pay were in fact 'on demand'.

Clauses 2.1 and 4.2 in particular were relied upon by ACP. The former described each of the guarantors as "primary obligor and not as surety" and the latter comprised a 'conclusive evidence clause' which – as noted at point 6 above – tends to suggest an on demand construction.

The Court found, however, that clause 4.2 related to interest only and, being of this limited application, did not operate to determine the nature of the instrument as a whole.

In addition, the terms of the APGs only required the consortium to guarantee repayment of the advance payments "as and when due pursuant to the Contract", rather than an independent requirement to pay the outstanding sums. The APGs also required the consortium effectively to step into the shoes of GUPC to perform any obligations of which GUPC was in breach under the Contract; again reinforcing the ancillary nature of the APG.

The Court also noted the relevance of the Marubeni presumption against the APGs being construed as on demand given the members of the consortium were construction firms and not in the financial services sector.

Crucially, the decision of the Court emphasises that it is not enough simply to establish that a guarantor's liability is primary, as ACP succeeding in doing here by reference to "primary obligor" language used. It is a further and distinct step for a claimant to show that the obligations imposed are autonomous from the underlying contract and that the substance of the instrument can therefore be described as truly 'on demand'.

Given the particularly onerous consequences of on demand bonds it is not surprising that commercial entities (and indeed financial institutions) will be extremely cautious entering into such documents and terms may be 'watered-down' during the drafting and negotiation process. Equally, beneficiaries to guarantees will understandably seek to introduce terms which provide, in their view, 'iron-clad' protection for when the worst happens. As with any contract, establishing the intention of the parties and looking at the overall substance at drafting stage is critical to avoid any surprises further down the track.