“On demand” or “see to it” guarantee?

View PDF

Authored by: Joseph Chung

The issue before England’s Court of Appeal in Shanghai Shipyard Co Ltd v Reignwood International Investment (Group) Company Ltd [2021] EWCA Civ 1147 was construction of a guarantee given to support the obligation of a buyer to pay the final instalment of the price under a shipbuilding contract. The question was whether the guarantee was an “on demand” guarantee or a “see to it” guarantee in which the guarantor’s liabilities were no greater than those of the buyer. Having regard to the wording used in the guarantee, the court found in favour of the builder and held that the guarantee was an on demand guarantee.

Background

Shanghai Shipyard Co (the Builder) entered into a Ship Building Contract (Contract) with Reignwood as the buyer, under which the Builder agreed to build an offshore drillship (Vessel) for US$200 million. Reignwood came to be involved in the purchase of the Vessel at the behest of three individuals who had established a company, Opus Offshore Limited (OOL), with a view to purchasing the drillships for operation in the deep sea offshore drilling industry. Reignwood had agreed with the management of OOL to participate as a financial investor for the purpose of the purchase of the drillships, which would be held by a special purpose vehicle owned by OOL as the holding company. The Contract provided that the US$200 million purchase price should be paid in three instalments, the first (US$ 10 million) within 30 days of the effective date of the Contract, the second (US$ 20 million) six months later, and the third (the final instalment of US$ 170 million) upon delivery.

Reignwood entered into an “Irrevocable Payment Guarantee” in favour of the Builder in the terms required by the Contract (Guarantee). At this stage Reignwood was still the buyer under the Contract, such that the guarantee was not a third party guarantee. The contemplated substitution of the special purpose vehicle did not take place until a little over a year later, when the Contract was novated by an agreement under which all Reignwood’s rights and obligations as buyer were transferred to Opus Tiger 1 (Buyer), a 100% subsidiary of OOL.

The Guarantee provided that Reignwood IRREVOCABLY, ABSOLUTELY and UNCONDITIONALLY guaranteed, as the primary obligor and not merely as the surety, the due and punctual payment by the Owner of the Final Instalment of the Contract Price of US$170,000,000. Clause 4 of the Guarantee provided that in the event of a dispute between the Owner and Builder as to whether: (i) the Owner is liable to pay to the Builder the Final Instalment; and (ii) the Builder is entitled to claim the Final Instalment from the Owner, and such dispute is submitted either by the Owner or Builder for arbitration in accordance with Clause 17 of the Contract, Reignwood shall be entitled to withhold and defer payment until the arbitration award is published and shall not be obligated to make any payment unless the arbitration award orders the Owner to pay the Final Instalment and that if the Owner fails to honour the award, Reignwood shall pay the Builder to the extent the arbitration award orders (Proviso).

The Builder gave notice of completion of the Vessel to the Buyer and subsequently made a demand to the Buyer for the final instalment and other sums allegedly due under the Contract. Later, the Builder sent a notice of default to the Buyer for non-payment of the sums allegedly due, and after that, a cancellation notice to the Buyer. The Builder then made a demand of Reignwood, the Guarantor, for the final instalment under the Guarantee. At some stage there arose a dispute between the Builder and Buyer as to whether the Vessel was in a deliverable condition, the Buyer contending that the Vessel contained a number of major and critical defects.

The Builder commenced proceedings against Reignwood under the Guarantee. The claim was defended by Reignwood on the grounds, amongst others that, (i) the Guarantee was a “see to it” guarantee in which the Guarantor’s liabilities were no greater than those of the Buyer, and that the Buyer had no obligation to pay the final instalment of the price as a result of defects in the Vessel and/or the absence of Classification Society approvals; and (ii) in any event the proviso in Clause 4 of the Guarantee was engaged and accordingly no sums were due unless and until the subject of a London Arbitration award.

High Court Decision

The issues before the court of first instance were whether:

1. on a true construction of the Guarantee, it was a demand guarantee, such that the Guarantor’s liability under it arose by reason of the demand only, if the Buyer was liable to pay the final instalment under the terms of the Contract, OR it was a “see to it” guarantee or a conditional payment obligation, such that the Guarantor’s liability under it arose upon the demand only if the Buyer was liable to pay the Final Instalment under the terms of the Contract.
   
   
2. the Guarantor was entitled to refuse payment under Clause 4 pending and subject to the outcome of the arbitration between the Builder and the Buyer in respect of a dispute as to the Buyer’s liability to pay and the Builder’s entitlement to claim that Final Instalment, (i) only if the arbitration had been commenced between those parties as at the date of the demand; or (ii) regardless of when such arbitration is or may be commenced.

The court held that the guarantee was a “see to it” guarantee and that the Guarantor was entitled to refuse payment under Clause 4 pending and subject to the outcome of an arbitration between the Builder and Buyer in respect of a dispute as to the Buyer’s liability to pay and the Builder’s entitlement to claim that Final Instalment, regardless of when such arbitration is or may be commenced.

Court of Appeal Decision

“On demand” or “see to it” Guarantee?

The Court of Appeal reversed the first instance decision, holding that the Guarantee was an on demand guarantee. It found that the critical language of the Guarantee pointed strongly towards it being a demand guarantee, namely:

• The capitalised words “ABSOLUTELY and UNCONDITIONALLY” would convey to a businessman that the obligations were not conditional on the liability of the Buyer.

• The words “as primary obligor and not merely as the surety” were a clear indication that the document was not a surety guarantee.

• The words used that trigger the obligation “upon receipt by us of your first written demand”. Payment against demand is the hallmark of a demand guarantee.

• The words used “upon receipt by us of your first written demand we shall immediately pay to you…” Immediate payment would not be appropriate in the case of a surety guarantee, in which some period would be needed for the guarantor to investigate and form a view on whether there was an underlying liability to make the final instalment payment under the Contract.

• Express provision that obligations on the Guarantor are to be unaffected by any dispute under the Contract.

• The Proviso is more supportive of the Builder’s case than that of the Guarantor. When triggered, it involved an obligation to pay against a document, namely the arbitration award. It did not involve an obligation to pay in respect of an underlying liability. The Guarantor was not party to the arbitration agreement in the Contract, and but for this Proviso would not be bound by any award in an arbitration between the Builder and Buyer. The award might go by default against the Buyer, without any detailed consideration of the merits, but if the document were a surety guarantee Reignwood would be entitled to challenge whether the Buyer was indeed liable notwithstanding that the tribunal had so held, absent the agreement in the Proviso to abide by the award. The Proviso therefore binds Reignwood to pay what may not be an underlying liability; it involves payment against a document, namely an award. Another indication that it involves payment against a document, not a liability, is that the obligation arises the moment an award is made, irrespective of any subsequent challenge. In other words the Proviso to Clause 4, if triggered, does not introduce a surety obligation.

• Clause 10 limits the interest payable to 60 days’ worth. This envisages prompt payment on demand, not the lengthy delay which might be contemplated to resolve a dispute about the Buyer’s liability.

Arbitration Proviso

The Builder argued that in order for the arbitration Proviso to be triggered, there must be both a dispute and the commencement of arbitration prior to a valid demand being made. If that has not occurred before a demand is made, the Builder has an accrued right to payment under the Guarantee, which is a right to payment “immediately upon a valid demand”. The court held that the Proviso defined the circumstances in which the demand guarantee ceased to be payable on demand and became payable against an award. It provided, unsurprisingly, that the commencement of an arbitration is necessary to convert the obligation to become one to pay against an award. That, the court said, was the natural meaning of the words: it required not only that there is a dispute but also that the dispute “is submitted” to arbitration. Both were expressed as the condition on which the Guarantor is “entitled to withhold or defer payment.” If an accrued right to payment has arisen at the date of demand, there is nothing in the clause to suggest that it is thereafter suspended, or if enforced that there is a right of repayment pending the award. The court said that the language of the Proviso did not suggest that it was triggered by a dispute alone, but only when and if the dispute was submitted to arbitration.

Comments

Whether a performance bond is an “on demand” or “see to it” bond (sometimes called a “default bond”) is a dispute frequently dealt with by the courts. If the parties had consulted lawyers to draft their bonds, this could have been avoided. Simple standard wording should be included in the bond to reflect the true intention of the parties.

Key Contacts

Joseph Chung

Partner | Litigation and Dispute Resolution

Email or call +852 2825 9647