Court of Appeal Provides Important Guidance on the Construction of Guarantees

In Shanghai Shipyard v Reignwood International Investment (Group) Company Ltd [2021], the Court of Appeal construed a guarantee provided to a shipyard for payment of the final instalment of a drillship as an “on demand” guarantee.

The Court of Appeal’s judgment has significant implications for companies involved in shipbuilding and offshore construction, as well as other industries which rely on guarantees.

The judgment provides important guidance in respect of the construction of guarantees, addressing when a guarantee is likely to be construed as an “on demand” guarantee (where the obligation to pay arises through a demand being made under the guarantee) and when a guarantee is a “see to it” guarantee (where the beneficiary is only entitled to receive payment after establishing a liability of the obligor).

Background

The Builder had agreed to construct an offshore drillship for a purchase price of US$200 million, under the terms of a shipbuilding contract. To secure the risk of non-payment in respect of the final instalment of US$170 million (the “Final Instalment”), the Builder was the beneficiary of an “Irrevocable Payment Guarantee” (the “Guarantee”) issued by Reignwood (the “Guarantor”).

Following the Buyer’s refusal to take delivery on the basis that the vessel was not deliverable, the Builder made a demand under the Guarantee for payment of the Final Instalment.

The matter was first heard in the Commercial Court by Knowles J, who held that the Guarantee was a “see to it” guarantee rather than an “on demand” guarantee. The Court of Appeal unanimously overturned the Commercial Court’s judgment, holding that:

1. The correct contractual interpretation of the Guarantee was that of an “on demand” guarantee.
2. The Guarantor was not entitled to rely on the proviso contained in Clause 4 of the Guarantee to assert that it was entitled to withhold or defer payment until an arbitration award under the shipbuilding contract had been published. The Court of Appeal held that the Builder had an accrued right to payment at the time it made a demand under the Guarantee, and that there was no clear language in the Guarantee which divested the Builder’s right to payment.

First Issue – Was the Guarantee an “on demand” or “see to it” guarantee?

The first issue was whether the Guarantee was a demand bond making the Guarantor liable to make payment regardless of the Buyer’s liability to pay the Final Instalment, or whether it was a “see to it” or “surety” guarantee, where the Guarantor was entitled to withhold payment until the beneficiary established that the Buyer was liable to pay under the shipbuilding contract.

The Court of Appeal held that the primary focus in construing guarantees should be the words used by the parties and the commercial context in which they are used. Based on the language of the Guarantee, the Court of Appeal held that the Guarantee was an “on demand” guarantee (overturning the decision of the High Court), relying on the following factors:

1. The Guarantee contained the words “we IRREVOCABLY, ABSOLUTELY and UNCONDITIONALLY guarantee … as the primary obligor” in Clauses 1 and 3. The Court of Appeal held that the use of the words “ABSOLUTELY” and “UNCONDITIONALLY” would convey to a businessman that the obligations were not conditional on the liability of the Buyer.
2. Clause 1 expressly included wording which confirmed the obligations were “as the primary obligor and not merely as the surety”. The Court of Appeal rejected the argument that the words “not merely as the surety” were surplusage and stated they were consistent with the Guarantee being an “on demand” guarantee.
3. The Guarantee contained the wording “upon receipt by us of your first written demand”. The Court of Appeal stated that “payment against demand is the hallmark of a demand guarantee”.
4. The Guarantee also contained the wording “we shall immediately pay to you”. The Court of Appeal held that “immediate payment would not be appropriate in the case of a surety guarantee”.
5. Clause 7(a) contained wording providing that the obligations of the Guarantor “shall not be affected or prejudiced by” any dispute under the shipbuilding contract.
6. The Guarantee contained a proviso which defined the circumstances in which the Guarantee ceased to be payable on demand and instead became payable against an arbitration award. As the Guarantor failed to procure the commencement of arbitration under the shipbuilding contract within 15 days of the Builder’s request for payment under the shipbuilding contract, the proviso in the Guarantee had not been triggered by the time the Builder had made a demand under the Guarantee. Accordingly, the Guarantor was obliged to pay the Builder following receipt of their demand.
7. Clause 10 of the Guarantee limited the interest payable to 60 days and the Court of Appeal held that this envisaged “prompt payment on demand as opposed to a lengthy delay which might be contemplated to resolve a dispute about the Buyer’s liability”.

The Court of Appeal considered the Guarantor’s submission that the Guarantee contained clauses akin to boilerplate clauses found in surety guarantees. However, Popplewell LJ found the indications contained in these clauses had limited weight and were “insufficient to displace the much stronger factors” indicating that the Guarantee was an “on demand” guarantee.

The Court of Appeal also considered the relevance of “Paget’s Presumption”. Previously, in the case of Wuhan Guoyo Logistics Group v Emporiki Bank of Greece [2014], the Court of Appeal had stated that where an instrument is not issued by a bank or other financial institution, “cogent indications that the instrument was intended to operate as a demand guarantee will be required”.

In the Commercial Court decision, Knowles J had placed considerable weight on the fact that the Guarantor was not a bank or financial institution. However, the Court of Appeal held that institutional identification should not drive the resulting analysis of whether a guarantee was on “see to it” or “on demand” terms, with Popplewell LJ remarking that the key to assessing counterparty risk is “the commercial and financial strength and probity of the guarantor” and this is independent of the nature of business carried out by the guarantor.

The Court of Appeal said it would be “a recipe for commercial uncertainty” if a guarantee given by a bank would “mean something different” if the exact same wording was adopted by a non-bank. This would displace “the reasonable expectations of parties as objectively expressed in the words of their agreement”.  Therefore, the identity of a guarantor should not lead to any preconceptions as regards the nature of the guarantee instrument. Crucially, weight needs to be placed on the wording of the instrument which “parties have chosen to express their bargain, interpreted in accordance with the well-established rules of construction”.

The Court of Appeal also noted the importance of cashflow to the shipbuilding industry, who rely on the timeous payment of instalments to fund the construction of vessels. In this context, and based on the Guarantee wording, the Court of Appeal held the Guarantor was obliged to make payment on demand. As a result, regardless of the dispute under the shipbuilding contract, the Guarantor was obliged to “pay now and argue later” in relation to the underlying dispute.

Second Issue – Was the Guarantor entitled to withhold and defer payment until an Arbitration Award had been issued under the shipbuilding contract?

Clause 4 of the Guarantee contained wording providing that if the Buyer failed to pay the Final Instalment, and such default continued for 15 days, then “upon receipt by us of your first written demand, we shall immediately pay to you … all unpaid Final Instalment”.

However, Clause 4 also contained a proviso stating:

“In the event that there exists dispute (sic) between the [Buyer] and the Builder as to whether:

1. The [Buyer] is liable to pay to the Builder the Final Instalment; and
2. The Builder is entitled to claim the Final Instalment from the [Buyer]

and such dispute is submitted either by the [Buyer] or by [the Builder] for arbitration … we shall be entitled to withhold and defer payment until the arbitration award is published”.

The Court of Appeal held that this proviso had not been triggered, as under the wording of the remainder of Clause 4, arbitration proceedings had to be commenced within 15 days of the demand being made under the shipbuilding contract. The Court of Appeal accepted the Builder’s submission that in order for the proviso to be triggered, there must have been both a dispute and arbitration commenced prior to a valid demand being made under the Guarantee. As a result, the Court of Appeal held that the Builder had “an accrued right to payment under the Guarantee”, and the later commencement of arbitration did not divest the Builder’s right to payment. 

Whilst the Guarantor argued that the 15-day window to commence arbitration under Clause 4 was uncommercially short, this argument was rejected by the Court of Appeal, who stated “a short timeframe is entirely understandable in what is otherwise a demand guarantee whose essential rationale is to protect cashflow.”

Comment

The Court of Appeal’s decision will be welcomed by beneficiaries seeking to call on guarantees not given by banks or financial institutions and who wish to assert the guarantor is obliged to pay upon presentation of a valid demand.

The Court of Appeal’s judgment is helpful in indicating that it is the wording of the guarantee, rather than the identity of the parties, which is key to establishing whether a guarantee is an “on demand” or “see to it” guarantee.

Parties should therefore carefully review the wording of guarantees they are considering providing or receiving prior to execution. If a party requires an “on demand” guarantee, they should ensure that the wording is suitable for that purpose and the guarantee does not contain wording which could be argued constitutes a “see to it guarantee”. Similarly, parties who are providing a guarantee who wish to ensure that it will only function as a “see to it” guarantee or who wish to withhold or defer payment pending the outcome of arbitration proceedings concerning an underlying contract should ensure that the guarantee contains wording making that clear.