Newsletter No. 62 (EN)

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I.       Introduction

In international trade, importers are particularly exposed to the risk that the exporter is not able to perform its contractual duties. Besides the commercial risks of insolvency and protracted default, the exporter may become incapable of performing his duties due to the risks attached to selling to public or private entities in territo­ries where political factors may have an im­pact. Some such political risks are the cancella­tion of import or export licenses, the imposi­tion of embargos or frustration of contract due to war or confiscation.

Importers in international trade therefore often wish to have a security that the exporter will fulfil his obligations. In order to secure the contract, an exporter may be required to pro­vide a guarantee that takes the form of a De­mand Guarantee. Demand Guaran­tees provide protection to the importer against late, defective or non-performance by the exporter or contractor. Many contractors is­sue guarantees in the form of tender guaran­tees (also “bid guarantees”), advance payment or stage payment guarantees, performance or re­tention bonds.

Demand Guarantees must be differentiated from another financial instrument used in international trade, the Letter of Credit (“L/C”). L/Cs provide security for the ex­porter against non-payment.[1] The typical Demand Guarantee, however, is issued in order to reduce the risk of non-performance. This newsletter is meant to

give a short overview on the characteristics and risks of Demand Guarantees.

II.    Legal Nature and Features of Demand Guarantees

A Demand Guarantee is a contract by which a guarantor, usually a bank or another financing insti­tution, undertakes to pay to the importer/employer a sum of money up to the maximum quoted amount on the Demand Guarantee upon representation of a demand together with any other documents specified under the terms of the bank’s guarantee.

1.       The Contractual Relations: Direct and Indirect Guarantees

A Demand Guarantee can be issued as a Di­rect or Indirect Guarantee. Whereas in the con­stella­tion of a direct guarantee three sub­jects are involved, there are four subjects en­gaged in an Indirect Guarantee.

A Direct Guarantee is provided by the ex­porter’s bank to the importer/employer (beneficiary) di­rectly. In this case there are three contracts:

• the underlying contract, between the ex­porter/contractor and the importer/employer (e.g. a sales contract, (plant) construction contract or a contract for services);

• the reimbursement contract between the exporter/contractor and his bank; and

• the actual Demand Guarantee between the bank and the importer/employer.

The structure of the contractual relations in a Di­rect Guarantee can be seen in Appendix 1 be­low.

In the case of an Indirect Guarantee, the guar­antee is provided by the importer’s own bank. The exporter’s bank (instructing bank) instructs the importer’s bank (issuing bank) to issue the guarantee in favour of the beneficiary. It is the issuing bank only that assumes the obligations of the guarantor. It does not act as an agent of the instructing bank. In this case, there are four contracts. There neither is a contractual relation­ship between the beneficiary and the in­structing bank nor between the exporter and the issuing bank.

The structure of the contractual relations in an Indi­rect Guarantee can be seen in Appendix 1 below.

2.      Legislation Governing Demand Guar­antees

The characteristics of a Demand Guarantee de­pend on the applicable legislation and jurisdic­tion. In general, a bank guarantee will contain a provision stating the choice of law. In absence of such provision, conflicts of law provisions will most often provide that the location of the bank’s office will be the decisive criterion regard­ing the applicable law, since the bank ren­ders the characteristic main service (Art. 34 (a) Uniform Rules for Demand Guarantees; “URDG”).

In addition to the national law, the Interna­tional Chamber of Commerce (“ICC”) has pub­lished several sets of example rules concern­ing Demand Guarantees: The “Uni­form Rules for Contract Guarantees” of 1978 (Publication No. 325) did not gain wide accep­tance. In 1992, the “Uniform Rules for De­mand Guarantees” were issued, and in 2010 a revised version of the URDG (Publication No. 758) was released. Although not used fre­quently, it is recommended to incorporate them in inter­national contracts since these rules state the most common and widely used practice in international trade.

Under German law and the URDG (Art. 5 (a) URDG), the main feature of a Demand Guaran­tee is that it is legally independent from the underlying contract between the exporter/contractor and the importer/employer, i.e. it is an abstract payment undertaking.

In general, payment must be made upon calling of the guarantee, e.g. upon presentation of a written demand that complies with the provi­sions of the Demand Guarantee. Many De­mand Guarantees are payable on first demand without any additional documents (so-called First Demand Guarantees). This reflects their ori­gin in replacing cash deposits. However, First Demand Guarantees more and more require at least a statement indicating that the exporter/contractor is in breach of the underlying contract (although this is contradic­tory to their nature of being payable on first demand).

III.  Special Risks of Demand Guar­antees: Unfair Calling and Expiration

There are two major risks inherent in Demand Guarantees: Unfair calling of the guarantee and the absence of an expiration date of the guarantee.

1.       Unfair Calling

Since the Demand Guarantee is legally separate from the underlying contract, it contains the risk of being called for unfairly although the underlying contract’s condi­tions have been fulfilled. The URDG does not con­tain provisions regarding this case. There­fore, it depends on the jurisprudence and the leg­islation of the applicable national law to determine in which case a payment request is regarded to be un­fair, giving the exporter/contractor a chance to prevent the bank from paying out the guarantee sum.

Un­der German (procedural) law, the exporter/contractor may seek a “provisional injunction” (Einstweilige Verfügung) against the bank. However, the in­junction will only be issued in case the benefici­ary obviously misuses his position. In other jurisdictions, there are no legal remedies at hand to prevent unfair calling of Demand Guarantees. Apart from that, experience shows that legal actions prior to calling are frequently not successful. 

2.      Expiration

A clear expiry date should be stated in the De­mand Guarantee. The URDG contain a set of expiry provisions. A standard clause is: “This guarantee shall expire, even if this docu­ment is not returned, on … at the lat­est.” However, some countries, especially in the Middle East, may not accept a Demand Guarantee which includes an expiry date as this may not be enforceable under local laws. Further, cases are known where exporters/con-tractors were pushed to extend the expiration date, by threatening to call the Demand Guarantee.

IV.  Insurance

The risk of unfair calling (as well as of fair calling, e.g. where the contract would not be performed for political reasons, such as non-renewal of export licenses) may be insured. The insurers range from national export credit agencies to private insurers. Although unfair calling of a guarantee does not occur often, in certain cases it may be recom­mendable to seek insurance coverage.

V.     Summary

Special prudence should be exerted when drafting the Demand Guarantee. Critical cir­cumstances are the expiration of the guaran­tee, the choice of law and its legal separation from the underly­ing contract. Especially when doing business in regions where the performance of a con­tract depends on political impact; it might be recommendable to take out an unfair calling in­surance.

[1] For more information on L/Cs and other instruments to secure performance and obligations under contracts, please refer to our Nerwsletter No. 13.