Curbing risks with independent guarantees in construction sector

In recent years, with the continuous stream of international projects contracting business and the vigorous growth in the investment in, and construction of, domestic infrastructure, independent guarantees have repeatedly made an appearance in the course of the performance of project contracts. With a view to facilitating the development of the business of construction enterprises and reducing the risks associated with independent guarantees, the author would like to briefly discuss and analyze the judicial practice applicable to independent guarantees in China.

Concept and nature

The concept of “independent guarantee” has its origin in the Uniform Rules for Demand Guarantees, published by the International Chamber of Commerce in 1992. The rules define an independent guarantee as follows: a demand guarantee means any guarantee, bond or other payment undertaking, however named or described, by a bank, insurance company or other body or person, given in writing for the payment of money on presentation in conformity with the terms of the undertaking of a written demand for payment and such other document(s) as may be specified in the guarantee.

The specific feature of an independent guarantee lies in the fact that although it arises from an underlying contract, it is, in principle, independent from it and from the underlying transaction, and is not affected by the validity of the underlying contract. Any claims lodged under the guarantee do not rely on the underlying contract and are not conditional on whether a breach of the underlying contract has occurred.

Supreme Court perspective

In the book entitled New Interpretation and Explanation, and Application of the Security Law, the Civil Division II of the Supreme People’s Court (SPC) states that, “with the exception of the … circumstance in international trade where it is common for the validity of a guarantee contract to be independent of the validity of the master contract, in other circumstances the validity of a security contract is subordinate to the validity of the master contract. If the master contract is invalid, the security contract is invalid”.

In a speech given at a national symposium on civil and commercial adjudication in May 2007, Xi Xiaoming, vice president of the SPC, set out his views on the judicial application of independent guarantees as follows: “Considering the unusual severity of the liability under independent security, as well as the fact that such a system can give rise to such wrongs as fraud and abuse of rights, and more particularly, in order to avoid seriously affecting or perturbing China’s legal system pertaining to security, independent security can be used only in international commercial transactions at present. The provision in the first paragraph of article 172 of the Property Law reading ‘unless otherwise provided in law’ further expresses the standpoint that parties may not provide for independent security interests.

“Accordingly, with respect to the handling of independent security, an insistence needs to be placed on maintaining the security system as subordinate rules, and where parties, in a situation where the master contract is valid, provide for an independent guarantee or independent security interests in a commercial transaction that is not international in nature, the independence of the security is to be denied and it is to be changed into a valid subordinate joint guarantee or security interests.”

In KUB Power v China Everbright Bank, Shenyang branch concerning performance of an independent guarantee undertaking, the Intermediate People’s Court of Shenyang municipality, Liaoning, held that although the guarantee in question mentioned the contract between Shenyang Machinery and Equipment Import and Export Corporation and the plaintiff, pursuant to relevant provisions of the Uniform Rules for Demand Guarantees it could be determined that the guarantee in question was irrelevant to the underlying contract. The court ordered the defendant, China Everbright Bank, Shenyang branch, to pay the plaintiff, KUB Power, the guarantee amount of US$174,150.

In the import agency contract dispute between Hunan Machinery Import and Export, Hainan International Leasing and Ningbo Dongfang Investment, the SPC held that although the Hainan’s letter of guarantee specified that “the security liability under this letter of guarantee shall not lapse if the import agency agreement becomes invalid due to a reason attributable to the commissioning party”, such independent security should not be used in domestic civil activities. The court determined that this provision was invalid.

A construction enterprise may opt for a closed-ended guarantee, clearly specifying the dates and conditions for entry into effect and expiration. In this way, once the date of expiration or a condition of expiration arises, the security liability can be released. Such conditions as “until the date of final acceptance of the project”, which are relatively difficult to determine or are disputable, should be avoided.

The guarantee should have a clear-cut maximum guarantee liability. Due to the unusual severity of independent guarantees, failure to specify a clear maximum could result in the risks associated with the guarantee increasing exponentially.

A construction enterprise can negotiate with the owner to have guarantees issued for each bid lot or individual work, breaking up the security amount and liabilities. Once a bid lot or individual work satisfies the conditions for termination of the security, or the security expires, the corresponding guarantee expires or terminates, thus lightening the security liabilities.

Counter security

Where a construction enterprise can negotiate, or where local national laws permit, the construction enterprise should actively seek to have the owner provide counter security. Such counter restriction can help in preventing fraud by the owner, or the arbitrary, or lodging in bad faith by the owner of a claim under the guarantee.

With respect to a claim lodged by the security rights holder under a foreign-related independent guarantee and the documentation, it is necessary to co-operate in a timely manner in the review by the bank providing the security. Where there is evidence showing that the claim lodged by the security rights holder involves fraud, the “fraud, stop payment” legal procedure should be started immediately.

With respect to a claim lodged by the security rights holder under an independent guarantee without a foreign element, the construction enterprise should actively prepare the evidentiary materials, co-operate with the bank providing the security in denying the independence of the guarantee, and block the claim lodged by the security rights holder under the guarantee.