More tips on how to make use of independent letters of guarantee

Due to the ambiguity of the provisions on the scope of application of independent letters of guarantee (LOG) in judicial practice in China, Chinese enterprises and financial institutions find themselves in a passive position in international commercial activities.

For example, in a certain foreign power station project, domestic company A is the general contractor and company B a subcontractor. Based on the general contract, company A issues an independent LOG to the foreign counterparty, while company B issues an independent LOG to company A in respect of the subcontracted portion. Company A then institutes an independent LOG legal action against the bank acting as company B’s guarantor.

Based on current trial practice, the independent LOG issued to the foreign counterparty by company A is valid and the bank acting as guarantor for company A is required to bear security liability; and once company A bears the liability and seeks recourse against the bank acting as guarantor for the subcontractor, company B, the independence of the independent LOG issued by company B could be denied because of a lack of a foreign element, thereby exposing the general contractor, company A, to a major performance and recourse risk.

China’s acceding to the World Trade Organisation prominently exposes the above-mentioned problem. For example, where both are financial institutions, the independent LOG issued by a foreign-funded financial institution when launching business in China is valid; whereas the independent LOG provided by a wholly Chinese-owned financial institution to a domestic trading entity is not legally supported. This is because the former has a “foreign element”, so the court recognises its validity, whereas the latter is domestic security, so the court denies its validity.

Improving the system

Immediate clarification of the scope of application of independent letters of credit and improvement of the relevant legal provisions appear particularly necessary. Recently, the Supreme People’s Court has, with a view to standardising the trial of disputes involving independent LOG and making the yardstick for judgments and rulings uniform, drafted the Provisions of the Supreme People’s Court on Several Issues Concerning the Trial of Disputes Involving Independent Letters of Credit (Draft for Comment). The revision of the laws on independent letters of credit is imminent.

The author is of the opinion that current laws genuinely constitute an impediment to the establishment by parties of means of independent security. China should actively revise and improve the Security Law and other related domestic laws, and gradually establish in the country an independent security system that is in keeping with international commercial rules. The issuance of specific regulations on the applicable entities, scope of application and “foreign element” of independent LOG will be of benefit to Chinese enterprises and financial institutions wishing to go global and in enhancing their competitiveness in the international trade and commerce environment.

Response in current circumstances

In the current situation, when applying independent LOG in local dispute resolution, there exists a difference in their validity depending on whether there is or is not a foreign element involved, placing both parties in an adverse position in commercial transactions. The author’s recommendations to domestic enterprises and financial institutions when opting to apply independent LOG follow. First, it is important to accurately define what is a “foreign element” to avoid conceptual confusion. This has a practical guiding significance for the application of independent LOG.

1. At present, the determination of a foreign element is based on the legal relationship of the LOG itself, whereas there still exists a relatively major debate on the practice of determining whether there is a “foreign element” based on the underlying contractual or security relationship.
2. In the foreign elements, the territory has a foreign connection. When creating an independent LOG, it is necessary to distinguish whether it is foreign-related security or domestic security, particularly in respect of Hong Kong, Macau and Taiwan. Although Hong Kong and Macau are special administrative regions of China, in current judicial practice when dealing with the issue of foreign-related security, organisations from Hong Kong and Macau are treated as “offshore organisations”. Accordingly, security provided for the above-mentioned three regions is treated as foreign-related security.
3. In the foreign elements, the intersection between territory and entity. When creating an independent LOG, security provided where the creditor is a Sino-foreign equity joint venture financial institution in China is not foreign-related security. However, where the creditor is a foreign-funded financial institution in China, pursuant to the Administrative Measures for the Provision of Security to Foreign Parties by Domestic Organisations, formulated by the People’s Bank of China, and the Implementing Rules for the Administrative Measures for the Provision of Security to Foreign Parties by Domestic Organisations, formulated by the State Administration of Foreign Exchange, such security is deemed foreign-related security.

Second, the legal effect of the independent LOG entered into between commercial entities in China needs to be understood. As mentioned above, based on current legal provisions and the consensus in judicial circles, if parties agree upon independent security in the domestic market, either of the two following results may arise:

1. When the master contract is invalid, the security contract is found to be invalid pursuant to article 172 of the Property Law, and the guarantor is ordered to bear the attendant liability for culpa in contrahendo pursuant to articles 7 and 8 of the Interpretations of the Supreme People’s Court on Several Issues Concerning the Application of the Security Law; or
2. When the master contract is valid, while finding the method of independent security invalid, converting it into valid subordinate joint and several security, whereupon the guarantor is still required to bear joint and several guarantee liability, which remains valid as per the contract.

The application of independent letters of credit in local dispute resolution is subject to relatively stringent restrictions at the present time, and accordingly, enterprises and banking institutions need to be prudent when opting to apply independent LOG in their commercial dealings.

Li Tao is a senior partner at Dacheng Law Offices