Performance of underlying contract and guarantee fraud

Independent guarantee is a financial guarantee instrument that is often used to assure rapid realization of the creditor’s right. When the guarantor reviews the documents presented by the beneficiary, if the documents are totally consistent with the provisions of the guarantee and superficially consistent with one another, the guarantor must undertake the payment obligation without the need to review the performance of the underlying contract, pursuant to the Uniform Rules for Demand Guarantees.

The performance of the underlying contract is not an item the guarantor must review when making the payment, but in practice the court will usually examine this factor once a guarantee fraud occurs. A typical case in this regard is of guarantee fraud under dispute involving Eastern Property, Anhui Foreign Economic Construction Group (AFECC), a bank in Costa Rica, and Anhui Branch of China Construction Bank Corporation (CCB Anhui). As the developer, Eastern signed a construction contract with the contractor, AFECC, and the actual construction company, AFECC Central America, a local subsidiary. After signing the contract, Eastern applied for payment of the amount under the guarantee to the guarantor bank on account of AFECC Central America’s default.

Considering that China had not explicitly stipulated independent guarantee or guarantee fraud when the case was heard, the People’s High Court of Anhui province drew the principle of fraud exception set out under international general practice and international treaties, and judged the conduct of the beneficiary Eastern to constitute a guarantee fraud. Under this case, the Anhui court asserted that it was necessary to perform a review of the performance of the underlying contract during the trial of a dispute pertaining to guarantee fraud.

After AFECC had submitted an effective overseas arbitration award acknowledging that AFECC Central America had not incurred a default event, the court thought that AFECC had performed its obligations under the underlying contract, and therefore Eastern had no right to claim payment.

In November 2016, the Supreme People’s Court (SPC) issued a judicial interpretation entitled the Provisions Regarding Several Issues during the Trial of Cases Involving Independent Guarantee, which was the first legal document pertaining to independent guarantee in China. Apart from specifying the definition of independent guarantee, the provisions also stipulate the events that must constitute a guarantee fraud under article 12: (1) The beneficiary and the guarantee applicant or other persons collude to fabricate an underlying transaction; (2) Third-party documents submitted by the beneficiary are counterfeit or untrue in content; (3) The court judgment or arbitration award asserts that the debtor under the underlying transaction bears no liability of payment or compensation; (4) The beneficiary confirms the full performance of the debt under the underlying contract or confirms the mature payment event indicated on the independent guarantee has not occurred; (5) Other situations where the beneficiary is clearly aware of no claim for payment but still abuses such right.

At the same time, the provisions specifically mention that when trying a dispute involving the guarantee fraud, the court must review the above-mentioned events to determine facts pertaining to the underlying transaction. Notwithstanding the provisions, even if the guarantee applicant can prove the full performance of the debt under the underlying transaction, it does not necessarily mean that the beneficiary’s claim constitutes a guarantee fraud, and the court will still need to judge the correlation between the claim for payment under the guarantee and the debt under the independent guarantee.

Pursuant to the provisions, the Nanjing Intermediate People’s Court tried a tort dispute between CSUN, a Nanjing-based photovoltaic subsidiary of China Electric Equipment Group, and Alpha Company, and it is to date the only guarantee fraud case that can be searched through public channels following the issuance of the provisions. The guarantee under the case indicated that where CSUN fails to issue a new guarantee 15 days before the expiration of the current guarantee, the beneficiary, Alpha Company, can claim compensation form the bank. The expiry date of the guarantee under the case was 31 December 2013, and the new guarantee CSUN had applied for was issued on 25 December 2013, so Alpha Company decided to claim compensation.

After Alpha Company submitted the claim application, CSUN immediately filed a lawsuit to the Nanjing court, claiming that the guarantee specified that the guarantee must remain in effect for another two months upon expiration, so the expiry date must be 28 February 2014, and that Alpha Company did not have reason for a claim, but had committed a guarantee fraud. CSUN asserted that Alpha Company had committed a guarantee fraud on the grounds that Alpha Company had violated a catch-all clause (article 12) specified in the provisions, that is, “other situations where the beneficiary is clearly aware of no claim for payment but still abuses such right”.

The court confirmed that CSUN had performed the debt under the underlying contract, but Alpha Company had claimed the payment based on a different understanding of the effective period of the guarantee than that of CSUN, instead of the performance of the debt under the underlying contract, and judged Alpha Company did not abuse a right while clearly aware of no right to claim the payment. Therefore, the court rejected CSUN’s claim.

From these two cases and the contents of the provisions, it can be seen that when requesting the court or arbitration commission to confirm a guarantee fraud, the guarantee applicant must bear the burden to prove the events listed by article 12, and in particular prove the debt under the underlying contract has been fully performed (unless the debt under the underlying contract does not relate to the right to claim the payment under the guarantee). For this reason, if the court judgment or arbitration award asserts that the guarantee applicant has not committed a default under the underlying contract, the judgment or award will be strong evidence supporting the guarantee applicant under the litigation or arbitration involving the guarantee fraud.

Blake Yang is a senior associate and Franz Li is an associate at Martin Hu & Partners