Tips on the restrictive use of independent letters of guarantee

Different from the traditional subordinated guarantee, although the independent guarantee is based on the underlying contract, the guarantee becomes independent once issued and the payment under the guarantee would only depend on the guarantee itself, and has nothing to do with the underlying contract. The guarantor would pay the amount available under the undertaking once it receives the claim from the beneficiary.

Independent guarantees are becoming the mainstream trend internationally, because guarantors are not willing to be involved in underlying transactions, while beneficiaries wish to have a more appropriate guarantee. In contrast, under the subordinated guarantee, once the claim is paid, the guarantee bank may be involved in litigation due to the underlying contractual relationship, which may jeopardise its interests and reputation.

To avoid this, banks tend to issue the independent guarantee. Compared with subordinated guarantee, the independent guarantee can provide the beneficiary with better protection, since it can avoid any defences against claims raised by the beneficiary and assure that the interests of the beneficiary would not be compromised due to defects in the underlying contract.

Restriction of application

Under the current legal framework, the use of independent letters of guarantee in is restricted in China. Article 5 of the Guarantee Law says: “A guarantee contract is an ancillary contract of the principal contract. If the principal contract is nullified, the guarantee contract shall be null and void accordingly. Where it is otherwise agreed in the guarantee contract, such agreement shall prevail.” The second paragraph of article 7 of the Administrative Measures on Domestic Institutions Providing Guarantees for Foreign Parties is consistent with article 5 of the Guarantee Law. It is generally acknowledged that such articles recognise and provide room for the legitimacy of independent guarantees.

However, paragraph 1 of article 172 of the Property Law stipulates that “for the creation of a security right, a guarantee contract shall be concluded in accordance with the provisions of the law and other relevant laws. A guarantee contract is an ancillary contract of the principal contract. When the principal contract is nullified, the guarantee contract shall be null and void accordingly, unless otherwise stipulated by laws”.

Limit on validity

The Property Law limits the validity of independent guarantees with the wording “otherwise stipulated by laws”, different from the provision “where it is otherwise agreed in the guaranty contract, such agreement shall prevail” in the Guaranty Law. Since the Property Law should prevail when the two laws are in conflict, article 172 of the Property Law has to some extent replaced article 5 of the Guaranty Law. Strictly speaking, PRC laws and regulations only recognise the subordinate status of guarantee contracts.

The vice-president of the supreme court, Xi Xiaoming, indicated at the 2007 National Civil and Commercial Trial Working Conference in Nanjing that given the unusual severity of obligation under the independent guarantee, and the risk of fraud or abuse of rights, and especially to avoid serious impact on the foundation of China’s guarantee legal regime, the independent guarantee can only be used in international commercial transactions.

This standpoint from the supreme court set the tone for the legitimacy of independent guarantees used in China. The court only admits that the independent guarantee is valid when provided by domestic institutions to foreign parties, but denies its independence when it is used in China.

In current judicial practice, China affirms that the independent guarantee used in China is subordinate. In the final judgment of the import agent case Hunan Machinery and Equipment Import & Export, Hainan International Leasing v Ningbo Eastern Investment, the supreme court explicitly denied the validity of the independent guarantee used in China for the first time. The court ruled that although the guarantee contract provided that the liability under the letter of guarantee would not be exempted when the import agency agreement is nullified due to the trustor, this kind of independent guarantee cannot be used in China, so the clause was null and void.

In such judgments, although the supreme court denies the independence of independent guarantees used in China and its validity for in-advance payment, the court still recognises the subordinate status of this kind of guarantee and the guarantor must still bear the joint and several liabilities under the effective undertaking.

No detailed explanation

It is worth noting that the supreme court has confirmed that the independent guarantee can only be used in foreign-related civil and commercial cases, but it does not explain in detail how to determine whether a case is foreign-related. The Opinions of the Supreme People’s Court on Certain Issues Concerning the Implementation of the General Principles of the PRC Civil Law (Trial) provides that where either party or both parties of a civil relationship are foreign, a stateless person or a foreign legal person, or where the subject matter of a civil relationship is located in a foreign country, or where the legal facts that the civil rights or obligations are established, changed, or extinguished occur in a foreign country, such civil relationship will be one involving foreign elements.

But given the complication of commercial relationships, it is always difficult to distinguish foreign-related elements from non-foreign-related elements in significant civil and commercial disputes. And it is still controversial whether the determination of foreign-related elements should be based on the guarantee relationship itself, or should take both the underlying contract and the guarantee relationship into consideration.