Judicial recognition of independent letters of guarantee

Letters of guarantee (L/Gs) are a key instrument for balancing efficiency and risk in the finance business, and are widely used in commercial transactions, construction projects, tendering, financing and acquisitions, judicial guarantees and other such fields.

Based on the differences in the responsibility for payment under an L/G and the relationship in the underlying transaction, letters of guarantee can be divided into independent letters of guarantee and accessory letters of guarantee. Independent letters of guarantee present a special issue in judicial recognition due the extrinsic nature of their difference.

Principal legal features

The first issue in judicial recognition in an L/G dispute case is to determine whether the L/G in question is an independent L/G or an accessory security. As the nature of an L/G directly determines the type of payment obligation that the issuer bears, the obligation of an issuer of an independent L/G lies in payment upon complying presentation, rather than in performance of the obligation on behalf of the debtor, when the debtor fails to repay.

Articles 1 and 3 of the Provisions of the Supreme People’s Court on Several Issues Concerning the Trial of Independent Letter of Guarantee Dispute Cases (the Interpretations) state that whether an L/G is an independent L/G lies in examining whether the text of the L/G creates an independent payment obligation for the issuer upon complying presentation, i.e., greater stress is placed on distinguishing the legal attribute of the L/G, rather than the form of the clauses of the L/G. The most prominent features that distinguish an independent L/G from a general guarantee are independence and documentation.

Independence is the core feature of an independent L/G. Once it enters into effect, an independent L/G is independent from the underlying contract relationship and the L/G application relationship, and the rights and obligations of the issuer and the beneficiary are entirely reliant on the provisions of the L/G, and unaffected by the underlying contract.

In addition to the independence of its effectiveness, articles 6 to 10 of the interpretations set out provisions on the independence of the review of the independent L/G, the independence of the defence, the non-statutory nature of the right of recourse, and the independence of the transfer of such an L/G. The above-mentioned characteristics jointly give rise to the independence of an independent L/G.

Although the precondition to documentation is the principle of independence, the effect of documentation itself is indispensable. As an independent L/G exists independent from the underlying contract, once the beneficiary asks the issuer to perform its payment obligation, the issuer is required to review the document provided by the beneficiary based on the document review criteria specified in the independent L/G.

The document is the key basis on which the issuer performs its payment obligation to the beneficiary. The issuer does not need to examine the performance of the underlying contract, and, as long as the beneficiary submits a claim document consistent with the provisions of the L/G, the issuer is required to pay on demand.

Criteria for judicial recognition and practical recommendations. Articles 1 and 3 of the interpretations emphasise the formal requirements for the formation of an independent L/G and, in particular, the express statement of “payable on demand” is regularly misconstrued in practice as restricting the textual existence form of an independent L/G.

In fact, in judicial practice, if the L/G issued by a financial institution specifies the document on the basis of which payment is to be made, and the maximum amount, but does not expressly state that it is “payable on demand”, or that such model rules for independent L/G transactions as the Uniform Rules for Demand Guarantees of the International Chamber of Commerce are applicable, the judge will usually use his or her own discretion to determine the nature of the L/G based on its textual content.

For example, the Zhejiang High Court held, in a review and adjudication supervision civil order in the retrial of a contract dispute, that although such phrases as “unconditional payment” or “payable upon demand” did not appear in the text of the L/G, it did specify the maximum amount payable, based on the document, on the basis of which payment was to be made, and stated that the Xihu sub-branch of Hangzhou Bank would compensate the beneficiary up to the maximum amount of the L/G. Accordingly, it was possible to conclude that the payment obligation of the issuer was independent from the underlying transaction relationship and the L/G application legal relationship, and that it only bore the payment obligation upon complying presentation.

Pursuant to relevant provisions of the interpretations, and in light of the effective judgments in independent L/G dispute cases organized and collated by the authors, the determination of the nature of independent letters of guarantee by courts is currently based mainly on the following criteria: (1) whether the issuer is a bank or a non-bank financial institution; (2) whether the issuer’s payment obligation is independent from the underlying transaction relationship and L/G application legal relationship, i.e., independence; (3) whether the issuer’s payment obligation is reliant solely on the document specified in the L/G, i.e., documentary character; and (4) whether the L/G specifies the maximum amount.

As compared to other letters of guarantee, independent letters of guarantee are subject to stringent requirements in respect of the conditions for their constitution, and in the absence of any of the necessary conditions, an independent L/G will be found by a court to be an accessory L/G, or a guarantee.

Cases involving disputes over the recognition of an independent letter of guarantee are usually quite complex. Any expressions of an ambiguous nature appearing in the text of an L/G, such as a citing of the underlying transaction, the simultaneous existence of independence clauses and accessory clauses, unclear designation of the payment document, etc., will make recognition of an independent L/G more difficult in judicial practice.

From the perspective of the issuer of an independent L/G, as a professional financial institution, it must use clear and understandable language and style in issuing such an L/G, failing which, in the event of a difference of opinion arising, the court is more likely to support the claims of the beneficiary.

Accordingly, as an issuer, it must closely review the content of the independent L/G and avoid any ambiguity or misunderstanding in language, failing which it will bear the adverse consequences.

Yang Guang is a partner and Wang Chengtao is an associate at Lantai Partners