China: Trial Practice of Foreign-related Independent Guarantees in demand

Last Updated: 17 December 2012
Article by Jiang Rongqing

Bank Guarantees in China

When Chinese enterprises ("the contractor" or "contractors") are providing engineering services such as construction and shipbuilding ("the project" or "projects") to foreign project employers ("the employer" or "employers"), it is frequently the case that the employer would demand the contractor to apply to certain banks for the issuance of a bank guarantee which is independent from the underlying contracting contract, irrevocable and on-demand ("foreign-related independent guarantees" or "guarantees").

Due to their peculiar competitiveness in the field of engineering (including but not limited to reasonable price, convenient financing etc.), Chinese contractors have been taking a rising share in the worldwide contracting market. They have contracted projects worth larger and larger amounts of money, and technologies involved therein are also more and more complex. Yet such a trend has nevertheless brought certain problems. For instance, contractors have more conflicts with employers in performance of contract, and employers from time to time demand guarantees. Cases in which contractors apply to Chinese courts for withholding payment under foreign-related independent guarantees are also on the rise.

To ensure the certainty and succeeding rates in the contractors' application for withholding the payment under guarantees, and to provide them with effective protection of their guarantees, authors of this article would like to dig into the nature of foreign-related independent guarantees as well as the law and practice in Chinese courts when dealing with this kind of case.

1. Types and Legal Relationships concerning Foreign-Related Independent Guarantees

According to various purposes, foreign-related independent guarantees can be divided into tender guarantees, advance payment guarantees, performance guarantees, and maintenance/warranty guarantees. According to the legal relationship with the guarantor, on the other hand, foreign-related independent guarantees can be divided into direct guarantees and indirect guarantees.

Direct guarantees are guarantees issued by Chinese banks directly to the employer as per application of the contractor. By issuing such guarantees, the guarantor provides security to the employer directly, without involving a correspondent bank. Legal relationships are as follows,

Under a direct guarantee, the employer enters into an underlying contract with the contractor, constituting a contractual relationship; the contractor applies to Chinese banks to issue a guarantee, constituting an entrusting relationship; Chinese banks issue guarantees to the employer, constituting a guarantee relationship.

An indirect bank guarantee, however, is issued by Chinese banks to the employer by instructing another bank appointed by the employer (the appointed bank) as per the application of the contractor. Then, the appointed bank issues a guarantee to the employer, while the Chinese bank issuing a counter guarantee to the appointed bank. Legal relationship as follows,

Under indirect guarantees, the employer enters into an underlying contract with the contractor, constituting a contractual relationship; the contractor applies to Chinese banks to issue a counter guarantee, constituting a entrusting relationship; the Chinese bank issues a counter guarantee to the appointed bank, constituting a counter-guarantee relationship; the appointed bank issues a guarantee to the employer, constituting a guarantee relationship.

Thus, whether under direct guarantees or indirect guarantees, only the issuing bank and the employer are parties of the guarantee. The contractor is not a party of the guarantee and has no guarantee relationship with the employer.

2. Nature of Foreign-Related Independent Guarantees

Both the International Chamber of Commerce (ICC) Uniform Rules for Demand Guarantee (URDG, ICC Publication No. 458), and its upgrade version of ICC Uniform Rules for Demand Guarantee (URDG, ICC Publication No. 758) stipulate a guarantee is by its nature independent and on-demand.

That is, the contractor has given up the right to prevent the bank from paying in compliance of the guarantee to the employer at the time he instructs the bank to issue a demand guarantee. Accordingly, the employer is only obligated to provide a general statement when making a demand, instead of confirming, establishing or proving that the contractor has breached the underlying contract.

Based on its nature of independent and on-demand, guarantees provide sufficient protection to the employer. In case any dispute which cannot be settled through negotiations between the employer and the contractor arises, it has become an efficient mechanism for employers to claim the liability of the contractor by making a demand to the bank.

3. Fraud Exception Rule of Foreign-Related Independent Guarantee

Although foreign-related independent guarantees are independent and on-demand by its nature, when the employer demands the guarantee in a fraudulent manner, however, the contractor still has the right to protect itself with certain measures, namely the fraud exception rule of demand guarantee.

In practice, as a effective counter approach against employers' unfair calling,the contractor can apply to competent Chinese courts for an injunction suspending payment under the guarantee, by virtue of the employer's fraudulent demand of the guarantee. Soon after the issuance of such an injunction, the contractor shall bring lawsuits against the employer and the bank before competent courts to stop payment under the guarantee.

4. Chinese Courts' Trial Practice in Cases concerning Withholding Payment under Foreign-Related Independent Guarantees before August 27th, 2011

Up till now, there were no guiding laws or regulations concerning cases involving withholding payment under foreign-related independent guarantees. As China is not a case law country, a Chinese court dealing with such guarantee cases is not necessarily bound by the decisions other courts made before it. It can even make a judgment which is opposite to that of other courts. Before August 27th, 2011, Chinese trial practice in cases concerning withholding payment under foreign-related independent guarantees can be concluded as a total mess, where some courts stick strictly to the independent and on-demand nature of guarantees thus refusing to check out the performance of the underlying contract when examining whether there is fraud in the employer's demand, and some other courts dig thoroughly into the performance of the underlying contract without any respect to the independent and on-demand nature of guarantees. In a word, neither courts nor relevant practitioners in China have managed to strike a balance between the independent and on-demand nature of guarantees and examination of the fulfillment conditions of the underlying contract, leading to the fact that hardly any cases or arguments concerning cases of withholding payment under guarantees can be convincing.

We can be sure at one point, however, that if contractors have provided proper property security, Chinese courts would normally award an injunction to suspend the bank from paying the amount under the guarantee, and accept the case brought by the contractor against the employer and the bank to stop paying certain amount under the guarantee.

5. Chinese Courts' Trial Practice in Cases concerning Withholding Payment under Foreign-Related Independent Guarantees after August 27th, 2011

The Supreme Court of China has already drawn its attention to the arising amount of cases concerning withholding payment under guarantees as well as messy situation of courts' trial practice in such cases. After the Libyan event in February 2011, Chinese contractors with projects in Libya are all challenged by the issue of guarantee demand. Relevant industry association and authorities have raised this problem repeatedly to the Supreme Court of China, hoping that Chinese courts can provide judicial protection to Libya-related guarantees. Under such circumstances, the Supreme Court of China summoned a forum for presidents of nationwide commercial court presidents to discuss foreign-related commercial trial practice. And on August 27th, 2011, the guiding opinion for fraudulent demand of guarantees ("guiding opinion") was published.

The guiding opinion has made it quite clear about how to try cases concerning withholding payment under guarantees. Although it is not an officially promulgated legislation, we can hopefully wait to see it making a difference to the present messy situation of trial practice.

According to the guiding opinion, two kinds of situations fall into the category of unfair calling, one is that documents submitted by the beneficiary are not qualified; the other is that although documents are qualified, it can be proved with evidence that the underlying contract is against public orders, and it is obviously fraud or abuse of the beneficiary's rights... The second situation is a general condition to apply the fraud exception rule of independent guarantees. Courts shall use this standard to decide whether to support contractors' claim for suspending or even withholding payment. It is the ultimate nature of independent guarantees that it shall be independent from the underlying contract, and the fraud exception rule seems quite abstract. So judges have quite flexible room to use their discretionary power which shall be cautious. If the contractor can provide preliminary evidence to prove the employer's fraud or abuse of rights, its application to suspend payment should be supported as once the amount of money has been paid, it is hard to get it back. As to the final decision of whether to withhold the amount, adequate and manifest evidence shall be provided and judgment will be made after a judicial trial. During trial practice, courts can refer to Article 19 of the United Nations Convention on Independent Guarantees and Stand-by Letters of Credit ("Convention"), decide whether there is an independent guarantee fraud according to specificsituations of the case... The decision about existence of fraud cannot be made without examination of the performance conditions and validity of the underlying contract.

As is stipulated in Article 19 of the United Nations Convention on Independent Guarantees and Stand-by Letters of Credit ("Convention"), if any one of the following conditions are manifest and clear, the guarantor/issuer, acting in good faith, has a right to withhold payment: (1) any document is not genuine or has been falsified; (2) no payment is due on the basis asserted in the demand and the supporting documents; or (3) judging by the type and purpose of the undertaking, the demand has no conceivable basis. For the purposes of subparagraph (3), several specific conditions are further regulated: (a) the contingency or risk against which the undertaking was designed to secure the beneficiary has undoubtedly not materialized; (b) the underlying obligation of the principal/applicant has been declared invalid by a court or arbitral tribunal, unless the undertaking indicates that such contingency falls within the risk to be covered by the undertaking; (c) the underlying obligation has undoubtedly been fulfilled to the satisfaction of the beneficiary; (d) fulfillment of the underlying obligation has clearly been prevented by willful misconduct of the beneficiary; (e) In the case of a demand under a counter-guarantee, the beneficiary of the counter-guarantee has made payment in bad faith as guarantor/issuer of the undertaking to which the counter-guarantee relates.

As the Convention invoked in the guiding opinion for fraudulent demand of guarantees has stipulated how to decide whether there is fraud in employer's demand quite clearly, a case being tried in Tianjin Court of China concerning withholding payment under guarantees might have a dramatic turnover in its second instance.

6. Analysis of Chinese Latest Cases concerning Withholding Payment Under Foreign-Related Independent Guarantees

In a recent foreign-related independent guarantee case, the writer was entrusted by a Pakistan employer to be the attorney against a Chinese cement design institute ("the Chinese contractor"), before two Tianjin courts, and the trial period started before August 27 th , 2011. The trial of the court of first instance and the court of second instance has fully reflected the development of the above mentioned trial practice of foreign related independent guarantee in China.

In this case, the Chinese contractor undertook the obligation of design, supply, testing a cement plant capable of producing 6700 tons of cement per day through the underlying contract with the Pakistani employer. A Chinese bank ("Bank"), upon the application of the Chinese contractor, issued an advance-payment guarantee and a performance guarantee, with the amount of 3,500,000 USD, in favor of the Pakistani employer.

Disputes arose when the cement plant supplied by the Chinese contractor failed to meet the contract standard, which could not be settled through friendly negotiation. In October, 2009, the Pakistani employer claimed whole amount of the performance guarantee. The Chinese contractor applied promptly to Tianjin No.2 Intermediate Court (Court of First Instance) for suspending the payment in reason of fraudulent demand. At the same time, the Chinese contractor filed a lawsuit against the Pakistani employer and the bank before the same court to stop the payment.

After the Chinese contractor provided proper property guarantee, Court of First Instance made an injunction for suspending the payment, and also accepted the case filed by the Chinese contractor against the Pakistani employer and the bank.

Prior to the publication of guiding opinion for fraudulent demand of guarantees on August 27th, 2011, Court of First Instance ruled that the Pakistan employer fraudulently demanded guarantees merely for dispute under the contract between the parties, and stopped the Bank from paying under the guarantee.

While the case was heard before Tianjin High Court (Court of Second Instance), however, the guiding opinion for fraudulent demand of guarantees was already published. Court of Second Instance heard this case in compliance with the guiding opinion for fraudulent demand of guarantees, demanding the Chinese contractor to prove in a sufficient and obvious manner either that the underlying obligation has been undoubtedly fulfilled by the Chinese contractor to the satisfaction of the Pakistan employer or that its fulfillment has been obviously prevented by the Pakistani employer's willful misconduct. It turned out that the Chinese contractor failed to fulfill its obligation of proof, and thus shall undertake the risk of losing the case.

7. Approaching Withholding Payment under Chinese Foreign Related Independent Guarantee in Light of Relevant International Law

In this case, as per the promise made by Chinese government of fair and equitable treatment and the continuous protection for Pakistan investment in China in the Agreement Between the China and Pakistan on the Reciprocal Encouragement and Protection of Investments (the "Investment Protection Agreement") and the Free Trade Agreement between China and Pakistan (the "Free Trade Agreement"), the first author, as the attorney of Pakistani employer, reported the violation of the Court of First Instance to both the Commerce Department of China and Pakistan, and also submit the case to ad hoc arbitration tribunal set up in accordance with the Convention on the Settlement of Investment Disputes Between States and Nationals of Other States ("ICSID") to initiate arbitration proceedings against Chinese government. Once the case is established, it will probably undermine China's image and reputation in the world. As long as the ad hoc arbitration tribunal has made a arbitration award in favor of the Pakistan employer, the final judgment of Chinese court might be overruled and Chinese government might consequently be required to make indemnification to the Pakistan employer for such erroneous judgment.

8. Conclusions

Based on the above analysis, we observe that no matter if it is a direct guarantee or an indirect one, contractors are entitled to apply for withholding payment before a Chinese court, yet to finally win the case, a thorough demonstration of whether there is the exceptions stipulated in Article 19 of the Convention together with an examination of the underlying contract is necessary. In practice, some practitioners who simply work the case superficially, do not, or cannot, take time to analyze the possibility of winning the case. Under circumstances where contractors do not have grounds to apply for withholding payment at all, once the case is failed, they may not only lose the market share and good banking credit in that certain project country, but also do harm to Chinese banks' credit in the international financial field. What is more, the image and reputation of Chinese government in the world can also be undermined.

Hence, it is the authors' suggestion that when faced with an employers' demand, contractors shall first of all organize a group of specialists in the field of international engineering (instead of the field of guarantees) to dig thoroughly into the underlying contract, finding out whether there are exceptional conditions in Article 19 of the Convention. After finding concrete reasons for withholding payment, it shall not postpone to apply to a Chinese court for withholding payment. Additionally, if faced with judicial injustice during their demand, employers may try to find out whether its mother country has entered into any bilateral investment treaty in favor of them with China, and to take full advantage of the investor-state arbitration mechanism for better protection of employers' interests under guarantees.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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