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Be aware of issues surrounding on-demand guarantee

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Issuing Bank Guarantees are very common in connection with international commercial contracts. Most prime contractors will demand their subcontractor to provide an on-demand guarantee to cover the prime in the event the subcontractor fails to perform its obligations as contracted. Oftentimes the prime contractor draws against an on-demand guarantee without justification. Therefore, contractors should be aware of various issues surrounding the on-demand guarantee.

Governing Law and Jurisdiction

The guarantee should specify the governing law and jurisdiction that such guarantee is subject to. Most guarantees issued in accordance with international standards are subject to the ICC’s Uniform Rules for Demand Guarantees (“URDG”). Under the URDG, disputes between the guarantor (bank) and the beneficiary (usually prime contractor) shall be settled exclusively by a court in the country of the guarantor or if the guarantor has more than one place of business by a court of the country of the branch which issued the guarantee, unless the parties agree otherwise. When selecting a bank, parties should have the guarantee issued by a branch in a location that is convenient for both parties, in the event of a dispute.

Guarantee Reference in the Contract

When drafting the contract, the party that will have to provide a guarantee, should make sure to specify the terms of the guarantee within the contract so that when the instructions are issued, they should include the agreed terms from the contract. Under the URDG, a demand for payment must be supported, at a minimum, by a written statement stating: (i) that the contractor is “in breach of his obligations under the underlying contract”, and (ii) “the respect in which” the contractor is “in breach”. Therefore, the contract language should require more than the minimum and such should be reflected in the guarantee instructions as well. The guarantee should also contain language requiring the guarantor to notify the principal when a demand is made against the guarantee. This can give the principal an opportunity to discuss alternatives with the beneficiary prior to the funds being distributed.

When there is no Breach

There is a large financial risk when an on-demand guarantee is issued granting the other party a right to draw against it whenever they do please, especially if no breach occurs to trigger such. Even if the beneficiary is wrong, the guarantee must be paid. Under URDG, in the event of a demand, the guarantor must “without delay” inform the principal (the subcontractor) or, where applicable, his instructing party (such as a bank who has given a counter-guarantee), and in that case the instructing party shall inform the principal (the subcontractor). URDG further provides that the guarantor shall have a “reasonable time” within which to examine a demand and to decide whether to pay.

Ideally during the notice period and guarantor’s review of the demand, the subcontractor/principal may pursue action (whether through arbitration or court) to prevent the demand from being paid. There is always the possibility that the guarantor will not notify the principal about the demand notice, so it is just best to make sure the terms of the contract and guarantee provide the subcontractor/principal with a right to be notified.

email: najmahbrown@aladwanilawfirm.com

By Najmah Matisse Brown