Update on Independent Guarantees under Chinese law
In China, independent guarantees are widely used. However, until recently there has been little or no guidance under Chinese law as to how these guarantees are to be interpreted.
On 18 November 2016, Supreme People’s Court of the People’s Republic of China issued Provisions of the Supreme People’s Court on Several Issues concerning Trial of Disputes over Independent Guarantee (“Judicial Interpretation”). The Judicial Interpretation formally came into force on 1 December 2016 and now represents the law that should be followed by all Chinese courts.
An independent guarantee is essentially an on demand guarantee. It is independent of the underlying contractual relationship between the applicant and beneficiary. Consequently, payment by the issuer of independent guarantee may not be subject to a legal default under the contract. Where a guarantee is to be treated as an independent guarantee, the issuer and the applicant will not be able to use any dispute in connection with the contract between the applicant and the beneficiary as a defence against payment, except in the case of fraud.
Identification of independent guarantee
The definition of an independent guarantee under the Judicial Interpretation is crucial for an understanding of how that guarantee can serve its function as an independent guarantee.
The Judicial Interpretation provides that an independent guarantee can only be issued by “a bank or a non-banking financial institution”. Most independent guarantees in the shipbuilding projects in China are issued by Chinese banks and so satisfy this requirement. However guarantees that are commonly issued to release vessels that have been arrested in China are in many cases issued by insurance companies or P&I clubs and the question arises as to whether such organisations qualify as a non-banking financial institution.
There is currently an argument going on in China as to whether the China Shipowners Mutual Assurance Association (CPI), who is registered with Ministry of Civil Affairs rather than the bank administration authority, is to be considered to be a non-banking financial institution. The view expressed by commentators is that guarantees issued by P&I Clubs may not fall within the definition of an independent guarantee under the Judicial Interpretation.
The definition as provided in the Judicial Interpretation also imposes the requirement that the guarantees are in effect on demand guarantees for specified amounts. Thus guarantees that (i) contain a clause which provides a mechanism of suspension of payment due to ongoing court proceedings or arbitrations; or (ii) fail to state the supportive documents to be submitted together with the payment demand; or (iii) fail to state its “maximum guaranteed amount” may not qualify as independent guarantees.
How to prevent the payment under an independent guarantee?
An independent guarantee is intended to be for the benefit of the beneficiary. Therefore the issuer and the applicant need to consider the risks associated with the use of an independent guarantee. Other than the requirement for supporting documents and maximum guarantee amount, the Judicial Interpretation provides a mechanism to prevent payment under the independent guarantee in cases of fraud.
The applicant, the issuer or the instructing party of the independent guarantee may apply to the court to avoid payment under an independent guarantee. There are five grounds on which payment under an independent guarantee may be considered to be fraudulent: (i) the transaction is fraudulent, (ii) the documents presented by the beneficiary are false, (iii) there is a court decision or arbitration award holding that the debtor is not liable to payment, (iv) confirmation from beneficiary that debtor’s obligation is fulfilled or not triggered, and (v) other beneficiary’s deliberate abuse of rights where the beneficiary clearly knows it does not have rights to demand payment.
Fraudulent transactions and presenting false documents are obvious cases of fraud but the other grounds for preventing payment are less obviously connected with fraud. The third ground may well exclude ongoing court proceedings and arbitrations are excluded, but foreign court decisions and arbitration awards, even where these have not been formally recognised by Chinese court, should be sufficient to prevent payment where these show that the debtor is not liable for the claim. The fourth ground refers to the circumstances which beneficiary has confirmed that no debt is due and this is inconsistent with the payment demand under the guarantee. The fifth ground refers to any other deliberate and malicious abuse of rights to make payment claims against the issuer.
It is not easy to successfully prevent the payment under an independent guarantee. The Judicial Interpretation provides stringent conditions to be satisfied and imposes serious consequences where an invalid application for preventing the payment has been made. There must be clear evidence of the existence of fraud, to the standard “beyond reasonable suspicion” and the party making the application must show that absent an order from the Court there would be a significant risk of harm to the legitimate rights and interests of the claimant. In addition the applicant has to provide a security sufficient to compensate the possible loss incurred to the respondent.
The promulgation of the Judicial Interpretation is a positive step forward in clarifying Chinese law relating to independent guarantees. While applauding its arrival it must also be recognised that the Chinese Courts have been given considerable powers of discretion both as regards deciding what is an independent guarantee and the grounds on which payment may be delayed or avoided. Prudent review with assistance from legal experts will continue to be essential when negotiating the provision or acceptance of independent guarantees in China.