Always on demand? – Shanghai Shipyard Co Ltd v Reignwood International Investment (Group) Company Limited

On 23 July 2021, in a decision with potentially far-reaching implications for the shipbuilding industry and for guarantees generally, the Court of Appeal issued a judgment addressing what makes a guarantee issued by an entity other than a financial institution a “demand guarantee" rather than a “see to it guarantee”.

The Court of Appeal rejected the presumption that a guarantee issued by any entity other than a ­financial institution should be considered a “see to it guarantee” just because of the guarantor’s status. According to the Court, what matters are the terms of the guarantee, not the guarantor’s characteristics.

Demand and see to it guarantees

A “demand guarantee” is an absolute undertaking to pay a sum of money without reference to the details of any underlying dispute, i.e. a guarantor is obliged to pay upon receipt of a demand regardless of whether there is a dispute under the underlying contract.

In contrast, a “see to it guarantee” is a secondary obligation whereby the guarantor is liable only to the extent that the guaranteed party is liable, i.e. a guarantor can normally wait for any liability dispute arising under the underlying contract to be resolved before becoming obliged to make a payment under the guarantee.

In practice, many guarantees issued in a shipbuilding context, particularly by parent companies, contain terms that are traditionally found in both demand and see to it guarantees. In Shanghai Shipyard Co Ltd v Reignwood International Investment (Group) Company Limited, the Commercial Court, and subsequently the Court of Appeal, looked at the guarantee issued by Reignwood to determine how it should be characterised.

The facts

Shanghai Shipyard Co Ltd (the builder) and Reignwood International Investment (Group) Limited (the original buyer and guarantor) were parties to a shipbuilding contract dated 21 September 2011 for the construction of a drillship for a total price of $200 million. The contract was subsequently novated to bring in a new buyer, Opus Tiger 1 Pte Ltd (the novated buyer), which was an ­indirect subsidiary of the guarantor, and a guarantee was provided by the guarantor to secure payment by the novated buyer of the final instalment of the purchase price of $170 million (the guarantee).
The novated buyer did not accept delivery of the drillship and so the builder made a demand on the guarantee. The demand was refused by the guarantor, pending resolution of the dispute as to whether the novated buyer was obliged to take delivery. After the demand had already been made, the dispute was submitted to arbitration.

The decision in the Commercial Court

The Commercial Court was asked to determine two issues – namely:

  • whether the guarantee issued in this instance was a see to it or demand guarantee; and
  • whether the guarantor was ­entitled to refuse payment under clause 4, pending the outcome of an arbitration between the parties in respect to a dispute regarding the novated buyer’s liability to pay the final instalment:

    – only if the arbitration had been commenced between those parties by the date the demand was made; or
    – regardless of when such arbitration was commenced.

In arriving at its decision, the Commercial Court focused on the fact that the guarantee had not been issued by a bank and, in line with case law, concluded that where an instrument is not provided by a bank or other financial institution, there needs to be cogent indications that the instrument is intended to operate as a demand guarantee. Based on the language of the guarantee and consideration of the factual background, the Court held that the guarantee was a see to it guarantee.

In respect of the second issue, the builder argued that even if the guarantee was a see to it guarantee, the ­proviso in clause 4 of the guarantee operated as a defence to a claim under the guarantee only if the arbitration was commenced before the demand was made, which was not true in this case. Therefore, in the absence of an arbitration, the guarantor was obliged to make payment.

The Court was not persuaded that the benefits of clause 4 would arise only when the dispute had been submitted to arbitration before the demand under the guarantee was made, and so it held that the true construction of the clause entitled the guarantor to refuse to make the payment pending the arbitration outcome, notwithstanding when the arbitration was commenced.

Overturn of the Commercial Court’s decision

On 23 July 2021 the Court of Appeal unanimously overturned the Commercial Court’s decision on both issues.

In respect of the first issue, the Court of Appeal emphasised the following:
What matters for the purposes of counterparty risk is not the nature of the business carried on by the guarantor as such, whether banking, other financial business or commercial trading activity. It is simply the commercial and financial strength and probity of the guarantor. […]

[The Guarantor] clearly exercised a financing function beyond that which might arise between parent and subsidiary in an established group of companies in relation to the group’s business.

Thirdly, in the shipbuilding context it has long been established that payment and refund guarantees may be demand guarantees.

The Court of Appeal was keen to emphasise that wording took precedence over any assumptions as to the nature of the guarantee based on the guarantor or otherwise.

The Court then considered the language of the guarantee and identified the following as indicators that the guarantee was a demand guarantee as opposed to a see to it guarantee:

  • the words “ABSOLUTELY” and “UNCONDITIONALLY” in clauses 1 and 3 of the guarantee, which conveyed no conditionality on the buyer’s liability;
  • the words in clause 1 “[as primary obligor] and not merely as the surety”, which clearly indicated that the document was not a surety, i.e. a see to it guarantee;
  • the words “upon receipt by us of your first written demand” in clause 4, which “is the hallmark of a demand guarantee”;
  • the words “we shall immediately pay to you” in clause 4, which would be inappropriate in a surety guarantee, given the time needed to investigate the underlying liability; and
  • clause 7(a), which provided that obligations on the guarantor were to be unaffected by any dispute under the building contract.

The proviso in clause 4 was held merely to be a carve out of what was otherwise a demand guarantee; when triggered, “it involves an obligation to pay against a document, namely the arbitration award. It does not involve an obligation to pay in respect of an underlying liability”.

In respect of the second issue, the builder submitted that in order for the proviso in clause 4 to be triggered and prevent a payment obligation from arising, there had to be “both a dispute and the commencement of arbitration prior to a valid demand being made”. The buyer argued that a dispute only needed to exist. The Court disagreed with the buyer’s argument on the basis that if the buyer was right, “the on demand obligation would be suspended indefinitely by the existence of a dispute and that would occur in every case of non-payment of the delivery instalment”.

Key takeaways from the Court of Appeal’s judgment

The Court of Appeal’s judgment provides guidance as to the factors that will determine whether a guarantee should be construed as a demand or a see to it guarantee. Any presumption arising solely from whether the guarantor is a financial institution, parent company or other type of entity has seemingly fallen away. English law will look to the language used, without the nature of the entity issuing the guarantee tainting the interpretation. Wording such as “unconditionally” and “immediately” and differentiation from traditional see to it guarantee obligations is likely to mean, regardless of the nature of the entity issuing the guarantee, that a guarantee is a demand guarantee.

Where a guarantee has a proviso, such as that in clause 4, that excuses payment where a dispute has arisen and arbitration has been commenced, strict compliance with both aspects must be satisfied before any demand on the guarantee is made for the payment obligation to be suspended. As such, where similarly worded guarantees are in place and it becomes apparent that a beneficiary may soon have a right to make a claim on the guarantee, this judgment is likely to lead to arbitrations being urgently commenced before any demand is made in order to provide guarantors with a basis for suspending payment.

This judgment serves as reminder of the need to be careful when drafting guarantees and to strictly adhere to their terms.

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