According to the statistical communiqué of the National Bureau of Statistics of China, in 2017, the total business revenue through contracted overseas construction projects in the Belt and Road countries reached US$85.5 billion, up by 12.6% over the previous year[1]. Along with the implementation of the Belt and Road Initiative, Chinese companies have accelerated their pace to go overseas. The guarantees issued for international construction projects and the resulting disputes have also increased significantly year on year.
This article intends to outline the types and characteristics of guarantees for international construction projects, analyze typical clauses in these guarantees, and make our recommendations on risk prevention for these guarantees in light of the issues we have encountered in the practice of dispute resolution. In view of the fact that a guarantee is usually provided in the form of a bank guarantee in practice, the guarantees for international construction projects discussed in this article refer specifically to bank guarantees for international construction projects.
I. Types and characteristics of guarantees for international construction projects
Guarantees for international construction projects mainly include bid guarantees, advance payment guarantees, performance guarantees and quality/maintenance guarantees.
Bid guarantee is a letter of guarantee issued by a bank (guarantor) at the request of a bidder (guarantee applicant) in favor of the employer. The purpose of a bid guarantee is to ensure that the bidder will not withdraw or modify its bid after submission, refuse to execute the contract after being confirmed as the bid winner, or refuse to make a deposit as the performance bond or provide a performance guarantee. Otherwise, the employer is entitled to confiscate or keep the bid guarantee. The amount of a bid guarantee is generally 2%-5% of the contract amount.
Advance payment guarantee is a letter of guarantee issued in favor of an owner or a bid issuer (beneficiary) by a bank (guarantor) at the request of a contractor (guarantee applicant). The purpose of an advance payment guarantee is to ensure that the bank undertakes to refund the down payment made by the beneficiary if the contractor fails to perform the contractual obligations. The amount of an advance payment guarantee generally equals the down payment, which is 10%-30% of the total contract price.
Performance guarantee is a letter of guarantee issued in favor of an owner or a bid issuer (beneficiary) by a bank (guarantor) at the request of a contractor (guarantee applicant). The purpose of a performance guarantee is to ensure that the contractor fulfills its contractual obligations and responsibilities, and that the owner or the bid issuer may request the guarantor to undertake the guarantee responsibility within the limit of the guarantee if the contractor fails to perform the contract. The amount of a performance guarantee is generally 5-20% of the total contract price.
Quality/maintenance guarantee is the guarantee issued by a bank (guarantor) in favor of an owner or a bid issuer (beneficiary) at the request of a contractor or supplier (guarantee applicant). Its purpose is to ensure that the quality of a project or goods meets the requirements of the contract, failing of which and refusal to conduct maintenance or replacement will entitle the beneficiary to make a demand. The beneficiary may deduct a corresponding proportion directly from the project payment as the guarantee, or otherwise require a bank guarantee. The amount of a quality/ maintenance guarantee is generally 5 -10% of the total contract price.
In addition to the above-mentioned guarantees, international projects may also involve various trade guarantees for equipment purchase and leasing etc., such as retention money guarantees, loan guarantees and financial leasing guarantees. These guarantees are not specifically for international contracted projects and will not be covered in this article.
II. Typical risks with guarantees for international construction projects and how to prevent them
For international construction projects, contractors and owners or bid issuers (i.e. the guarantee beneficiaries) are usually from different countries or regions, and relevant guarantees generally are numerous in variety and of high amount. Therefore, disputes arising from these guarantees are complicated and diverse. An analysis on potential disputes and risks concerning the typical terms of the guarantees is provided as follows:
II. Typical risks with guarantees for international construction projects and how to prevent them
For international construction projects, contractors and owners or bid issuers (i.e. the guarantee beneficiaries) are usually from different countries or regions, and relevant guarantees generally are numerous in variety and of high amount. Therefore, disputes arising from these guarantees are complicated and diverse. An analysis on potential disputes and risks concerning the typical terms of the guarantees is provided as follows:
1. Nature of guarantees and independent guarantees
Construction projects in Belt and Road countries are mostly for large-scale infrastructures. Many general contractors will subcontract part of the project to subcontractors. Thus guarantees for international construction projects include the guarantees from general contractors to owners and guarantees from subcontractors to general contractors.
Owners (beneficiaries) will no doubt require demand guarantees. “Compensation before dispute settlement” is the biggest motivation for the owners to do so. General contractors will in turn ask subcontractors to provide the same type of guarantees. Other forms of guarantees such as irrevocable documentary credits, certified checks or bank checks may also be used, but it is most common to see irrevocable independent demand guarantees in practice.
Whether the guarantees issued by banks are independent guarantees is one of the most common disputes in practice. The court or arbitral tribunal usually determines whether a guarantee is an independent guarantee in essence based on its content. Wordings that facilitate interpretation as independent guarantees include:
The guarantee states “pay on demand”;
The guarantee states that the bank provides “an unconditional and irrevocable guarantee”;
The guarantee states that the payment is triggered upon “the receipt of a written notice from the beneficiary which declares that the guarantee applicant has failed to fulfil its contractual obligations, without the presentation of any supporting documents”;
The guarantee states it is subject to the model rules for independent guarantees, such as the ICC Uniform Rules for Demand Guarantees (URDG758);
Other clauses that expressly state that the payment obligation of the guarantor is independent of the underlying transaction and the application of the guarantee.
On the other hand, according to our experience, if the terms of demanding a payment are not limited to documents or the following expressions appear, it will be unfavorable for the guarantee to be deemed as an independent guarantee. For example, “the guarantee provided under this letter of guarantee is a joint and several guarantee”, “if the applicant defaults in the performance of the project contract, the bank will compensate you for the loss within the limit of the letter of guarantee” and “the bank will reimburse you for any losses related to the above contract within the limit of the letter of guarantee when your first written request is made” etc[2].
2. Essential provisions for independent guarantees
The ICC Uniform Rules for Demand Guarantees (URDG758) have not clearly defined the essential clauses for demand guarantees, as its provisions on guarantee amendments, amount changes, demands and examination are automatically applicable for any guarantee that indicates it is subject to the Rules. Nonetheless, there are still six aspects that should be clarified. Otherwise, a letter of guarantee may be considered invalid, ineffective or absent of the essence of an independent letter of guarantee[3] . The six aspects include (1) applicant information; (2) beneficiary information; (3) guarantor information; (4) underlying contract information (such as index number); (5) number of the letter of guarantee; and (6) maximum amount and currency of the letter of guarantee.
Article 3 of the Provisions of the Supreme People's Court on Several Issues Concerning the Trial of Cases of Independent Guarantee Disputes (Fa Shi [2016] No. 24) (the "Judicial Interpretation of Independent Guarantees") provides for the features of independent guarantees[4] . That is, independent guarantees must have two elements in the content, i.e. the documents based on which the payment is to be made and the maximum amount. Absence of either element means that the guarantor has to determine the performance of the underlying contract beyond the documents, and in this case the independence and paper-based nature of independent guarantees will be thus out of the question. Presumably, such guarantees would be deemed as accessory guarantees[5] .
3. Maximum amount and reduction provisions
As mentioned above, the maximum amount is an indispensable clause to an independent guarantee. If the maximum amount is not stated, the letter of guarantee may be deemed to be a general liability guarantee or joint and several liability guarantee. In addition, the parties will agree on reduction clauses and reduction rules in the contracts for certain international construction projects. Nonetheless, the problem that guarantee applicants may confront in practice is how to assert their rights in face of demands by beneficiaries, when the guarantee doesn’t set forth the documents accompanying the demand or the reduction criteria.
Article 7 of the Judicial Interpretation of Independent Guarantees provides: “for documents not covered by any independent guarantee, the relevant demand examination criteria as determined by the International Chamber of Commerce may be referenced.” Further, Article 25 of the Uniform Rules for Demand Guarantees (URDG758) provides: “a. the amount payable under a letter of guarantee shall be reduced accordingly by: (i) the amount paid under the letter of guarantee, (ii) the amount reducible under Article 13 (Note: according to Article 13, the parties may agree that the amount of the guarantee may increase or reduce on a specific date or when a specific event occurs), or (iii) the amount indicated in the document that the beneficiary signs to relieve part of the payment responsibility under the guarantee."
In judicial practice, some courts also find that a guarantor, namely, a bank, cannot reduce the guarantee amount solely on the basis of the reduction clauses when the guarantee does not stipulate the accompanying documents nor any reduction criteria. Their reasoning is for independent guarantees, the guarantor only needs to examine whether the beneficiary presents the eligible accompanying documents, rather than investigate the actual performance of the underlying contract, before it makes the payments. Therefore, based on the above provisions, the bank may require relevant documents that are executed by the beneficiary and meet the reduction criteria to complete the reduction.
Therefore, we would recommend that guarantee applicants or banks set forth reduction clauses to expressly specify the rules, time, arrangement and procedures, as needed to gradually reduce the amount and risk of the guarantee.
4. Provisions for the validity term and its extension
The validity term of a guarantee is not a mandatory clause of an independent guarantee, but an explicit expiry date can eliminate undertaking the guarantee liability indefinitely. Common disputes in connection with the validity term are caused by ambiguity in the clause. For example, “the validity term of this guarantee is up to (X days after) the expiration date of the quality guarantee as agreed in the contract”, “this guarantee is valid until 30 days after the bid validity term expires" etc. As the validity term of the guarantee is not fixed or dependent on a time determined by owners at its sole discretion, a guarantee may remain valid until it is revoked. Even if the validity term has expired from the bank or contractor’s perspective, the owner may still make a demand, increasing the risk of the guarantee. In addition, the guarantee applicant must pay the bank the guarantee fee within the validity term, resulting in increased financial costs.
In light of the above risks, it is recommended to specify the validity term of the guarantee, and to avoid expressions for automatic or ex parte extensions, such as “automatic extension upon expiration” and “the consent of the applicant or the issuing bank is not required for extension of the guarantee”. Nonetheless, based on our knowledge, some Belt and Road countries have specifically set up automatic extension clauses. For example, the Bank of India provides that the government is entitled to automatically extend underlying contracts and banks cannot be relieved of their responsibility under guarantees[6] . In such cases, contractors and banks should reasonably assess the exposures that such provisions may bring. In addition, from the perspective of reducing the risks of demand, any overlap of the validity terms of performance guarantees and the quality/maintenance guarantees should also be avoided as much as possible.
5. Determination of demand provisions
Demand provisions are the core of a guarantee. As discussed in the section of “the nature of guarantees and independent guarantees”, whether the terms of demanding a payment are limited to the accompanying documents (the demand notice is also a kind of document) determines the nature of a guarantee. A guarantor or a guarantee applicant may determine whether to exclude the presentation of document as a term to demand a payment based on their own needs and negotiation powers.
From the perspective of the beneficiary, the payment term may be set as the bank’s “receipt of a demand in writing from the beneficiary, stating that the guarantee applicant fails to perform the obligations under the contract” and“without presentation of any supporting documents”. From the perspective of the guarantor or guarantee applicant, the specific requirements for the beneficiary to submit the documents at the time of making a demand may need to be clarified, such as a demand letter, supporting statements and other documents. In addition, procedural requirements for application for guarantees may also be stipulated.
6. Provisions for governing law and dispute resolution
Many Belt and Road countries choose to the law of the country in which the beneficiary is domiciled as the governing law and provides that any dispute shall be subject to the jurisdiction of the court or arbitration institution of the country in which the beneficiary is domiciled or that of a third country. When selecting the governing law for a guarantee, the applicant is usually at a weak position in the negotiation. It is recommended to choose the law of the country in which the guarantee applicant is domiciled when it has an opportunity to do so. Of course, in practice, it is also possible to choose international conventions as the governing law, such as the Uniform Rules for Demand Guarantees (URDG758) or the United Nations Convention on Independent Guarantees and Standby Letters of Credit.
It is essential to note that although the dispute resolution approach is stated in the guarantee, the clause only be binding upon the guarantor and the beneficiary, and not directly applicable to the beneficiary and the guarantee applicant. In the absence of an arbitration clause (or even if there is one, it still remains a question whether the arbitration clause is applicable to guarantee fraud or infringement disputes), the court still has jurisdiction over the case when the guarantee applicant applies for suspension of demand or initiates legal proceedings of guarantee fraud.
III. Conclusion
The risk of subsequent disputes can be effectively mitigated by drafting the terms of guarantees carefully. However, the contractors are also advised to properly manage the performance process of relevant guarantees. For example, the contractors may need to, in the process of fulfilling the underlying contract, collect the evidence of performance and check its counter party’s performance of obligations in a timely manner, and remain cautious for potential demand frauds by beneficiaries. When facing potential demand or guarantee suspension lawsuits, the contractors should also promptly consult with legal counsels to understand relevant international practices and legal provisions, so as to effectively safeguard their legitimate interests in a timely manner.
See the Statistical Communiqué of the People's Republic of China on 2017 National Economic and Social Development released by National Bureau of Statistics of the People's Republic of China. Available at http://www.stats.gov.cn/tjsj/zxfb/201802/t20180228_1585631.html. Accessed on August 16, 2018.
The latter two cases are listed in the section of “How to Identify Demand Guarantees” of the Guide to the ICC Uniform Rule for Guarantee, as the cases not to constitute a demand guarantee. If the payment conditions contain a statement such as “regardless of the objection fi led by the applicant” or “no need to present proof of default or loss”, the guarantee is more likely to be considered as an independent guarantee under normal conditions. However, if a guarantee states that the guarantor’s payment obligation is conditional on the applicant’s presentation of supporting documents to evidence the default or it mentions that the guarantor’s payment obligation is limited to the loss caused to the beneficiary arising from any default by the applicant, it is more likely to be deemed as an ordinary guarantee. Therefore, similar to the expressions in the latter two cases, if a guarantee states that “the bank undertakes to pay the amount you request immediately within the limit of the letter of guarantee once you make a demand in writing” , ICC will consider it to be an independent guarantee as the payment conditions are limited to the presentation of documents.
See Page 107 of the Guide to the ICC Uniform Rule for Guarantee.
Article 3 of the Judicial Interpretation of Independent Guarantees provides, “Where the parties claim that a guarantee is in its nature an independent guarantee under the following circumstances: (1) the letter of guarantee states that the payment shall be made on demand; (2) the letter of guarantee states that the model rules for independent guarantees such as the ICC Uniform Rules for Demand Guarantees are applicable; (3) according to the content of the letter of guarantee, the payment obligation of the applicant is independent of the underlying transaction and the application of the guarantee and the it only bears the responsibility to pay upon proper presentation of required documents, the people's court shall uphold such claim, unless the guarantee does not specify the documents based on which the payment is to be made and the maximum amount. The people's court shall not uphold the claim that the guarantee is in its nature a general guarantee or a joint and several guarantee on the ground that corresponding underlying transaction is recorded in the independent guarantee..."
Zhang Yongjian and Shen Hongyu of the Supreme People's Court: Understanding and Application of the Provisions of the Supreme People's Court on Several Issues Concerning the Trial of Cases of Independent Guarantee Disputes, published in People's Justice (Application), No.1, 2017.
TheXia Linwenfen of International Settlement Document Center of Industrial and Commercial Bank of China: Protection and Control of Trade and Investment Risks in India, published in China Foreign Exchange, No.6, 2017, http://www.chinaforex.com.cn/index.php/cms/item-view-id-44409.shtml.
