We recently published an article entitled “Crossing the Rubicon – can you guarantee that you understand the terms of your guaranteed obligations?”, providing an insight into the recent Rubicon case.
This follow-on piece explores some key practical issues for each party to the arrangement to consider, as well as typical points of negotiation for both a beneficiary and an issuer in respect of a guarantee or on demand instrument.
What is the difference, and why is it important?
The difference between a guarantee and an on demand instrument is the type of liability that it creates. The liability of a guarantor under a guarantee is secondary because the obligation need not be met until the debtor actually defaults. On the other hand, an on demand instrument is an independent, autonomous instrument which imposes a primary contractual obligation (or primary liability) on the issuer to pay a specified sum of money on the presentation of a written demand which complies with the terms of an instrument. An on demand instrument is an indemnity, i.e. a promise to pay money on the happening of a specified event. Often the phrases “on demand instrument” and “indemnity” are used interchangeably.
Key issues for a beneficiary of a guarantee or on demand instrument to consider
A beneficiary should consider the following when seeking a guarantee instrument or an on demand instrument from a principal:
- if the beneficiary needs immediate access to funds in the event of a default by the principal it should request an on demand instrument because it creates a primary contractual obligation between the beneficiary and the guarantor;
- if the instrument specifies a period of time by which a payment should be made following a demand, this should be kept as short as is practical for the beneficiary. For example, to allow time for funds to clear before any related outgoing payments are due to be made by the beneficiary;
- if the beneficiary’s primary concern is to ensure that a solvent party is available to pay a sum due in respect of actual loss and damage incurred up to the relevant limit of liability in the event of non-performance by a principal obligor, a guarantee instrument may be more appropriate than an on demand instrument; and
- the cost of an on demand instrument tends to be higher – a principal will take these costs into account when setting the underlying contact price.
Key issues for a principal to consider
A principal should consider the following when arranging for a guarantee instrument or an on demand instrument to be issued to a beneficiary:
- a principal should be wary of on demand instruments. Once an on demand instrument has been issued, there is nothing, in the absence of the issuer's knowledge of fraud, to prevent the instrument being called upon. The principal should look out for phrases such as "on [first written] demand" or "on demand without proof or conditions", which usually mean that the instrument is an on demand instrument;
- the principal should also consider the cost of an on demand instrument. It is likely to be more expensive to provide an on demand instrument given the direct obligation that arises under it;
- an on demand instrument will create liquidity risk for the principal.
- the making of a demand under an on demand instrument can have an adverse reputational risk even where a demand does not need to be based on an established breach or default;
- the principal should consider including language in the underlying contract allowing it to claim against the beneficiary for any overpayment made under the instrument;
- depending on the complexity of the terms of the guarantee, the principal may wish to insist that the documents required to be presented for a valid demand under the instrument include some type of certification from an independent party or court (readers may note that the demand in the Rubicon case had to be accompanied by supporting documents; and
- it may be considered that banks are more likely to issue on demand instruments; whereas sureties and insurance companies will undertake the underwriting exercise involved in the provision of guarantees and will offer both on demand instruments and guarantee instruments.
Key issues for an issuer of a guarantee or an on demand instrument to consider
An issuer should try to reduce its risks under a guarantee instrument or on demand instrument and should consider the following points:
- where a guarantee instrument is issued, a risk which will often give rise to a claim against the issuer is the principal's failure to perform due to insolvency. The issuer should investigate the principal's financial position and assess the risk involved, the nature of the contract and the principal's ability to perform;
- the nature of an on demand instrument means that the issuer cannot avail itself of the defences and counterclaims available to the principal. As a result, on demand instruments are open to abuse. For example, a common practice has arisen that if the beneficiary wants to extend the validity of an on demand instrument, it may serve on the issuer a "pay or extend" claim. The issuer, and more particularly the principal, have little choice but to agree to the extension. As a result, obligations arising from on demand instruments can prove to be evergreen or determinable only with the concurrence of the beneficiary;
- if the issuer does not wish to run the risk of inadvertently conferring contractual rights on a third party, consider including a clause which excludes the Contracts (Rights of Third Parties) Act 1999. This helps to manage the scope of potential liability; and
- the issuer may want to include an undertaking from the principal that, if an overpayment is made, all amounts refunded should be paid to the issuer and held on trust to reimburse the issuer.
Negotiation points for a beneficiary and principal
An on demand instrument has obvious advantages for the beneficiary. It is therefore not surprising that beneficiaries will frequently require an on demand instrument. The principal's ability to resist such a request depends on its negotiating strength, but the following points may assist the principal:
- the beneficiary's main concern, particularly in domestic contracts, is the insolvency of the principal. This risk can often be adequately covered by the provision of a guarantee instrument issued by a reputable financial institution;
- an on demand instrument is purely a financial instrument where the issuer's prime consideration is the financial strength of the principal. However, the issuer of a guarantee instrument will carry out an underwriting exercise and will assess not only of the principal's financial position, but also the principal's ability to perform its contractual obligations. If there are concerns about the principal’s ability to perform, the beneficiary may take more comfort from guarantee instrument. This may need to be balanced against the scope of security held over the principal’s assets;
- an on demand instrument does not necessarily avoid litigation. If the beneficiary suffers damage in excess of the value of the on demand instrument, it will have to pursue the claim for the excess under the contract. If the principal disputes the claim, it (or its insurers) may pursue the beneficiary to recover any excess payment. Further poorly drafted demand provisions can also lead to litigation; and
- an on demand instrument may place additional costs and risks on the principal that will be reflected in the pricing. A commercial approach should be taken when balancing the risks and the costs.