Incoterms_® and Commercial Contracts

11.1 A note on terminology

Although the word “guarantee” is used here as the preferred general term, there is no international standard terminology. National legal systems are not consistent with each other in their treatment of the terms “guarantees”, “bonds”, “sureties”, “undertakings” and “indemnities”, etc. In practice, these terms are used as virtual synonyms by international traders. These security mechanisms may be provided by banks, insurance companies, specialized surety companies or other financial services firms.

“Standby credits” (also known as “standbys” or “SLCs”) are similar to guarantees and bonds. The use of standby credits arose when American banks were prohibited from issuing guarantees and therefore developed an alternative system. Standby credits, like guarantees and bonds, are primarily used to secure performance or payment. They are to be distinguished from the more traditional “letters of credit” or “documentary credits”, which are referred to as “commercial credits”. Commercial credits are used as the primary means of payment, whereas standby credits, like guarantees/bonds, are a backup system only to be used in the event of a default.

In the discussion below, the terms “demand” and “surety” will be used to describe two distinct categories of guarantee or bond. However, we cannot tell from the terms “guarantee”, “bond” or “standby credit” whether we are dealing with a demand instrument or a surety instrument. We must examine the particular characteristics and nature of a guarantee obligation in order to properly classify the guarantee as a demand or surety instrument.

The parties to a guarantee or bond are referred to as:

BENEFICIARY
The beneficiary is the party that receives the benefit of the guarantee in the event of nonperformance by the other party. In practice, this is most often the buyer or employer. In large construction contracts, the beneficiary is often a government entity.

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APPLICANT/(FORMERLY “ACCOUNT PARTY ” OR “PRINCIPAL ”)
The applicant is the commercial party that directs the issue of the guarantee. Examples of applicants/principals/account parties include construction companies that guarantee that a construction project will be completed, and large exporters that guarantee they will re-pay any sums advanced by the importer if the goods are not properly shipped.

GUARANTOR
The guarantor is the bank, insurance company or surety company that issues the guarantee on the instructions of the applicant or on its own behalf and is responsible for payment of a determined or determinable sum under the guarantee according to its conditions.

11.2 Main uses of guarantees, bonds and standby credits

The earliest form of commercial guarantee was the cash deposit. If one party failed to perform under the contract (e.g., the buyer failed to pay for or accept the contract goods, or the supplier failed to provide the contract goods), that party forfeited the deposit. The inconvenience of the cash deposit system was overcome with the advent of banks and other financial services providers that were willing to issue a guarantee or bond to the importer in lieu of the cash deposit. Such guarantees can be almost as good as cash to the beneficiary in the event of a default, but are cheaper and simpler to obtain for the counterparty.

The main uses in international trade of bonds/guarantees/standby credits include the following:

These cover the risk that the exporter or contractor will fail to adequately perform the contract. The guarantee amount is generally a stated percentage of the contract price, commonly up to 10%.

These secure performance in contracts awarded by competitive bidding. For example, a governmental entity will solicit competitive tenders or bids for a procurement or construction contract. The bidders are required to issue a guarantee in favour of the governmental entity. The guarantee ensures the buyer that the selected bidder will actually accept and sign the contract according to the terms of the bid. The guarantee amount is commonly set at from 2% to 5% of the contract value.

These ensure the return of the beneficiary’s advance payments in case of non-performance by the applicant. Thus, an importer who allows an exporter to draw a cash advance will require that exporter to issue a repayment guarantee in the event the exporter does not actually ship the contract goods in due time.

These guarantees are commonly used in contracts involving goods and services. For example, the employer in a construction project may negotiate to retain a certain percentage of the contract price as a sort of insurance against defects which are not immediately apparent.
Rather than lose the use of the retained funds, the contractor will prefer to issue a retention guarantee for payment of a specified sum in the event that building defects are eventually discovered.

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These secure the warranty obligations of equipment suppliers throughout the period of the supplier’s liability for defects.

These secure the payment obligation for an export contract. If an exporter grants “open account” payment terms, he may wish to oblige the importer to issue a guarantee or standby credit backing the payment obligation. If the importer fails to pay, the exporter draws against the guarantee.

11.3 Difference between “demand” and “surety” instruments

There is a fundamental legal and practical difference between 1) “demand” guarantees/ bonds, which represent something close to “instant cash” for the beneficiary, who only has to make a formal demand; and 2) “surety” guarantees/bonds, which are conditional because the beneficiary must first establish that he is entitled to the money, as by submitting a court judgement or arbitral award, before the guarantor will pay.

DEMAND GUARANTEES
Under a demand guarantee, the guarantor must pay on first demand by the beneficiary. There is no need to prove that the applicant has actually defaulted on a contractual obligation, so the beneficiary is assured a speedy and certain monetary guarantee - wherein lies the great
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value of such guarantees for beneficiaries. Demand guarantees are a close substitute for that more ancient system of security, the cash deposit. As a cash substitute, demand guarantees provide readily accessible, trouble-free security for the beneficiary. In most cases, the only documentary requirement for payment is that the beneficiary’s demand be in writing and accompanied by some statement as to the reason for the demand.

Clearly, there is a big risk associated with granting a demand guarantee. The applicant (party issuing the guarantee) takes the risk that the beneficiary will unjustifiably make the demand (as with the cash deposit, where the beneficiary could unjustifiably keep the cash). This is referred to as the problem of the unfair call. Although under some legal systems outright fraud or dishonesty by the beneficiary may enable the applicant to block payment under the guarantee, such circumstances can be very hard to prove. As a practical matter, it is extremely difficult to stop an unfair call. Prudent traders, therefore, prefer to avoid granting demand guarantees.

Demand guarantees are most commonly used when the beneficiary has great bargaining power and is able to impose the demand guarantee as a “take it or leave it” option. The classic example is that of major construction project tenders, in which contractors from around the globe compete for a single contract. Some applicants succeed in compelling their beneficiaries to grant counter-guarantees which can reduce the danger of an unfair call, but again this becomes a matter of negotiating strength. An extremely strong buyer may compel prospective counterparties to submit demand guarantees while refusing to grant corresponding counter-guarantees. When a trader feels that it is forced by commercial pressures to grant such a demand guarantee, the only practical protection against an unfair call may be to obtain insurance. Export insurers in some countries will provide insurance against unfair calls, provided that the commercial context meets certain requirements. The cost of this insurance can be factored into the exporter’s price tender.

Another difficulty inherent in the demand guarantee is that of setting an assured expiry date for the guarantee. Although guarantees are subject to an expiry date as a matter of routine, in practice the beneficiary may be able to force an extension of the validity period with a so-called “extend or pay” demand. The applicant has no more protection available against such a demand than against an unfair call. In the absence of established fraud enabling the guarantor to refuse payment, the applicant will have little practical alternative but to agree to the extension (note again, however, that some protection is provided in the procedural safeguards of the URDG). In some countries, the “extend or pay” practice is not at all uncommon and can result in repeated forced extensions of the guarantee period.

However, it is certainly possible that a call for an extension may have some legitimate commercial purpose. Thus, such a call can serve as a second chance granted to the contractor by the employer to perform according to contractual obligations. In such cases, it would be unfair to deprive the employer of recourse to a “pay or extend” statement.

From a legal perspective, demand guarantees are said to be independent or autonomous undertakings. The guarantee is independent and separate from the underlying contract. The guarantee obligation runs directly from the guarantor to the beneficiary and becomes binding upon the guarantor once issued, regardless of the applicant’s subsequent ability or inability to reimburse the guarantor. Thus, the insolvency of the applicant will not free the guarantor from its obligation to pay under the guarantee. Most importantly, the payment obligation is completely unaffected by an applicant’s allegation that the beneficiary has violated the terms of the underlying contract. Even when an applicant formally protests that the beneficiary’s demand is in bad faith and that the applicant is not in default, the guarantor
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will still have to pay against the beneficiary’s demand (assuming no clearly established fraud by the beneficiary).

Although a demand guarantee can be fixed for any percentage of the value of the underlying contract, because of its unconditional nature it is rare for applicants to agree to demand guarantees for more than a small fraction of the total contract value, e.g., in the 5% to 10% range.

SURETY BONDS/GUARANTEES (E.G., INSURANCE BONDS)
Under a surety or conditional guarantee, the obligation of the guarantor is triggered by the actual default or contractual breach of the applicant as evidenced in a document such as a court judgement or arbitral award. Thus, in order to claim under a conditional guarantee, the beneficiary must first be able to establish in documentary fashion that the applicant has failed to meet its contractual obligations.

In contrast to demand guarantees, surety guarantees are said to be secondary or accessory obligations, because the guarantor’s obligations are dependent on the applicant’s actual default in performance of the underlying contract. Moreover, the guarantor is only obliged to pay (or to perform the applicant’s obligations) to the extent of the applicant’s liability. The guarantor “steps into the shoes” of the applicant in order to fulfil the applicant’s obligations. Consequently, the guarantor may make use of any defences available to the applicant.

The use of conditional or accessory guarantees can eliminate or greatly reduce the problem of unfair calls. Therefore, such guarantees are (from the applicant’s point of view) preferable to recourse to demand guarantees. Since an applicant is assured under a conditional guarantee that there will be no payment or performance by the guarantor unless there is a proven default, the applicant may be willing to stipulate that the conditional guarantee cover a larger percentage of the total contract value. Thus, it is not unusual for conditional guarantees to be set at 30% or 40% of the contract value. Because of this higher percentage of coverage, a conditional guarantee may be attractive to the beneficiary as well. Moreover, it is possible to use the two forms of guarantee in tandem on the same contract, the demand guarantee for a small percentage and the conditional guarantee for a larger percentage of the contract value.

11.4 ICC uniform rules for guarantees and bonds

• ICC Uniform Rules for Demand Guarantees (“URDG 758” - the 2010 revision of URDG, first published in 1991)

ICC sought to standardize demand guarantee practice through the URDG, which were adopted in 1991 and revised in 2010. The URDG grew out of the perceived failure of an earlier set of rules (the ICC Uniform Rules for Contract Guarantees - “URCG”) to gain market acceptance. The URCG represented an attempt to provide an alternative to demand guarantees in view of the danger of unfair calls. Thus, the URCG required the beneficiary’s demand for payment to be accompanied by a court judgement or arbitral award establishing the fact of default. The approach of the URCG ran counter to the market reality of the frequently superior bargaining power of beneficiaries.

Despite its drawbacks, the demand guarantee continued to be widely used internationally and is now clearly here to stay. Employers/importers with strong bargaining positions see no reason to accept the kind of conditional guarantee covered by the URCG’s provisions. Of course, the URCG may still be used in those contexts where the exporter-applicant has been able to negotiate a conditional guarantee to be issued by a bank.

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The URDG thus reflect the market reality of the continued broad use of demand guarantees. As with the UCP, the URDG apply when they have been incorporated by a specific reference (as by a mention at the bottom of a bank’s guarantee application form).

The scope of the URDG is limited to demand guarantees that are themselves in writing and that provide for payment on written demand. Although standby letters of credit are legally similar to demand guarantees and therefore could fall within the scope of the URDG, standby practice is itself so specialized that it is expected that most standby credits will be issued subject to International Standby Practices (ISP98) or to the UCP for documentary credits. The URDG reaffirm the three basic principles of the demand guarantee:

• the independence of the guarantee from the underlying transaction;
• the documentary nature of the guarantee; and
• the limitation of the guarantor’s duty to review the written demand to an examination of whether the demand and any accompanying documents conform on their face with the terms of the guarantee.

The URDG requires specific, formal requirements for a demand. The demand must be in writing and in conformity with the express terms of the guarantee, and must also be supported by a statement of breach by the beneficiary. This statement must set forth the nature of the breach. Unless expressly stipulated in the guarantee, the statement of breach does not have to be provided by a neutral third party such as an independent engineer or arbitrator - the beneficiary’s own statement is acceptable. The intent of this provision is to discourage unjustified recourse to the guarantee, without going as far as to fundamentally alter its “on demand” nature.

The URDG have become a globally-recognized market standard for demand guarantees. Numerous banking federations have endorsed them, requesting their member banks to use the URDG as default rules. In 2002, the World Bank gave its backing to the URDG, marking a major step toward their worldwide acceptance by banks and parties to contracts. Every year, thousands of guarantees are issued in support of procurement and construction projects financed by the World Bank. The World Bank has now decided to incorporate the ICC rules in all of its model unconditional guarantee forms. This decision also allows new parties, particularly in emerging economies where the World Bank is active, to get to know the URDG and appreciate the many benefits that can be derived from their use.

The International Federation of Consulting Engineers (FIDIC) has also expressed confidence in the URDG by incorporating them in its model guarantee forms, widely used in construction contracts. The Organization for the Harmonization of Business Law in Africa in 1997 enacted a new Uniform Law on Security Interests whose chapter on guarantees mirrors the URDG. This law is now in effect in 15 African states.

• ICC Rules for Contract Bonds (“URCB 524” - first published in 1993) - apply to conditional or suretyship guarantees.
• ICC Rules for Contract Guarantees (“URCG 325” - first published in 1978), are intended for bank guarantees that require documentary proof of default (these rules attempt to prevent unfair calls by beneficiaries by requiring the beneficiary’s demand to be accompanied by a court judgement or arbitral award).

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ICC has issued two sets of rules which apply to surety or conditional guarantees, one of which was drafted primarily for guarantees issued by insurance and specialized surety companies, while the other is more general in application but was designed primarily with banks in mind as guarantors.

A potential disadvantage of the conditional guarantee for the beneficiary is that it may take quite some time to obtain the court judgement or arbitral reward specified in the guarantee as triggering the guarantor’s obligation. In the interest of assuring a quick remedy for the beneficiary, the ICC Uniform Rules for Contract Bonds provide for the possibility of alternative documentary measures. Thus, the parties may agree that the guarantee obligation will be triggered by presentation of a “certificate of default” issued by an independent architect, engineer or ICC pre-arbitral referee. Another alternative is that the guarantor, upon its own investigation, may issue a certificate of default.

Because conditional guarantees may require the guarantor to ascertain the factual details of alleged defaults by the applicants, banks have been reluctant to issue them. Insurance companies and specialized surety companies have experience in the investigation of the contingencies surrounding defaults and are more willing to issue conditional guarantees. Surety companies are specialized in the management of conditional guarantees. However, there are no hard and fast rules; insurance companies and other firms may also be willing to issue demand guarantees, and banks may issue conditional guarantees.

In 2000 the United Nations Convention on Independent Guarantees and Stand–by Letters of Credit entered into force. The Convention is designed to facilitate the use of independent guarantees and stand-by letters of credit, in particular when only one or the other of those instruments may be traditionally in use.

11.5 ICC rules for standby credits: International Standby Practices (ISP98)

a. History

As noted above, the standby credit is very similar to the demand guarantee. Standby credits developed in the US during a period in which US regulations did not allow banks to issue bank guarantees. However, standby credit practice has spread internationally and standbys are now issued worldwide. Previously, standby credits were issued under the rules developed for commercial credits, the UCP (Uniform Customs and Practice for Documentary Credits), but a number of UCP articles were perceived to be inappropriate for standby letters of credit. As a result, ICC adopted a set of rules specifically designed for standbys, the International Standby Practices (ISP98) (ICC Publication 590). These rules were originally developed under the auspices of the Institute of International Banking Law and Practice with the cooperation of the International Financial Services Association (IFSA).

b. Reasons for developing ISP98

Although standbys and commercial letters of credit have features in common, there are important differences which impelled the drafters to develop separate rules. As the Preface to ISP98 notes: “Standbys are issued to support payment, when due or after default, of obligations based on money loaned or advanced, or upon the occurrence or non–occurrence of another contingency.” As security instruments, they operate in much the -ame way as guarantees. Though standbys started as a US product, they have achieved remarkable worldwide success. In recent years, non-US bank standby transactions have largely exceeded those of US banks in the US. Overall, the value of standbys issued annually now dwarfs that of commercial letters of credit.

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c. Major elements of ISP98

The ISP98 rules are considered more detailed and legalistic than other ICC rules. A higher degree of precision was felt to be necessary because standbys involve a wider legal and commercial community than commercial letters of credit, and large-value standbys often involve extremely detailed and complex provisions. In any case, the ISP rules can be varied by the text of a standby, and if ISP98 conflicts with mandatory law, applicable law will control. ISP98 is divided into 10 rules, each of which has several sub-rules. An outline of some of the major provisions follows:

• Rule 1 General Provisions: (Scope, application, definitions and interpretations)
• Rule 2 Obligations: (Obligation of different branches, agencies, and other offices; conditions to issuance; nominations; etc.)
• Rule 3 Presentation: (What constitutes a presentation; when timely presentation is made; partial drawing and multiple presentations; extend or pay; etc.)
• Rule 4 Examination: (Examination for compliance; required signature on a document; identical wording; non-documentary terms and conditions; standard document types; etc.)
• Rule 5 Notice, Preclusion, and Disposition of Documents: (Timely notice of dishonour; notice of expiry; issuer request for applicant waiver with and without a request by the presenter; disposition of documents, etc.)
• Rule 6 Transfer, Assignment and Transfer by Operation of Law: (Transfer of drawing rights and conditions thereto; acknowledgement of assignment of proceeds and conditions thereto; rights and obligations of a successor in the event of a transfer by operation of law, etc.)
• Rule 7 Cancellation: (Consent of beneficiary required to cancel his rights; issuer’s discretion regarding a decision to cancel, etc.)
• Rule 8 Reimbursement Obligations: (Right to reimbursement; refund of reimbursement; bank-to-bank reimbursement, etc.)
• Rule 9 Timing: (Duration of standby; calculation of time; time and day of expiration, etc.)
• Rule 10 Syndication/Participation

From the perspective of standby beneficiaries, several UCP articles are inappropriate. By insisting on a credit subject to ISP instead of UCP, the beneficiary can avoid the need to exclude the inappropriate ICC rules, among which are:

• UCP 600 article 36: (When it is impossible to present documents prior to the expiry because the offices where presentation is to be made are closed due to an event of force majeure (civil strife, earthquake, war, “act of God”, etc.), the UCP requires the bank to dishonour documents presented after the expiry. Commercial credit as well as standby credit beneficiaries often modify article 36).
• UCP 600 article 32: (When the credit provides for installments and any installment is not drawn or shipped on schedule, the letter of credit terminates).
• UCP 600 sub-article 14 (c): (When the credit stipulates a transport document and the documents are presented later than 21 calendar days or another specified period after the shipment date, the bank must reject the documents, even though they were presented prior to the expiry date).

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d. Incorporating ISP98

As with other ICC contractual rules, ISP98 should be specifically incorporated into the text of the credit, in this case the standby, in order to have legal effect. The drafters suggest wording such as “This undertaking is issued subject to the International Standby Practices 1998” or “Subject to ISP98”.

11.6 Demand guarantee operation and procedure – direct vs. indirect

Three-party guarantees involve the applicant, the beneficiary and a guarantor (a bank or other trusted third party). Typically, the exporter-applicant will instruct its bank to issue the demand guarantee in favour of the importer-beneficiary. The bank will require the applicant to enter into a reimbursement contract, obliging the applicant to repay any sums paid out under the guarantee to the beneficiary. If the beneficiary believes the applicant has failed to fulfil the contract, the beneficiary will present a written demand for payment to the guarantor. The guarantor will pay regardless of any information it may receive concerning the underlying contract. The guarantor will then claim reimbursement from the applicant under the counter-indemnity.

This guarantee is similar to the direct guarantee except that a bank in the beneficiary’s country is added to the guarantee chain. Here, the applicant’s bank instructs a bank in the beneficiary’s country to issue the guarantee in favour of the beneficiary. The applicant’s bank must itself agree to reimburse the beneficiary’s bank via a “counter-guarantee”. In some countries, the local banking authorities may issue administrative rules that have the practical effect of requiring that demand guarantees be in the indirect form.

The indirect structure poses certain disadvantages for the applicant. First, since two banks are involved, the charges will be higher. Second, the guarantee issued by the bank in the beneficiary’s country may be subject to the mandatory law of the beneficiary’s country. The application of local law may preclude certain defences against fraudulent or abusive calls that might be available under the law of the applicant’s country.

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