Incoterms_® and Commercial Contracts

Summary

Many international transactions are supported by security instruments known as “guarantees”, “bonds” or “standby credits”. The purpose of these instruments is to guarantee performance by the counterparty by functioning somewhat like cash deposits, in that they are forfeited in the event of a breach.

Guarantees, bonds and standbys thus protect one party from a breach by providing a financial disincentive to the other party. These instruments also provide a form of quick compensation in the event that there is a default.

Security instruments are particularly useful in the international context because the alternative course of action — enforcing the contract in court — can be so expensive and time-consuming.

It is crucial to distinguish between the following two main kinds of instruments:

> “Demand” instruments unconditional guarantees that require payment upon the beneficiary’s mere demand; and

> Conditional or surety instruments require the beneficiary to establish that there has been a default, as by providing an engineer’s certificate or an arbitral award.

Demand instruments are very common but are nonetheless potentially dangerous because there is little to prevent a beneficiary from claiming the guarantee even when it is not entitled to do so (the problem of the “unfair call”).

14.1 Terminology: Guarantees/Bonds/Standbys

Although the word “guarantee” is used in this chapter as the preferred general term, there is no international standard term. National legal systems are not consistent in their treatment of the terms “guarantees”, “bonds”, “sureties”, “undertakings”, “indemnities”, etc. As a result, these terms are often used loosely be international traders, as if they were all synonyms (they are not).

These security mechanisms may be provided by banks, insurance companies, specialized surety companies or other financial services firms.

Since it is difficult to rely on terminology alone, it is important to distinguish between the two main types of guarantee or bond:

> Demand instruments

To receive payment under “demand” instruments, the beneficiary only has to demand payment (though in some cases the actual form of the written demand is specified). Such instruments provide the beneficiary with prompt access to funds regardless of any objection from its counterparty. The two most common forms of demand instrument are the demand guarantee (also referred to as a “bank guarantee”) and the standby letter of credit. The hallmark of these demand instruments is that it is easy for the beneficiary to access the guarantee funds, and that there is virtually no risk that the demand will be denied.
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> Surety or conditional instruments

To receive payment under “surety” or conditional instruments, the beneficiary must first prove that some condition or contingency has occurred which entitles the beneficiary to receive payment. This requirement protects the applicant from unfair or unsubstantiated claims by beneficiaries. These instruments are often referred to variously as contract bonds, performance bonds, suretyship bonds or guarantees, conditional guarantees, or accessory guarantees.

In this chapter, the terms “demand” and “surety” are used to describe these two distinct categories of guarantee or bond.

Note that we cannot tell from the simple terms “guarantee”, “bond” or “standby credit” whether we are dealing with a demand instrument or a surety instrument. For example, when business people use the term “performance bond” they are usually talking about conditional instruments, but in some cases they may be referring to a demand instrument. We must therefore examine the particular characteristics of a guarantee obligation in order to properly classify it as a demand or surety instrument.

“Standby credits” (also known as “standbys” or “SLCs”) are similar to guarantees and bonds. The use of standby credits arose during a period of time when American banks were prohibited from issuing bank guarantees (essentially, the American banks made use of the existing documentary credit structure to create a type of credit that would function like a bank guarantee). Standby credits, like guarantees and bonds, are primarily used to secure performance or payment. Standby credits must be carefully distinguished from the more traditional “letters of credit” or “documentary credits”, which are referred to as “commercial credits”. Commercial credits are used in the export trade as the primary means of payment, whereas standby credits, like guarantees/bonds, are a backup system which is only used in the event of a default or breach.

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 non- performance by the other party. In practice, this is most often the buyer or employer. In large con struction contracts, the beneficiary is often a government entity.

> 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.

14.2 Principal Uses of Guarantees/Bonds/Standby Credits

The earliest form of commercial guarantee was the cash deposit. If the party who gave the deposit 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:
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> Performance bond (or guarantee or SLC)

Performance bonds or guarantees provide protection against the risk that the exporter or contractor will fail to perform the contract. The guarantee amount is generally a stated percentage of the contract price, commonly up to 10%.

> Payment guarantee (or bond or SLC)

Payment guarantees secure the payment obligation 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.

> Bid bond (or guarantee or SLC)

Bid bonds 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 accompany their bid with a bid bond or 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 would be in the range of 2% to 5% of the contract value.

> Advance payment guarantee/Repayment guarantee (or bond or SLC)

An advance payment guarantee ensures the return of the beneficiary’s advance payments in case of non-performance by the applicant. For example, an importer who allows an exporter to draw a cash advance will require the exporter to issue a repayment guarantee in the event the exporter does not actually ship the contract goods on time.

> Retention guarantee (or bond or SLC)

Employers in large construction projects may negotiate to retain a certain percentage of the contract price as 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.

> Maintenance guarantee/Warranty guarantee (or bond or SLC)

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

14.3 Differences between Demand and Surety Instruments

As noted above, there is a fundamental legal and practical difference between 1) “demand” guarantees/ bonds, which represent something close to “instant cash” for the beneficiary; and 2) “surety” guarantees/bonds, which oblige the beneficiary to establish that the conditions triggering payment of the guarantee have occurred.

> Demand guarantees

Under a demand guarantee, the guarantor must pay on first demand by the beneficiary. Since there is no need for the beneficiary to prove that the applicant has actually defaulted on a contractual obligation, the beneficiary is assured ready access to the guarantee funds — wherein lies the great value of such guarantees for beneficiaries. 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 large risk for the applicant (party who applies to bank or surety company to provide the guarantee). The applicant takes the risk that the beneficiary will unjustifiably demand the guarantee funds — 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 hard to prove. As a practical matter, it is often impossible to prevent 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 minimum requirements. The cost of this insurance can be factored into the exporter’s price tender.

Another difficulty inherent in the demand guarantee relates to the expiry date of the instrument. Although all guarantees are subject to an expiry date, a beneficiary may force the applicant to grant an extension of the validity period with a so-called “extend or pay” demand. If the applicant does not agree to extend the expiry period, the beneficiary seizes the guarantee funds. 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 commercial contexts, the “extend or pay” practice is not uncommon and can result in repeated forced extensions of the guarantee period.

This is not necessarily an objectionable practice — a call for an extension may have a legitimate commercial purpose. Thus, such a call can serve as a second chance
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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. This means that the guarantor’s obligation 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, even the insolvency of the applicant will not free the guarantor from its obligation to pay under the guarantee. Most importantly, the guarantor’s 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, the guarantor will still have to pay against the beneficiary’s demand (assuming there is 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/Conditional guarantees

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 covers 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.

14.4 Direct vs Indirect Structures (Demand Guarantee)

> Direct (three-party) guarantee

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.
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> Indirect (four-party) guarantee

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.

14.5 Uniform Rules for Demand Guarantees and Bonds

> ICC Uniform Rules for Demand Guarantees (URDG 758)

ICC sought to standardize demand guarantee practice through the ICC Uniform Rules for Demand Guarantees (URDG 758), 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 attempted to respond to the problem of unfair calls by providing an alternative to demand guarantees. 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.

However, as it turned out the approach of the URCG ran counter to the market reality of the frequently superior bargaining power of beneficiaries, and therefore was not widely used. The demand guarantee continued to be widely used internationally. Employers/importers with strong bargaining positions often do not wish to accept the kind of conditional guarantee covered by the URCG’s provisions. Of course, the URCG may still be used when the exporter-applicant has been able to negotiate a conditional guarantee to be issued by a bank.

The URDG thus reflect the market reality that demand guarantees continue to be very widely used. 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 so specialized that most standby credits will be issued subject to International Standby Practices (ISP98) or, less commonly, to the UCP for documentary credits.

The URDG reaffirm the three basic principles of the demand guarantee:

1. Independence of the guarantee from the underlying transaction;
2. Documentary nature of the guarantee; and
3. Limitation of the guarantor’s duty to review the written demand to a mere examination of whether the demand conforms to the terms of the guarantee.

The URDG require a few 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 alter its “on demand” nature.
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The URDG are the global 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 subject to the URDG are issued in support of procurement and construction projects financed by the World Bank. The World Bank incorporates the ICC rules in its model unconditional guarantee forms.

The International Federation of Consulting Engineers (FIDIC) also supported the URDG by incorporating them in its model guarantee forms, which are very widely used in construction contracts.

In 1997, the Organization for the Harmonization in Africa of Business Law (OHADA) enacted a new Uniform Act on Security Interests whose chapter on guarantees mirrors the URDG. This Act is now in effect in 15 African states.

14.6 Uniform Rules for Conditional or Accessory Guarantees

> ICC rules for conditional guarantees

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

> ICC Uniform 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).

A potential disadvantage of conditional guarantees for the beneficiary is that it may take quite some time to obtain the court judgement or arbitral reward which will trigger the guarantor’s obligation. In the interest of assuring a quick remedy for the beneficiary, the ICC Uniform Rules for Contract Bonds allow 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. In comparison, insurance companies and specialized surety companies have more 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 absolute rules in this regard — 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 standby letters of credit, in particular when only one or the other of those instruments may be traditionally in use.

14.7 Uniform Rules for Standby Credits: International Standby Practices (ISP98)

> Background

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
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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).

> ISP98: specific rules for standby credits

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 same 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 dwarfs that of commercial letters of credit.

> Key provisions of ISP98

The ISP98 rules are considered more detailed and legally-complex 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 because large-value standbys often involve extremely detailed and complex provisions.

The ISP rules can be varied or overridden by the text of a standby. If ISP98 conflicts with mandatory law, applicable law will control.

ISP98 is divided into 10 rules, each of which has several sub-rules:

> 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

One of the reasons for the development of the ISP98 was that it was felt that a few of the rules in the UCP (the previous alternative to the ISP98) were inappropriate for standbys. 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:
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> 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 instalments and any instalment 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).

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”.

True/False

1. A key difference between a commercial credit and a standby credit is that a commercial credit is usually intended as the means of payment in a sale contract, while the standby credit is used to secure performance.
2. The ICC Uniform Rules for Contract Guarantees met with immediate, global acceptance and have been endorsed by the World Bank and other international organisations.
3. “Suretyship” guarantees are granted on a conditional basis, meaning that the beneficiary’s right to access the guarantee funds is conditional upon the beneficiary establishing that the applicant has defaulted (as by presenting an engineer’s certificate or arbitral award).
4. Demand guarantees and standby credits are governed by the same set of uniform rules, the URDG (Uniform Rules for Demand Guarantees).
5. One of the benefits of a demand guarantee is that the account party faces no risk that the beneficiary may exercise an “unfair call.”

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