Article

Factual Summary: Buyer contracted with Seller to build a software system that would support Buyer's Third Generation 3G mobile telephone network for a total price of £13,485,610. Before any work began on the project, Buyer was to make an advance payment of £1,059,305 to Seller and thereafter to make five additional lump sum payments upon completion of given "milestones" by given socalled Milestone Dates. The final milestone was the completed system.

The agreement required Seller to obtain an "advance payment bond" in a form annexed to the agreement from Issuer for £1,059,305 benefiting Buyer.

Buyer made the advance payment to Seller and Seller obtained the required bond in favor of Buyer.

The agreement permitted Buyer/Beneficiary to draw on the bond on termination of the agreement. It specified that Beneficiary could terminate the agreement if Seller/Applicant was in persistent breach or material breach of the agreement. The agreement specified the damages that Beneficiary could recover if it terminated the agreement, but had no express provision for repayment of the advance payment.

Buyer/Beneficiary was required under both the draft bond annexed to its agreement with Seller and the bond issued by Issuer to present the following documents to draw on the performance bond:

A. Buyer's certificate stating (I) that the Supplier is in breach of its obligations under the Agreement (II) the respect(s) in which the Supplier is in breach, and (III) the amount claimed represents the extent of the Supplier's liability to repay the said Advance Payment.

B. A copy of the Buyer's written notice to Supplier of its intention to draw down the present Performance Bond, such notice to be dated at least 5 days prior to the attempted draw down for a sum up to the amount defined above.

For reasons that were disputed between Seller/ Applicant and Buyer/Beneficiary, Seller/Applicant failed to meet the first four Milestone Dates specified in the agreement. There was no written record of any modification of the Milestone Dates, and the agreement specified that changes to the dates required an instrument in writing.

Without prior warning, Buyer/Beneficiary sent two notices to Seller/Applicant of Buyer/Beneficiary's intention to draw on the full amount of the bond. The first notice stated that Buyer/Beneficiary was terminating the agreement. The second notice stated that Buyer/Beneficiary would draw down the total amount stated in the performance bond.

Prior to any actual drawing, Seller/Applicant applied for an interim injunction to prevent Buyer/ Beneficiary from drawing on the performance bond pending a full trial on the action to restrain Buyer's breach of contract. Upon ex parte application, without notice to Buyer/Beneficiary, a temporary restraint on drawing was imposed which was replaced by the Buyer/Beneficiary's agreement not to call the bond until the hearing on an interim injunction. At the conclusion of the hearing, the court was not prepared to issue its decision. Since the bond was about to expire, the Seller/Applicant agreed that the sum bonded would be paid into the court to be disbursed in accordance with its decision. Following a full hearing at which the Buyer/Beneficiary was represented, the court dismissed the application.

Legal Analysis:

1. ISP98 Rule 1: The court stated:

Although this case is concerned with a contract describing itself as a performance bond, the principles governing the court's supervisory jurisdiction in relation to a beneficiary's threatened call are not limited to bonds. This bond is subject to ISP98 which governs International Standby Practices which are stated in Rule 1 to include documentary standby letters of credit. Such documents include performance, financial and direct pay standby letters of credit and any similar undertaking which is independent, irrevocable and documentary in nature. Thus many other performance, bank and retention bonds and guarantees are subject to the same considerations.

2. Independent Undertakings; Standby LCs; Bank Guarantees: In describing the types of undertakings (standbys, performance, bank, and retention bonds and guarantees) to which ISP98 applies, the court stated:

All these cases are concerned with situations where an issuer, whether bank, financial institution or other independent party, agrees irrevocably to make a payment to a beneficiary against the presentation of documents without any consideration of the underlying transaction or the validity of the grounds for, or the merits of, that payment to the beneficiary. The issuer has a sole overriding obligation before making payment which is to ensure that the documents that are presented conform strictly and in all respects with the requirements for presented documents that govern the documentary credit in question. These credits are used to finance, secure or assist an underlying commercial transaction whether of sale, services or the provision of work and materials and to give comfort to one party to that transaction that the other party will honour or discharge a payment obligation to which that underlying transaction subjects it to.

3. Injunction; Independence; Standbys; Injunction, English Law; Fraud: The court stated that:

This faith in and reliance upon the integrity of standby payments is vital for international and, indeed much national, commercial activity. It is for this reason that English courts have developed a clear non interventionist approach when an issuer making payment to a beneficiary is asked to desist by a third party, usually the other party to the underlying transaction who will also be the customer of the issuer and who will have to reimburse the issuer when the issuer claims reimbursement for its payment under the documentary demand. Only if the issuer is about to make payment to the beneficiary in circumstances where fraud, dishonesty or bad faith in relation to the demand is shown to exist or where the original issue of the documentary credit was procured by fraud or, possibly, where the underlying transaction was itself procured by fraud will a court intervene to restrain payment by the issuer to a beneficiary.

4. ISP98 Rule 1.05; Fraud; Injunction: In describing the non-interventionist approach of English courts with respect to requests to interrupt payment, the court indicated that "[t]his approach conforms to the principles governing documents to which ISP98 applies since Rule 1.05 provides that it is only defences raised by an issuer to a payment demand that are based on fraud, abuse or similar matters that are to be left to the applicable law."

5. Injunction; Fraud: Although recognizing that:

[T]he third party potentially interested in the payment, who is both a party to the underlying transaction and who procured the credit and stands to loose out if the standby credit is called upon and paid out by the issuer, will always have a vital concern if the issuer is about to make a payment in circumstances where the beneficiary has no ground to make a documentary demand or is doing so in contravention of its agreement with the third party contained in the underlying transaction, ...

the court stated that "the English courts are reluctant to intervene on its behalf, albeit that the good standing of the issuer will not usually be affected since any intervention would stop a demand before it is made."

6. Injunction; Fraud; Good Faith; Bad Faith: The court stated that "[a] lack of good faith has for a long time provided a basis to restrain a beneficiary from calling a bond or guarantee." In explaining this exception, the court gave an example of a situation where a beneficiary had imposed a lien without any justification for the purpose of drawing on the guarantee. Describing the approach of the Singapore courts, the court stated:

In an appropriate case, the Singapore courts will restrain a call by a beneficiary where it appears that the call is being made without good faith. The courts will, however, only intervene where the beneficiary has acted so unfairly or with conduct that is so reprehensible or lacking in good faith that a Court of conscience would either restrain or refuse to assist the party in question.

In one of the cases, the call had been made "merely as a bargaining chip to compel the third party subcontractor to agree terms favourable to the main contractor on which the subcontractor would return to site to undertake further work." The court, however, cautioned that "the bad faith needed to found a restraining application must be both significant and clearly established."

7. Fraud; Injunction; English Law; Balance of Convenience: The court summarized the principles of English law on enjoining independent undertakings as follows:

1. A third party seeking to restrain a beneficiary from calling a bond must initially show that such an application is supporting an underlying entitlement or claim based on a breach by the beneficiary of the underlying contract or on some other cause of action or basis for injunctive relief such as fraud, restitution or a breach of faith.

2. When a third party seeks to restrain a beneficiary from calling a bond, or from receiving the product of a call, the court's starting point is that a call will ordinarily only be restrained where there has been fraud in setting up or calling the bond or where there is a lack [or] a breach of faith by the beneficiary in threatening a call.

3. The basis for a contention of a breach of faith must be established by clear evidence even for the purposes of interim relief. A breach of faith can arise in such situations as: a failure by the beneficiary to provide an essential element of the underlying contract on which the bond depends; a misuse by the beneficiary of the guarantee by failing to act in accordance with the purpose for which it was given; a total failure of consideration in the underlying contract; a threatened call by the beneficiary for an unconscionable ulterior motive; or a lack of an honest or bona fide belief by the beneficiary that the circumstances, such as poor performance, against which a performance bond has been provided, actually exist.

4. In addition, where it appears that the call would be a nullity, a court will intervene to restrain that invalid call. Examples are where a condition precedent to a call has not yet been fulfilled; where the bond is a "see to it" bond necessitating prior proof of loss by the beneficiary or poor performance by the third party which has not yet been established; or where the demand or the supporting documents show that the demand does not conform to the requirements imposed by the bond for a valid demand.

5. Otherwise, a threatened call will not be restrained. In particular an allegedly incorrect calling of a performance bond will not be restrained merely because the factual basis of the call arising out of the underlying contract is disputed. Thus disputes as to whether a breach of contract, determination of a contract for cause, a repudiation of contract or the incurring of loss have occurred, where these are events covered by the performance guarantee, will not be allowed to found an application to restrain a call unless these disputes reveal a breach of faith by the beneficiary. Any consequent payment under the bond to the beneficiary which over-compensates the beneficiary may be recouped in the "accounting" exercise that the third party may claim in subsequent litigation against the beneficiary under the underlying contract.

6. If interim relief is being sought, a court will not intervene unless a third party has a real prospect of succeeding in both the entitlement to restrain the call and in its underlying claim which ought to be tried out before a call is made. This conforms to the overriding objective of proportionality required by the CPR.

7. Where these principles point to the grant of interim injunctive relief, it will also be necessary to consider and apply the balance of convenience.

8. Fraud; Injunction: The principal argued that the statement required by the Bond related to liability to repay the advanced payment, whereas there was no obligation in the underlying contract to repay the advanced payment so that the beneficiary could not lawfully provide the required certificate. After considering the provisions of the underlying contract in considerable detail and taking into account the "obvious commercial purpose of the Bond," the court concluded that the bond was to assure repayment of any portion of the advance payment that was unearned in the event of default. The court also ruled that the principal had no realistic prospect of proving its claim.

9. "See To It" Guarantee; Suretyship; Accessory Guarantee: The court distinguished the analysis that would apply to an independent guarantee from that applicable to a so-called "See to it" guarantee. Drawing on a line of Australian cases, the court described "See to it" guarantees as

where bonds and guarantees provided by contractors in support of retention or advance payments have been construed with the aim of distinguishing those that are performance guarantees from those which are dependent on, or have as a precondition, the need by the caller to establish loss or an entitlement under the underlying contract to recovery or damages.

Under these dependent guarantees, the beneficiary must prove the loss before it is able to make a claim. Contrasting the See to it Bond with an independent undertaking, the court said that in the latter,

is one which must be honoured in accordance with its terms following a demand which is, on its face, regular and in conformity with the terms of the instrument. In such circumstances, unlike the [See to it] type of obligation, the bank or other guarantor, is not concerned with relations between the supplier and the beneficiary or customer ... nor with the question whether the supplier has performed his contractual obligations or not nor with the question of whether the supplier is in default or not. The bank must pay according to its guarantee, on demand, without proof of conditions.

10. ISP98; Independent Undertaking: In deciding whether or not the bond was independent, the court said that "[p]articular regard must be had to the fact that the Bond was issued subject to ISP98. This document seeks to codify International Standby Practices and is applicable to standby instruments such as this Bond." In this process, the court quoted from Rules 1.06 (Nature of Standbys) and 1.08 (Limits to Responsibilities)

11. ISP98; Independent Undertaking; Independence; Independent Guarantee; Dependent Undertaking: As to whether or not the bond in the case at bar was an independent undertaking or not, the court stated that the provisions that it cited from the ISP "suggest that the Bond is a demand or performance instrument." The court stated that this conclusion was "reinforced" by additional factors:

The language of the Bond suggests that it is a demand bond. Thus, it states that claims should be made upon presentation of the defined buyer's certificate and a buyer's written notice to the supplier of its intention to draw down the bond without any additional qualification that the supplier should be, or be shown to be, in default or has been held liable to pay loss or damages.

The four criteria of a demand bond identified by Paget ... are all present in this case. Thus, the Bond: (i) relates to an underlying transaction between parties in different jurisdictions viz a buyer incorporated in England but whose shareholders are based in Hong Kong, Japan and the Netherlands and a seller incorporated in Israel; (ii) was issued by a bank; (iii) contained an undertaking which was the equivalent of an undertaking to pay, on demand,; (iv) contained no clauses excluding or limiting the defences available to the guarantor bank. This is in contradistinction to the guarantee in the Gold Coast case which, although ultimately held to be an on demand guarantee, stated that "any variation, amendment to or waiver given in respect of the [underlying agreements] will not limit, reduce or exonerate [the bank's] liability under this Guarantee ...."

The sum guaranteed is made payable against documents and not against facts. The obligation being guaranteed, being the carrying out of material obligations under the Agreement, was set out to identify the happening on which it was intended that the demand could be made.

12. See To It Guarantee; Dependent Guarantee; Independent Guarantee: The principal argued that under the terms of the agreement that gave rise to the bond, there could be no lawful termination and, therefore, no lawful drawing unless there was proof of a termination, a judgment or arbitral award. The court stated that this "somewhat tortuous reasoning is unsustainable" since it "flies in the face of the language and underlying commercial purpose of the Bond." The court concluded that the bond was a demand or performance bond that turns on presentation of required documents and not proof of underlying events.

13. Injunction; Independence: The principal argued that the alleged basis for the drawing was improper because the dates on which performance was due had been varied. The court noted that this contention was disputed by the beneficiary and that there were three witness statements on this point. After considering the evidence and the language of the agreement, the court stated that either party could be correct or partially correct. The court, however, took note of the requirement that any modification of the agreement was required to be by a signed writing and of the fact that there was no such signed writing. Since there was no modification of the agreement or that the beneficiary was responsible for all the delays and variations which had occurred, the court concluded that the beneficiary's notice of termination which was a predicate for the drawing under the bond "cannot be shown to be erroneous and, indeed, might well have been wholly justified."

14. Injunction; Independence: The principal argued that it had performed the underlying contract without any breach which would justify the termination and the drawing. Noting that the principal's arguments were based on disputed interpretations and facts and that there were arguments that could be made that it was in default under the agreement and that there had been no departure by the beneficiary from the procedural requirements of the agreement, the court concluded that a restraint of the drawing could not be sustained. As to whether a restraint on the drawing could be justified on the basis of a procedural lapse in the underlying agreement, the court stated that "these grounds of challenge are, on analysis, not open to [the principal] since they are neither allegations of want of good faith nor allegations of want of a jurisdictional basis to call the Bond."

15. Bad Faith; Good Faith; Independence; Injunction: The principal argued that the beneficiary "threatened to call the bond in bad faith." In part, it was claimed that the drawing was for "ulterior purposes, namely to draw attention away from the fact that it wanted a premature let out from the Agreement and to reduce the scope of the [system] to be supplied." The court dismissed these assertions as "mere speculation without any factual basis" and stated that "on the basis of the currently available evidence, a case of want of faith has no factual basis to support it and must be rejected."

Comments:

1. The court commented that an intervention by a court to enjoin a drawing by the beneficiary would not directly affect the credit standing of the issuer because it would stop a drawing before it was made. While this observation may be correct in a very limited sense, namely the relationship between the issuer and the beneficiary of that independent undertaking as to that undertaking, it is incorrect as to the effect of an injunction on the reputation of a country's bank instruments. If it became known that the independent undertakings of a particular country could be readily enjoined, they would cease to be creditworthy or cash collateral would be required. If the undertaking involved a beneficiary from another country, a confirmation or counter guarantee would be required. Ultimately, the principal/applicant would be even more exposed than before in such a situation because in the rare situation where an intervention is warranted, it would not have any effect.

2. The conclusion that the court reached is to be applauded. The reasoning it employed, however, is likely to cause many LC practitioners and lawyers some concern. If every application for an injunction required a hearing, witness statements, briefs, and a lengthy analytical opinion construing the detailed provisions of the underlying agreement, payments on independent undertakings would be subject to delay even if payment was ultimately made. Often it is delay that is the tactical goal of the principal/applicant. As a result, the credibility of the undertaking is diminished.

3. The focus of the question in the opinion of many should not be whether or not the allegations of the petitioner are correct, but whether there is a colorable basis for making the drawing. If the beneficiary has any legitimate basis for the drawing, it should not be restrained. As a result, in this case the question would be whether or not the principal was able to prove that there was no legitimate basis to the drawing. The existence of a dispute on the legitimacy of the drawing should be enough to justify the conclusion that restraint was not warranted. Such a determination can be made without immersing oneself in the details of the underlying agreement or its construction. Such an approach would leave open the possibility of restraint in those situations where there is no basis for the drawing or where there is a basis but one that is caused by the abusive acts of the beneficiary itself. Such a claim requires allegations and evidence that are dramatic and not detailed contractual construction and interpretation of matters that are disputed.

[JEB/bso]

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The views expressed in this Case Summary are those of the Institute of International Banking Law and Practice and not necessarily those of ICC or the other partners in DC-PRO.