Article

Factual Summary: Contractor entered into a contract with the Saudi Ministry to service its F-5 aircraft. Under the contract, Contractor was obliged to arrange for a performance bond described as "letter of guarantee for final deposit" to be issued by Local Bank in the sum of SAR21,075,000. The performance bond provided, in relevant part:

[Local Bank], ('the Guarantor') hereby irrevocably and unconditionally guarantees the payment to you of SAUDI RIYALS [21,075,000] (SAR --[21,075,000] only) [5]% of the value of the Contract ... covenant and agree as follows: The guarantor shall forthwith on demand made by you in writing and notwithstanding any objection by the Contractor pay you such amount aggregate the above mentioned amount of SAUDI RIYALS....

The covenants herein contained constitute unconditional and irrevocable direct primary obligations of the Guarantor. No alteration in the terms of the Contract and no modification or extension of the Contract ... shall in any way release the Guarantor from any liability hereunder ...

This guarantee is governed by and shall be construed in accordance with the laws and regulations of the Kingdom of Saudi Arabia.

To induce Local Bank to issue its performance bond, Contractor arranged for its Parent Company to issue a counter guarantee. Parent/Counter Guarantor issued a "Deed of Guarantee and Indemnity" unconditionally undertaking to pay to the Local Bank on its first written demand any and all amounts which Contractor failed to pay Local Bank. The counter guarantee provided, in relevant part:

1. The [Counter] Guarantor unconditionally and irrevocably guarantees to the [Local] Bank the payment of, and undertakes to pay to the [Local] Bank on its first written demand, any and all amounts which the [Contractor] fails for any reason whatsoever to pay to the [Local] Bank, whether related to principal, commission or other amounts, up to a maximum amount of 21,075,000 Saudi Riyals (SR 21,075,000) ...

8. The total amount due and payable to the [Local] Bank (including costs and expenses) shall be based on the [Local] Bank's records, which, in the absence of manifest error, shall be binding on the [Counter] Guarantor. A statement in writing signed by the [Local] Bank certifying the amount due at any time from the [Contractor] and/or the [Counter] Guarantor shall be conclusive evidence of the matters so certified. ...

11. This Deed of Guarantee & Indemnity shall be governed by and construed in accordance with the laws of England and the Guarantors submit to the non-exclusive jurisdiction of the English courts ....

Contractor also provided a "guarantee application and counter indemnity" to Local Bank, undertaking to indemnify it for all sums paid to Saudi Ministry.

Although Contractor had completed the service contract, the performance bond was extended from time to time and eventually the Saudi Ministry demanded payment. On receipt of the demand, Local Bank informed Counter Guarantor of the Saudi Ministry's demand and sought payment under the counter guarantee. Counsel for Counter Guarantor objected, claiming that any drawing was abusive since the underlying transaction had been performed. Local Bank honoured the performance bond and then formally claimed from Counter Guarantor under its counter guarantee and from Contractor under Contractor's counter indemnity.

When payment was not made, Local Bank sued Counter Guarantor and Contractor in England for wrongful dishonour of the counter guarantee and counter indemnity, and moved for summary judgment. The trial court granted summary judgment to Local Bank because its performance bond was an autonomous payment obligation which entitled a beneficiary to be paid regardless of a dispute about the underlying transaction except where the fraud exception applied. The trial court ruled that the Counter Guarantor had no realistic prospect of success with its defense because there was insufficient evidence of LC fraud. On appeal, affirmed.

Legal Analysis:

1. Fraud; Guarantee; Independent; Independent Undertaking; Title; Undertaking: The appellate court noted that the trial court "held that the obligations in the counter-indemnity constituted autonomous payment obligations which are treated similarly to letters of credit and other documentary credits." The appellate court then noted that:

It is now well-established that where a bank issues a confirmed letter of credit or performance bond, the bank must pay if a demand under it is made, irrespective of any dispute between the beneficiary and the bank's customer as to whether the demand is justified or not. To this principle there is an exception where there is clear fraud to the knowledge of the bank. ... ... For the fraud exception to apply, it must have this knowledge at the date it makes payment to the beneficiary ....

2. Independent Undertaking; Summary Judgment, Standard of: The appellate court described the standard of summary judgment in the case as:

... whether [Counter Guarantor] has shown that there is a real prospect that it will be able to prove the fraud exception at trial, that is show at trial that [Saudi Ministry] did not honestly believe that it had a right to make a demand under the performance bond and that [Local Bank] knew this. This is a high hurdle to meet at trial. As Ackner LJ observed in ... [United Trading Corporation SA v Allied Arab Bank Ltd, [1985] 2 Lloyd's Rep 554, 561 (C.A.)] ... "the evidence of fraud must be clear, both as to the fact of fraud and as to the bank's knowledge".

The court also stated that the standard of proof "(in relation to fraud) was whether it was seriously arguable that on the material available the only realistic inference was that the beneficiary could not honestly have believed in the validity of its demand on the performance bond."

3. Fraud: In considering and rejecting Counter Guarantor's argument that it had a "real prospect of success" in showing that the fraud exception applied, the appellate court noted that

"completion of the contract does not mean that there could not have been contractual claims following completion, for example under warranties." The appellate court also noted that Counter Guarantor did not object to the extension of the performance bond. The court rejected the assertion that the assignment of the proceeds of the service contract may have given Local Bank "any relevant knowledge for the purpose of the fraud exception" as well as the suggestions that "[Local Bank] operates in an environment in which banks accede to demands made by the Saudi government" or that "[Saudi Ministry] has made similar claims before" could be proved or would show that Local Bank had knowledge of fraud.

The appellate court then, in noting that Saudi Ministry never offered an explanation for its demand, rejected the notion that "failure on the part of the beneficiary to produce an explanation for a demand amounted to proof or evidence of fraud. In my judgment, the failure to reply to telephone calls is not evidence of fraud." It then stated "[i]t was unfortunate that, when informed of [Saudi Ministry] 's demand, [Counter Guarantor] did not take the opportunity to put before the bank a complete dossier showing clearly that there was no basis on which [Saudi Ministry] could make any demand under the performance bond. As it is, payment under the performance bond has now been made. The authorities make it clear that it was not for [Local Bank] to investigate whether the demand was justified." Pill, J., noted in concurring that "[t]here are no admissions by the beneficiary, though admissions are not the only way in which fraud can be proved."

The appellate court concluded "[i]t would be pure speculation to hold that there was a real prospect of success on the ground that there might turn out on disclosure to be" clear evidence of fraud. The appellate court decided that Counter Guarantor had not "discharged the burden on it of showing that it has a real prospect of proving by clear evidence the fraud exception at trial."

Comments by Professor James E. BYRNE:

While this judgment is correct in its several conclusions regarding claims of LC Fraud, the distinction between the proof of fraud with respect to the beneficiary of the local guarantee and the local guarantor would benefit from some emphasis. Even were the beneficiary of the local guarantee to have made a fraudulent drawing, the local guarantor would have had to have paid in bad faith to defeat its rights to claim on the counter guarantee running to it. In the case of a local guarantor subject to local jurisdiction, proof of bad faith would not constitute actual knowledge of the fraud. It would require that the local guarantor have sufficient proof of it to be able to defend that claim in a local court. Where the beneficiary of its guarantee is a government ministry, such proof is likely to be difficult to find.

Here, particularly, the law applicable to the local guarantee is critical. In this respect, the suggestion put to the ICC Banking Commission that the law of the counter guarantee should control the guarantee in the event that none is chosen is revealed as particularly absurd.

Therefore, it is troubling to note the suggestion of the court that the counter guarantor should have put before the local guarantor "a complete dossier showing clearly that there is no basis on which the [Saudi Ministry] could make any demand under the performance bond." A worse suggestion cannot be imagined. The lawyers for the applicant for the counter guarantee would, no doubt, be delighted to comply and to produce reams of documents. This suggestion brings to mind the activities of the applicants for the standbys backing the Lloyds standbys and guarantees who did precisely that. In that situation, however, the English courts which were on the receiving end were less than sympathetic to the claims of the counter guarantors regarding the allegations with which they were besieged, which included local investigations and claims of securities fraud on the part of the Lloyd's Syndicates.

Rather, what the court should have suggested is that the counter guarantor or its applicant should place these dossiers before a court in the country of the local guarantee. Short of proof that the local guarantor has itself participated in LC Fraud, nothing less would justify a complying refusal to honor the counter guarantee.

The court notes that there are no admissions of fraud by the beneficiary but suggests that there are other ways to prove LC Fraud. Short of a determination that is binding on the Guarantor in the country where the local guarantee is issued, it is hard to imagine what.

[LHD]

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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.