Article

Factual Summary:

Beneficiary, Applicant and Applicant’s Central America Co. Ltd (Constructor) signed a construction contract for a commercial/residential complex project in Costa Rica on 16th January 2010.

On 28th May 2010, Guarantor issued a performance guarantee in the amount of USD 2,008,000 in favor of Beneficiary covering the performance of the project valid until 12th October 2011 (later extended to 12th February 2012) against the counter guarantee issued by Counter Guarantor, who undertook to make payment within 20 days upon receipt of the claim made by Guarantor. Both of the counter guarantee and performance guarantee were subject to URDG458.

On 7th February 2012, the Constructor applied for arbitration from the Costa Rica Association of Architects and Engineers Dispute Resolution Center (COLEGIO FEDERAL DE INGENIEROSY DE ARQUITECTOS), requesting the cancellation of the contract and compensation of USD 1,213,487.30 from Beneficiary because Beneficiary had seriously defaulted by delaying payment and related interests for the completed construction work.

On 10th February 2012, Guarantor claimed for USD 2,008,000 from Counter Guarantor by SWIFT stating that they had received claim from Beneficiary, and requested Counter Guarantor to make payment before 16th February 2012.

On 12th February 2012, the Costa Rica Court of Administrative Litigation issued an interlocutory injunction suspending payment by Guarantor at the request of Applicant.

On 27th February 2012, the trial court ordered the suspension of payments under both the counter guarantee and performance guarantee at Applicant’s application due to guarantee fraud disputes.

On 6th March 2012, Costa Rica Court of Administrative Litigation issued judgment against the Constructor and lifted the interlocutory injunction.

On 16th March 2012, Guarantor informed Counter Guarantor that they decided to suspend payment under the guarantee until the disputes were solved and stated that they would act according to the decisions of the court in China, and requested Counter Guarantor to extend the validity date of the guarantee until the disputes were settled by court in China.

On 20th March 2012, Counter Guarantor extended the validity of the guarantee as requested and replied that they would undertake to make payment to Guarantor under the counter guarantee immediately, once it was ordered by the court in China.

On 21st March 2012, Guarantor paid Beneficiary under the guarantee.

On 9th July 2013, Costa Rica Association of Architects and Engineers Dispute Resolution Center delivered an arbitration award against Beneficiary and ordered Beneficiary to pay the progress payments for No. 1-18 of the project and interests USD 800,058.45 to the Constructor. The arbitration award ordered the termination of the contract due to Beneficiary’s serious defaults in the performance of the contract. However, the request of progress payment for No.19 of the project was not supported by the arbitration award since it did not pass the inspection by the developer because of quality problems.

Applicant sued Beneficiary in the trial court, arguing that Beneficiary defaulted under the underlying contract and that the payment obligations under the underlying contract were pending during the process of arbitration, while Beneficiary still made a claim on the guarantee from Guarantor after the Costa Rican court had issued an injunction. Therefore, Applicant argued that Beneficiary violated the principle of good faith and committed fraud by abusive use of the independence principle of guarantee.

Applicant requested the trial court to decide that: 1. Beneficiary’s act constitutes guarantee fraud; 2. The civil action of Beneficiary’s claim under the guarantee is invalid; 3. Counter Guarantor is not allowed to pay Guarantor under the counter guarantee; 4. Guarantor is not allowed to pay Beneficiary under its guarantee.

On 9th April 2014, the trial court decided ([2012]He No. 4 Civil Court Trial No.00005) that Beneficiary’s act of claiming under the performance guarantee constituted fraud, and Counter Guarantor was ordered to stop payment of USD 2,008,000 to Guarantor under the counter guarantee.

Upon appeal, appellate court upheld trial court’s decisions on 19th March 2015 ([2014] Wan No. 2 Civil Court Final No. 00389).

On 21st May 2015, the Supreme Court of the Republic of Costa Rica dismissed Beneficiary’s appeal that the arbitration award was invalid.

Beneficiary applied for retrial from the Supreme People’s Court of the P.R. China.

On December 14th 2017, the Supreme People’s Court affirmed Beneficiary’s retrial petition and overturned the decisions of trial court and appellate court.

Legal Analysis:

  1. Legal Analysis:

Jurisdiction

Beneficiary and Guarantor argued that Applicant was not entitled to bring lawsuits in China. Guarantor claimed that courts in China have no jurisdiction over the case because the legal relationship of the demand guarantee only exists between Beneficiary and Guarantor, which are both located outside of the territory of China, and the Chinese court decisions to suspend payment under the guarantee have obviously exceeded their power, especially since a court in Costa Rica had already issued enforceable decisions.

However, the courts in China dismissed such arguments. The Supreme People’s Court offered the following analysis：

“The habitual residences of Beneficiary and Guarantor are outside of the territory of P.R. China and the case is of the nature of foreign business disputes. According to article 8 of The Law of the Application of Law for Foreign-related Civil Relations of the People’s Republic of China, Lex fori shall apply to the determination on the nature of foreign-related civil relations.”

The court noticed that Applicant is the parent company of its Central America Company, and Guarantor issued its performance guarantee in favor of Beneficiary against the counter guarantee issued by Counter Guarantor at its instruction.

The Supreme People’s Court also examined the context of guarantee in determination of the nature of the guarantee: “According to the context of the guarantees [Emphasis added]，the payment obligations of Guarantor and Counter Guarantor are both independent from the underlying transaction relationship and guarantee application legal relationship. Therefore, the guarantee may be ascertained as independent demand guarantee, and the counter guarantee may be determined as independent demand counter guarantee”.

Since the counter guarantee in which Applicant applied to the trial court for suspension of payment due to guarantee fraud was issued by Counter Guarantor, the Supreme People’s Court stated that the place of Counter Guarantor should be considered as the place where the tort occured, and the trial court located at the place of tort shall have jurisdiction over the case.
2. Applicable laws/rules

Both the trial court and appellate court considered that the guarantees are subject to URDG and the autonomy of will shall be respected when the parties choose applicable laws or rules.

According to article 44 of The Law of the Application of Law for Foreign-related Civil Relations of the People’s Republic of China, the laws of the place of the tort shall apply in determining the liabilities for such tort, the determination of guarantee fraud, and the standards for suspension of payment shall apply to PRC laws.

As there is no stipulation on the determination of guarantee fraud in the URDG and PRC laws, the trial court and appellate court referred to the United Nations Convention on Independent Guarantees and Standby Letters of Credit (Convention).

The trial court applied the Convention and concluded that that “from the type and purpose of the guarantee, it may be determined that there is no basis of Beneficiary’s claim, and Guarantor may refuse to pay Beneficiary according to good faith principle and exercise their rights of fraud exception”. The appellate court pointed out that even if the trial court did not specify the exact articles of the Convention, the statement made by the trial court was Article 19 of the Convention.

The appellate court further analyzed:

“…Convention reflects the general rule of independent guarantee and standby operation in international trade practice which is widely recognized by the international community, therefore, even if China has not accessed into the Convention, the guidance of the rules in the Convention cannot be denied…”.

However, the Supreme People’s Court considered that since the guarantees are subject to URDG, such rules should be considered as constituting part of the guarantees in question. The Supreme People’s Court agreed with the trial court and appellate court that the laws at the place of the tort shall apply to liabilities for the tort, and the standard for determination of guarantee fraud not covered by URDG shall be governed by the PRC laws.

However, the Supreme People’s Court reversed the decisions by the trial court and appellate court that the Convention shall be applicable in determining guarantee fraud. The Supreme People’s Court explained:

“China has not acceded to the Convention, and the parties of this case did not agree to apply and incorporate Convention or the relative contents thereof as the international trading rules in the guarantees. According to the principle of autonomy, Convention is not applicable”.

3. Examination standards of underlying transaction

The trial court and appellate court observed that according to URDG, when examining the documents presented by the beneficiary with reasonable care, the guarantor only needs to ascertain whether or not they appear on their face to conform with the terms of the Guarantee and whether the documents conform on their face to be inconsistent with one another, without the need of examining the performance of underlying contract.

Both lower courts referred to the fraud exception rules in the Convention and concluded that courts should make the necessary examination of the underlying contract performance while hearing guarantee fraud disputes, especially when enforceable decisions for the underlying contract have already been made by a foreign court or arbitral tribunal. The facts determined by such foreign institutions could be regarded as the evidence in determining the performance of underlying contract.

The Supreme People’s Court disagreed\s based on the following analysis:

“As both parties insisted that the counterparty had defaulted in the performance of underlying contract and claimed their rights according to the underlying transaction, therefore, we have to determine whether there is factual basis for the Beneficiary to claim under the underlying contract with their prima facie evidence. When hearing the case of independent guarantee and the related counter guarantee, the People’s Court should adhere to the limited principle and necessity principle, and the scope of the examination should be restricted to the fact whether Beneficiary has clear knowledge that there is no default of the counterparty under the underlying contract or there exists no other facts leading the payment of the independent guarantee. Otherwise, the examination of the underlying contract will shake the “payable upon demand” mechanism value of the independent guarantee.” [Emphasis added]

4. Guarantee fraud

The trial court and appellate court noted that the Arbitration panel had determined in the arbitration award that Beneficiary had seriously defaulted in performance of the contract and should be liable for No.1-18 progress payments to Applicant. The courts stated that the purpose of the performance guarantee was to cover the performance of the construction contract by the Constructor, while Beneficiary was unable to provide evidence of serious defaults in performance of the contract by Contractor and already knew that Constructor had submitted arbitration application due to contract disputes.

Therefore, both courts decided that Beneficiary’s actions constituted guarantee fraud in making an abusive demand under the guarantee without any basis and violated the principle of good faith, hence the demand was invalid and Guarantor should stop payment to Beneficiary under the guarantee.

The Supreme People’s Court overturns the decisions of trial court and appellate court that Beneficiary constitutes guarantee fraud in their demand under the guarantee, and concludes:

“As the project inspection report constitutes the prima facie evidence of Applicant’s defaults in the underlying contract, and the evidence submitted by Applicant is insufficient to prove that such report is fake or forged, nor does the evidence suffices in proving that Beneficiary knew that there were no defaults by the Applicant under the underlying contract or any other issues leading to the payment under the independent guarantee. Based upon the Applicant’s breach of the underlying contract, Beneficiary’s act of demanding under the guarantee according to the contract does not constitute guarantee fraud.”

The Supreme People’s Court refers to Article 68 in its Opinions on Several Issues of the Implementation of ‘General Principles of the Civil Law of the People’s Republic of China’(Trial version), which stipulates that fraud mainly appears as fictitious facts and concealment of the truth.

The Supreme People’s Court noted that “the guarantee makes it clear that payment is to be made against the stipulated documents. When claiming that Beneficiary’s demand constitutes independent guarantee fraud, the applicant should provide evidence proving that Beneficiary has conducted one of the following actions when demanding under the independent guarantee: 1. the contents of the demand documents are false or the demand documents are forged; 2. there is no factual and reliable basis for the demand at all.” [Emphasis added]

Since the guarantee covered the quality of the construction and other defaults, the Supreme People’s Court considered that to satisfy the required proof justifying their execution of the guarantee stipulated by the guarantee, the Beneficiary only needed to provide the prima facie evidence proving the quality problems in the construction work. During the performance of the underlying contract, the project inspection report issued by the Beneficiary’s supervisor on 23rd January 2012 evidences quality problems in the construction work, constituting the required prima facie evidence of the quality problems.

5. Arbitration award

Beneficiary provided the project inspection report signed by the architect of AIA International Architects Firm stating that the Constructor’s construction work was poor. However, the arbitration award granted by the Costa Rica Association of Architects and Engineers Dispute Resolution Center provided by the Applicant did not determine that there were severe defaults in the constructor’s construction work. In case of conflicts between the project inspection report and arbitration award, the appellate court quoted Article 77 of Several Provisions of the Supreme People’s Court on Evidence in Civil Procedures and decided that there was legal and factual basis for the trial court to make judgment based upon the arbitration award.

Applicant argued that Beneficiary’s action constituted independent guarantee fraud according to Article 12 (3), (4) and (5) of the PRC Supreme People’s Court’s Provisions on Several Questions about Independent Guarantees Disputes Cases (“PRC Independent Guarantees Provisions”).2 However, as the case is retried according to judgment supervision processes, the Supreme People’s Court considered that based on Article 25 of the PRC Independent Guarantees Provisions,3 the articles cited by Applicant are not applicable and do not support Applicant’s argument.

The Supreme People’s Court further explains the issues related to the PRC Independent Guarantees Provisions as follows:

“Independent guarantee is dependent of the underlying transaction between the principle and beneficiary, and the independent guarantee issuing bank is only responsible for the examination of documents presented by the beneficiary and determines whether the documents comply with the terms and conditions of the guarantee, and decides whether to honor or not at their own discretion. The guarantor’s obligation of payment shall not be affected by the defense of underlying transactions between the principal and the beneficiary.” [Emphasis added]

The Supreme People’s Court analyzes that “When submitting prima facie evidence confirming the quality problems in the project, Beneficiary’s rights under the guarantee shall not be affected even if Beneficiary does not proceed with law suits or arbitration resolution procedures determining defaults by the counter party. Beneficiary’s rights under the guarantee shall not be affected as well even if there are ongoing law suits or arbitration procedures under the underlying contract, as long as there is no final decision that the obligor of the underlying transaction fails to make payment or be liable for compensation. Furthermore, even if the enforceable court decision or arbitration award determines that the Beneficiary constitutes breach of the underlying contract, the existence of the default facts does not necessarily constitute necessary condition of guarantee ‘fraud’.” [Emphasis added]

The Supreme People’s Court therefore concludes that “…the Guarantee covers the quality of the construction and other default actions, while the default by the Beneficiary in non-payment of the project has no logical cause and effect of the matter. Beneficiary does not necessarily constitute fraudulent claim under the independent guarantee for their defaults in performing the underlying contract. [Emphasis added] Article 12(3) of PRC Independent Guarantees Provisions restricts the conditions of determining independent guarantee fraud as “The debtor of the underlying transaction has no payment nor compensational obligations according to the court judgment or arbitral award”, therefore, unless otherwise agreed by the guarantee, the examination of the underlying contract should be limited within the performance issues covered by the guarantee, and it should be very cautious when incorporating the beneficiary’s defaults under their underlying contract into the examination scope of guarantee fraud.” [Emphasis added]

The Supreme People’s Court noted that the arbitration award only determined that Beneficiary defaulted and did not determine that Applicant’s obligations for payment or compensation were to be relieved because of Beneficiary’s defaults. The court therefore considers that “the contents of the arbitration award cannot be relied upon to determine that Beneficiary constitutes guarantee fraud according to Article 12(3) of PRC Independent Guarantees Provisions”.

The court also pointed out that the evidence submitted did prove that the Constructor had not performed all the obligations under the Construction Contract, and there was no evidence that Beneficiary had confirmed the full performance of the underlying transaction debts or non-occurrence of payment due issues. Furthermore, the court considers that the existing evidence could not prove that the Beneficiary abused their rights when they knew that they did not have the rights for demand as well.

The Supreme People’s Court further stated that “Despite of the fact that Beneficiary defaulted in underlying contract affirmed by arbitration award, however, Applicant’s payment or compensation obligations are not relieved as a result. Even if according to interpretation of PRC Independent Guarantees Provisions, the scenario in this case does not constitute guarantee fraud.”

Comments by Jun XU:

1. Independence principle

It is of crucial importance for the Supreme People’s Court to affirm the independence principle of both the independent counter guarantees and guarantees, and to set up very important guidance after the enactment of the PRC Independent Guarantees Provisions, especially in the circumstances when the Guarantor has made payment in good faith and claims from the Counter Guarantor afterwards but before the settlements of disputes under the underlying transaction.

Article 14 of PRC Independent Guarantees Provisions provides protection for the guarantor who issues a guarantee at the counter guarantor’s instruction, stating: “the People’s Court shall not order the suspension of payment when the issuer has made payment in good faith under the independent guarantee at the instruction of the instructed party.”

The trial court and appellate court considered that Guarantor violated the decision of the trial court in honoring the claim by Beneficiary after their receipt of the trial court’s order in suspending payment under the guarantee and in their promise to Counter Guarantor to suspend payment until the disputes were settled in Chinese courts. Such an act is obviously against the principle of good faith and should be liable for legal consequences.

Despite of the fact that the Supreme People’s Court does not quote Article 14 of PRC Independent Guarantees Provisions, the judge offered the following analysis:

“Due to the nature of independent guarantee, guarantor is directly liable for payment towards the Beneficiary in additional to the obligor. There is no accessary relationship in the rights of defense between the independent guarantee and main obligations. Even if the obligor exercises their rights of defense in certain dispute resolution procedures, the independent guarantor shall not necessarily be awarded the defense interests. Furthermore, even if Beneficiary has made fraudulent claims under the independent guarantee, it cannot be presumed that guarantor constitutes fraudulent demands under the independent counter guarantee. Only when the guarantor has clear knowledge that Beneficiary makes fraudulent claims and violates the principle of good faith, and then claims under the counter guarantee from the counter guarantor, the guarantor can be considered as making fraudulent demands under the counter guarantee.” [Emphasis added]

The Supreme People’s Court states that Applicant should provide evidence proving that the Guarantor honored the claim when they had clear knowledge about Beneficiary’s independent guarantee fraud, but still violated the principle of good faith and further claimed under the counter guarantee in the name of beneficiary, and Guarantor therefore constitutes fraudulent demand under counter guarantee. In absence of such evidence, the Supreme People’s Court rules that the Applicant’s petition for stop payment has no factual basis.

2. Underlying transaction

According to Article 14 of PRC Independent Guarantees Provisions, the petition for suspension of payment for the reason that the beneficiary defaults under the underlying transaction shall not be supported by the People’s Court.

It is surprising that the trial court and appellate would incorrectly refer to the Convention and as a result of which, adopted wider scope of examination standards regarding the underlying transaction.

However, we have also seen some local courts adopt the necessary and limited examination standards regarding the underlying transaction. For example, in the Powers Links International v. Far East Cable Co. Ltd. [2016] 4 (Su Civil Final No.932)(P.R.China ) case, the court determined that they may make a necessary limited examination regarding the content and performance of the underlying contract “related to the guarantee”. In Jiangsu Taihu Boiler Co., Ltd. vs Pt. Kraktau Engineering5 [2013](Su Commercial Foreign Final No.0006)(P.R.China), the court decided that “the court may conduct necessary and limited check of the contents of the underlying contract related to the guarantee and the performance thereof and that the sphere of the limited check should be restricted to whether the beneficiary makes an abusive claim despite it already knowing that there is no default or other due payments by the debtor in the underlying transaction.”

However, what is important is that the Supreme People’s Court clearly endorses the “limited principle and necessity principle” standards for the examination of the underlying transaction which shall be adhered in guarantee cases tried after the enactment of PRC Independent Guarantees Provisions.

3. Governing law and Jurisdiction

It is also very important for the Supreme People’s Court to correct the inappropriate reference by the trial court and appellate courts to the rules in the Convention when the parties did not agree to the incorporation of the Convention.

The rules regarding governing law and jurisdiction in URDG458 are less clear than those in URDG 758.

Article 27 of URDG458 stipulates : “Unless otherwise provided in the Guarantee or Counter-Guarantee, its governing law shall be that of the place of business of the Guarantor or Instructing Party (as the case may be) …”.

Article 28 of URDG458 stipulates : “Unless otherwise provided in the Guarantee or Counter-Guarantee, any dispute between the Guarantor and the Beneficiary relating to the Guarantee or between the Instructing Party and the Guarantor relating to the Counter-Guarantee shall be settled exclusively by the competent court of the country of the place of business of the Guarantor or Instructing Party (as the case may be) …”.

However, when determining jurisdiction, it is reasonable for the courts to refer to The Law of the Application of Law for Foreign-related Civil Relations of the People’s Republic of China rather than the above specified articles of URDG458. When determining the governing law, the Supreme People’s Court correctly interprets the application of URDG and overturns the decisions by the trial court and appellate court that the Convention may be referred to.

4. Additional documents

The Supreme People’s Court is correct in the interpretation of additional documents in the case.

URDG458 did not address the issue of additional documents, while article 19(d) of URDG758 stipulates that the additional documents will be disregarded.

The guarantees in the case were issued subject to URDG458. Article 9 of URDG 458 only generally stipulates “All documents specified [Emphasis added] and presented under a Guarantee, including the demand, shall be examined by the Guarantor …” However, it is international banking guarantee practice not to examine additional documents not called for by the guarantee and Article 9 of URDG458 also implies that only documents stipulated shall be examined by the Guarantor.

According to Article 7 of PRC Independent Guarantees Provisions, the People’s Court shall determine the compliance of documents on their face according to the documents examination standards stipulated in the independent guarantee; absent of such stipulation in the guarantee, the relative standards of documents examination set up by ICC may be referred to.

The Supreme People’s Court correctly reverses the decisions by the appellate court about the additional document project inspection report.

The Supreme People’s Court rejected the Applicant’s claim that the project inspection report was fake because the guarantee does not stipulate such document to be presented by Beneficiary to Guarantor or require the capacity of the issuer when claiming under the guarantee, and the Beneficiary’s rights under the guarantee are not affected whether the Beneficiary has presented such report or not.

The Supreme People’s Court further states that the appellate court confused the issuer of the project inspection report by recognizing that the project inspection report is in conflict with the facts determined in the arbitration award submitted by Applicant that the Applicant did not default on the construction work.

1
Jun Xu, Deputy General Manager, Bank of China, Jiangsu Branch, China; a Member of ICC Banking Commission’s Executive Committee, a Member of ICC DOCDEX, and a DCW Editorial Advisory Board Member

2
Article 12: Each of the following circumstances shall be considered as guarantee fraud:

3
Article 25 of the PRC Independent Guarantees Provisions: For cases not yet awarded final judgment after the effective date of these Provisions, these Provisions apply. For cases with final judgment and any party applies for retrial or the People’s Court re-trial according to judgment supervision processes, these Provisions shall not be applicable.

4
Abstracted in DCW July/August 2017 at 26; 2018 Annual Review of International Banking Law & Practice at 592.

5
Abstracted in 2015 Annual Review of International Banking Law & Practice at 423.

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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 the ICC or Coastline Solutions.