Demand Guarantees

What are demand guarantees in commercial transactions?

A demand guarantee is a form of irrevocable security instrument, which is equivalent to an irrevocable letter of credit, in other words it is similar to a contract of indemnity.

Demand guarantees are used in a variety of domestic and international commercial contracts. Some examples of where demand guarantees are used include; building and construction, export trade, supply of material, agency, and redistribution of goods.

An example of how a demand guarantee operates, the construction industry may be considered. In commercial construction contracts a demand guarantee ensures against the risk of non-performance, delayed performance or defective performance of the building contractors obligations.

Another method of explaining a demand guarantee is by the use of the terms, unconditional performance bond or guarantee or demand bond.

A demand guarantee can either be a direct or indirect instrument.

A direct demand guarantee as example, is where a construction company agrees to build an office tower for a developer. The builder under the contract with the developer is required to provide a demand guarantee as security for their performance. This security will be a monetary amount, which the developer may call up if the builder fails to complete the property under the contract to a required standard or time frame, or other conditions under the contract between the parties which triggers the demand to be enforced.

How the demand guarantee operates under the contract between the builder and the developer is that the agreement between the parties may stipulate the builder is required to provide a 15% performance bond on the total value of the contract. This performance bond is arranged by the builder with their bank, as example ABC Bank. The builders bank then issues the written demand guarantee to the developer. When the builder defaults under the contract, the developer presents the demand guarantee with notice of the default by the builder to the issuing bank, which is ABC Bank, and the bank is then required to pay out the amount under indemnity on the guarantee. The bank will then seek reimbursement of the amount paid out to the developer under the demand guarantee from the builder.

Generally, in most circumstances the bank that provides the demand guarantee on behalf of the applicant party, such as the builder, the bank will secure the demand guarantee by way of taking a security over assets or cash sums that are under the control of the builder to the amount of the guarantee to be covered.

An indirect demand guarantee involves another step. Using the example above, the builder under the contract with the developer procures a demand guarantee with ABC Bank, who then counter guarantees the payable demand with XYZ Bank. XYZ Bank then issues a demand guarantee in written format to the developer. When the builder defaults under the contract, the developer makes a demand on XYZ Bank to payout the indemnity under the demand guarantee. XYZ Bank then seeks reimbursement from ABC Bank, who then enforces the debt amount against the builder.

When the developer claims on the demand guarantee, whether the situation is direct or indirect, the developer only needs to provide the issuing bank notice of the demand and that the builder has defaulted under the contract. The bank is then required to comply with the demand guarantee by issuing the indemnity amount payable. There is no requirements for debt collection or court litigation to secure the amount payable under the demand guarantee, as the issuing bank is required to payout.

Demand guarantees may only be set aside, or stopped from being paid out, if there is fraud on the part of the beneficiary, who is the party that was requiring the demand to be paid out in their favour, and that the bank was aware of the fraud. This is a complex area of law that requires careful assessment before allegations are raised against parties.

Another alternative where a demand guarantee may be set aside, or stopped from being paid out, is where unconscionable conduct occurs by the beneficiary, who is receiving the benefit of the demand, or that of the issuing bank. Again here, the law is complex and requires careful assessment.

Demand guarantees are a necessary part of business between contracting parties, and there are rules for demand guarantees that parties may incorporate into their contracts. One of these rules is the International Chamber of Commerce Uniform Rules for Demand Guarantees, which came into effect 1 Jul 2010 and is commonly referred to as URDG 758. This rule will achieve a fair procedure between contracting parties for handling demands under demand guarantees, and reduce the scope of fraudulent conduct in the enforcement of the guarantees by the beneficiaries, who are the party that may call up the guarantee if there is a default by the applicant, which is the other contracting party.

Demand guarantees carry significant risks for the applicant, who is required to procure the guarantee from their appointed bank for the benefit of the beneficiary. So if a contract has a demand guarantee clause, take a proactive step, call me, and get that legal advice to protect your legal rights and interests.

The comments in the aforementioned do not constitute legal advice and are general in nature, and if legal advice is required please contact: John Melis at Legal AU Pty Ltd (03) 9999 7799

Legal AU Pty Ltd Lawyers are “Liability limited by a Scheme approved under Professional Standards Legislation.”