A demand guarantee, also called an independent letter of guarantee, is a commercial undertaking with the feature of
independence to the underlying contract. It has gained acceptance and is widely used as a preferred financial tool in
commercial activities in China, both domestically and internationally. However, the independence of the demand guarantee is a doubleedged sword. Lacking regard for the underlying contract makes the demand guarantee more vulnerable to fraudulence.
On December 1 2016, the first law specifically addressing the demand guarantee in China came in to force, Provisions of the Supreme People’s Court on Certain Issues Concerning Trial of Cases Involving Independent Letter of Guarantee Disputes (“ the Provisions”). This article will focus on the specific features of demand guarantee in China regarding its definition, vulnerability to fraudulence and the good faith of bank.
Definition of demand guarantee
The definition of a demand guarantee is provided in Article 1 of the Provisions that any letter of guarantee issued by the banks or any nonbank financial institution in China undertaking the demand payment, whether it contains foreign elements or not, shall be defined as a demand guarantee. Article 3 of the Provisions further provides features characterising the demand guarantee.
Accordingly, a demand guarantee in China shall contain all of the
following four features:
1) Payment on demand;
2) Documents required for payment;
3) Maximum amount of payment;
4) Issued by banks or non-bank financial institutions.
The expiry date or event, subject to the agreement between the beneficiary and the guarantor, is not a legal element of the demand guarantee under Chinese law. URDG or any other model rules of demand guarantee is also not a necessary element to define a demand guarantee in China, but may be deemed as the governing law if specified in the demand guarantee by the Chinese courts. To increase certainty of judicial practice, it is highly recommended to specify the governing model rules in the demand guarantee.
A demand guarantee under Chinese law is independent to the underlying contracts and not conditional on actual default by the principal in the underlying transaction. As provided in Article 3 of the Provisions, the Chinese courts shall not uphold the claims that the provisions of Guarantee Law regarding the general guarantee or joint guarantee that shall apply to the independent letters of guarantee. On no occasion should the underlying contract be examined when the beneficiary calls for payment under a demand guarantee. The guarantor’s liability for payment shall be triggered when the documents specified in the letter of guarantee are presented and be deemed on their face as compliant. The beneficiary is entitled to payment upon presentation of a complying demand without the need for the guarantor to seek the applicant’s approval.
Guarantee fraud is an exception from the requirement to make payment. In the case of a fraudulent guarantee, the Chinese court can issue an injunction order or judgment to stop payment under the demand guarantee.
According to Article 12 of the Provisions, there are five circumstances where the court shall determine that the guarantee
fraud has transpired:
(1) Where the beneficiary maliciously colludes with the applicant for the letter of guarantee or others to fabricate the underlying transactions;
(2) Where a document presented by the beneficiary from a third party is forged or its contents are false;
(3) Where the obligor of the underlying transaction has been determined to undertake no responsibility for payment or
compensation by judicial judgment or arbitration award;
(4) Where the beneficiary confirms that debts of the underlying transaction have been fulfilled or the events under which the payments become due provided by the independent letters of guarantee do not occur; or
(5) Where the beneficiary abuses its right to demand payment while clearly knowing the lack of standing to demand payment.
Article 20 further specifies that the court’s determination on the guarantee fraud shall be beyond a reasonable doubt.
Reasonable Doubt is the standard of proof applied in Chinese criminal law cases. It is the highest standard of proof in law which means that no other logical explanation can be derived from the facts except that the defendant committed the crime/fraud thereby overcoming the presumption that he is innocent until proven guilty.
In China’s civil litigation normally the standard of proof is proof by a preponderance of evidence. It requires establishing a high probability that the facts sought to be proved are true. It is a lower burden of proof in comparison to Reasonable Doubt.
Under PRC law, fraud refers to the act of one party inducing the other party to make a manifestation of wrong intention by deliberately informing the other party of false information or deliberately concealing facts.
The circumstances where the guarantee by the beneficiary may be deemed as fraudulent beyond a reasonable doubt is set forth in Sections (1) to (4) of Article 12. It is noted in Sections (3) and (4) of Article 12 that the plaintiff would have to prove that he had held no responsible for payment or compensation in the underlying contract by a court judgment, arbitration award or by the beneficiary’s confirmation. Otherwise, the fraud accusation to the performance of the underlying contract may be regarded as a contractual dispute over debts or obligations, rather than fraud.
Section (5) of Article 12 is a miscellaneous clause to offer a broader application of fraud in circumstances other than Sections (1) to (4) by referring to it as a manifest abuse of its right to demand payment by the beneficiary. It must be read together with Article 20 the principle of Reasonable Doubt, which stresses the value of the prudent intervention to the independence of demand guarantee by the PRC courts. In this circumstance where fraud has been proven beyond a reasonable doubt, (i) the calling of the guarantee by the beneficiary should be proved to have a complete lack of justifiable basis, and (ii) the beneficiary should be proved to have clearly known that he lacks standing to demand payment.
Based on the above, as long as there is a dispute over the underlying contract, the beneficiary’s calling of the guarantee cannot be deemed as fraudulent or abuse of standing unless there is evidence beyond the reasonable doubt to prove the circumstance in Section (5) of Article 12. Notwithstanding, since the Provisions do not provide how to determine “clearly knowledge”, it may not be limited to only effective judgment, arbitration award or the beneficiary’s confirmation (where it can be derived that the beneficiary knows or should know his lack of right to demand payment), and could extend to other circumstances beyond a reasonable doubt.
The bank’s payment in good faith
The guarantor’s payment in good faith is the circumstance that falls outside of the fraud exception. According to Article 14 of the Provisions, where the guarantor has made payments in good faith under the demand guarantee, the court shall not suspend nor terminate the payment issued to secure such guarantor’s right to recourse under the demand guarantee. There is no express definition of “good faith” given in the Provisions. In essence, the concept of good faith is regarded by the Supreme Court as a matter falling under the judge’s discretionary power.
In the practice of Chinese civil law, “good faith” generally refers to a “lack of awareness”, namely a circumstance where the tortfeasor performs a legal act without any awareness of any fact that materially affects the effectiveness of his legal act. It is a common view in in the letter of credit law practice that the standard of not-good-faith is that a third party participating in the letter of credit transaction has not known or should not know the beneficiary’s act of claim is fraudulent, which could be taken as reference here. The law for demand guarantee in China looks to apply a higher standard of proof to the bank’s notgood- faith, as good faith under Article 14 must be read together with Article 20, the principle of Reasonable Doubt under the Provisions, that the court shall be convinced by the evidence that there is no other logical explanation which can be derived from the facts except that the guarantor has known or should have known the beneficiary’s demand was fraudulent.