Trade Finance: The New Rules for Guarantees

Guarantees are used in trade finance to secure payment in the event of default. The main parties are the applicant (usually exporter or seller), guarantor (bank) and beneficiary (buyer or importer). A typical example would be a performance guarantee to secure a contract wherein the exporter approaches its bank and furnishes the performance guarantee in favour of the importer with the right to call the guarantee any time before the expiry date upon which the guarantor is expected to pay on demand without demur.

The beneficiary is expected to invoke the guarantee only when there is breach on the part of the applicant (called ‘principal’ in URDG 458, the previous set of rules) who originates the guarantee in the first place. The guarantor is not expected to investigate the breach or ask for its proof. The attractiveness of a guarantee lies in the fact that they are independent undertakings unconcerned with the underlying relationship (sales contract or agreement) between the buyer and seller. While letters of credit (LCs), another popular trade finance product, are used as the primary means of settlement, guarantees are secondary recourse in default situations.

The International Chamber of Commerce (ICC) Paris has published a revised set of rules governing guarantees. These rules, called the Uniform Rules for Demand Guarantees 758 (URDG 758) and consisting of 35 articles, will come into force from 1 July 2010 and replace the existing URDG 458. These rules have been around for the past 18 years and found acceptance by international bodies like the World Bank and United Nations Commission on International Trade Law (UNICTRAL), as well as commercial banks globally.

Although it is labeled as a revision, the new dispensation will fundamentally alter the way guarantees are perceived, issued and invoked. A common theme running through the revision is the deliberate effort to bring URDG in line with the ICC rules on LCs called the Uniform Customs and Practice (UCP). From a practitioner’s point of view, this makes eminent sense as in most banks the desk handling LCs and guarantees are the same, so staff had to master two set of rules. Practitioners reading the revised URDG might well have wondered if these were the UCP rules written from a guarantee perspective.

This article looks at the key changes and innovations brought about by URDG 758. To aid clarity, there is an opening section on ‘Definitions’ (Article 2). In fact, the very definition of a guarantee has been concisely reworded to ‘any signed undertaking, providing for payment on presentation of a complying demand. Under 458 it was a longer definition, i.e. a written undertaking for the payment of money on presentation in conformity with the terms of the guarantee. Guarantees are used in default situations to assure the beneficiary that payment will be made by the guarantor without demur on demand.

The single most significant change in the revision is contained in Article 20, which restricts the time available for a guarantor to decide whether to pay or reject a presentation under a guarantee to ‘five business days following the day of presentation’. The earlier imprecise standard of ‘allowing a reasonable time’ has been deleted. This feature brings the treatment of presentations in line with LCs.

Which documents are required to support a complying demand when a guarantee is called? One, according to the URDG, a demand asking for payment and two, ‘a statement by the beneficiary indicating in what respect the applicant is in breach of its obligations.’ The two may now be combined in a single document and it can also be in electronic form. New features include how to advise and amend guarantees, again mirroring the relative LC articles, i.e. advising only ‘genuine guarantees’ or bear the consequences, and the need for all parties to a guarantee to consent to an amendment before it takes effect. Besides, an amendment cannot be partly accepted.

A guarantor is only liable for the amount stated in the guarantee and not for collateral damages, costs or compensation which might result due to non-performance. When does a guarantee come to an end? This is asking the obvious if the guarantee has an expiry date. But what if it does not – i.e. it is an open-ended guarantee? Although rare, the rules now consider this possibility and state that the ‘guarantee shall terminate after the lapse of three years from the date of issue’.

The handling of ‘extend or pay’ requests is now more explicit, removing uncertainty. Georges Affair, who chaired the revision process, has mentioned that such requests constitute 90% of cases in practice. Under URDG 458 when a request to extend a guarantee was received, the guarantor could suspend payment for a ‘reasonable time’. Now the guarantor ‘may suspend payment for a period not exceeding 30 calendar days.’

Another brilliant innovation incorporated as a response to market demand is the process to be followed when force majeure intervenes and a guarantee expires during this time. The earlier blanket disclaimer – which was patently unfair on the beneficiary as it was left with no remedy in such an eventuality – has been corrected by unequivocally stating that if the guarantee expire at a time when presentation or payment is prevented by force majeure the guarantee shall be extended for a period of 30 calendar days from the date of expiry.
Each article now has a heading unlike previously, when articles were grouped by section. This will hopefully make it easier to locate the article one is looking for in the life cycle of the guarantee without requiring the user to remember the article number.

What guides a banker to decide to pay or refuse a demand under a guarantee? First, they would be guided by the terms of the guarantee itself. Second, if the terms are silent, by URDG, which are incorporated by reference. If both these are lacking, then bankers and courts are in the new rules enjoined to be guided by ‘international standard demand guarantee practice’. These are not codified, but are mainly local practices and the body of conventions, ICC decisions and precedents which will be applied to settle a grey area by courts. For example: in certain jurisdictions, extension of expiry date, even if provided for in the guarantee, would not apply if the local law prohibits such extension without central bank approval. The concept of international standard demand guarantee practice has been borrowed from the well accepted ‘international standard banking practice’, which bankers use to resolve doubts while reviewing documents presented under LCs.

Two more concepts lifted from the rules on LCs are those relating to transferability and assignment. It seems that there is a fraudulent market for selling guarantees as a product having a value of its own. To circumvent this, there is a requirement for transfer of not just the rights, but obligations too. Regarding assignment, the beneficiary may assign any proceeds to which it may be entitled to a third party.

Recognising availability or otherwise of foreign exchange (FX) at the time of making payment under a guarantee, the URDG now allows discretion to the guarantor to make payment ‘in the currency of the place for payment’ (i.e. local currency of guarantor). This would help beneficiaries in those countries who may have issues with having hard currency to meet obligations.

Counter guarantees have been given an important place in the revision, with separate articles devoted to it in their own right rather than being appended with guarantees. A counter guarantee arises in a situation where the beneficiary desires a bank in its own country to issue the guarantee as it is not comfortable with the country risk of the applicant’s guarantor bank. For this, the applicant approaches its bank and requests it to be arranged. The guarantor (called ‘instructing party’ in URDG) requests a bank in the beneficiary’s country to issue the guarantee in favour of the beneficiary in consideration for which it agrees to issues a counter guarantee in favour of that bank. An important distinction is also made to the effect that, if a guarantee is subject to URDG, the counter guarantee is also subject to URDG but not the other way round.

For guidance and enable quick transition to the new rules, a set of model forms compatible with the new rules have been given as appendices in URDG 758. In conclusion, the revision is a fair attempt to balance the interests of the applicant and beneficiary in a guarantee besides aligning them with the LC rules.

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