Refund Guarantees

Author:
Mark Davis

Edition:
1st Edition, 2015

Chapter
2
Definitions and characteristics
Introduction
2.1
There are essential differences under English law between different types of guarantee instruments. There are two different types of
guarantee contracts, which are relevant in the context of refund guarantees, both of which come within the general heading of ‘contracts of
suretyship’. The first is a contract of guarantee; the second is a contract of indemnity. The nature of the instrument in question is a matter of
construction of the instrument as a whole,1 and the description of an instrument as a ‘guarantee’ is never of itself determinative.2

2.2
As Sir William Blackburne noted in Vossloh AG v Alpha Trains (UK) Ltd,3 contracts of suretyship are an area of law ‘bedevilled by
imprecise terminology’ and ‘it is important not to confuse the label given by the parties to the surety’s obligation (although the label may be
indicative of what the parties intend) with the substance of that obligation’.

2.3
It is, therefore, necessary to have an understanding of the relevant English law concepts and terminology in order to understand the
nature of the obligations assumed by the guarantor in any given case.

2.4
This chapter will introduce the key features and characteristics of (1) contracts of suretyship; (2) contracts of guarantee; and (3) contracts
of indemnity, insofar as they are relevant to refund guarantees.4

Contracts of suretyship
2.5
Suretyship is a generic term for contracts by which the surety agrees in favour of the creditor to be answerable for the debt or obligations
of the principal debtor. In most English common law jurisdictions the terms ‘surety’ and ‘guarantor’ are used interchangeably, and will be used
in this way in this book.

2.6
In the context of a refund guarantee, the principal debtor is the builder under the shipbuilding contract and the creditor, to whom the
promise is made, is the buyer under the shipbuilding contract. The surety is the issuer of the refund guarantee.

2.7
The relevant obligation, for which the surety agrees to be answerable, is that of the builder to refund one or more pre-delivery instalments
to the buyer. Such obligation typically arises under the shipbuilding contract in the event that the buyer exercises its contractual right to
terminate the contract for cause such as insolvency of the builder, excessive delay in delivery, total loss of the vessel, and/or material breach
of the builder’s obligations under the contract.

2.8
Contracts of suretyship fall into two main categories, namely contracts of guarantee and contracts of indemnity. Refund guarantees are
routinely issued in either form. Although the word ‘guarantee’ is often used to describe both contracts of guarantee and contracts of
indemnity, there are important differences between the two. Whether a contract falls into one class or another (or contains a combination of
the two) is a question of construction in each case,5 which as the case law demonstrates, is not always easy to resolve.6

Contracts of guarantee
Definition and characteristics

2.9
Contracts of guarantee are commonly referred to as ‘contracts of guarantee, properly so-called’ ‘traditional guarantees’ ‘true guarantees’
‘see to it guarantees’ or ‘secondary obligation/liability instruments’.

2.10
In Vossloh AG v Alpha Trains (UK) Ltd,7 Sir William Blackburne gave the following definition of a contract of guarantee:

‘A contract of guarantee, in the true sense, is a contract whereby the surety (the guarantor) promises the creditor to be responsible for the
due performance by the principal of his existing or future obligations to the creditor if the principal fails to perform them or any of them.’

2.11
A contract of guarantee is predicated upon the existence of a valid obligation owed by the principal debtor to the creditor. In Lakeman v
Mountstephen,8 Lord Selborne affirmed the principle that there can be no suretyship unless there is a principal debtor and no-one can
guarantee anybody else’s debt unless there is a debt of some other person to be guaranteed.9

2.12
The secondary nature of the surety’s obligations means that the surety will generally only be liable to the same extent as the principal
debtor is liable to the creditor and will also usually be discharged from liability under the guarantee if the underlying obligation is void or

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unenforceable, or if the obligation ceases to exist. This is known as the ‘principle of co-extensiveness’.

2.13
The principle of co-extensiveness is not, however, an immutable rule. It is open to the parties expressly to exclude or vary any of their
mutual rights or obligations which would otherwise result from the classification of an instrument as a guarantee. The issue of the extent of
the liability of the surety will always depend upon the true construction of the instrument.10

2.14
In Moschi v Lep Air Services Ltd and Others,11 Lord Diplock reviewed the authorities dating back a century or more to identify the nature
of a contractual promise in a guarantee, namely whether it gives rise to an obligation on the part of the guarantor to pay a sum of money to
the creditor if the debtor did not do so, or to an obligation to ‘see to it’ that the debtor performs his own obligations to the creditor. He held
that by the beginning of the nineteenth century it was taken for granted that the obligation was of the latter kind.12

2.15
Thus, typically, the guarantor’s obligation is to ‘see to it’ that the debtor performs his contract. If the debtor does not do so, the creditor’s
remedy against the guarantor is in damages for breach of contract. In Vossloh, Sir William Blackburne explained the position as follows:13

‘… if for any reason the principal fails to act as required by his contract he not only breaks his own contract, but he also puts the surety in
breach of his contract with the creditor, thereby entitling the creditor to sue the surety, not for the unpaid debt, but for damages. The
damages are for the loss suffered by the creditor due to the principal having failed to do what the surety undertook that he would do.’

2.16
Thus, in the context of refund guarantees, if the builder fails to repay the pre-delivery instalments when due, the buyer will have a claim
for damages against the guarantor for its failure to ‘see to it’ that the builder performs his obligations under the shipbuilding contract.

2.17
The secondary nature of the liability of the guarantor has the important consequences that (i) the guarantor will not be liable under the
guarantee unless it can be established that the principal debtor is liable under the underlying contract;14 (ii) if the obligation of the principal
debtor is unenforceable or is discharged, the guarantee will also be discharged; and (iii) the guarantor may avail itself of all the defences
which are available to the principal debtor.

2.18
Although the liability of the guarantor is secondary in the sense that it is in addition to, and not in substitution for the liability of the
principal debtor, in the absence of express wording in the guarantee to the contrary, this does not prevent the creditor from seeking to
enforce the guarantee before or at the same time as seeking to enforce against the principal debtor.15

2.19
However, the nature of the contractual promise will depend in each case upon the particular terms of the agreement.16 Another possible
form of agreement is where a person undertakes that if the principal debtor fails to pay any instalment he will pay it. In such a case the
guarantor undertakes a personal liability to pay upon demand in the event that the principal fails to do so. If the principal fails to pay, the
surety’s liability sounds in debt rather than in damages. Where the contract gives rise to an independent personal liability, the ‘guarantee’ is
not a contract of guarantee at all but a contract of indemnity.17

2.20
A refund guarantee may either be of the ‘see to it’ variety or contain an independent promise to pay. In the former case the refund
guarantor will be liable to the creditor to ensure that the builder refunds the advance payments of the purchase price, should such repayment
become due under the shipbuilding contract. The liability of the guarantor is both co-extensive with and ancillary or secondary to the liability
of the builder as principal and sounds in damages. In the latter case, the guarantor’s liability to pay is not premised upon establishing breach
of the shipbuilding contract, but arises independently of the shipbuilding contract and sounds in debt.

Contracts of indemnity
2.21
A contract of indemnity denotes a contract where the person who gives the indemnity undertakes his indemnity obligation by way of
security for the performance of an obligation by another.18 The indemnity obligation is to make good a loss suffered by another.19

2.22
Unlike a contract of guarantee, the indemnifying party assumes a primary obligation, either alone or jointly with the principal debtor,
which is independent of any liability which the principal debtor may owe to the creditor.20 The essence of the arrangement is that the
indemnifying party will be obliged to pay regardless of the existence or breach of the underlying contract in respect of which it is provided by
way of security.21 The principle of co-extensive liability does not, therefore, apply to contracts of indemnity.

2.23
The key difference between a contract of guarantee and a contract of indemnity is that a contract of guarantee will be discharged if
there is a material variation in the underlying contract to which the guarantor has not consented or the underlying contract becomes void,
unenforceable or is compromised. A contract of indemnity will not be discharged in any of those circumstances. Otherwise, and with the
exception of the duty of disclosure discussed in paragraphs 2.80 to 2.88 below, the rights and duties of the parties to a contract of indemnity
are generally the same as those of the parties to a contract of guarantee.22

2.24
The nature of an indemnity has the important consequences that (i) the creditor may make a demand under a contract of indemnity
without having to establish a breach of the underlying contract; (ii) the surety will be obliged to pay out in accordance with a compliant
demand regardless of any dispute in respect of the underlying contract, save only in the case of fraud of which the surety has knowledge;
and (iii) the courts will not intervene to restrain payment under instruments such as demand guarantees other than in wholly exceptional
circumstances.23 However, as explained in paragraphs 2.42 to 2.48 below, the beneficiary under a contract of indemnity has a duty to
account to the principal debtor for any sum which he receives in excess of his true loss under the underlying contract.

Demand guarantees
2.25
Performance bonds and demand guarantees are particularly stringent forms of contracts of indemnity, akin to a letter of credit.24 They
are ‘unconditional’ or ‘on demand’ instruments which are commonly used in a variety of commercial and finance transactions as security for a

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seller’s obligation to deliver goods or a buyer’s obligation to pay the sums due under a contract for sale.

2.26
The nature of a performance bond was discussed in the leading case of Edward Owen Engineering Ltd v Barclays Bank International
Ltd.25 In that case a contract was made between the plaintiff English suppliers and Libyan customers for the supply and installation of
glasshouses. A performance bond was issued in favour of a buyer which was payable ‘on first of our demand without any conditions of proof’.
The buyer failed to provide a letter of credit, which the suppliers accepted as a repudiation of the contract. The Court of Appeal held that the
bank had to pay out under the bond in accordance with its terms. In his judgment, Lord Denning MR said the following about performance
bonds:

‘… these performance guarantees are virtually promissory notes payable on demand. So long as the Libyan customers make an honest
demand, the banks are bound to pay: and the banks will rarely, if ever, be in a position to know whether the demand is honest or not. At any
rate they will not be able to prove it to be dishonest. So they will have to pay.

All this leads to the conclusion that the performance guarantee stands on a similar footing to a letter of credit. A bank which gives a
performance guarantee must honour that guarantee according to its terms. It is not concerned in the least with the relations between the
supplier and the customer; nor with the question whether the supplier has performed his contracted obligation or not; nor with the question
whether the supplier is in default or not. The bank must pay according to its guarantee, on demand, if so stipulated, without proof or
conditions. The only exception is when there is a clear fraud of which the bank has notice.’

2.27
In Marubeni Hong Kong and South China Ltd v Government of Mongolia, Carnwath LJ said:26 ‘“demand bonds” (however described) are
a specialised form of irrevocable instrument, developed by the banking world for its commercial customers. They have been accepted by the
courts as the equivalent of irrevocable letters of credit.’

2.28
In the case of a demand guarantee, the obligation to pay arises on first demand (or on first demand supported by a specified document)
without any independent evidence of the validity of the claim (save only to the extent that such evidence may sometimes be provided by a
specified document (e.g. a certified copy of an arbitral award)).27 Such instruments are usually issued by banks and they have more of the
characteristics of a promissory note than the characteristics of a guarantee.28 There is a presumption that a performance bond is conditioned
upon documents rather than facts or proof of breach.29

2.29
Thus, where refund guarantees are issued in this form, the surety is obliged to pay upon receipt of a compliant demand,30 regardless of
whether the builder has, in fact, become liable to refund the payment under the shipbuilding contract. There is an exception in the case of
fraud of which the bank has knowledge31 but, as discussed in paragraphs 19.6 to 19.22 below, this is of exceptionally limited application in
practice.

2.30
A bank or other financial institution which issues such an instrument does not have to concern itself, therefore, as to whether a dispute
exists between the builder and the buyer as to the buyer’s entitlement to a refund of the pre-delivery instalments under the shipbuilding
contract, or with the rights and wrongs of any such dispute. The surety’s concern is whether the demand complies with the terms of the
instrument. If it does the issuer must pay, absent fraud of which the bank has knowledge.32

2.31
It is inherent in the nature of such instruments, that where the surety pays out under a demand guarantee in accordance with a compliant
demand, the builder has no recourse against the surety, even if it subsequently turns out that the buyer was not entitled under the
shipbuilding contract to terminate the contract and to claim a refund of the pre-delivery instalment(s).33 The builder’s remedy in such
circumstances is to pursue a claim against the buyer. Thus if the builder disputes the buyer’s entitlement to a refund, it may bring
proceedings against the buyer under the shipbuilding contract. However, because the courts have been steadfastly unwilling to interfere with
the operation of autonomous instruments such as performance bonds or demand guarantees,34 it is only in the most exceptional
circumstances that the builder will be able to restrain payment by the surety to the buyer under the demand instrument.35

ICC Uniform Rules for Demand Guarantees ICC Publication No 758

2.32
The ICC publish uniform rules for demand guarantees so as to encourage good demand practice which is equitable to all concerned.
The latest version of the rules, the 2010 ICC Uniform Rules for Demand Guarantees (ICC Publication No. 758) (“URDG”), was introduced on 1
July 2010 to replace the 1992 ICC Uniform Rules for Demand Guarantees (ICC Publication No. 458). The URDG are contractual in nature and
only apply if expressly incorporated into a contract.

2.33
It is a characteristic of all guarantees subject to the URDG that they are payable on presentation of one or more documents. The
documentary requirements specified in demand guarantees vary widely. At one end of the spectrum is a guarantee which is payable on
simple written demand, without a statement of default or other documentary requirements. At the other end of the spectrum, a guarantee
may require presentation of a judgment or arbitral award. Between these two extremes lie various intermediate forms of guarantee, such as
guarantees requiring a statement of default by the beneficiary, with or without an indication of the nature of the default, or the presentation of
a certificate by an engineer or surveyor. All of these fall within the scope of the URDG.36

2.34
It is the intention of the rules and of the parties who incorporate the URDG into their guarantees, that payment is to be made against
documents, without reference to the underlying contract between the principal and the beneficiary.

2.35
Where the URDG are incorporated into a refund guarantee the instrument will take effect as a demand guarantee, unless the guarantee
contains language which is inconsistent with the URDG.37

Determining the nature of the instrument

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2.36
The true nature of any particular instrument is in every case to be determined as a question of construction of the instrument as a whole.
The issue of construction must be considered without preconceptions and in its factual and contractual context, having regard to its
commercial purpose.38 The approach to be taken to the issue of construction is discussed further in Chapters 4, 5 and 6. The issue of
construction of a guarantee instrument is not always easy to resolve, and the language of primary and secondary liability is routinely found in
the same contracts.

Strength of security
2.37
It will be readily appreciated that from the buyer’s perspective the strength of the security is much greater if a refund guarantee is
provided in the form of a demand guarantee, rather than a true guarantee where the guarantor’s liability is co-extensive with, and therefore
dependent upon, the liability of the builder. With a demand guarantee the buyer and its financiers have the comfort of knowing that the buyer
will be entitled to payment under the refund guarantee, simply by making a demand in accordance with its terms, irrespective of whether
there is a dispute with the builder as to its entitlement to a refund under the shipbuilding contract. Thus even if the bank/financial institution
were to refuse payment under the instrument, it should be possible to obtain a judgment or arbitration award against the guarantor relatively
quickly and inexpensively, without the need for a full trial. Because a demand guarantee is akin to a letter of credit and constitutes an
independent and autonomous contract, the scope for dispute as to the surety’s obligation to pay is extremely limited,39 and it is only in the
most exceptional of circumstances that the courts will interfere to restrain payment under such an instrument.

2.38
Under a true guarantee the buyer runs the risk that it will not be able to secure repayment from the builder and/or guarantor of the pre-
delivery instalment(s) without the significant cost and delay of a full-blown trial in arbitration or court proceedings,40 since the guarantor will
not be obliged to pay under the refund guarantee unless it can be established that the builder is liable to repay the pre-delivery instalment(s)
under the shipbuilding contract. Further, the buyer may lose its right to reimbursement by the guarantor altogether, where there has been a
material variation in respect of the underlying shipbuilding contract without the guarantor’s consent, as considered more fully in Chapter 14,
and in the circumstances described in Chapter 16.

2.39
On the other hand, it is easy to understand that a builder may be reluctant to procure a primary obligation instrument to secure its
obligation to refund pre-delivery instalments to the buyer, since it exposes itself to the risks that (1) the buyer may obtain payment from the
issuer by making what is, or turns out to be, an unjustified demand; (2) the builder will be able to do nothing to prevent payment by the bank
pending resolution of any dispute as to the builder’s obligation to refund the pre-delivery instalment(s) under the shipbuilding contract save
only in the most exceptional circumstances;41 and (3) where, as is commonly the case, the builder provides counter-security to its bank to
secure the bank’s agreement to provide the refund guarantee(s) to the buyer, the builder runs the financial risk that the bank will take
immediate steps to enforce its security against the builder, before the builder can pursue its remedies against the buyer under the
shipbuilding contract.

2.40
The builder should, therefore, be aware that if it procures a refund in the form of a demand guarantee, it may be powerless to prevent
an unscrupulous buyer from making demand against and collecting under the guarantee. Unless the builder has in place a guarantee from a
bank or similar financial institution of all of the buyer’s obligations arising out of or in connection with the shipbuilding contract, it may find
itself in the invidious position where the buyer is able to collect under the demand guarantee, and the builder’s only remedy is against an
offshore special purpose vehicle which has dissipated the proceeds of the demand and has no other assets.

2.41
Whether in any given case the parties will agree that a demand guarantee or a traditional guarantee shall be provided will depend
largely upon the strength of their negotiating positions and/or the demands of and their relationships with their financiers. The inherent
conflict of interest between the buyer’s natural preference for a demand guarantee and the builder’s obvious desire to procure a traditional
guarantee is not always happily resolved, and in many cases the wording of the refund guarantees used and/or the nature of the instrument
is unclear, ambiguous, or at least open to argument.42

Duty to account
2.42
It is implicit in the nature of primary obligation instruments that there will be an accounting in due course between the relevant parties. If
the buyer collects under the demand guarantee but has suffered no loss, unless the terms of the instrument expressly allow him to keep the
windfall profit, he will have a duty to account to the builder for it.43 This rule mitigates to some extent the potentially harsh consequences of
providing a demand guarantee.

2.43
In Cargill Potter LJ explained the position as follows:

‘…such a bond is a guarantee of performance. That is not to say it is a guarantee in the sense that it has all the normal incidents of a contract
of surety; it is of course a contract of primary liability so far as the bank that gives it is concerned. However, it has the feature that its purpose
is to provide security to the buyer for the fulfilment by the seller of his contractual obligations: see Kerr J. in R. D. Harbottle (Mercantile) Ltd. v.
National Westminster Bank Ltd. [1978] Q.B. 146, 149B. Second, its purpose is also that the buyer may have money in hand to meet any claim
he has for damage as a result of the seller’s breach. Third, it confers a considerable commercial advantage upon a buyer. Not only does the
buyer have an unquestionably solvent source from which to claim compensation for a breach by the seller, at least to the extent of the bond,
but payment can be obtained from the seller’s bank on demand without proof of damage and without prejudice to any subsequent claim
against the seller for a higher sum by way of damages. In these circumstances the obligation to account later to the seller, in respect of what
turns out to be an overpayment, is a necessary corrective if a balance of commercial fairness is to be maintained between the parties.’44

2.44
Potter LJ went on to hold that the use of the word ‘forfeit’ in relation to the bond at issue in that case did not negative the buyer’s
obligation to account, should the sum paid out exceed the damage actually suffered.45

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2.45
In Wuhan Guoyu Logistics Group Co Ltd & Anr v Emporiki Bank of Greece SA,46 Tomlinson LJ affirmed the ‘well-established analysis’
that the underlying contract between the buyer and seller is subject to an implied term that the beneficiary will account to the other party to
the underlying contract to the extent to which the beneficiary has been overcompensated by the guarantor. He cited the following statement
from Staughton LJ in Cargill with approval:

‘The general situation as to performance bonds is that they provide that the bank or the other party giving the bond has to pay forthwith,
usually on demand. But subsequently there has to be an accounting between the parties to the commercial contract.’

2.46
Tomlinson LJ stated that the legal route by which this obligation to account arises is by way of an implied term in the underlying
contract, but it has also been suggested that the liability to account may arise instead as a matter of legal analysis on equitable principles of
restitution to prevent unjust enrichment of the beneficiary.47

2.47
In the case of demand guarantees, a buyer will, therefore, have a duty to account to the builder where a call on the refund guarantee
exceeds the true loss sustained and a right to claim a higher sum from the builder if the loss exceeds the sum paid out under the demand
guarantee.

2.48
The question of accounting does not arise in the case of a traditional guarantee, because the guarantor’s liability is co-extensive with
that of the principal debtor and the buyer cannot therefore recover from the guarantor more than is owed by the builder.

Are monies paid over by a bank under a guarantee pursuant to a

‘wrongful’ demand held on trust?
2.49
In Wuhan Guoyu Logistics Group Co Ltd & Anr v Emporiki Bank of Greece SA,48 the Court of Appeal considered the issue as to whether
money paid over by a bank under a guarantee, pursuant to a demand which, in fact, turned out to be wrongful, was held by the recipient on
trust for the bank, or alternatively on trust for the buyer who would in turn hold the money on trust for the bank.

2.50
In that case a shipbuilding contract for the construction of a bulk carrier was concluded, and Emporiki Bank of Greece SA (“the Bank”)
issued what was described as a ‘Payment Guarantee’ in favour of the seller in respect of the second instalment payable by the buyer under
the shipbuilding contract (“the Payment Guarantee”).

2.51
The shipbuilding contract contained a provision to the effect that the second instalment was payable by the buyer within five banking
days of receipt of (i) a refund guarantee issued by the seller’s Bank in a prescribed form and (ii) a certificate of confirmation of cutting of the
first steel plate in the seller’s workshop.

2.52
In due course the seller demanded in good faith payment of the second instalment from the buyer. The buyer contended that the
second instalment was not, in fact, due and did not pay it.

2.53
Demand for payment by the Bank under the Payment Guarantee was made some two years after the demand made of the buyer. The
Bank declined to pay. It contended that the Payment Guarantee was a traditional guarantee of the buyer’s obligation rather than an on
demand performance guarantee; the buyer’s obligation to pay the second instalment had not been determined to have accrued due.

2.54
The seller brought proceedings against the Bank, claiming payment under the Payment Guarantee of the amount of the second
instalment and sought summary judgment. In June 2012, Christopher Clarke J held that the Payment Guarantee was a guarantee properly so-
called and not an on demand bond.49 He therefore refused the seller’s application for summary judgment. In December 2012, the Court of
Appeal allowed the seller’s appeal and overturned the judgment of Christopher Clarke J.50

2.55
In a postscript to his judgment in the Court of Appeal, Longmore LJ stated that there had been some argument as to the legal position if
the underlying position turned out to be that the buyer was never obliged to pay the second instalment under the shipbuilding contract, and
whether the seller would hold the amount paid by the Bank on constructive or resulting trust for the buyer. Longmore LJ indicated that this
issue would be better considered when finality had been reached in the arbitration under the shipbuilding contract.

2.56
In October 2012 the arbitration tribunal appointed by the parties pursuant to the shipbuilding contract issued its award in relation to the
dispute between the seller and the buyer over the termination of the shipbuilding contract. The tribunal concluded that the second instalment
had not, in fact, fallen due from the buyer to the seller because the refund guarantee provided by the Bank was not in the prescribed form. In
December 2012, the Bank paid just over US$10.5 million (representing the amount of the second instalment and interest) into an escrow
account in the joint names of the Bank’s and the seller’s solicitors.

2.57
The arbitration award became final in January 2013 when Cooke J refused permission to appeal against the award. In May 2013, the
Bank agreed to the release of the amount in the escrow account to the seller’s solicitors, but before doing so it issued an application for an
order declaring that in the event that it made payment, the seller would hold the money on trust either for the Bank or for the buyer who
would, in turn, hold it on trust for the Bank. The Bank also argued that because of the tribunal’s conclusion, the seller had received the money
by reason of a mistake.

2.58
The Court of Appeal refused the Bank’s application. Tomlinson LJ (with whom Rimer and Longmore LJJ agreed) held that:

‘…There is here no analogy with cases of mistake, where by definition no obligation to pay ever arose. Here, on making its demand of the
bank on 22 June 2011 the Seller acquired a complete and immediately enforceable cause of action against the Bank. The Bank was obliged
to pay immediately, as paragraph 4 of the Payment Guarantee spells out in terms. Thereafter the Seller’s right to payment from the Bank was
indefeasible, and it is of no relevance that the Seller subsequently discovers that his demand, although made in good faith, was in fact made
upon an incorrect premise.’51

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2.59
Tomlinson LJ went on to explain the rationale that an on demand guarantee is intended to be ‘an autonomous contract, independent of
disputes between the seller and the buyer as to their relative entitlements pursuant to the different contract between themselves’52 and ‘that
same rationale underlies the equally well-established analysis that the underlying contract between seller and buyer, or between beneficiary
and the party at whose instance the guarantee is procured, is subject to an implied term that the beneficiary will account to the other party to
the underlying contract to the extent to which the beneficiary has been over-compensated by the guarantor’.53

2.60
He went on to state that these principles ‘…are completely inimical to the implication of a trust impressed upon the monies in the Seller’s
hands by reason of circumstances arising after accrual of the Seller’s completed cause of action under the guarantee. It is critical to the
efficacy of these financial arrangements that as between beneficiary and bank the position crystallises as at presentation of documents or
demand as the case may be, and that it is only in the case of fraudulent presentation or demand by the beneficiary that the bank can resist
payment against an apparently conforming presentation or demand’.54

2.61
It follows from this decision that where monies are paid out pursuant to a demand which is, or turns out to be, unjustified, such sums are
not held on trust and the recipient is free to utilise them as he sees fit. However, the beneficiary has a duty to account to the other party (i.e.
the builder) to the extent to which he has been over-compensated by the guarantor.

Prepayment and right of set-off

2.62
In some cases, the buyer under a shipbuilding contract is required to make a prepayment to be offset against the purchase instalments
when they fall due. In such a case an issue may arise as to whether the surety can get the benefit of any right of set-off in the event that the
buyer subsequently defaults.

2.63
This issue was considered in the case of Hyundai Shipbuilding & Heavy Industries Co v Pournaras.
55 In that case the principals were
the buyers of four vessels which were to be built by the claimant Korean shipyard. The contract price of the vessels was to be paid in five
instalments. The buyers made a prepayment of US$1.25 million to be applied to the first instalments under the shipbuilding contracts when
they fell due. The payments were guaranteed by the defendants. The guarantee provided as follows:

‘… in consideration of your entering into the shipbuilding contract…the undersigned hereby irrevocably and unconditionally guarantees the
payment in accordance with the terms of the contract of all sums due or to become due by the buyer to you under the contract, and in case
the buyer is in default of any such payment the undersigned will forthwith make the payment in default on behalf of the buyer.’

2.64
The prepayment was insufficient to cover the sum of the first instalments under the four shipbuilding contracts. The buyers failed to pay
the remainder when it fell due and the second instalment was not paid in one of the four cases. The builder terminated the four contracts for
the buyers’ repudiatory breaches and brought proceedings against the guarantors under the letters of guarantee. The builder applied for
summary judgment.

2.65
The guarantors argued that (1) on their true construction the letters of guarantee created an obligation on the part of the guarantor to
‘see to it’ that the buyer would perform his obligations under the guarantee, and the remedy open to the builder was for damages for breach
of contract if the buyer failed to do so; (2) in any event once the shipbuilding contracts had come to an end, the liability to pay the instalments
under the guarantees ceased and was replaced by a claim not in debt but for damages; (3) the buyers would, in principle, be entitled to set-
off the sums which had been pre-paid against the builder’s losses and the guarantor would also be able to take advantage of this right of set-
off; and (4) the court should grant relief against liability even assuming that they were wrong on (1)–(3) above, on the grounds that it would be
unconscionable that the guarantors should pay over large sums of money to the builder in circumstances where there would be little chance
of getting it back if the buyers were able to recover part of the instalments paid.

2.66
At first instance, Donaldson J gave judgment for the plaintiffs on the basis that the guarantors had no arguable defence to the claim. The
defendant guarantors appealed to the Court of Appeal.

2.67
In the Court of Appeal, Roskill LJ gave the leading judgment (with which Stephenson LJ agreed) and upheld the judgment at first
instance on the following grounds:

(1) when construed as a whole against the factual matrix of the background the commercial purport, obvious intent and true construction
of the guarantee was such that the defendants’ contention that all the guarantee did was to bind the guarantor to ensure performance
by the buyer of the buyer’s obligations, was not arguable. Upon its true construction the meaning of the guarantee was that if the buyer
did not pay in time the guarantor would pay;
(2) the fact that the shipbuilding contracts came to an end did not free the buyers from their respective obligations to pay the various
instalments, liability for which had already accrued. Therefore the defendants’ several liabilities for those instalments under the
guarantees remained wholly unaffected;
(3) the buyers could, in principle, recover from the plaintiffs the difference between the amount of the instalments and that sum which
represented the loss or damages that the plaintiff had suffered. However, the guarantor was not entitled to the benefit of this set-off so
as to avoid paying the sums claimed against them, since the guarantee enabled the plaintiffs to recover from the guarantor the amount
due, irrespective of the position between the plaintiff and the buyers;
(4) there was no authority in support of the guarantor’s claim for relief against liability, there was no relevant equitable principle
applicable in the circumstances of this case analogous to relief from forfeiture, and there was nothing unconscionable in holding the
guarantor to the contracts;
(5) Donaldson J was correct, therefore, in his conclusion that there was no arguable defence to the claims.

2.68
Roskill LJ stated obiter that he was content to assume, as a matter of English law, that the buyers could, in principle, recover from the
builder the difference (if any) between the amount of the instalments and the sums that represented the loss or damages that the builder
suffered; the question was whether the guarantors could take advantage of that right which might allow the guarantors to reduce or
extinguish their liability under the guarantees. Roskill LJ went on to consider the principle that the surety may avail himself of any right to set

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off or counter claim which the principal debtor possesses against the creditor, but stated that to find that the guarantors could take
advantage of this would nullify the commercial utility of the guarantee.56

2.69
The decision in Pournaras was followed shortly afterwards by a decision in Hyundai Shipbuilding & Heavy Industries Co Ltd v
Papadopoulos,
57 which dealt with a virtually identical guarantee. In that case the underlying shipbuilding contract provided for payment in
five instalments. The buyer failed to pay the second instalment. The builder cancelled the contract and sued the guarantors for the second
instalment.

2.70
At first instance, Lloyd J held that the facts of this case were ‘substantially indistinguishable’ from that of Hyundai Shipbuilding & Heavy
Industries Co Ltd v Pournaras
58 and that the defendant guarantors had no arguable defence. Lloyd J, therefore, gave summary judgment in
favour of the claimants.

2.71
The defendants appealed to the Court of Appeal seeking to distinguish this case from the previous Hyundai
59 decision on the grounds
that (1) in the previous Hyundai decision the builder did not invoke its contractual right to rescind the contract (as it had in this case) but
treated the non-payment of instalments by the buyer as entitling the builder to treat the contracts as terminated, and (2) in that case, the writ
was issued against the guarantors before the repudiation was accepted whereas in this case, it was issued after the cancellation.

2.72
In the Court of Appeal60 Roskill LJ gave the leading judgment (with which Geoffrey Lane and Bridge LJJ agreed) and upheld Lloyd J’s
judgment at first instance.

2.73
The Court of Appeal held that (1) there were no valid grounds for distinguishing this case from the earlier Hyundai 61 decision; (2) on the
true construction of the guarantee the fact that the contract came to an end did not relieve the buyers from their obligation to pay the
instalments, liability for which had already accrued; (3) there was no reason why the order of events should affect the accrued right to the
instalment in question; and (4) there had been a default by the buyers and as a result, the defendants became liable forthwith to make the
payments in respect of which the buyers had defaulted.

2.74
The defendants appealed to the House of Lords.

2.75
The House of Lords (consisting of Viscount Dilhorne, Lord Edmund-Davies, Lord Fraser, Lord Russell and Lord Keith) upheld the decision
of the Court of Appeal.

2.76
In his judgment Viscount Dilhorne went on to state that if, contrary to his view, cancellation of the shipbuilding contract did deprive the
builder of its accrued right to payment of the second instalment, the builder nonetheless was entitled to have recourse to the guarantors for
the amount of the instalment. The terms of the guarantee required payment of the instalments on the due date, the builder had an accrued
right to payment by the guarantors and, even if the builder had lost its right against the buyer on cancellation, it would not have deprived the
builder of its accrued right to payment by the guarantors.

2.77
Viscount Dilhorne rejected the guarantors’ contentions that they were entitled to set-off the second instalment against the builder’s
claim for loss and damage.

2.78
In Andrews and Millett, The Law of Guarantees, it is suggested that the rationale for the obiter statement of Roskill LJ in the first Hyundai
case that even though the buyers may be able to recover the prepayment, the defence or cross-claim was not open to the sureties is sparse,
and appears to represent an exception to the principle of co-extensive liability.62 The authors also suggest that Viscount Dilhorne’s finding in
the second Hyundai case that even if the cancellation had deprived the builder of its accrued rights to the second instalment, this would not
deprive the builder of its rights of recourse against the sureties, is unsupported by authority other than the obiter statement of Roskill LJ.63

2.79
If, however, the two Hyundai decisions are properly to be regarded as having been decided upon the basis that as a matter of
construction the guarantee instruments were contracts of indemnity and not contracts of guarantee, the conclusions reached in those cases
would be defensible.64 Looked at in that way, the two decisions in Hyundai would not lead to a departure from the rule of co-extensive
liability. Under a guarantee properly so-called the guarantor would be able to avail itself of the buyer’s right of set-off, whereas under a
contract of indemnity the surety would not.

Duty of disclosure
2.80
A contract of guarantee is not a contract of utmost good faith which requires full disclosure of all material facts by both parties.65 The
creditor, therefore, owes no general duty to make disclosure to the guarantor, whose obligation is to assess for himself the risk he is taking
by entering into the guarantee.66 However, the creditor does owe a more limited duty of disclosure, namely to disclose ‘unusual features’.67
If he fails to do so, the guarantor will be discharged from liability under the guarantee.68

2.81
In North Shore Ventures Ltd v Anstead Holdings Inc,69 the Court of Appeal conducted an extensive review of the earlier cases which
considered the issue of the extent of the duty owed by a creditor to make disclosure to a prospective surety.70 The Chancellor, Sir Andrew
Morritt, gave the leading judgment (with which Smith and Tomlinson LJJ agreed) and held that the duty of care does not go further than the
limit set by Lord Campbell in Hamilton v Watson and by Lord Scott of Foscote in Royal Bank of Scotland v Etridge (No. 2) in the passages
quoted below:

‘…I should think that this might be considered as the criterion whether the disclosure ought to be made voluntarily, namely, whether there is
anything that might not naturally be expected to take place between the parties who are concerned in the transaction, that is, whether there
be a contract between the debtor and the creditor, to the effect that his position shall be different from that which the surety might naturally
expect; and, if so, the surety is to see whether that is disclosed to him’ 71

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‘…in my opinion, the obligation should extend to unusual features of the contractual relationship between the creditor and the principal
debtor, or between the creditor and other creditors of the principal debtor, that would or might affect the rights of the surety…’ 72

2.82
In North Shore Ventures Sir Andrew Morritt made it clear, therefore, that the creditor must disclose unusual features of the contractual
relationship between the creditor and the debtor (or between one creditor and another creditor of the debtor) but is otherwise under no duty
to disclose matters which might be material for the guarantor to know.73

2.83
A creditor is not, of course, obliged to disclose matters which are already known to the surety or which the surety could reasonably be
expected to know. If, however, a surety asks a question of a creditor, he must answer it truthfully from the information which he already has.74

2.84
The duty of disclosure will extend to any side letter between the builder and the guarantor.75 This issue arose in the case of Coal
Distributors LW v National Westminster Bank LW (1981).76 In that case a shipbuilder was required to obtain a bank guarantee under a
shipbuilding contract, the terms of which gave the builder an option to replace the original guarantee with guarantees in progressively
smaller amounts in line with the progress of construction. The builder agreed with the buyer by way of a side-letter not to exercise the option
and failed to disclose the existence of the side-letter to the surety.

2.85
In his judgment, Neill J referred to Pidcock v Bishop
77 as an illustration of the ‘well-recognised principle’ that if there is a side-
agreement affecting the responsibilities of the surety, that is something which the creditor should make known. However, he distinguished
the case from Pidcock v Bishop on the facts and held that as the side-letter could not have had any effect on the attitude of the bank, it was
not necessary to be disclosed.

2.86
No similar duty of disclosure is owed by a creditor to a surety in the case of a primary obligation instrument such as a performance
bond. In WS Tankship II BV v Kwangju Bank Ltd,78 the defendants contended that irrespective of whether the guarantees were, upon their
true construction primary or secondary obligation instruments, they were discharged from liability on the basis of non-disclosure by the
creditor of various loans made over the course of the contractual relationship.

2.87
Blair J held that the guarantees were demand guarantees imposing primary liability, and went on to consider the defence of non-
disclosure. Citing Andrews and Millett, The Law of Guarantees,79 he stated that ‘the jurisprudential basis of the creditor’s duty of disclosure to
the surety is somewhat unclear. In some cases, the duty has been said to arise from the presumed basis of the guarantee, in others, on the
basis that asking the surety to enter into the contract involves a representation that there is no unusual feature about the transaction affecting
the risks that he is being asked to undertake. The authors conclude that the principle is an independent one, though its precise boundaries
have yet to be defined…’.80

2.88
Blair J rejected the bank’s submission that an implied representation applies equally to demand guarantees, for which it was accepted
by the bank that there was no authority. He held that a demand guarantee which is issued by a financial institution for a fee is very different
from a traditional contract of guarantee and that the disclosure obligation owed by a creditor to a surety has no application to the beneficiary
of a demand guarantee.81

Exclusion of the duty of disclosure

2.89
There is nothing, in principle, to prevent a party from seeking to protect against the consequences of non-disclosure by inserting
express wording to that effect in the guarantee. Such wording will be effective if the failure to disclose an ‘unusual feature’ of the underlying
contract is innocent or negligent,82 but almost certainly will be ineffective if the concealment amounts to fraud.83

1 Gold Coast Ltd v Caja de Ahorros del Mediterraneo [2001] EWCA Civ 1806, [2002] 1 All ER (Comm) 142, [2002] 1 Lloyd’s Rep 617 (CA) [15].

2 Ibid; WS Tankship II BV v Kwangju Bank Ltd and another [2011] EWHC 3103 (Comm), [2012] CILL 3155; IIG Capital LLC v Van Der Merwe
[2008] EWCA Civ 542, [2008] 2 All ER (Comm) 1173, [2008] 2 Lloyd’s Rep 187; Vossloh Aktiengesellschaft v Alpha Trains (UK) [2010] EWHC
2443 (Ch), [2011] 2 All ER (Comm) 307.

3 [2010] EWHC 2443 (Ch), [2011] 2 All ER (Comm) 307 [20]; see also the discussion in Chapter 6.

4 For a detailed examination of the subjects see Andrews and Millett, Law of Guarantees (6th edn, Sweet & Maxwell 2011) paragraph 1–015;
O’Donovan and Phillips, The Modern Contract of Guarantee (2nd English edn, Sweet & Maxwell 2010) chapter 13; Paget’s Law of Banking
(14th edn, LexisNexis Butterworths 2014) chapter 34; and Chitty on Contracts (31st edn) paragraph 44.

5 Moschi v Lep Air Services Ltd [1973] AC 331; Associated British Ports v Ferryways NV [2009] EWCA Civ 198, [2009] 1 Lloyds Rep 595.

6 Wuhan Guoyu Logistics Group Co Ltd v Emporiki Bank of Greece SA [2012] EWCA Civ 1629, [2013] 1 All ER (Comm) 1191, [2014] 1 Lloyd’s Rep
266; Gold Coast Ltd v Caja de Ahorros del Mediterraneo [2001] EWCA Civ 1806, [2002] 1 All ER (Comm) 142, [2002] 1 Lloyd’s Rep 617; Meritz
Fire & Marine Insurance Co Ltd v Jan de Nul NV [2011] EWCA Civ 827, [2012] 1 All ER (Comm) 182, [2011] 2 Lloyd’s Rep 379; WS Tankship II BV
v Kwangju Bank Ltd and another [2011] EWHC 3103 (Comm); and see the discussion in Chapter 5.

7 Supra n. 3 at [23].

8 (1874–75) LR 7 HL 17.

9 Ibid at 24.

10 Andrews and Millett, Law of Guarantees (6th edn, Sweet & Maxwell 2011) paragraph 6–002.

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11 [1973] AC 331, [1972] 2 All ER 393.

12 Ibid at 348.

13 Supra n. 3 at [23].

14 Sampson v Burton (1820) 4 Moo CP 515; Mallet v Bateman (1865–66) LR 1 CP 163 171; Fahey v MSD Spiers Ltd [1973] 2 NZLR 655.

15 Fahey v MSD Spiers Ltd (1973) 2 NZLR 655 (CA) 659.

16 Supra n. 11 (Lord Reid).

17 Ibid at 349 (Lord Diplock).

18 Ibid.

19 Andrews and Millett, paragraph 1–012; Marubeni Hong Kong and South China Ltd v Government of Mongolia [2005] 2 Lloyd’s Rep 231;
Chitty on Contracts (31st edn) paragraph 44–008.

20 Clement v Clement (1996) 71 P&C RD 19; Andrews and Millett, paragraph 1–013.

21 Supra n. 3 at [28].

22 Ibid at [26].

23 As explained in Chapter 19.

24 It is a contractual undertaking, usually by a bank, to pay a specified sum of money to a third party upon the occurrence of a stated event,
usually the non-fulfilment of a contractual obligation to that third party.

25 [1978] QB 159 (CA), [1978] 1 All ER 976.

26 [2005] EWCA Civ 395, [2005] 2 Lloyd’s Rep 231 [23]; this case is discussed in paragraphs 6.2 to 6.21.

27 Marubeni Hong Kong and South China Limited v The Mongolian Government [2004] EWHC 472 (Comm) [137] (Cresswell J).

28 Supra n. 25 at 170–171.

29 IE Contractors v Lloyds Bank Plc [1990] 2 Lloyd’s Rep 496 (CA) 500 (Staughton LJ).

30 Supra n. 25 at 172.

31 United City Merchants (Investments) Ltd v Royal Bank of Canada [1983] 1 AC 168 (HL); Edward Owen Engineering Ltd v Barclays Bank
International Ltd [1978] QB 159 (CA), [1978] 1 All ER 976; Bolivinter Oil SA v Chase Manhattan Bank NA [1984] 1 WLR 392.

32 Supra n. 25 at 172.

33 Wuhan Guoyu Logistics Group Co Ltd v Emporiki Bank of Greece SA [2013] EWCA Civ 1679, [2014] 1 All ER (Comm) 870.

34 As discussed in Chapter 19.

35 Paragraphs 19.6 to 19.7.

36 Introduction to 1992 ICC Uniform Rules for Demand Guarantees (ICC Publication No 458).

37 Meritz Fire & Marine Insurance Co Ltd v Jan de Nul NV [2011] EWCA Civ 827, [2012] 1 All ER (Comm) 182.

38 Gold Coast Ltd v Caja de Ahorros del Mediterraneo [2001] EWCA Civ 1806, [2001] EWCA Civ 1806, [2002] 1 All ER (Comm) 142, [2002] 1
Lloyd’s Rep 617 [15]; Marubeni Hong Kong and South China Ltd v Government of Mongolia (CA) [2005] EWCA Civ 395, [2005] 2 Lloyd’s Rep
231 [28] (Carnwath LJ).

39 Where the nature of the instrument itself is not in dispute, the only issue that is likely to arise is whether the demand is made in
accordance with the terms of the instrument. This is a matter of construction which should be relatively easy to resolve.

40 Or possibly both if the shipbuilding contract and guarantee contain different dispute resolution mechanisms; see further paragraphs
9.10.5–9.10.7 below.

41 Supra n. 34.

42 Wuhan Guoyu Logistics Group Co Ltd v Emporiki Bank of Greece SA [2012] EWCA Civ 1629, [2013] 1 All ER (Comm) 1191, [2014] 1 Lloyd’s
Rep 266; see the discussion in Chapter 5.

43 Comdel Commodities Ltd v Siporex Trade SA [1997] 1 Lloyd’s Rep 424; Cargill International SA v Bangladesh Sugar and Food Industries
Corporation [1998] 1 WLR 461 (CA).

44 Ibid at 468–469.

45 Ibid at 469.
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46 Supra n. 33.

47 Andrews and Millett, 16–036.

48 Supra n. 33.

49 [2012] EWHC 1715 (Comm), [2012] 2 All ER (Comm) 685.

50 Supra n. 42; this decision is discussed in paragraphs 5.17 to 5.23 below.

51 Supra n. 33 at [20].

52 Ibid at [21].

53 Ibid.

54 Ibid at [22].

55 [1978] 2 Lloyd’s Rep 502.

56 Ibid at 507–508.

57 [1980] 2 All ER 29, [1980] 2 Lloyd’s Rep 1.

58 Supra n. 55.

59 Ibid.

60 Hyundai Shipbuilding & Heavy Industries Co Ltd v Papadopoulos [1979] 1 Lloyd’s Rep 130.

61 Supra n. 55.

62 Andrews and Millett, 6–030.

63 Ibid.

64 Ibid.

65 Seaton v Heath [1899] 1 QB 782 (QB) 786.

66 Ibid at 793.

67 The legal basis for the imposition of the duty is unclear, but Andrews and Millett suggest at paragraph 5–015 that the failure to disclose
amounts to an implied representation that the undisclosed facts do not exist.

68 Bank of India v Patel [1982] 1 Lloyd’s Rep 506 (QB) 515 (Bingham J), ‘a surety is discharged if the creditor acts in bad faith towards him or is
guilty of concealment amounting to misrepresentation’. Approved on appeal [1983] 2 Lloyd’s Rep 298 (CA) 301–302 (Goff LJ).

69 [2011] EWCA Civ 230, [2012] Ch 31.

70 Hamilton v Watson (1845) 12 Cl&F 109; Lee v Jones (1864) 17 CB (NS) 481; London & General Omnibus Co. Ltd v Holloway [1912] 2 KB 72;
Smith v Bank of Scotland 1997 SC (HL) 111; Royal Bank of Scotland v Etridge (No. 2) [2001] UKHL 44, [2002] 2 AC 773; and Palmer v
Cornerstone Investments & Finance Co. Ltd [2007] UKPC 49.

71 Hamilton v Watson (1845) 12 Cl&F 109 1344.

72 Royal Bank of Scotland v Etridge (No 2) [2001] UKHL 44, [2002] 2 AC 773 (HL) 848 (Lord Scott of Foscote).

73 Supra n. 68 at [31].

74 Westminster Bank Ltd v Cond (1940) 46 Com Cas 60.

75 Pidcock v Bishop 107 ER 857, (1825) 3 B&C 605.

76 Unreported, QBD, 4 February 1981.

77 Supra n. 74.

78 [2011] EWHC 3103 (Comm), [2012] CILL 3155.

79 Andrews and Millett, 5–015.

80 Supra n. 77 at [149].

81 Ibid.

82 Andrews and Millett, paragraph 5–027 and O’Donovan and Phillips, paragraph 4–20.

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83 HIH Casualty & General Insurance Ltd v Chase Manhattan Bank [2003] UKHL 6, [2003] 1 All ER (Comm) 349 [16].

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