Article / 6 Dec 2021

Enforcement of Deferred Consideration Guarantees: instrument construed as a demand bond

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Gateley Legal

The July 2021 judgement of the Court of Appeal in the case of (1) Shanghai Shipyard Co. LTD and (2) Reignwood International Investment (Group) Company Limited contains important guidance on the interpretation of guarantees as either a) conditional (surety) instruments or b) demand instruments where liability is predicated solely on a written demand.

Background Facts 

Reignwood (an investment holding company) provided a guarantee to Shanghai Shipyard for payment of the final instalment (USD $170 million) due from the buyer (a special purpose company defined in the shipbuilding contract as the “Owner” in which Reignwood had an investment interest as a 30% shareholder in an intermediate holding company).

The guarantee was described as an “Irrevocable Payment Guarantee” and Reignwood undertook “IRREVOCABLY, ABSOLUTELY and UNCONDITIONALLY” to “guarantee in accordance with the terms hereof, as the primary obligor and not merely as the surety, the due and punctual payment by the Owner” of the final instalment of USD 170 million.

The guarantee further provided that in the event of a payment default in respect of the final instalment, Reignwood on receipt of a first written demand from Shanghai Shipyard would “pay to you… all unpaid Final Instalment”. There was, however, a proviso which stipulated that in the event that there was a dispute between Shanghai Shipyard and the Owner and that dispute was referred to arbitration, Reignwood could withhold payment and would then become bound to make payment only when an arbitration award was made requiring payment.

Shanghai Shipyard gave notice of completion of the vessel and the Owner failed to pay the Final Instalment. On 23rd May 2017 Shanghai Shipyard demanded payment of USD 170 million from Reignwood under the bond. 

Reignwood declined payment and the Owner disputed the entitlement of Shanghai Shipyard to payment alleging defects. Reignwood initiated  arbitration proceedings in the name of the Owner in June 2019.

The Issues

Reignwood contended that the bond should be construed as a surety instrument so that it would not be liable unless the primary liability of the Owner (which was disputed) was established and that in any event the proviso to the payment obligation took effect so as to suspend its payment obligation once the dispute was referred to arbitration.

The Decision 

The bond was construed as a demand guarantee and it was held that as the demand made by Shanghai Shipyard on 23rd May 2017 created an immediate payment entitlement, Shanghai Shipyard had an accrued right to payment that was enforceable notwithstanding the subsequent reference to arbitration in 2019 (had the arbitration been commenced before the demand was made the issuer’s obligation would have been treated as an obligation to pay on demand once the arbitration award was made).

In reaching its decision, the Court of Appeal also expressed views on the approach to the interpretation of bonds and guarantees and in particular:

  • The commercial context within which the instrument was provided was important - it was the general practice, for sound commercial reasons, for shipbuilding payment guarantees of this nature to take effect as demand instruments. 
  • In construing a guarantee wording, the use of discrete words and phrases considered in previous judgements (for example the use of the word “demand” or an express reference to the primary obligation in the bond) was of limited assistance. Each instrument had to be construed as a whole. If, however, an exact form of words (described as “materially identical”) was utilised in the same commercial context (e.g. shipbuilding) it would generally be treated as having the same effect since those drafting bonds which included such wording must have intended them to so intend.
  • Different rules of interpretation would not be applied based upon the identity or nature of the guarantor. Reignwood sought to rely upon a “presumption” that an instrument would generally be construed as a demand bond if issued by a bank but that as Reignwood was an investment holding company the presumption would be that the bond was intended by the parties to be a conditional surety instrument. That argument was rejected so that different interpretations would not be applied to bonds in the same form simply because they were issued by “non-banks”.

Implications

The courts will take the same approach to construing and interpreting bonds issued by sureties regulated and operating as insurers as they adopt where instruments are issued by banks. The same approach will also be taken where, for example, the issuer is not a regulated entity but a commercial company.

The commercial context within which the bond is issued may be of relevance to its construction and interpretation.

The case underlines the importance of clear drafting as each instrument will be construed individually in accordance with its terms. The use of certain key words or phrases (such as “demand”) will not, of itself, determine the nature of the instrument. If, however, the wording of the bond is substantially identical to that considered in a decided case where the commercial context is also substantially the same, the bond would generally be treated as having the same effect.

If a bond is treated as a demand instrument where a written demand of itself creates a liability on the part of the issuer, the accrued right to payment will not generally be affected by a subsequent act or dispute.

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