Clause and effect: “see to it” and “on demand” guarantees

Iain Drummond considers the recent case of Shanghai Shipyard Co. Ltd. V. Reignwood International Investment and its implications for parent company guarantees in construction contracts.

9th November 2021

In the recent case of Shanghai Shipyard Co. Ltd. V. Reignwood International Investment (Group) Company Limited [2021] EWCA Civ 1147 the Court of Appeal (COA) unanimously overturned the first instance decision and found a parent company guarantee to be a guarantee “on demand”. Despite arbitration proceedings having commenced under the underlying contract, the COA found the guarantor liable to pay $170 million under the guarantee. The COA emphasised that the words used in the guarantee and the commercial context of the guarantee are critical factors.

“On demand” and “see to it” guarantees

In construction projects, where a subsidiary company enters into a contract with a third party, it is common for the third party to request a parent company guarantee to ensure the performance of the contract. In that situation a parent company can give a guarantee to provide a level of security in respect of the obligations of its subsidiary under the contract. Typically, these guarantees are intended to protect employers against contractor insolvency. However, they are also sometimes called for in respect of employers whose financial covenant is uncertain.

Where an “on demand” guarantee is entered into, the obligation to pay arises immediately in the event of a default and upon a demand being made under the guarantee. 

A document is more likely to be an “on demand” guarantee where it includes an undertaking to pay “on demand” and it excludes or limits the defences available to a guarantor. 

A “see to it” guarantee is a secondary obligation, thus it is necessary to establish liability before the beneficiary is entitled to benefit from the guarantee. 

Background

Shanghai Shipyard (the builder) entered into a bespoke contract with a special purpose company (the buyer) dated 21 September 2011 for the construction of an offshore drillship for $200 million. Investment company Reignwood (the parent company) acquired an indirect shareholding in the buyer. Reignwood funded payment of the first $30 million instalment due by the buyer under the contract, and entered into a payment guarantee in respect of the remaining $170 million final instalment. 

The buyer refused to take delivery of the drillship, stating that it was defective, and defaulted on payment, so Reignwood was called upon to pay under the guarantee but failed to pay. Meantime, the buyer commenced arbitration proceedings against Shanghai Shipyard under the contract to determine whether the ship was in a deliverable condition. Shanghai Shipyard then commenced proceedings against Reignwood in the High Court in England to enforce the guarantee.

Commercial court action

In its court action, Shanghai Shipyard argued that the guarantee was “on demand” and that the arbitration proceedings that the buyer sought to pursue had not been raised in a timely manner.

Clause 4 of the contract (as detailed in the judgment) contained an arbitration ‘carve out’ providing that in the event of  a dispute between Shanghai Shipyard and the buyer, Reignwood would be entitled to withhold payment pending the outcome of the arbitration: 

“i.  Only if the arbitration has been commenced between those parties as at the date the Demand is made; or

ii.  Regardless of when such arbitration is or may be commenced."

Reignwood argued that the guarantee was a “see to it” guarantee and that it had no obligation to pay because clause 4 was engaged, the arbitration hearing had concluded, and the arbitration award was awaited. Further, the drillship remained in the possession of Shanghai Shipyard. 

The court at first instance agreed that the guarantee was not an “on demand” guarantee but was a “see to it” guarantee. In arriving at that decision the court applied a presumption against interpreting guarantees as “on demand” guarantees.  

The court held that Reignwood was only liable to pay under the guarantee when it was established that the buyer was liable to pay the final instalment. 

COA decision

Shanghai Shipyard appealed successfully to the COA. The COA determined that the guarantee was “on demand” and Reignwood was obliged to pay. 

The COA gave no effect to the clause 4 Arbitration ‘carve out’ because arbitration proceedings had been issued after the demand for payment under the guarantee had been made. Also, the COA carefully examined the wording in the guarantee to determine whether it was an “on demand” or a “see to it” guarantee, in particular the following:  

“… we, [Reignwood] hereby IRREVOCABLY, ABSOLUTELY and UNCONDITIONALLY 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 the Contract Price amounting to a total sum of United States Dollar US$170,000,000…”

“upon receipt by us of your fist written demand, we shall immediately pay to you…”

The COA held that the use of the words "absolutely and unconditionally" pointed away from a requirement to first establish liability of the buyer and that the words "as primary obligor and not merely as surety" were a clear indicator that it was not a “see to it” guarantee. Further, the words “upon receipt by us of your first written demand, we shall immediately pay to you” were held to be hallmark of a demand guarantee. 

Points to take away

The COA held the guarantor accountable to Shanghai Shipyard in respect of obligations that the buyer may not be liable to pay, and Reignwood now faces a $170 million demand. 

The arbitration ‘carve out’ clause reinforced the position that the guarantee was “on demand” because absent a timely reference to arbitration a payment requested under the guarantee was unconditional. The decision is a stark warning for those who provide and obtain guarantees to be careful that the terminology used clearly reflects the intended status of the guarantee. Such documents often contain antiquated and unclear terminology, which is unhelpful. An instrument that incorporates the ICC Uniform Rules for Demand Guarantees (URDG) is likely to be an “on demand” guarantee but should not be automatically assumed.

For more information please contact Iain Drummond, Partner in our property and infrastructure disputes team, at iain.drummond@shepwedd.com, or your usual Shepherd and Wedderburn contact.