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The use of independent guarantees

The independent guarantee is a surety allowing claiming money from the guarantor that secured performance of obligations of a primary debtor (the principal) set forth in a transaction between the latter and beneficiary. It is a frequently used meaning to seek compensation by the beneficiary for the principal’s default avoiding direct litigation against it.

The key provisions for regulating independent guarantees that represent the common umbrella of rules at the international level for international operations are embodied in the UN Convention on Independent Guarantees and Stand-by Letters of Credit (New York, 1995) to which Russia is not a Contracting State. 

International Chamber of Commerce Uniform Rules for Demand Guarantees and some other books of rules published by NGOs offer an additional set of harmonized rules. Many newly formed jurisdictions, including Russia, have adopted national legislation that introduced rules for independent guarantees fully or partly reflecting the internationally developed standards. At the moment, Civil Code governs independent guarantee’s matters in Russia.

In business, an independent guarantee is often used to secure the performance of obligations of the parties to agreements on construction, provision of services, sale, and purchase.

The independence principle

As generally understood, an independent guarantees fully independent from the existence or validity of the secured underlying obligations of the principal. It leads to banning the guarantor that issued the guarantee from rejecting the beneficiary’s demand for payment with arguments stemming from the secured obligations’ nature.

In particular, the guarantor may normally test the payment demand based on its facial conformity with the independent guarantee’s terms and conditions. There is one broadly admitted exception to this rule also enacted in the referred UN convention of 1995 stating that the guarantor may withhold payment when the underlying obligation has been fulfilled or such fulfillment has been clearly prevented by the misconduct of the beneficiary.

In Russian practice, an independent guarantee is most often provided in the form of a bank guarantee issued by a credit institution. For instance, in cases when a bank guarantee secures performance of obligations of the constructor in a very costly construction agreement, payments under it may exceed several billions of rubles. The reluctance of the guarantor to honor a payment demand is comprehensible considering that its perspectives to recover the money transferred to the beneficiary back from the principal based on the regress rule may be fruitless due to the principal’s insolvency.

The recent amendments to the Russian Civil Code of 2015 have aimed at strengthening the independence principle of independent guarantees. Nevertheless, judiciary practice still tends to act carefully when dealing with writs submitted by beneficiaries due to denial of guarantors to honor their payment demands.

Compensatory approach vs. punitive approach

Considering that Russia is a civil law jurisdiction, judiciary practice may not generally create legal precedents that have to be followed by courts in similar cases. The exception is that the Russian Constitution as well as the Federal constitutional law “On the Supreme Court of the Russian Federation” provide that the Supreme Court may give explanations on matters of judiciary practice to courts. Additionally, commercial courts may also refer to effective rulings of the recently abolished Russian Supreme Commercial Court. 

At present, the only relevant act, adopted by the Presidium of the Russian Supreme Commercial Court in 1998, offers just one recognized exception from the independence principle of independent guarantees. It states that the guarantor may reject payment when the beneficiary has already fully received the fulfillment of the secured obligations from the principal and unfairly claims the payment from the guarantor for the purpose of its unjust enrichment. This logic generally reflects the approach developed at the international level. In the meantime, it seems that judiciary practice does not believe this exception is enough to procure fairness.

Seemingly, Russian courts have developed a concept of compensatory nature of an independent guarantee. Under that concept, the beneficiary may not demand from the guarantor a payment under a guarantee that is higher than the beneficiary’s losses from the breached obligations of the principal secured with such independent guarantee. This approach is often used when an independent guarantee secures performance of obligations of monetary nature, for example, to return an advance payment, or to pay penalties under the contract.

In the meantime, the compensatory concept is not uniformly applied in Russian courts: some courts fully support it while others deny it referring to the principle of the guarantee’s independence. This inconsistency in court’s behavior may often lead to legal uncertainty.

On the one hand, this compensatory approach can be justified as an attempt of Russian courts to deal with possible unfair advantage beneficiaries may take. On the other hand, Russian law does not clearly forbid the existence of independent guarantees of punitive nature. The essence of independence implies that an independent guarantee may be of a purely punitive character, for instance, when the principal’s secured obligation is not directly linked to any monetary loss.

Moreover, there is the absence of legislative regulations that manifestly and clearly set forth which independent guarantees must be treated as either punitive or compensatory and what rules must apply to assess disproportionality of compensation. It leads to an enormous degree of court’s discretion in the relevant litigation.

These existing problems lead to such situations when different courts resolve disputes with similar circumstances differently on the basis of preferences and views of particular judges. Apparently, it is high time for the Supreme Court to interfere and to describe clearly the criteria in its explanations for courts.

Practical outcomes

In light of the above, we have the following practical advice. For the guarantor, the best strategy may be to limit its liability under an independent guarantee in its wording to block any potential claims stemming from its denial to pay duly to the beneficiary. Also, it makes sense to request an opinion of the principal on the nature of its breached secured obligations when having received a payment demand from the beneficiary. In addition, it is wise to reject the payment with a sign of possible disproportionality.

Thus, in case of litigation, there is a chance that the court will decide that the claim of the beneficiary is not proportional and cut the amount of the payment following the compensatory concept logic.

For the beneficiary, the best strategy may consist in demanding from the principal to request its guarantor to issue an independent guarantee that embodies the latter’s unlimited liability for failing to pay under the guarantee. Also, it is important to clearly state in the guarantee that it secures performance of obligations of any nature. In addition, it matters to carefully word a demand for payment to the guarantor fully facially complying with the guarantee’s terms and conditions.

Summing it up, the existing Russian judiciary practice of the litigation related to independent guarantees lacks uniformity and demonstrates a high degree of court’s discretion. In this light, it is highly important to take a very careful approach in the very initial steps. For instance, by wording independent guarantees and demands to pay under them thoroughly and in detail while paying attention to provisions that may potentially lead to negative interpretation in case of future litigation.

The time of brief and vaguely formulated independent guarantees popular in the Russian market for years has gone.

The article is available here: http://www.cisarbitration.com/2018/02/14/russian-courts-tend-to-find-independent-guarantees-as-quite...