A comprehensive examination of bank letters of guarantee and independent guarantees issued under the URDG 758 rules, covering the legal nature of the guarantee and its difference from suretyship, the first demand clause, the independence and documentary principles, the types of guarantee, the parties and the counter-guarantee structure, unfair demands and interim injunctions, the bank's defences, post-payment recourse and the place of the URDG 758 in Turkish law.
The search for security that one party will perform its obligation is a need encountered in tenders, undertakings, supply and every field of international trade. The bank letter of guarantee is the mechanism that meets this need through the payment undertaking of a bank, and it is one of the most widely used instruments of security in Turkish commercial life. Whereas the letter of credit secures the payment of the sale price, the letter of guarantee secures the performance of an obligation, the completion of a work in conformity with the contract, or the satisfaction of a debt. In international transactions, letters of guarantee are increasingly issued within the framework of the Uniform Rules for Demand Guarantees prepared by the International Chamber of Commerce and in force since 1 July 2010, known by its abbreviation as the URDG 758. This article comprehensively examines the legal nature of bank letters of guarantee, the first demand structure, the independence principle, the counter-guarantee mechanism, the problem of unfair demands and interim injunctions, and the URDG 758 rules, in the light of Turkish law.
1. The Concept and Function of the Letter of Guarantee
A bank letter of guarantee is an instrument of security whereby a bank undertakes to pay a certain sum to the beneficiary in the event that the person in whose favour the letter is issued fails to perform a certain obligation. There are three basic figures in the relationship; the principal, who requests the bank to issue the letter and is generally the debtor of the underlying relationship, the bank which issues the letter, and the beneficiary, in the position of the creditor who is to benefit from the guarantee. The economic function of the letter of guarantee is that the beneficiary may rely on the undertaking of a strong institution of high payment capacity, namely the bank, independently of the principal's solvency and good faith. The beneficiary is thereby able, in the event of the principal breaching its obligation, to collect its receivable directly from the bank without entering into a lengthy judicial process. Letters of guarantee are used in a very wide field, as provisional and definitive security in tender processes, as security for the recovery of advance payments, as security for the due performance of the contract, and for the satisfaction of public obligations such as customs and tax.
2. Legal Nature and Difference from Suretyship
The legal nature of the bank letter of guarantee was long debated in Turkish doctrine, and today the prevailing view is settled to the effect that the letter of guarantee is in the nature of a guarantee contract. The most important consequence of this nature is the distinction of the letter of guarantee from suretyship. Suretyship is an accessory obligation; the liability of the surety depends on the existence and validity of the principal debt, if the principal debt is extinguished the suretyship is also extinguished, and the surety may raise against the creditor the defences belonging to the principal debtor. In a letter of guarantee of a guarantee nature, by contrast, the undertaking of the bank is independent of the principal debt; the bank may not as a rule raise the defences arising from the underlying relationship between the principal and the beneficiary, and performs its undertaking as its own independent obligation. This distinction is decisive in practice; whereas in suretyship the creditor may be required first to have recourse to the principal debtor, in a letter of guarantee of a guarantee nature the beneficiary may have recourse directly to the bank. In Turkish practice, bank letters of guarantee, particularly those that are unconditional and carry a first demand clause, are assessed with this independent guarantee character.
3. The First Demand Clause
The strongest and most widely used form of bank letters of guarantee in practice is the letter of guarantee carrying a first demand clause. In such letters the bank undertakes to pay upon the first written demand of the beneficiary, without seeking any proof, justification or document. The purpose of the first demand clause is to relieve the beneficiary of the burden of proof based on the underlying relationship and to render the guarantee immediately convertible into cash. In this structure the beneficiary may demand payment merely by declaring that the principal has failed to perform its obligation; the bank has no obligation to investigate the material accuracy of that declaration. The case law of the Court of Cassation consistently confirms this point; in a letter of guarantee containing an unconditional undertaking to pay on first demand, the bank is not obliged to investigate whether the demand is well founded. That said, the same case law also draws an important limit; this nature does not mean that even a demand known to be unfair will be met unconditionally. While the first demand clause gives the beneficiary great power, the possibility of the abuse of that power has given rise to the exceptions examined below.
4. The Independence Principle
The cornerstone of the law of letters of guarantee and of the URDG 758 rules is the independence principle. According to this principle, the undertaking of the guarantor bank is independent of the underlying debt relationship on which it is based and of all other relationships. Under the relevant article of the URDG 758, a guarantee is by its nature independent of the underlying relationship, and the guarantor is in no way concerned with or bound by that relationship. The fact that a reference to the underlying relationship has been made in the text of the guarantee is only for the purpose of identifying the subject of the guarantee and does not change the character of the guarantee as an independent and primary undertaking. The practical consequence of this independence is as follows; the arising of a dispute in the underlying contract between the principal and the beneficiary, the principal's assertion that it has not in fact breached its obligation, or defences based on the underlying relationship do not, as a rule, affect the bank's payment obligation. The bank may not enter into the substance of the underlying relationship and, being unable to do so, may not refuse payment on these grounds. The independence principle is the essence of the security function of the letter of guarantee; the insulation of the undertaking from disputes concerning the underlying relationship enables the beneficiary to rely on the guarantee with confidence.
5. The Documentary Principle
The natural extension of the independence principle is the documentary principle. Under the URDG 758, the guarantor bank deals with documents, and not with the goods, services or performance to which those documents may relate. The bank examines the demand made to it solely on the documents; it assesses whether the demand complies with the terms of the guarantee and with the documents provided for in the guarantee. Whether the performances forming the subject of the underlying relationship have actually been rendered, whether the goods are defective, or whether the work has been completed in conformity with the contract falls outside the bank's field of examination. The URDG 758 adopts the principle that conditions not linked to a document are also deemed invalid; where there is a condition stated in the guarantee but for which it is not indicated by which document it is to be established, the bank deems that condition to have been fulfilled and disregards it. This principle, by preventing the bank from making commercial or technical assessments, renders the letter of guarantee a foreseeable and swiftly operating instrument. The examination consists of checking whether the documents are consistent with the text of the guarantee and with one another.
6. Types of Letter of Guarantee
Letters of guarantee are classified according to various criteria. According to the payment structure, the most basic distinction is between conditional and unconditional letters of guarantee. In a conditional letter of guarantee, the beneficiary's entitlement to payment depends on its proving that a condition stated in the letter has been fulfilled. In an unconditional letter, that is, one carrying a first demand clause, the mere demand of the beneficiary suffices. As regards duration, letters of guarantee may be for a fixed term or open-ended; in fixed-term letters the bank's obligation is limited to a certain expiry. According to their subject, a provisional letter of guarantee is used at the stage of participation in a tender, a definitive letter of guarantee at the stage of the signature and due performance of the contract, and an advance letter of guarantee as security for the recovery of an advance paid in cash. In international trade, functional types such as the performance guarantee, the payment guarantee and the tender guarantee also stand out. The URDG 758 provides an applicable framework for all these types and comes into play by reference being made to the rules in the text of the guarantee.
7. The Counter-Guarantee Structure and International Transactions
In international transactions the beneficiary most often demands a letter of guarantee issued by a bank in its own country, since it is difficult to rely on the undertaking of a foreign bank and to pursue it where necessary. This need gives rise to the counter-guarantee structure. In this structure the bank in the principal's country gives a counter-guarantee to the bank in the beneficiary's country; the bank in the beneficiary's country, relying on that counter-guarantee, issues a local letter of guarantee, that is, a guarantee, in favour of the beneficiary. When the beneficiary demands, the local bank pays, then collects from the principal's bank on the basis of the counter-guarantee, and that bank has recourse against the principal. An important contribution of the URDG 758 is that it expressly regulates that the counter-guarantee, just like the guarantee, is independent. The counter-guarantee is independent both of the guarantee to which it is connected and of the underlying debt relationship; the counter-guarantor is not bound by these relationships, and the making of a reference to the underlying relationship in the counter-guarantee for the purpose of identifying the subject of the guarantee does not affect this independence. The independence of each link of this multi-layered structure enables the international guarantee chain to operate with confidence.
8. The URDG 758 and Its Place in Turkish Law
The URDG 758 is a set of rules prepared by the International Chamber of Commerce introducing uniform rules for demand guarantees. It replaced the earlier URDG 458 rules and entered into force on 1 July 2010. The URDG 758 is neither a statute nor an international treaty; however, where reference is made to it in the text of the guarantee, it becomes binding between the parties. As regards Turkish law, the nature of the URDG 758 is assessed as an international commercial custom established in the field of banking. Where express reference is made to the rules in the text of the guarantee, those rules become the content of the contract and are applied to the extent that they do not conflict with the mandatory provisions of the Turkish Code of Obligations. The adoption of the URDG 758 rules places the letter of guarantee within an internationally accepted and foreseeable framework and enables the parties to speak the same language of rules in cross-border transactions. It must not be forgotten that the rules are limited by the mandatory provisions of domestic law and may not override those provisions.
9. The Problem of Unfair Demands
The power that the first demand clause confers on the beneficiary brings with it the risk of an unfair demand. The beneficiary's attempting to convert the letter of guarantee into cash even though the principal has in fact fully performed its obligation is the most contested problem of practice. The independence principle comes under tension here; on the one hand the function of the guarantee requires the bank to pay swiftly without entering into the underlying relationship, on the other the legal order does not protect the manifest abuse of a right. The balance accepted in Turkish law is as follows; the rule is that the bank pays on first demand and is not obliged to investigate the merits of the demand. However, where it is clear beyond any doubt and known with certainty by the bank that the beneficiary's demand is unfair, the bank may, by virtue of the rule of good faith, refrain from being made an instrument of this manifest abuse. This exception is interpreted narrowly; the mere existence of a dispute concerning the underlying relationship, or the principal's allegation of unfairness, is not sufficient for the bank to refuse payment. The unfairness must be so obvious and liquid as to require no proof. Otherwise every commercial dispute would paralyse the function of the guarantee.
10. The Bank's Defences and Grounds for Refusing Payment
Although the independence principle prevents the bank from raising defences based on the underlying relationship, it does not mean that the bank is wholly devoid of defences. The bank, as a party to the letter of guarantee relationship itself, may refrain from payment by raising its own defences arising from that relationship. Examples of these defences are that the letter of guarantee is forged, that it has expired, that the demand does not comply with the terms of the guarantee and the documents provided for, or that the demand exceeds the amount of the guarantee. Since these matters concern the bank's own legal position, they do not conflict with the independence principle. For example, the bank is not obliged to pay under an expired letter of guarantee; if the demand does not include the documents provided for in the letter, the bank may raise that absence of documents. These defences arise directly from the terms and validity of the letter of guarantee itself, without entering into the substance of the underlying relationship. The bank's careful assessment of these defences is important both for avoiding unfair payments and for correctly managing its liability towards the principal.
11. Interim Injunctions and the Staying of Payment
The most effective route available to the principal in the face of an unfair demand is to obtain an interim injunction from the court restraining the bank from paying. The principal may, asserting that the beneficiary's demand is unfair, seek the staying of the conversion of the letter of guarantee into cash. However, the courts approach such applications with caution, having regard to the function of trust that the letter of guarantee performs in commercial life. An interim injunction is granted only where the unfairness of the beneficiary's demand has been established by strong prima facie proof; the mere allegation of a dispute based on the underlying relationship is not considered sufficient for an injunction. There is an important legal subtlety at this point; even where a clause has been inserted in the text of the letter of guarantee to the effect that the consequences of the dispute between the principal and the beneficiary will not be taken into account, that clause does not require the bank to disregard an interim injunction issued by a court. A bank which pays notwithstanding a duly issued injunction may become liable towards the principal. For this reason the bank must stay payment in the face of an injunction served on it.
12. Post-Payment Recourse Relationships
After the bank has paid the beneficiary, the relationship turns into recourse claims. As a rule, since the bank issued the letter of guarantee upon the demand and instruction of the principal, it has the right to claim the amount it paid from the principal. This recourse relationship rests on the letter of guarantee issuance contract between the bank and the principal, and the bank most often secures this risk in advance by collateral, counter-guarantees or cash blocking. In international structures involving a counter-guarantee, the recourse chain is layered; the local bank which pays has recourse against the counter-guarantor bank, and that bank against the principal. The bank's ability to preserve its right of recourse depends on its having made the payment in conformity with the terms of the letter of guarantee; where payment is made contrary to the terms, for example on the basis of an expired letter or notwithstanding a duly issued injunction, the bank may lose its right of recourse. Where there is no counter-guarantee relationship between the principal and the bank and the bank has nonetheless paid, the question of having recourse to the provisions on unjust enrichment may arise; that route, however, carries a tension with the independent character of the letter of guarantee.
13. Termination and Return of the Letter of Guarantee
The obligation binding the bank under a letter of guarantee is extinguished in various circumstances. In fixed-term letters of guarantee the obligation is as a rule extinguished by the expiry of the term stated in the letter; if no due demand has been received by that expiry, the bank is released from the obligation. The return of the original of the letter of guarantee to the bank is also a ground extinguishing the obligation; for the letter of guarantee is in the nature of a document of presentation, and the return of its original demonstrates that the guarantee has been released. The beneficiary's releasing the bank in writing, that is, waiving its rights arising from the letter of guarantee, also extinguishes the obligation. In open-ended letters of guarantee the situation is more complex; in these letters the bank's obligation is not extinguished automatically, and the bank assumes a long-term risk. In practice, the uncertainty created by open-ended letters of guarantee leads banks and principals to avoid such letters as far as possible. Where the guarantee has been terminated, the return of the original copy of the letter to the bank is important for clarifying the position of the parties' obligations.
14. Matters Requiring Attention in Practice
The sound conduct of the letter of guarantee relationship depends on the correct drafting of the text of the letter from the outset. For the principal, the most critical matter is the correct understanding of the risk assumed and of the terms of the letter; when a letter carrying a first demand clause is signed, it must be known that the beneficiary can collect from the bank almost unconditionally. The letter being for a fixed term limits the principal's risk in point of time, and it is to the principal's benefit to avoid open-ended letters. For the beneficiary, in order for the guarantee to be functional, it is preferable for the letter to carry a first demand clause and to be unconditional and of a guarantee nature. In international transactions, the parties' making express reference to the URDG 758 ensures the application of the rules and foreseeability; moreover, the law to which the guarantee is subject and the competent court or arbitration should also be clearly agreed. Linking the conditions in the text of the guarantee to documents, avoiding vague conditions not linked to a document, and writing the amount, term and the particulars of the beneficiary and the principal in a manner leaving no room for doubt, prevent disputes that may arise later at the outset.
15. Conclusion and Recommendations
Bank letters of guarantee are, when structured correctly, instruments that provide strong and swift security in commercial relationships, but whose parties must well understand their risks owing to the first demand structure. The prominent considerations in this field are as follows. The guarantee nature of the letter of guarantee and its difference from suretyship must be correctly understood, and it must be known that the bank's undertaking is independent of the principal debt. In letters carrying a first demand clause, it must be borne in mind that the beneficiary has great collection power, and correspondingly that an unfair demand can be prevented only in obvious and liquid cases. The principal must avoid open-ended letters and limit the risk it assumes by term and amount. In international transactions, the counter-guarantee structure and express reference to the URDG 758 ensure that the relationship proceeds foreseeably. In the case of an unfair demand, the route of an interim injunction must be operated carefully, only on strong evidence and so as not to impair the function of trust of the guarantee. The legal review of the text of the letter of guarantee, of the rules to which it is subject and of the dispute resolution mechanism is the most productive investment to be made at the very outset of the process.
This article acquires its full meaning when considered together with the other legal layers of international trade. Our article on letters of credit and the UCP 600 rules, which addresses payment security, our analysis of choice of law and jurisdiction agreements in international commercial contracts and our article on the CMR Convention and the liability of the carrier address the matters that, together with the letter of guarantee, complete the security and payment structure of international trade.
For advisory services on bank letters of guarantee, independent guarantees under the URDG 758 rules, counter-guarantee structures, unfair demand and interim injunction proceedings and the structuring of international security and guarantee relationships, you may contact us at info@guzeloglu.legal.