Performance Guarantee and Letter of Credit
A performance guarantee stands on a similar footing to a letter of credit. A bank that gives a performance guarantee must honor that guarantee according to its term. Studies show that performance guarantees have become an established aspect of international trade, and somewhat their activities are similar to those of standby letters of credit (Kozolchyk 319). Both are usually treated as confidential contracts whose actions shall not be interfered with by the courts or any other legal institution on the grounds of immaterial to either the credit or guarantee. However, although performance guarantees and letters of credit have similarities in many aspects, there are also some differences, such as when there is a fraud that has come to the attention of the bank.
Performance guarantees
A performance guarantee is an instrument issued by the bank or any other financial institution for payment of a stipulated amount of money. Most performance guarantees are payable on first demand without the need for any additional documents. As a result, performance guarantees have continually replaced cash deposits. In other terms, a performance guarantee is considered as a cash substitute, and for this reason, it must be honored. It is more of personal security where the bank promises payment on the impending beneficiary should the principal default on the performance of his obligation as indicated in a contract (Guttmann 167). It is as well essential to note that performance guarantees are issued in lieu of cash deposits to preserve the liquidity of companies involved, especially in cases where there is no enough cash on hand. Even though the issuance of a performance guarantee may be considered as an insolvency issue resulting in a considerable amount of risk, it is critical for the survival of some companies. This is so because performance guarantees help companies with a limited amount of cash reserve to operate without tying up more capital.
The primary purpose of a performance guarantee is to enable a beneficiary to have immediate access to funds to remedy any alleged default in the underlying contract with the principle. The idea for this particular financial instrument is to ‘pay now’ and dispute later. Through this, it prevents the performance of the project in question from getting held up due to lack of funds. It is required that the bank pays if documents for payment comply with those mentioned in the demand guarantee. As a result, the bank’s obligations remain to be autonomous from the impending contract between the principal and defendant. This implies that, in principle, the ban is obligated to pay if complying documents are presented even in a case where the principle and beneficiary have noted the there is a default in the original impending contract. Therefore, once the terms and conditions of a performance guarantee are met, the beneficiary is automatically entitled to claim payment.
Performance guarantees are used in a wide range of aspects such as in construction contracts and contracts for international sale and purchase of goods and services. In construction contracts, performance guarantees provide a monetary amount that can be claimed by the guarantee of the beneficiary in the case a contractor fails to meet their obligation as agreed upon in the contract. An example of a case that illustrates how a performance guarantee works in a contract is the Clough Engineering Limited v Oil & Natural Gas Corporation Limited [2008] FCAFC 136. In this case, it was established that a party to a contract might require a performance guarantee under two circumstances. One is when there is when to provide security when there is a claim in the contract, and there has arisen some difficulties in recovering from the other party. The second situation is when the beneficiary needs to be allowed to make a call in a bare claim before the determination of the entitlement claim. The court used this case to put more emphasis on the difference between the two situations. It stated that in case the guarantee is unconditional, just like in the present case, the court would generally assume the latter alternative.
Under the sale contract act, performance guarantees are used to secure performance. Securing performance entails providing security in the case of non-performance of a contract. The working of performance guarantee has been illustrated in the Edward Owen Engineering Ltd v Barclays Bank International Ltd. In this particular case, the appellant Edward Owen (A) entered into a contract with a buyer from Libya (B) to not only supply but also erect glasshouses at strategically identified areas. Here, payment was to be effected under a confined letter of credit, and as such, A was to provide a 10% performance guarantee of the contract value. It followed that A Instructed B to give a bond against their counter-guarantee. As such, the defendant took a deliberate action to instruct Umma Bank, Libya, the bond payable ‘one demand without a letter of proof or condition.’ Since B had failed to open the letter of credit, in response, A refused to supply the items. Regardless, B made a claim from Umma Bank under the performance guarantee and Umma bank and, in turn, claimed directly from Barclays Bank International. The court granted an interim injunction to restrain B from paying. Upon appeal, the Court of Appeal indicated that an injunction should not be allowed. In this case, the performance guarantee was seen to be similar to a letter of credit. This is so because the undertaking of the bank and the underlying contract were two separate entities. As such, it was required that the bank fully owners its obligations as long as the terms of the impending guarantee were satisfied.
A letter of credit
A letter of credit is a financial instrument used in both domestic construction projects and international trade. It is issued by a bank on behalf of the buyer to make payments to the beneficiary upon fulfillment of obligations. The buyer applies for a letter of credit and presents a credit substantiation or collateral to justify the issuance of the letter of credit and, for that reason, pays the bank some fees. A letter of credit has its origin as a way of circumventing a banking law that categorically proscribes banks or other financial institutions from assuming liability for third party obligations. Besides, a letter of credit plays the same role as a performance guarantee, in this case, however, without committing its assets. It is as well essential to note that even though the bank is liable for payment upon submission of a letter of credit and relevant supporting document, the bank’s assets cannot be caught in the crossfire because they are not committed to the transaction for various reasons. This is so because, in most cases, the buyer has been approved for a loan that has been guaranteed by standard loan underwriting or has deposited sufficient funds with the issuing bank. In the United States, letters of credit were created as a means of payment undertaking that is primary in form but intends to be used a fall back in the event where the principal defaults any of the terms of the contract. Today, letters of credit are extensively used in a wide range of transactions, including trade investments, lease agreements, and stock purchases.
There are different types of letters of credit, depending on the nature of the transaction undertaken. Here, it is essential to note that even though there are a definite place and time for each type of letter of credit, people should be aware that there are specific stipulations that might result in increased bank fees or features that might otherwise cause future problems for either of the parties involved. Some common types of letters of credit include confirmed. Irrevocable, transferable, read the clause, Differed, and letter of credit at sight. A confirmed letter of credit entails adding more security to ensure the seller further. It has an additional stipulation, which indicates that in a situation where the buyer’s issuing bank defaults from paying the agreed amount, the seller’s bank guarantees the payment instead. Transferable letters of credit are often used in cases involving intermediaries or when there are more than two parties involved. In this particular case, the credit can easily be transferred to other entities as long as the first beneficiary agrees.
A letter of credit at sight indicates that all payments shall be made as soon as received goods or services are documented. The payment may either be done by the buyer or the buyer’s issuing bank and, in that way, providing more time for the buyer to fulfill the debt. Apart from the letter of credit at sight, we have the red clause letter of credit. This is of a unique type because it obligates the buyer’s issuing bank to make partial payments to the seller before shipping the product or providing any other service. Also, we have the deferred letter of credit, which is often used to allow for deferred payments for a specified period from the buyer. This type of letter of credit aims to reduce the risk of non-payment and the overall cost of the letter of credit. Besides, a deferred letter of credit is considered to be more enticing for buyers, thus making it more likely to accept buying goods and services. Finally, there is the irrevocable letter of credit that allows the buyer to either amend or cancel the letter of credit provided that other parties involved agree.
Comparative analysis of a letter of credit and performance guarantee
Letters of credits, in many instances, are used in place of performance contracts across many parts of the globe. There is, however, a general misconception that performance guarantees are different from letters of credit, which might be true in some way and different, not valid in other ways. The similarity or difference mainly depends on the context. For example, in the United States, when banks were banned from using performance guarantees, the term, letter of credit was adopted to stand in for the performance guarantees. As such, from a legal point of view in the United States, performance guarantees are similar to a letter of credits. This is because both are financial instruments, are dependent on the underlying contract, and they are both documentaries in character. Perhaps, the only difference that could exist here is that of practice and business use.
Besides, from the commercial point of view, a letter of credit is considered a different product because it supports moneyless performance and an extreme range of other financial performances. Nevertheless, both documents are monitored and governed by banking practices which makes them more similar than different
Over the years, a letter of credit has developed into an inclusive financial support instrument that comprises a broader range of uses apart from the normal performance guarantee. Letters of credit are now used to support both financial and non-financial obligations of the principal as well as provide assured credit enhancement for its undertaking. Evidence shows that, unlike other countries, in the United States, letters of credit are mostly used to guarantee money obligations that have been incurred in transactions on the capital market. As such, the letter of credit is becoming more similar to a performance guarantee. Also, concerning their legal regime and function, letters of credit and performance guarantee are identical, with their form being the main difference. Even though slight variations exist between a letter of credit and a demand guarantee, according to the law, there is no difference between these two financial instruments and implicated by Edward Owen Engineering Ltd v Barclays Bank International Ltd.
Even though historical differences exist in the development of these two financial instruments, they still serve the same economic function and, for this reason, are somehow considered to be equivalent. A letter of credit seeks to compensate a beneficiary an agreed amount of money upon failure of the principal to default payment or any other obligation, and so does a performance guarantee. Examples of cases that can be used to illustrate the similarity in the functionality of a letter of credit and a performance guarantee include National Infrastructure Development Co. Ltd. v. BNP Paribas [2016] and Wood Hall Ltd v The Pipeline Authority (1979). The latter is a performance guarantee case that saw the complainant compensated for the losses suffered in a contract with the defendant. A similar compensation was awarded to the claimant in the first case. These two cases clearly indicate that the two financial instruments can be used to substitute each other. From the above examples, one can also deduct that the use of the terms, ‘performance guarantee’ and ‘letter of credit,’ only depend on the geographical setting. In some areas, what is referred to as a letter of credit may be a performance guarantee in other areas.
In areas where a letter of credits can be differentiated from performance guarantees, the difference is often on the scope of protection that the documents can provide to the beneficiary. A performance guarantee offers more protection than a letter of credit. The latter would only protect non-payment while a performance guarantee would protect a wide range of situations that include non-performances, underperformances, and in late performances. The other difference, and perhaps the main one, is as illustrated in theThemehelp Ltd v West. In this case, it was established that both performance guarantees and letters of credit could be treated as autonomous contracts. However, the presiding judge in the case pointed out that there would only be an exception when there is a fraud. In his judgment, Waite LJ, the presiding judge, cited the famous Lord Diplock’s formula, which explains how the presentation of documents in a fraudulent form may alter the similarity between a letter of credit and a performance guarantee.
The fraud exception
The autonomy of letters of credits and performance contracts is altered when fraud exists in either document. The fraud exception exists both when there is fraud in the tendered documents and when there is a fraudulent transaction that mainly aims to make a payment claim fraudulent. When there is a possibility of the existence of fraud in either the letter of credit or performance guarantee, proving of such evidence is what brings the difference between the two. Fraud can exist when, for instance, one forges documents, and thereby the court uses these documents to make judgments. The forging can be in the form altering a part of the whole of the document or making a contractual agreement document without the consent of the other party. The difference, therefore between a performance guarantee and a letter of credit concerning fraud evidence is that in a letter of credit, the for one to prove that demand for payment is fraudulent, there should be proof that the defendant knows that there is fraud or rather, the circumstances surrounding the demand have interfered with fraud. On the other hand, in a performance guarantee, as established in the Insaat Ve Sanayi A.S v Banca Populare Dell’Alto Adige SPA, as long as there is evidence of fraud, whether the defendant knows it or not, the whole contractual process is considered illegal.
Therefore, one of the differences brought out by the fraud exception is that while it would be challenging to provide evidence for fraud in the case of letters of credit, it is somehow easier to do so in performance guarantees. An example of a fraud exception case regarding letters of credit is the National Infrastructure Development Co Ltd v Banco Santander SA [2017] EWCA Civ 27 (NIDCO v Santander. In this case, after a dispute between the parties, the complainant made a fraudulent claim of $ 35 million instead of $ 31 million, which had been agreed upon in the letter of the contract. The court first sleeked to be satisfied that the complainant was aware of their misrepresentation before making the final judgment. On the other hand, in the Enka Insaat Ve Sanayi A.S v Banca Populare Dell’Alto Adige SPA [2009], all the court needed to establish was whether there was a misrepresentation or rather, fraud payment demand that had been made by the defendant. There was no need to establish whether the defendant was aware of the fraud or not. All the above cases concern fraud exception, but the first one is under letters of credit, while the second one is underperformance guarantee. As can be seen, proving for the existence of fraud in letters of credit is more difficult when compared to proving the same thing in performance guarantees.
Conclusion
Buyers of goods and services both in domestic and international trade insist on the issuance of a performance guarantee. With a performance guarantee, the buyer is assured of security for the due performance of the seller’s obligations in the underlying contract. Besides, for this process to be effective, a bank provides its undertakings to pay but in certain right circumstances, for instance, where a buyer demands payment to be made. If this particular demand is made in accordance with terms of the guarantee, the bank is automatically obliged to not only make payments but also look to its customers for indemnity. Based on this analysis, it is conclusive that a letter o of credit is on a similar footing to a performance guarantee. This is so because a bank that issues a letter of credit or performance guarantee must always commit to honor the warranty according to its terms fully. It is as well essential to note that when one of these named financial instruments has been issued, the bank is not concerned about the relations of the supplier and buyer but rather whether or not the supplier has successfully performed its obligations as outlined in the underlying contract. It is a question of whether or not the supplier has defaulted their obligations. In the case of a default, the bank must ensure that it pays according to its instruments and on-demand as stipulated in the underlying contract. The only difference that exists between the two documents is the scope of protection that they can offer to the beneficiaries. Nevertheless, the two documents are similar in many ways and are, at times, used interchangeably.
Works cited
Kozolchyk, Boris. “Emerging Law of Standby Letters of Credit and Bank Guarantees, The.” Ariz. L. Rev. vol. 24, no. 1, 1982, pp. 319.
Guttmann, Egon. “Bank Guarantees and Standby Letters of Credit: Moving Toward a Uniform Approach.” Brook. L. Rev. vol. 56, no. 2, 1990, 167.