Inconsistency in fraud exception and burden of proof

A well-recognized principle in independent guarantee disputes is that unless the fraud exception applies, the court will not review or determine the underlying transaction. However, if the fraud exception does apply, to what extent should the court assess the underlying transaction? The answer varies among different judges and courts. For example, the Hangzhou Intermediate People's Court was reluctant to review the underlying transaction in the case of China Machinery Engineering Corp. v. China Construction Bank Hangzhou Baoshi Branch due to the existence of a separate dispute resolution clause in the contract. There are also those who are only ready to carry out a review limited to issues connected to guarantee fraud. In Jiangsu Taihu Boiler Co. Ltd. v. PT. KRAKTAU Engineering, the Jiangsu Higher People's Court made it clear that the court's review should be limited to circumstances where the beneficiary abused its right of demand, i.e. the beneficiary knew very well that the principal did not breach the underlying contract but still demanded payment under the guarantee. And in other cases, the courts prefer a more in-depth and protracted investigation into the underlying transaction. For example, in Shenyang Mining Machinery Import & Export Corp. v. ELECTROTHERM (India) Ltd., the Shenyang Intermediate People's Court took the position that the court should investigate the underlying transaction and determine the fraud claim based on the results.

Chinese courts also take different views on the allocation of burden of proof. While most hold that the principal holds the burden to prove that there is no basis for the beneficiary to demand payment under the guarantee, there is at least one case where the court shifted the burden of proof to the beneficiary. In the same Shenyang Mining v. ELECTROTHERM case, the court held that the evidence submitted by the defendant, who was also the beneficiary of the guarantee, failed to prove the plaintiff's breach of contract and thus considered that the defendant's demand for payment constituted guarantee fraud.

The new Provisions

Chinese courts' jurisdiction confirmed

A key issue often debated is whether Chinese courts have jurisdiction over guarantee fraud disputes, especially if the underlying contract or the letter of guarantee has a dispute resolution clause referring to foreign litigation or arbitration. Historically, court attitudes regarding the jurisdiction issue have been more or less aligned—that guarantee fraud is of a separate and different nature from disputes arising out of the underlying contract or the letter of guarantee. The SPC Provisions reaffirm this position by stating that “the court at the location where the guarantor or the defendant is domiciled shall have jurisdiction over guarantee fraud disputes.” This shows that the local courts have jurisdiction over guarantee fraud claims only if the guarantee is issued by Chinese banks.

That said, the Provisions provide an opt-out mechanism for parties wishing to resolve any guarantee fraud dispute in a forum other than Chinese courts. Specifically, the parties may enter into a written agreement either before or after the dispute arises, selecting arbitration or a foreign court to govern the dispute.

Stricter criteria for suspension orders

Having realized that arbitrary issuances of suspension orders result in poor performances of independent guarantees and affect the reputation of Chinese banks and courts, the SPC's Provisions clarify the conditions for granting the order. They include:

1. the applicant (i.e. the principal to the independent guarantee) has provided evidence showing a high possibility that guarantee fraud exists;
2. the case is urgent and the applicant will suffer irreparable damages if no suspension of payment is ordered; and
3. the applicant has provided adequate security for compensating the damage that might be suffered by the respondent (i.e. beneficiary) due to improper application.

Compared with previous court practices, the SPC Provisions impose rather stringent obligations, such as by mandating courts to conduct a preliminary substantive review as to the existence of guarantee fraud. The test of “high likelihood” must be applied, a requirement in line with Article 20 of the United Nations Convention on Independent Guarantees and Stand-by Letters of Credit (UN Convention).

Another restriction imposed on the suspension order relates to the counter guarantee. According to the Provisions, the court should not issue a suspension order if the guarantor has already made a bona fide payment following the beneficiary's demand. In cross-border transactions, a counter guarantee issued by a Chinese bank is often required to secure the performance of the guarantee (usually issued in the beneficiary's home country). This restriction therefore helps mitigate the concerns of local protectionism posed by the state-owned nature of most Chinese banks, and may largely decrease the number of suspension orders.

However, one uncertainty remains as to what constitutes a “bona fide payment”. For instance, should a payment be regarded as “bona fide” if the bank does not notice the discrepancies in the beneficiary's demand documents? The principal may challenge the bank's intention by asserting that the bank's ignorance of the discrepancies implies bad faith. It therefore remains to be seen how the courts will interpret this in practice.

Scope of guarantee fraud clarified

The previous inconsistencies in court practices were mainly due to the silence in PRC law on the application of fraud exception. To resolve this issue, the SPC Provisions clearly specify what constitutes guarantee fraud. According to Article 12, guarantee fraud can only be established in the following circumstances:

1. the beneficiary and the principal or other parties colluded with each other to fabricate a sham underlying transaction;
2. a third party's document presented by the beneficiary is false or untrue;
3. a court judgment or an arbitral award decides that the debtor of the underlying transaction is not liable for payment or indemnity;
4. the beneficiary confirms that the underlying transaction has been fully performed or the condition for payment has not crystalized; or
5. any other circumstances under which the beneficiary abuses the right to demand payment while knowing that there is no basis for the demand.

SPC Judge Zhang Yong, the key driver of the Provisions, summarized the above grounds into three categories: (i) fabrication of a sham transaction to deceive the guarantor bank; (ii) forgery of documents presented by the beneficiary for the purpose of making a demand; and (iii) obvious abuse of the beneficiary's right to demand payment under guarantee. For the third category, the Provisions enumerate two examples that constitute the abuse of demand right—the principal's non-breach of the underlying contract has been confirmed by either a) a court judgment or arbitral award or b) the beneficiary himself. This is quite a narrow scope compared with previous court practices or the UN Convention. Although the SPC Provisions provide a catch-all provision aiming to cover other possible abuses of the demand right, the gravity of those violations should be proportionate to these two examples.

Defined extent of court review

Some judges previously reviewed underlying transactions in such a far-reaching manner that they seemed to be acting as the adjudicator of the dispute relating to the breach of the underlying contract. This is inappropriate in the view of the SPC Provisions, which reject an approach that resembles a substantive trial of the contractual dispute. Instead, the Provisions restrict the court's scope of review to only matters stipulated under Article 12 and raised by the principal.

The Provisions also require courts to apply the test of “beyond any reasonable doubt” in determining guarantee fraud claims. This standard is apparently higher than the “preponderance of probability” test previously applied by Chinese courts.

Fraud risk management

Based on the Provisions and observations of Chinese courts in handling guarantee fraud matters, foreign companies (as the beneficiary) wishing to avoid or mitigate risks connected to enforcement of independent guarantee letters in China are recommended to consider the following:

• If foreign companies have concerns of having fraud claims heard by Chinese courts, they may consider entering into a written agreement with all parties, such as the principal and the bank, to submit any fraud claim to arbitration or the exclusive jurisdiction of an overseas court. Ideally, parties can agree to submit disputes under the underlying contract, the guarantee letter and fraud claims to one venue. Arbitration is recommended due to the worldwide enforceability of the arbitral award under the New York Convention.
• Instead of having a Chinese bank directly issue the independent guarantee, foreign companies may request for a bank guarantee issued by foreign banks which can be supported by a counter guarantee issued by local banks.
• Foreign companies should properly document any default of the Chinese party that could trigger the demand for payment under the independent guarantee. If possible, foreign companies should consider soliciting an admission of fault or breach from the Chinese party. Also, in the event that the Chinese party commits any breach, foreign companies should avoid making any statement which could be deemed by Chinese courts as a confirmation of completion of the contractual performance by the opposing party.

Peng Shen, Special counsel, and Hailin Cui, Associate
Baker & McKenzie, Beijing

A record number of Chinese enterprises have been investing overseas after the PRC government's unveiling of the One Belt, One Road strategy. This, in turn, boosted the growth of the independent guarantee business of domestic banks, with official figures pinning the total value of independent bank guarantees issued by Chinese banks in 2015 alone at $292.92 billion.

But their selective dishonoring of bank guarantees has been criticized over the years. A number of foreign companies have been aware of the non-enforceability of guarantees issued by Chinese banks due to inconsistency in both local courts' granting of suspension orders for payments under the independent guarantee and decisions regarding guarantee fraud matters. To ensure enforceability and unify court practices, on November 18, 2016 the Supreme People's Court (SPC) issued the Provisions on Several Issues Concerning the Trial of Independent Guarantee Dispute Cases (Provisions), which came into effect on December 1.

The release of these Provisions is a milestone. They define, and set out the scope for, independent guarantees for the very first time. They also recognize the legal effect of domestic independent guarantees—a mark of true judicial innovation in China. Most importantly, they improve the protection of independent guarantees by limiting the issuance of a suspension order and the application of the fraud exception rule. Guarantee fraud is the only means available for challenging guarantee demands in China and has been frequently deployed by domestic businesses to avoid payment.

Traditional court practices

Suspension orders casually granted

Compared with other jurisdictions such as the UK where it is difficult to succeed in an application for a suspension order, it is relatively easy to obtain one in China. Local courts regard the suspension order as a form of preservation measure under the PRC Civil Procedure Law. Accordingly, the courts apply the following conditions when determining whether to grant the order:

1. irreparable harm will be caused if the order is not granted; and
2. security is provided.

In practice, the courts usually give less weight to the first condition (as irreparable harm is often presumed) and primarily focus on the second. Previous cases suggest that as long as the principal (i.e. the guarantee applicant) claims guarantee fraud to the court and provides security to the court's satisfaction, the court will likely grant the suspension order.

Inconsistency in fraud exception and burden of proof

A well-recognized principle in independent guarantee disputes is that unless the fraud exception applies, the court will not review or determine the underlying transaction. However, if the fraud exception does apply, to what extent should the court assess the underlying transaction? The answer varies among different judges and courts. For example, the Hangzhou Intermediate People's Court was reluctant to review the underlying transaction in the case of China Machinery Engineering Corp. v. China Construction Bank Hangzhou Baoshi Branch due to the existence of a separate dispute resolution clause in the contract. There are also those who are only ready to carry out a review limited to issues connected to guarantee fraud. In Jiangsu Taihu Boiler Co. Ltd. v. PT. KRAKTAU Engineering, the Jiangsu Higher People's Court made it clear that the court's review should be limited to circumstances where the beneficiary abused its right of demand, i.e. the beneficiary knew very well that the principal did not breach the underlying contract but still demanded payment under the guarantee. And in other cases, the courts prefer a more in-depth and protracted investigation into the underlying transaction. For example, in Shenyang Mining Machinery Import & Export Corp. v. ELECTROTHERM (India) Ltd., the Shenyang Intermediate People's Court took the position that the court should investigate the underlying transaction and determine the fraud claim based on the results.

Chinese courts also take different views on the allocation of burden of proof. While most hold that the principal holds the burden to prove that there is no basis for the beneficiary to demand payment under the guarantee, there is at least one case where the court shifted the burden of proof to the beneficiary. In the same Shenyang Mining v. ELECTROTHERM case, the court held that the evidence submitted by the defendant, who was also the beneficiary of the guarantee, failed to prove the plaintiff's breach of contract and thus considered that the defendant's demand for payment constituted guarantee fraud.

The new Provisions

Chinese courts' jurisdiction confirmed

A key issue often debated is whether Chinese courts have jurisdiction over guarantee fraud disputes, especially if the underlying contract or the letter of guarantee has a dispute resolution clause referring to foreign litigation or arbitration. Historically, court attitudes regarding the jurisdiction issue have been more or less aligned—that guarantee fraud is of a separate and different nature from disputes arising out of the underlying contract or the letter of guarantee. The SPC Provisions reaffirm this position by stating that “the court at the location where the guarantor or the defendant is domiciled shall have jurisdiction over guarantee fraud disputes.” This shows that the local courts have jurisdiction over guarantee fraud claims only if the guarantee is issued by Chinese banks.

That said, the Provisions provide an opt-out mechanism for parties wishing to resolve any guarantee fraud dispute in a forum other than Chinese courts. Specifically, the parties may enter into a written agreement either before or after the dispute arises, selecting arbitration or a foreign court to govern the dispute.

Stricter criteria for suspension orders

Having realized that arbitrary issuances of suspension orders result in poor performances of independent guarantees and affect the reputation of Chinese banks and courts, the SPC's Provisions clarify the conditions for granting the order. They include:

1. the applicant (i.e. the principal to the independent guarantee) has provided evidence showing a high possibility that guarantee fraud exists;
2. the case is urgent and the applicant will suffer irreparable damages if no suspension of payment is ordered; and
3. the applicant has provided adequate security for compensating the damage that might be suffered by the respondent (i.e. beneficiary) due to improper application.

Compared with previous court practices, the SPC Provisions impose rather stringent obligations, such as by mandating courts to conduct a preliminary substantive review as to the existence of guarantee fraud. The test of “high likelihood” must be applied, a requirement in line with Article 20 of the United Nations Convention on Independent Guarantees and Stand-by Letters of Credit (UN Convention).

Another restriction imposed on the suspension order relates to the counter guarantee. According to the Provisions, the court should not issue a suspension order if the guarantor has already made a bona fide payment following the beneficiary's demand. In cross-border transactions, a counter guarantee issued by a Chinese bank is often required to secure the performance of the guarantee (usually issued in the beneficiary's home country). This restriction therefore helps mitigate the concerns of local protectionism posed by the state-owned nature of most Chinese banks, and may largely decrease the number of suspension orders.

However, one uncertainty remains as to what constitutes a “bona fide payment”. For instance, should a payment be regarded as “bona fide” if the bank does not notice the discrepancies in the beneficiary's demand documents? The principal may challenge the bank's intention by asserting that the bank's ignorance of the discrepancies implies bad faith. It therefore remains to be seen how the courts will interpret this in practice.

Scope of guarantee fraud clarified

The previous inconsistencies in court practices were mainly due to the silence in PRC law on the application of fraud exception. To resolve this issue, the SPC Provisions clearly specify what constitutes guarantee fraud. According to Article 12, guarantee fraud can only be established in the following circumstances:

1. the beneficiary and the principal or other parties colluded with each other to fabricate a sham underlying transaction;
2. a third party's document presented by the beneficiary is false or untrue;
3. a court judgment or an arbitral award decides that the debtor of the underlying transaction is not liable for payment or indemnity;
4. the beneficiary confirms that the underlying transaction has been fully performed or the condition for payment has not crystalized; or
5. any other circumstances under which the beneficiary abuses the right to demand payment while knowing that there is no basis for the demand.

SPC Judge Zhang Yong, the key driver of the Provisions, summarized the above grounds into three categories: (i) fabrication of a sham transaction to deceive the guarantor bank; (ii) forgery of documents presented by the beneficiary for the purpose of making a demand; and (iii) obvious abuse of the beneficiary's right to demand payment under guarantee. For the third category, the Provisions enumerate two examples that constitute the abuse of demand right—the principal's non-breach of the underlying contract has been confirmed by either a) a court judgment or arbitral award or b) the beneficiary himself. This is quite a narrow scope compared with previous court practices or the UN Convention. Although the SPC Provisions provide a catch-all provision aiming to cover other possible abuses of the demand right, the gravity of those violations should be proportionate to these two examples.

Defined extent of court review

Some judges previously reviewed underlying transactions in such a far-reaching manner that they seemed to be acting as the adjudicator of the dispute relating to the breach of the underlying contract. This is inappropriate in the view of the SPC Provisions, which reject an approach that resembles a substantive trial of the contractual dispute. Instead, the Provisions restrict the court's scope of review to only matters stipulated under Article 12 and raised by the principal.

The Provisions also require courts to apply the test of “beyond any reasonable doubt” in determining guarantee fraud claims. This standard is apparently higher than the “preponderance of probability” test previously applied by Chinese courts.

Fraud risk management

Based on the Provisions and observations of Chinese courts in handling guarantee fraud matters, foreign companies (as the beneficiary) wishing to avoid or mitigate risks connected to enforcement of independent guarantee letters in China are recommended to consider the following:

• If foreign companies have concerns of having fraud claims heard by Chinese courts, they may consider entering into a written agreement with all parties, such as the principal and the bank, to submit any fraud claim to arbitration or the exclusive jurisdiction of an overseas court. Ideally, parties can agree to submit disputes under the underlying contract, the guarantee letter and fraud claims to one venue. Arbitration is recommended due to the worldwide enforceability of the arbitral award under the New York Convention.
• Instead of having a Chinese bank directly issue the independent guarantee, foreign companies may request for a bank guarantee issued by foreign banks which can be supported by a counter guarantee issued by local banks.
• Foreign companies should properly document any default of the Chinese party that could trigger the demand for payment under the independent guarantee. If possible, foreign companies should consider soliciting an admission of fault or breach from the Chinese party. Also, in the event that the Chinese party commits any breach, foreign companies should avoid making any statement which could be deemed by Chinese courts as a confirmation of completion of the contractual performance by the opposing party.

Peng Shen, Special counsel, and Hailin Cui, Associate
Baker & McKenzie, Beijing