Judicial Remedies for Guarantee Fraud and Abusive Demands on Independent Guarantees Under PRC Law

In recent years with the advancement of China’s “One Belt One Road” initiative, the use of independent guarantees, also known as demand guarantees (Guarantees), has become one of the most common tools used for supporting international trade, investment and project contracting. According to guarantee dispute cases collected and represented by the authors in recent years, we have found that Chinese enterprises are increasingly facing more guarantee demand disputes. This article focuses on analyzing risks of fraudulent callings and abusive demands under guarantees and counter-guarantees and the legal remedies seen from the perspective of Chinese law and in leading Chinese cases. ¹

1. Fraud and Abusive Demands under Independent Guarantees

1.1 Beneficiary Fraud and Abuse of Demand Rights under Guarantees: Article 12 of the Judicial Interpretation on PRC Independent Guarantee Provisions

Article 12 of the Provisions of the Supreme People’s Court of the People’s Republic of China on Several Issues Concerning the Trial of Disputes over Independent Guarantees (PRC Independent Guarantee Provisions)² stipulates five types of Independent Guarantee fraud:

Independent Guarantee fraud shall be found by a People’s Court under one of the following circumstances:

(1) The Beneficiary, acting in collusion with the Guarantee Applicant or any other party, has fabricated the underlying transaction;

(2) Any of the third-party documents presented by the Beneficiary is forged or contains false information;

(3) Any court judgment or arbitral award finds that the party obligated on the underlying transaction shall not be liable for payment or damages;

(4) The Beneficiary acknowledges that the obligations under the underlying transaction have been fully discharged or that the payment triggering event specified in the Independent Guarantee has not occurred; or

(5) The Beneficiary otherwise knowingly abuses its right to demand payment when it has no such right.

There are actually two exceptions to the independence principle: the first exception is Beneficiary Fraud provided in paragraphs (1), (2), (3) of Article 12, while the second exception is Beneficiary’s Abusive Demand Claims stipulated in paragraphs (4) and (5) of this article.

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1.1.1 Case 1: Tianjin Higher People’s Court: Gharibwal Cement Limited v. Sinoma Technology & Equipment Group Co., Ltd (Permanent Injunction Remedy against Guarantee Fraud)

In this case,³ the court held that there was no obvious evidence of default and the applicant had fully performed its design, delivery, and installment obligation; the project was in the test-run phase under the underlying contract. Therefore, the beneficiary made a fraudulent demand which constituted independent guarantee fraud and the Court ordered that the guarantor should terminate payment of the guarantee to the beneficiary. This is a case of success in that payment under the independent guarantee was permanently terminated properly by the court order.

1.2 Proof of Fraud under Counter-Guarantees

Generally speaking, there are two ways fraud can occur under a counter-guarantee: (1) collusion between the local guarantor and the local beneficiary where the local guarantor abuses its right to demand under the counter-guarantee even though it knows that the beneficiary’s demand under the independent guarantee is fraudulent; and (2) fraud by the local guarantor bank alone under the counter-guarantee.

1.2.1 Case 2: Supreme People’s Court Retrial Case: Inmobiliaria Palacio Oriental S.A. v. Anhui International Economic Construction (Group) Co., Ltd
(Proof of Fraud by Beneficiary and Local Guarantor, a Case of Failure for Application of Permanent Injunction under a Counter-Guarantee)

In determining fraud and abuse of rights in cases of cross-border independent guarantee demands, the Supreme People’s Court established the “double fraud” standard through judicial precedents.⁴ In order to determine whether fraud is found in an independent counter-guarantee, a court shall not only review for independent guarantee fraud itself, but also examine whether the local guarantor fraudulently asserted its rights to the counter-guarantor. Only when the local guarantor knows that the beneficiary has raised a fraudulent demand and nevertheless paid the beneficiary in violation of the principle of good faith (and meanwhile the local guarantor knowingly demands payment under the counter-guarantee from the counter guarantor) can it be determined that the local guarantor has made a fraudulent demand under the counter-guarantee.

1.2.2 Case 3: Supreme People’s Court Retrial Case: Sepco Electric Power Construction Corp. v. GMR Kamalanga Energy Limited (Beneficiary Fraud under the Local Guarantor, a Case of Failure for Application of Permanent Injunction under a Counter-Guarantee)

In this case,⁵ applicant Sepco Electric Power submitted the Arbitration Award under the underlying contract and a copy of the Declaration of the parent company of the GMR KAMALANGA Energy Limited (Energy Company), claiming that the beneficiary Energy Company had breached the underlying contract and knew that it had no right to demand payment under the independent guarantee, thus abusing its right to demand, which constituted independent guarantee fraud.

The Supreme People’s Court held that:

1.2.3 Case 4: Supreme People’s Court Retrial Case: CAMA Luoyang Aviation Protective Equipment Co. v. UBAF (Hong Kong)
(Proof of Local Guarantor’s Fraud, a Case of Partial Success of Permanent Injunction Being Granted under a Counter-Guarantee)

In this case,⁶ a local guarantor received a non-complying demand from the beneficiary. The local guarantor (a Hong Kong bank) on one hand dishonored the guarantee to the beneficiary who presented the demand because of a discrepancy. On the other hand, however, the local guarantor presented its demand to the counter guarantor (a Chinese bank), stating in the demand that it had received a complying demand from the beneficiary. In the second instance judgment, Supreme People’s Court of PRC held that the local bank’s action was fraudulent and accordingly provided Permanent Injunction against the counter-guarantee as the legal remedy.

2. Judicial Remedies for Beneficiary Fraud under Chinese Law: Granting and Denying Temporary and Permanent Injunction Orders

Article 13 of the PRC Independent Guarantee Provisions states:

The Applicant, the Issuer, or the Instructing Party of the Independent Guarantee may, prior to or during the court litigation or arbitral procedure, file a petition with a People’s Court of the Issuer’s domicile or any other People’s Court with competent jurisdiction over the Independent Guarantee fraud dispute to suspend the payment under the Independent Guarantee in the event they find out that any of the circumstances provided in Article 12 [Fraud] has occurred.

If the applicant becomes aware of independent guarantee (or counter-guarantee) fraud circumstances set out in Article 12 of the PRC Independent Guarantee Provisions, it may apply to the Chinese Court with jurisdiction for a temporary injunction order prior to filing of lawsuit or applying for arbitration to prevent the issuer or local guarantor from making payment. At the same time, Article 20 of the PRC Independent Guarantee Provisions provides:

After hearing a case on an Independent Guarantee fraud dispute, if a People’s Court finds beyond reasonable doubt that there is Independent Guarantee fraud, and that the circumstances provided in the third paragraph of Article 14 [Suspension of Payment] have not occurred, it shall enter a judgment terminating the payment obligation of the Issuer under the Independent Guarantee.

Thus, if a Chinese court with jurisdiction held that the case meets the circumstance in Article 20, the court will permanently terminate payment of the amount under the independent guarantee.