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In English writings, traditionally the term "guarantee" denotes an accessory (secondary) or "conditional" type of obligation. The essence of the instrument is the promise to answer for the duty of another should the other default. The beneficiary of such a promise will not be entitled to payment unless it can adduce evidence of the occurrence of the event, which the guarantee secures. Thus the issuer’s liability to pay arises only in cases of actual default of the principal and not by a mere demand. In addition the issuer in cases of litigation can raise any defences available for the principal. Thus if it later appears that the contract between the principal and the beneficiary was void, the guarantor may raise this defence to avoid paying the beneficiary. In addition the surety could raise defences which are not available to the principal, these include (i) materially increasing the risk of the issuer without consent of the issuer by contract changes (ii) alterations (iii) improper payments. For further analysis on the defences available to the issuer.
Major differences distinguish letters of credit from “demand guarantees”; in the latter instrument the obligation to pay is conditioned within the terms of the bank’s promise, therefore if the demand guarantee is payable upon the beneficiary’s written first demand he is assured payment notwithstanding any defence related to any other underlying transactions. Proof of default is not needed and issuers are not concerned with the underlying contract nor can they raise any defence available to the underlying contracting party.
This type of guarantee is usually used in a wide range of different and often complex transactions. These transactions include: payment upon the seller’s default in a sale of goods transaction; security for service contracts or construction contracts; paying the fee of a solicitor in case he secures a divorce for a client; underwriting the liability of partners in joint venture agreements; and they have even been used to secure the payment of a ransom. Each type of business or transaction may require the issuance of a certain type of guarantee. The typical demand guarantee is simply used to provide financial security against default in performance of a non-money obligation, in which case the guarantee is usually given by the seller/contractor (the account party) to the buyer/employer (the beneficiary).
There is much terminological confusion when distinguishing between demand guarantees and accessory guarantees. Indeed the issue has been disputed in some recent cases. No precise term has yet been adopted to distinguish between the two types of instruments. English courts, however, have agreed that the decisive factor in determining the type of the guarantee is to be found in the terms of the guarantee itself and not in how the guarantee is referred to in a particular transaction.
In the United States and Canada, demand guarantees are seldom issued with most money center banks preferring to issue a standby letter of credit instead, primarily due to the banks familiarity with the undertaking. English courts give standby credits the same legal status that is given to demand guarantees. In the pecking order of seniority this, for the most part is true. In cases of a bank becoming insolvent all credit undertakings are deemed to be on par with the common shares of the bank. See Bank of International Settlements Basel II and Basel III accords.
However, fundamental differences exist between the nature of Demand Guarantees and SBLC's. For example, SBLC's are issued as a contingent liability of the issuing banks and are issued in conjunction with a primary means of underwriting being considered. In effect SBLC's are as they sound.. there in a "Stand-by" position to a primary means of repayment. Demand Guarantees can be issued to be the primary means for repayment. In which case they are not necessarily contingent in nature. Because of the contingent and secondary means of collateral nature of the SBLC, it would be considered counter-intuitive for a bank to underwrite a loan or facility strictly on the basis of receiving an SBLC. A bank lending against an SBLC alone in such a manner would in effect be purposefully underwriting a loan with the expectation that there was to be a default... Which is not something your typical bank regulators would approve.
Demand Guarantee can be issued as the primary means for meeting the loan or facility repayment terms.
Demand guarantees developed to replace money deposits, which sellers had to provide to buyers in order to secure the latter against the former’s default under the contract. The substitution of money deposits by demand guarantees helped account parties to maintain their liquidity: they were no more forced to tie up their money for a considerable period of time pending completion of the underlying contracts, and where the account party had no sufficient money to pay an upfront deposit it was relieved from the expense of borrowing cash from a banker and paying interest on the loan during its life. The account party also benefits from the low cost of demand guarantees compared to other instruments such as accessory guarantees.
The account party might not trust the beneficiary enough to agree to provide him with a cash deposit; similarly the beneficiary might doubt the account party’s solvency and therefore ability to fulfill the underlying contract or its ability to rectify defaults in performance. The demand guarantee bridges the “gap of distrust” that exists between the parties. When the bank issues the demand guarantee, the beneficiary deals with a party whose financial strength he can trust and a party which would pay upon first demand regardless of an existing dispute between the parties on the performance of the underlying contract. More importantly, however, the demand guarantee is also used to reallocate the risks between the parties. In this regard, the demand guarantee is used to avoid three types of risk: judgment risks, execution risks and jurisdictional risks. Judgment risks include, inter alia, risks involved in taking the dispute to court, losing on a procedural issue, the risk of an unfriendly court, evidentiary problems and the threat of political uncertainty that could prevent an action being brought against a party. Execution risks include the risk that a plaintiff could not execute a judgment against the defendant. This is often due to defendant insolvency or due to the unenforceability of one country’s court judgments in another country. Finally jurisdictional risks are part of both the above risks: they revolve mainly around the costs and difficulty that a party would endure when bringing an action against the defendant who is usually located in another jurisdiction. Where the beneficiary is issued a demand guarantee by a bank in his own locality, the guarantee aims “to shifting of risks and the cost of bearing them from [the beneficiary to the account party]”. Should the beneficiary find the contractor in default, he can immediately seek compensation by demanding on the guarantee and it is the account party who is forced to bring an action to recover any disputed amount. The premise in such transactions is that by agreeing to provide a demand guarantee both the account party and the beneficiary agree that the latter should not be deprived of his money (money due under the guarantee) by litigation against him at the suit of the account party.