Role of Demand Guarantees in International Trade
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 ”. 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.
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