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Bank Guarantee: Should the Bank refuse payment?

Pedro Mota - 8 June 2020

The autonomous bank guarantee or "Upon first demand" is the guarantee by which the Bank that provides it is obliged to pay the beneficiary a certain amount of money, in the event of alleged non-performance or poor performance of a certain contract, the base agreement, without being able to invoke for its benefit any means of defence related to that same base agreement.

This type of guarantee has been provided by banks in the last 20 (twenty) years for two different purposes:

  1. The Guarantee for refund or repayment of advance payments (repayment bonds), which is intended to assure the contractor, who paid in advance, a part of the price established in a contract thus ensuring that the advance amount will be returned to him if the other party fails to repay instalments.
  2. The Guarantee of good performance of the contract (performance bonds) aimed at guaranteeing, before the beneficiary, the correct and punctual fulfillment of the obligations assumed by the other contractor in a given contract, for example, for the provision of services or works.

The possibility of legitimate refusal of payment by the Bank is limited to a very limited number of situations set out hereunder:

1st scenario

In case of manifest fraud or evident abuse in the activation of the guarantee by the beneficiary, that is, in cases where the Bank has in its possession evidence that the contractual breach has not occurred.

In this case, the Bank must refuse payment in the event of guarantee call, in result of the principle of good faith in the fulfilment of obligations and in the exercise of its rights to which the beneficiary of the guarantee is bound.

2nd scenario

The Bank finds it difficult to fully prove the knowledge that the payment is not due by the beneficiary, but the non-verification of the event is a self-evident or notorious fact.

Suppose that the Bank provides a guarantee of good execution of the subcontracting contract for painting works subject to the Public Procurement Code, and that the Bank has in its possession the provisional receipt of the general contract that occurred ten years ago.

Given that the guarantee period for such works is five years according to the Public Procurement Code, it is clear that all obligations arising from the subcontract contract have been extinguished. In the event that the Bank is confronted with the activation of the guarantee, it must refuse the payment based on the principle of good faith in the fulfillment of the obligations and in the exercise of its rights to which the beneficiary of the guarantee is bound.

The two scenarios, described above, give the Bank that issued the bank guarantee the right to cancel bank guarantees when (i) has in its possession evidence that the contractual non-compliance was not verified in the base agreement and (ii) has in its power evidence that the failure to verify non-compliance with the base agreement is an obvious fact.

This right of the Bank must be exercised, even if the bank guarantee mentions, for example, that (i) it is in force for an indefinite period or (ii) it is in effect until the original guarantee is returned (iii) or the guarantee remains in effect until cancelled by the beneficiary.

Once the possibility of non-compliance with the obligations arising from the base agreement is extinguished, the bank guarantee expires and ceases to have legal effects, since the Bank is no longer bound to make any payments under it.

This subject is of relevant importance to Banking, given the obligation to provision all guarantees that have not been cancelled.

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