First demand guarantees are excellent securities, but using them requires diligence

First demand guarantees have become well-established in Finnish financing and security operations during the last twenty years. Nowadays, the purpose of first demand guarantees is clear to all companies engaging in international business, and they are widely used both in financing agreements and extensive construction projects, for example. First demand guarantees are commonly used in international projects and financing because they are internationally known and well-established as security instruments. 

Well-prepared securities are necessary during economic downturns

During the current economic uncertainty and any economic recession there are, however, differing views of the situations in which first demand guarantees are binding on the guarantor and whether the guarantee is actually a commitment ancillary to the main agreement. History clearly repeats itself in this respect, because during the international bank crisis in the beginning of the 1990’s and the perhaps most difficult years of recession in Finnish history, people unfamiliar with guarantees gave the strangest assessments on the interpretation of first demand guarantees and how the rights under such guarantees are related to the main agreement. Some even suggested that a first demand guarantee was an unreasonable commitment in itself and should automatically be adjusted. In 1993, when I was writing a book on this matter, I heard constantly that first demand guarantees would be guarantees ancillary to the main agreement and the payment demands made based on a first demand guarantee would practically always constitute abuse of right. Fortunately, such claims are not made so often anymore.

When the economic cycle is good, actions concerning first demand guarantees are usually not instituted in courts or arbitral tribunals. However, if there is any lack of confidence or if a transaction forms a significant part of a party’s business operations, securities should be used in the transaction to safeguard the party’s position. Particularly during economic uncertainty, it is important that all security commitments used in business operations are prepared carefully and that the users know the basic issues in relation to using them. Well-prepared securities are sorely needed expressly during economic downturns.

Clear wording makes it easier to use and interpret security commitments

It is often forgotten that first demand guarantee arrangements are based on a binding offer and reply. Guarantee commitments are in practice given for what is agreed in the main agreement, even though a first demand guarantee is a commitment given by a third party to the creditor as a personal security commitment. If first demand guarantors could easily be released from their security commitments, it would immediately result in significant uncertainty in the market. During economic downturns, uncertainty regarding the operation of securities would lead to even bigger problems in business operations.

The starting point should be that first demand guarantees – like any other security commitment used in business operations – should be interpreted in accordance with the wording of each commitment. The less a security commitment leaves room for guessing the correct interpretation of its content and purpose, the clearer the use of the security commitment is. The wordings used in first demand guarantees have become established so that all terms and conditions deviating from established practice should be prepared carefully. In such a case, it should be noted that the terms and conditions of first demand guarantees are strict to start with, and they should not be unnecessarily mitigated.

Both parties need to be diligent when using securities

First demand guarantees are excellent securities in business operations, but the parties to the arrangement must be careful and diligent when preparing and drafting them. First demand guarantees are excellent collateral instruments because they are not ancillary to the main agreement, and the debtor (who is asking a third party to provide a first demand guarantee) cannot invoke the main agreement. The independence of a first demand guarantee is only severed in exceptional situations by the collateral taker’s fraudulent action. If the collateral taker in accordance with the main agreement or the first demand guarantee commitment acts fraudulently, the first demand guarantee or its independence are not given legal protection.

In addition, the operation of first demand guarantees is closely connected to the fact that the payment demand must be exactly in accordance with the guarantee. This principle, known as strict compliance, means that the first demand guarantor only pays the amount of guarantee if the payment demand under the guarantee has been made during the validity period of the guarantee and exactly in accordance with the terms and conditions of the guarantee. Otherwise, the first demand guarantor is not only entitled but also obligated to refuse to make the payment. For this reason, the creditor must carefully ensure when making the payment demand that the payment demand has been made correctly and in a timely manner.