Edited by Massimo Ferracci

Premise

The most in-depth and directly applicable work to financial institutions (including banks) regarding due diligence processes in foreign transactions is that carried out by the Financial Action Task Force – FATF (also known as GAFI).

It is a major international institutional body that sets international standards regarding, among other things, legislation on corruption and anti-money laundering.

In 1990, the FATF issued forty Recommendations, which are periodically updated. Nine Special Recommendations focused on the fight against terrorism have since been added.

The first recommendations concern the commitment of States in the fight against corruption and money laundering, while the next section deals with the "measures that financial institutions, non-financial businesses and professions must take to prevent money laundering and the financing of terrorism."

Among the standards promoted by the FATF, some are of more direct interest to the banking sector: Recommendation 5 requires banks to identify, among other things, the ultimate beneficiary of every foreign transaction. Recommendation 5 then specifies the due diligence elements that banks should consider to properly assess their customers. The elements of Customer Due Diligence (CDD) are:

1.  identify the customer and verify that the customer's identity is reliable, using independent sources and appropriate documentation and information;
2.  Identify the ultimate beneficiary of each transaction and take reasonable steps to verify the ultimate beneficiary's identity so that the financial institution is satisfied with the information collected. For legal entities, this should include gathering sufficient information to understand the customer's ownership and control structure;
3.  obtain information on the purpose and nature of the business relationship between the financial institution and the customer;
4.  Conduct ongoing due diligence on the relationship and the customer relationship and monitor transactions conducted throughout the duration of this relationship to ensure that the transactions conducted are consistent with the financial institution's knowledge of the customer, its business and risk profile, including, where applicable, the source of funds.

International bank guarantees also fall within this category, which we will now examine in detail.

Bank guarantees are instruments used to secure a debtor's obligations in foreign transactions. More specifically, they are personal guarantees issued by banks on behalf of their clients in the form of surety bonds or independent guarantee agreements.

A guarantee is personal when the person providing it obligates himself, with all his assets, towards a creditor to fulfill an obligation of another person.

Since international sureties and guarantees fall under the category of signature credits, they do not constitute an immediate loan of money from the bank but rather a commitment to address the potential insolvency or default of the customer for whom they are requested.

Guarantees are generally governed by the issuing bank's national law. Under Italian law, suretyship relationships are governed by Articles 1936 to 1957 of the Civil Code, as well as Articles 700, 701, and 702 of the Code of Civil Procedure, which establish that the debtor may prevent the issuing bank from performing its obligation in the event of enforcement.

The surety bond

Article 1936 of the Civil Code defines a guarantor as "...he who, by personally binding himself to the creditor, guarantees the fulfillment of another's obligation."

The surety bond is ancillary to the principal obligation and legally follows its fate. The guarantor can therefore raise against the creditor all the exceptions available to the principal debtor, refusing payment if the creditor is entitled to it and is not in default.

The autonomous guarantee

The autonomous guarantee is an atypical surety because it is completely abstract, separate from the contract between debtor and creditor and from the primary debt relationship.

It is an irrevocable commitment made by a bank to perform a financial service on first demand in the event that a third party fails to fulfill a specific obligation, provided that the conditions set out in the text of the guarantee have been met.

Therefore, any objections that the principal debtor might have raised cannot be raised and the bank cannot refuse payment.

If the supplier fails to fulfill, or only partially fulfills, its contractual obligations, the beneficiary will enforce the guarantee, without prejudice to the debtor's right, with all the implications that this entails, to resort to Article 700 of the Italian Code of Civil Procedure.

The autonomous payment guarantee is, due to its abstract nature, the most widespread and preferred form by creditors in the international arena.

However, the independent guarantee is independent of the provisions of Articles 1936 et seq. of the Civil Code. To prevent disputes by the debtor against the Bank for having paid sums not owed by him, or which he believes to be undue, it is therefore essential to clarify the characteristics of the guarantee at the time of the request and not to indicate any reference to "surety" or "guarantor" in the guarantee text, but rather to use terms such as "letter of guarantee," "commitment," or "guarantor." The customer, aware of the risks associated with the independent guarantee, namely that in the event of unjustified and unfair enforcement, the bank cannot refuse payment,

THE “ON FIRST DEMAND” GUARANTEES

The phenomenon of payable guarantees “on first demand” represents a form of self-defense developed in the practice of transnational trade as a product of the community of mercatores In response to the growth of risk factors resulting from greater global economic integration. For this reason, these guarantees were born and developed to meet the needs of transnational trade, autonomously and independently of national laws tied to traditional principles and categories.

In particular, these guarantees fulfill the security function precisely in the international context against the risks of "contract breakdown" caused by a large number of situations that are often linked and unforeseeable. In fact, the beneficiary is guaranteed against the failure to perform or the incorrect performance of the obligation set out in the contract even in the case in which the non-performance is not attributable to the debtor, transferring the "atypical risks” (as long as they are not linked to causes of non-performance) such as: economic policy laws of the debtor's country (restrictive measures for war reasons, confiscation of goods, import or export bans, currency obstacles); unexpected obstacles in the case of civil engineering contracts.

With these guarantees, the guarantor undertakes to pay a certain sum of money upon simple demand, provided that the beneficiary declares that certain conditions have been met: this is their peculiar characteristic. From this perspective, it can be observed how the "bonds"are substantially equivalent to bonds with the undeniable advantage of not requiring expensive immobilization of money, ensuring the beneficiary the availability of a sum that allows him to immediately compensate for damages, in contrast to the traditional "suretyship”which makes the right to payment subject to proof of default provided by the beneficiary.

In general, the function performed by the “bank guarantee” is to reallocate the risks between the principal debtor (“account party”) and the creditor (“benefit”). The extent of this reallocation of risks between the parties depends on the types of conditions to which payment is made subject.

In this sense, the “first demand bond”, that is, the type of guarantee that is predominantly used by economic operators in the context of transnational trade, is certainly characterised by a complete reversal of risks, operating according to the principle expressed by the well-known condition “pay first, argue later”. In fact, the beneficiary has the right to immediate payment (without having to demonstrate the debtor's default) which the bank will honour so as not to damage its own standing international.

TYPES OF BONDS AND ECONOMIC RISKS

The variety of risks associated with the life cycle of a contract, from pre-contractual negotiations to its conclusion and performance, can be covered by different types of guarantees. Although they bear different names, they serve the same purpose: protection against the principal's non-performance. However, the "labels" affixed to these guarantees often do not fully reflect their scope of application. For this reason, it is appropriate that the description of the covered risk be explicitly stated in the contract, along with the terms, conditions, and any other associated guarantees.

Performance Bond or Guarantee of Good Execution

The Performance Guarantee or Performance Bond or Garantie de bonne exécution or, finally, Guarantee of good execution defines the obligation that the issuing bank assumes, at the request of a supplier of goods or services, to make a payment to the beneficiary within the limits of a declared sum of money, or, if the guarantee so provides, the guarantor's choice to procure the execution of the contract, in the event of non-compliant execution by the ordering party of a contract stipulated between the same and the beneficiary.

Main features

Among the risks of the importer or the client of works, there is certainly also the risk that the goods received or the works completed do not comply with the agreed contractual conditions.

Leaving aside the risk of the importer of goods, due to its short duration, we must instead examine the much higher risk of the client of the works.

While it is true that the latter can sometimes check the quality and conformity of the works as they are carried out, it is also clear that for large "turnkey" systems the final verification will be possible only once the works are completed.

The company that competes for such work is therefore required to have a bank issue a Performance Bond, which guarantees its proper execution.

The purpose of the Performance Bond is to provide the client with a guarantee regarding the supply of the goods or the work to be performed, and must also be made valid for the period of time elapsing until the full delivery of the goods supplied or the full execution of the contractually established work.

The Performance Bond is issued upon awarding the contract and lasts until the completion of the work; the amount, which is naturally determined as a percentage of the contract price, is generally not subject to partial reductions, as is the case with the Advance Payment Bond, which will be discussed later.

International standards further specify that if the guarantee does not specify a final date by which the enforcement request must be received by the guarantor, such final date (expiry date) is deemed to be six months from the date specified in the contract for delivery or completion or from that of any related extension, or one month after the expiry of any maintenance period (guarantee period) provided for in the contract, if such maintenance period is expressly covered by the performance guarantee.

If no enforcement request has been received by the guarantor by the expiration date or if the claim submitted under the guarantee has been accepted in full satisfaction of all the beneficiary's rights, the guarantee ceases to be valid.

Finally, if a guarantee does not specify the documentation to be produced in support of a request for enforcement or simply requires a declaration of enforcement by the beneficiary, the beneficiary must present a judicial ruling or an arbitration award justifying the request, or the written agreement of the person ordering the request and the amount to be paid.

The Performance Bond therefore guarantees the client the payment of an amount as compensation for the damages that would arise from the failed or inadequate execution of the works and the supply of goods.

The guarantee, however, does not cover the costs that the client, the beneficiary of the Performance Bond, would incur as a result of the termination of the contract, namely those inherent in the need to call for another tender, bear any price increases that may have occurred in the meantime, and delay the execution of the scheduled work with the inevitable inconveniences.

But if the risks faced by the client are significant, it can be said that those faced by the customer are greater.

In fact, the concept of "good performance" includes objective elements, but also presents subjective considerations that should not be overlooked, regarding the quality and quantity of the client's performance, and such evaluations are entrusted exclusively to the client.

Precisely because of this subjectivity, first-demand guarantees can be called upon by the beneficiary arbitrarily, even if the beneficiary is acting in good faith.

Then, and not as rarely as one might think, bad faith foreclosures occur.

The customer would thus be deprived of a significant portion of its revenue, without any demonstration by the client of poor execution of the work or of the supply, even at an advanced stage of the work, if not even concluded, after having borne all the related costs.

There are therefore obvious interpretative problems with the concept of "good performance." In contracts that simply provide for the delivery of goods, good performance is limited to the result of the agreed-upon goods conforming to the contract.

In contracts that, however, provide for the execution of works in concept, the process is more complex because it extends to checking the appropriateness and quality of the work performed and, in the case of systems, their proper functioning.

Another problem, already mentioned above, that arises is the arbitrary enforcement of the guarantee. To avoid this situation and make the assessment of non-compliance more objective, a clause regarding external monitoring of the contract's performance can be inserted into the text. This principle of the need to justify the enforcement request has also been introduced in international standards, and this has been one of the most notable innovations, although it has been largely disregarded by users, due to the abuses of enforcement requests for the counterparty's non-compliance.

If the guarantee does not expressly require documentation but simply requires a request from the beneficiary, the documentation required by international regulations should be applied. The issued guarantee must, of course, be expressly subject to this documentation. This includes, in the case of a performance guarantee, the presentation of a judgment from an ordinary judge or an arbitration award justifying the request, or a declaration from the debtor acknowledging the validity of the request and its amount.

Finally, regarding duration, it is believed that the validity is automatically extended until the completion of the works or, in the case of systems, until the final testing.

(Part two continues in the July newsletter.)