The quote ‘Progress is cumulative in science and engineering, but cyclical in finance’ is a fantastic testimony that at any point in time there are contortions in the financial system. The increasing number of large-value bank guarantees issued against foreign banks’ counter-guarantees, and the many cases of claims and disputes are a reminder that we are quick in forgetting the lessons history has taught us. While the sun is yet to set in Melamchi, and the Nepali banks that had issued a guarantee to the Chinese contractor for the Melamchi Water Supply Project are yet to recover from the shock, the banking industry was hit by another case of a bank issuing the counter-guarantee, but being refused payment.

It was a few years ago that the Bank of Kathmandu and Himalayan Bank faced the music of Melamchi when a Chinese bank failed to make payment under its counter-guarantee. As if to prove that lightning can strike twice in the same place, the Melamchi project's second contractor, CMC di Ravenna, held a contract to build the Tanahu hydropower plant. It allegedly abandoned the project, and Tanahu Hydropower claimed the guarantee amount from the guarantor Nepal Investment Bank. The bank then asked the Italian bank that had issued the counter-guarantee, Intesa Sanpaolo, for payment. An Italian court, Tribunale di Bologna, ruled in favour of the Italian contractor, apparently on the grounds of forgery, and directed the Italian bank not to honour the claim. This left the Nepali bank staring at the possibility of a big hole in its balance sheet.

Risks and rewards

Against this backdrop, and with a number of infrastructure projects involving foreign counterparties kicking off, it is important that all stakeholders understand the risks and rewards of the usage of bank guarantees to execute a project. Whenever there is international bidding for an infrastructure construction project, it is not atypical to see many Chinese and Indian firms, along with some third country contractors, bidding for it. To win the contract, these offshore entities are required to issue bonds to the beneficiary.

The Public Procurement Regulation 2007 mandates that any issuance of such bonds by a foreign bank has to be counter-guaranteed by a Nepali bank. The key reason why a counter-guarantee from a Nepali bank is required is that it eliminates the risk of foreign jurisdiction. It is not uncommon for a foreign court to stop payment under bank guarantees. Having the bank guarantee issued by a local bank spares the beneficiary from this risk.

The essential characteristic of a demand guarantee is that it is independent of the underlying transaction between the applicant and the beneficiary that prompted the issuance of the guarantee. Being unconditional in nature, the guarantor is required to pay the claim without contesting it. The standard rules of guarantee are governed through Uniform Rules For Demand Guarantees (URDG) 758 which came into force in July 2010. URDG 758 quickly became the standardised text for issuance of demand guarantees worldwide. One key notable change in URDG 758 is that of governing laws. Pursuant to Article 34 of URDG 758, unless otherwise provided in the guarantee, its governing law shall be that of the location of the guarantor’s branch or office that issued the guarantee.

The same rule applies, mutatis mutandis, to counter-guarantees. This opens up the possibility of different laws that apply to guarantees and counter-guarantees. This has implications which the guarantee issuing bank needs to judiciously understand. So unless mentioned, the counter-guarantee issued by a foreign bank is subject to the rules and jurisdiction of the originating country. This allows the foreign contractor to contest the claim in the courts in its country. Hence, it is important that the Nepali bank, while issuing the baby guarantee against the counter-guarantee of a foreign bank, understands which jurisdiction and laws apply in case of a conflict. In a move to ensure consistency, Nepal Rastra Bank has issued a directive stating that all guarantees issued in Nepal have to follow the rules of URDG.

When the second claim on the guarantee issued to the Melamchi Water Supply Project by Standard Chartered Bank Nepal and Nepal Investment Bank was made, both these guarantee issuing banks and the counter-guarantee issuing foreign banks settled the payments timely, but not without leaving behind a gnashing nightmare. In the aftermath of these mini-crises, we have learnt that the business of issuing bank guarantees has its virtues; but it carries a vice that has razor-sharp teeth that could take away large chunks of flesh leaving you bleeding. The size of the sum involved in all these cases is so big that the Nepali banking industry was gripped by anxiety and the fear became palpable. Yet, bankers have repeatedly failed to learn from the past; and it is only fair that we dig some graves and unravel the perils of a banker’s hubris.

The enormity of risk

As is true with all humans, Nepali banks panicked when the Chinese bank refused to pay under the claim, and they became sceptical of foreign banks. But after a few seasons of good weather, most had forgotten the enormity of the risk and potential impact of issuing bank guarantees against the risk of a foreign counterparty. With a number of large infrastructure projects kicking off in the country, and most of them being undertaken by foreign contractors, it is time that project employers start appreciating the nuances of the guarantee terms and unravel the underlying structure.

The sun may set and the last rays of the orb may descend behind the hills above Melamchi, yet a quintessential question still reverberates: Are Nepali banks biting off more than they can chew when they issue a commitment of such enormity against the comfort of a foreign counterparty while remaining exposed to foreign jurisdiction and laws?

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