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Does The Accessory Principle Apply To Surety Bonds?

China’s surety bond market underwent significant development in 2016 and surety bonds have become one of the most important methods for securing a financial guarantee. However, due to a lack of clear Supreme Court guidance on the matter, the laws that apply to surety bonds issued by insurers in China are still the subject of much debate. This update addresses whether the Guarantee Law’s accessory principle applies to surety bonds issued by insurers in China.

Governing laws for interpreting surety bonds

A ‘surety bond’ is a written agreement that usually provides for monetary compensation to be paid to the obligee if the principal fails to perform acts as promised.

In China, surety bonds can be issued by banks (ie, bank guarantees) and insurers (ie, guarantee insurance). One difference between the two is that bank guarantees are drawn from a company’s credit lines on the bank’s terms, whereas, if an insurer issues a bond to guarantee performance, payments are made in the form of a premium and are not drawn from the company’s credit lines.

One of two Chinese laws could apply to the issuance of surety bonds, depending on whether the surety is regarded as:

• a security instrument governed by the Guarantee Law, which came into force in October 1995; or
• an insurance product governed by the Insurance Law, the most recent amendment to which came into force in April 2015.

Suretyship, guarantee contracts and guarantee insurance

Article 6 of the Guarantee Law defines ‘suretyship’ as an agreement between a surety and an obligee that the surety will perform the obligation or bear liability according to the agreement if the obligor fails to perform its obligations to the obligee.

Article 5 of the law provides that a ‘guarantee contract’ is “an accessory contract to the principal contract. If the principal contract is null and void, the guarantee contract shall be null and void accordingly. Where it is otherwise agreed in the guarantee contract, such agreement shall prevail.”(1) Under the Guarantee Law, a guarantee contract is an agreement between an obligee and a surety that is different, and yet ancillary, to the principal contract between the obligee and the obligor. The establishment, amendment and termination of a guarantee contract is premised on the principal contract. Where the principal contract is null and void, the guarantee contract shall also be null and void, unless otherwise agreed by the parties or stipulated by law.

Conversely, ‘guarantee insurance’ is a type of insurance policy that can be issued only by insurers. Even though guarantee insurance is regarded as being within the scope of ‘property insurance’ under Article 95 of the Insurance Law,(2) Chinese law provides no standardised legal definition of guarantee insurance.

The Supreme Court’s decision in a guarantee insurance dispute between two financial institutions held that ‘guarantee insurance’ is a type of insurance through which the insurer provides a guarantee to the insured (obligee) on behalf of the policyholder (obligor), in case the policyholder cannot perform its obligations as agreed in the contract with the insured and causes the insured to suffer an economic loss. In such cases, the insurer will bear the liability to compensate the insured in accordance with the agreement between the insurer and the policyholder. The Supreme Court further held that, even though guarantee insurance is a type of insurance, it is, in effect, a type of suretyship provided by the insurer to the insured.

In the China Insurance Regulatory Commission’s (CIRC) decision in the same case, it stated that “guarantee insurance is a type of property insurance”. This classification was later adopted by the Insurance Law.

Differing views

Although the Supreme Court and the CIRC have each provided definitions, disparity remains among law practitioners and scholars regarding the nature of guarantee insurance.

Article 36 of the Draft Interpretations of the Supreme Court on Issues in Trying Insurance Disputes provides that the courts “shall apply the Contract Law and the Insurance Law to ascertain the legal relationship between the parties when trying guarantee insurance contract disputes; the Guarantee Law shall be referenced where the Contract Law and the Insurance Law do not stipulate”.

Article 34 of the draft interpretations provides that “guarantee insurance contracts serve to guarantee the performance of the contractual obligations, which has the nature of suretyship”.

Article 38 of the draft interpretations provides that: “Guarantee insurance contracts shall be null and void where the principal contract is null and void, and the insurer is not to be held responsible for the insured liability. However, if the insurer knows the principal contract is void and still agrees to issue the guarantee insurance, the insurer shall assume the liability of compensation.”

Although the interpretations have yet to come into force and the extent of the official version is unknown, the draft interpretations have substantially influenced the views of some local courts regarding:

• the nature of guarantee insurance contracts; and
• the legal relationship between a guarantee insurance contract and its so-called ‘underlying contract’.

Specifically, the courts have applied the Guarantee Law in some guarantee insurance cases, holding that:

• a guarantee insurance contract is an ‘accessory contract’ to the underlying contract; and
• that guarantee insurance contracts are null and void where the underlying contract is null and void.

However, some courts have maintained the opposite view that:

• a guarantee insurance contract is independent from the principal contract; and
• its validity does not depend on the principal contract.

The ultimate reason behind this disparity is the absence of legislation and legally binding guidance in the guarantee insurance field.

Are guarantee insurance contracts insurance contracts?

Notwithstanding the above disparity, a guarantee insurance contract should arguably be regarded as an insurance contract governed by the Insurance Law, rather than a guarantee contract governed by the Guarantee Law. The reasons for this view, which is held by the majority of law practitioners and scholars in China, are as follows:

• The parties to a guarantee insurance contract are the insurer (surety) and the policyholder (obligor). The obligee to the principal contract, which is normally the insured or the beneficiary, is only a relevant contractual party to the guarantee insurance contract. In contrast, a guarantee contract is reached between the surety and the obligee, which serves as a suretyship to the obligor’s performance of its obligations. The obligor is usually not a requisite party to a guarantee contract.
• A guarantee insurance contract is a bilateral performance contract, whereas a guarantee contract is a unilateral performance contract. In a guarantee insurance contract, while receiving premiums from the policyholder, the insurer will provide a suretyship to the principal contract and compensate the obligee where the obligor fails to perform its obligations. However, a typical guarantee contract involves no consideration between the surety and the obligee. Specifically, the surety must simply fulfil its obligations under the guarantee contract where the obligor fails to perform its obligations under the principal contract.
• A guarantee insurance contract’s subject matter is the obligor’s credit, and one of the purposes of the contract is to spread the risk of a breach of contract by the obligor. However, the sole purpose of reaching a guarantee contract is to protect the obligee’s rights.

Comment

Although there are some similarities between guarantee insurance contracts and guarantee contracts, the legal relationships involved therein are different. According to existing legislation, unlike with a typical guarantee contract, there is no underlying contract on which the validity of a guarantee insurance contract depends. If the contract between the obligor and the obligee is null and void, the guarantee insurance contract should not necessarily be regarded as null and void.

Therefore, the Guarantee Law cannot be applied when analysing the legal relationships of a guarantee insurance contact, and the accessory principle derived from the Guarantee Law does not necessarily apply to surety bonds issued by insurers in China.

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