Dear Uncle Oswald
It is me again, Frikkie the fearless contractor. I was at a site hand-over meeting yesterday where the clever guys discussed on-demand guarantees. One of the engineers was of the view that an on-demand guarantee always exists independently from the underlying contract between the employer and the contractor, and that nothing can interfere with the guarantor’s obligation to pay in terms of the guarantee.
I recall that you held a different view at the rugby braai after we klapped the Italians. But, by that time, I’d already had my fourth celebratory Klippies and Coke and my attention was not quite focussed on your explanation of the independence principle and its exceptions. Would you mind telling me all about it again?
Fearless Frikkie
_______________________________________________________________
Dear Frikkie
I noticed that you were not quite with me at the rugby braai. It was a big moment, and it is a scientific fact that ‘brannewyn nie brieke het nie’.
In essence, what I said was that the independence principle renders an on-demand guarantee independent from the underlying contract, but that this so-called independence principle is not absolute. There is an exception to the general principle.
Perhaps I should start at the beginning.
WHAT IS AN ON-DEMAND GUARANTEE?
It is a contract in which a guarantor (normally, a financial institution) promises to pay a specific sum of money to a beneficiary (in construction context, the employer) upon receiving a demand in which a specific event is alleged. The event, for example the cancellation of a contract, need not be proved but often the guarantee instrument requires of the beneficiary to submit a specified document, for example a cancellation notice. Upon receipt of a demand which complies with the terms of the guarantee, the guarantor is obliged to honour the guarantee. Disputes relating to performance by the parties in terms of the underlying contract are irrelevant. Therefore, the beneficiary can rest relatively assured that it will receive payment from the guarantor in terms of the on-demand guarantee. Disputes relating to the entitlement of the beneficiary to the guaranteed sum must be dealt with separately between the beneficiary and his counterpart in the underlying contract. This is why on-demand guarantees are sometimes referred to as unconditional guarantees, as opposed to accessory guarantees. The judgment of the Supreme Court of Appeal in Lombard Insurance Company Ltd v Landmark Holdings (Pty) Ltd and Others[1] concerns a matter where the court had to consider whether a construction guarantee in fact constituted such an unconditional guarantee.
The contractual relationships between the relevant parties in this context normally work as follows. The creditor (in this context, the employer) in an underlying contract (in this context, a construction contract) has certain expectations. It sets out its expectations to the debtor (in this context, the contractor) in the underlying contract. Once they have concluded their underlying contract, the debtor (in this context referred to as the applicant) applies to a guarantor to issue a guarantee in accordance with the terms of the underlying contract. The debtor then becomes the applicant for the guarantee and the creditor becomes the beneficiary in terms of the guarantee. The applicant and the guarantor also enter into a separate contract of mandate that governs the relationship between them. If the guarantor deems the applicant sufficiently creditworthy, and finds the conditions of the guarantee acceptable, it will issue the guarantee in favour of the beneficiary. The beneficiary may then demand payment from the guarantor in accordance with the stipulations of the guarantee. The guarantor’s obligations towards the beneficiary are determined only by the guarantee. The guarantor’s obligations are independent of the underlying contract between the applicant and the beneficiary, and it is independent of the contract of mandate between the applicant and the guarantor. To demand payment under the guarantee, the beneficiary merely has to comply strictly with the conditions of the guarantee. Normally, these conditions require certain documents to be submitted. If the guarantor is satisfied that the documents are prima facie in conformity with the guarantee, it will pay the beneficiary. To recover what it has paid to the beneficiary, the guarantor is normally entitled, in terms of the contract of mandate, to be reimbursed by the applicant.
This is the usual scenario in its most basic form. Of course, it can become much more complex, and it normally does, but this will suffice for present purposes.
THE INDEPENDENCE PRINCIPLE
The reason for illustrating the usual scenario in its most basic form is merely to provide some background.
The beneficiary in terms of an on-demand guarantee seeks to achieve maximum certainty that it will be paid by the guarantor, as long as the beneficiary complies with the terms of the guarantee. The last thing a beneficiary wants, is to have its demand frustrated or delayed by the applicant raising, for example, a performance dispute arising from the underlying contract.
To achieve this objective, the independence principle is of vital importance. The independence principle detaches the payment obligation under the guarantee from performance in terms of the underlying contract. It renders the on-demand guarantee independent from the underlying contract.
The judgment of the Supreme Court of Appeal in FirstRand Bank v Brera[2] provides background to the application of the independence principle in the context of a construction contract.
As a general proposition, the independence principle detaches the payment obligation under the guarantee from performance in terms of the underlying contract. However, the question arises whether this detachment is absolute. In other words, is there no defence to the claim of a beneficiary under an on-demand guarantee?
The answer is no. The independence principle is not absolute. There is an exception to the independence principle.
THE FRAUD EXCEPTION
The only true exception to the independence principle is the fraud exception.
Since the 1940s, courts in common law countries around the world have disregarded the independence principle in instances where there was clear evidence of fraud. This approach had its origin in the New York County Supreme Court in the case of Sztejn. [3]
In this context there is a clear distinction between active intentional fraud on the one hand, and the usual underlying disputes relating to, for example, breach of contract on the other hand.
The precise basis of the fraud exception and the definition of fraud, who has to perpetrate it, whether the fraud must originate from the guarantee or from the underlying contract, and a number of other conceptual matters are still in the process of developing in South African law.
There are different notions of fraud. The fraud exception did not have its origin in the law relating to on-demand guarantees. It had its origin in the law relating to letters of credit. On-demand guarantees, and letters of credit have certain characteristics in common, but they are also very different.
English Law
English law initially recognised only fraud in the narrow sense as an exception to the independence principle. This means that originally, English law required that the fraud had to relate to the documentation presented by the beneficiary upon demanding payment from the guarantor. Over time, English law developed to a point where fraud in the wider sense was also recognised as a valid exception to the independence principle. Fraud in the wider sense includes situations where fraud relates to the underlying contract. English law developed even further. It now also recognises fraud as an exception to the independence principle in situations where the beneficiary could not honestly have believed that it had any basis for demanding payment from the guarantor under the guarantee. In this regard, the judgments in Banque Saudi Fransi[4] and Uzinterimpex[5] provide useful perspective.
South African Law
In 1996 the South African Appellate Division pronounced in Loomcraft[6] that our courts will prevent a guarantor from paying a beneficiary if it is established that the beneficiary was party to a fraud in relation to the documents presented to the guarantor.
This was a clear acknowledgment of fraud in the narrow sense as an exception to the independence principle. This was not yet a recognition of fraud in the wider sense, and also not yet a recognition of an absence of honest belief in an entitlement to payment.
Later in 1996 the Johannesburg High Court in Union Carriage[7] expressed support for the wider fraud exception in South African law. In other words, it appeared from this judgment that fraud in the underlying contract constitutes an exception to the independence principle.
By 2014 we had a clear indication that our courts also accepted fraud in the form of a lack of honest belief (or knowledge of a lack of entitlement) as an exception to the independence principle. In Guardrisk[8] the Supreme Court of Appeal stated that where a beneficiary who makes a call on a guarantee does so with knowledge that it is not entitled to payment, our courts will step in to protect the guarantor (and, indirectly, the applicant/contractor) and decline enforcement of the guarantee. For more detailed information in this regard, one ought to consider the judgments of the Johannesburg High Court in Group Five Construction,[9] the Cape Town High Court in Scatec Solar,[10] and the Supreme Court of Appeal in Dormell Properties[11] and Guardrisk.[12] This is a very basic historical overview on this topic. There are many other judgments dealing with the same topic, and the issues are wide ranging.
The point is simply this. As in the rest of the world, there has been a gradual legal development in South African law as to what our courts regard as constituting fraud in the context of an exception to the independence principle relevant to on-demand guarantees.
As is the case with most legal concepts, this development in South African law is ongoing. It commenced with fraud in the narrow sense, namely, documentary fraud. From there, it developed into fraud in the wider sense, namely to include conduct in the execution of the underlying contract. What we have at the moment is jurisprudence which takes cognisance of a situation where the beneficiary cannot honestly believe that it has a basis for demanding payment from the guarantor under the guarantee. In this regard, the beneficiary’s transactional conduct as a whole, including his conduct in the underlying contract, is emerging as a relevant consideration.
IN CONCLUSION
Frikkie, there you have it. Some material to read and think about over the festive season.
I would love to hear your thoughts, and the thoughts of our readers, on whether the gradual expansion of the fraud exception is a good thing for the construction industry.
Best regards
Uncle Oswald
[1] 2010 (2) SA 86 (SCA).
[2] FirstRand Bank v Brera 2013 (5) SA 556 (SCA)
[3] Sztejn v J Henry Schröder Banking Corporation 31 NAS 2d 631 (1941) (Supreme Court New York County Special Term)
[4] Banque Saudi Fransi v Lear Seigler Services Inc [2006] EWCA Civ 1130 at paragraph 12.
[5] Uzinterimpex JSC v Standard Bank Plc [2007] EWHC (1151) at paragraph 107.
[6] Loomcraft Fabrics CC v Nedbank Ltd 1996 (1) SA 812 (A).
[7] Union Carriage and Wagon Company Ltd v Nedcor Bank Ltd 1996 (CLR) 724 (W).
[8] Guardrisk v Kentz [2014] 1 All SA 307 (SCA).
[9] Group Five Construction (Pty) Ltd v MEC Public Transport Roads and Works Gauteng [2015] ZAGPJHC 55 (13/2/2015).
[10] Scatec Solar SA 163 (Pty) Ltd v Terrafix Suedafrika (Pty) Ltd [2014] ZAWCHC 63 (25/4/2014).
[11] Dormell Properties 282 CC v Renasa Insurance Co Ltd and Another 2011 (1) SA 70 (SCA).
[11] Guardrisk Insurance Co Ltd v Kentz (Pty) Ltd [2014] 1 All SA 307 (SCA).