South Africa: The Judgment Of The Supreme Court Of Appeal In The Reported Decision Of Dormell Properties v Renasa Insurance NNO 2011 (1) SA 70 Will Be Of Interest To The Construction Industry

Last Updated: 24 May 2011

The employer made a claim against the guarantor in terms of a construction guarantee following upon the cancellation of a building contract, on the grounds of the contractor's alleged breach of contract. The guarantor refused to pay the guaranteed amount as a consequence of which the employer instituted proceedings against the guarantor and the contractor. The court found against the employer who appealed to the Supreme Court of Appeal.

The judgment of the Court below turned on the date of expiry of the guarantee. The focus of this note is not, however, directed at this issue.

Subsequent to the date of judgment of the court a quo the dispute between the employer and the contractor had been referred to arbitration in which it had been found by the arbitrator that the employer had not been entitled to cancel the building contract. An application to admit evidence of the arbitration award on appeal was allowed.

In the majority judgment of the court on appeal it was held that it would amount to an academic exercise to find in favour of the employer because it would immediately have to repay the full amount to the contractor or to the guarantor on the grounds that the construction guarantee had been called without justification. In the result the appeal was dismissed. The appeal should, however, have been allowed in terms of the dissenting judgment handed down by Cloete JA. Apart from the question of whether the guarantee had expired, (which the full court found the court a quo to have decided incorrectly), there remained the question of whether the employer should be allowed to enforce payment under the guarantee given the outcome of the arbitration proceedings.

Cloete JA emphasised that in these circumstances there are three separate and distinct legal relationships between:

  • the employer and the contractor;
  • the employer and the financial institution that issued the performance guarantee; and
  • the contractor and the financial institution.

Cloete JA stated further that the disputes which had arisen between the employer and the contractor were irrelevant to the financial institution's obligation to perform under the construction guarantee. The arbitrator's ruling concerned the relationship between the employer and the contractor and it is of no relevance to the guarantor. This is clear from the judgment in Lombard Insurance Co Limited v Landmark Holdings (Pty) Ltd & Others 2010 (2) SA 86 (SCA) at paragraph 20 where Navsa JA said:

"The guarantee by Lombard is not unlike irrevocable letters of credit issued by banks and used in international trade, the essential feature of which is the establishment of a contractual obligation on the part of a bank to pay the beneficiary (seller). This obligation is wholly independent of the underlying contract of sale and assures the seller of payment of the purchase price before he or she parts with the goods being sold. Whatever disputes may subsequently arise between buyer and seller is of no moment insofar as the bank's obligation is concerned. The bank's liability to the seller is to honour the credit. The bank undertakes to pay provided only that the conditions specified in the credit are met. The only basis upon which the bank can escape liability is proof of fraud on the part of the beneficiary. This exception falls within a narrow compass and applies where the seller, for the purpose of drawing on the credit, fraudulently presents to the bank documents that to the seller's knowledge misrepresent the material facts.

In the present case Lombard undertook to pay the Academy upon Landmark being placed in liquidation. Lombard, it is accepted, did not collude in the fraud. There was no obligation on it to investigate the propriety of the claim. The trigger event in respect of which it granted the guarantee had occurred and demand was properly made."

Because the employer did not have to prove that it was entitled to cancel the building contract as a pre-condition to enforcement of the guarantee, Cloete JA found that the employer was not precluded from insisting on payment of the proceeds of the guarantee, notwithstanding that the arbitrator had found that the basis upon which the guarantee had been called up was unjustified. The employer was not obliged to set aside the arbitration award before calling up the guarantee.

Cloete JA then proceeded to deal with the question of whether the order sought by the employer on appeal would have no practical affect or result as contemplated in Section 21A of the Supreme Court Act 59 of 1959. He stated that what would have to be found as a positive conclusion of fact in order to support a conclusion that an order on appeal in favour of the employer would have no practical effect or result, is that there is nothing on which the guarantee could operate if it were paid out. That finding, he concluded, simply could not be made on the papers before the Court.

Finally, he dealt with the application by the financial institution to place further evidence before the Court on appeal. In his view the finding by the arbitrator was entirely irrelevant and he would accordingly disallow the application to place evidence of this fact before the Court because the employer did not have to prove that it was entitled to cancel the building contract.

The duty of a financial institution under a demand bond is to comply with the terms of its promise to pay. The financial institution is in no way concerned with any dispute between the employer and the contractor and is bound by its autonomous unconditional contract and requirement of strict performance. It is not affected by the underlying principal construction contract and payment should never be constrained at the instance of the financial institution save in a clear case of fraud.

The Australian jurisprudence on this issue supports the submission that provided the employer acts in good faith, the existence of a real dispute between the parties should not prevent the employer from calling the bond. Bank guarantees or other forms of unconditional security from contractors are a standard feature of Australian construction contracts. In the result, a substantial body of case law has evolved arising from contractors seeking to avoid calls by employers against the financial institutions which issued the performance guarantees. In the absence of fraud, the contractor is obliged to allege that recourse to his security amounts to a breach of an express or implied term of the principal construction contract. In most instances, this allegation is made by the contractor where a call is threatened by the employer before the contractor's default has been finally established by arbitration or litigation. However, the Australian Courts have tended not to allow this line of argument, on the basis that if unconditional security is required in terms of the construction contract, the employer should have immediate access to the security provided by the bond subject only to his claim having been made in good faith. The Australian Courts have concluded that a demand bond is to be treated effectively as "cash in hand" without regard to the degree or extent of the employer's complaint, provided only that the employer's conduct is bona fide.

The problem created by the majority judgment in this case is that it raises the spectre of the financial institution being entitled to challenge its unequivocal obligation to pay under the performance guarantee, by raising the merits of disputes under the principal building contract to which it is not a party. It is submitted that the approach adopted by Cloete JA is the correct approach because the duty of the financial institution under a demand bond is to comply with the terms of its promise to pay. The financial institution is in no way concerned with any dispute between the employer and the contractor. It is bound by its autonomous unconditional contract and the requirement of strict performance. It is not affected by the underlying principal construction contract and payment should never be constrained at the instance of the financial institution save in a clear case of fraud. To hold otherwise and to direct that the financial institution should not pay upon receipt of the demand but should be entitled to enquire into the rights of the employer and the contractor under a contract to which it is not a party, would be to depart from the ordinary meaning of the undertaking to pay on demand.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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