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.