Article

Factual Summary: In 2002, Guarantor, a shortterm insurance company, issued a construction guarantee on behalf of a construction company (Principal). The basis for the guarantee was a construction contract between Principal and Beneficiary of the guarantee. Guarantor also bound itself as principal debtor in favour of Beneficiary of the construction guarantee, undertaking to pay Beneficiary, on demand, the guaranteed sum or the full outstanding balance upon the happening of one of two eventualities:

- default by the principal (the construction company) resulting in cancellation or;

- a liquidation order being granted against the principal (the construction company).

The construction contract contained the following important clause:

"3. The Guarantor hereby acknowledges that: 3.1 Any reference in this Guarantee to the Agreement is made for the purpose of convenience and shall not be construed as any intention whatsoever to create an accessory obligation or any intention whatsoever to create a suretyship 3.2 Its obligation under this Guarantee is restricted to the payment of money 3.3 Reference to a practical completion certificate or to a final completion certificate shall mean such certificate as issued by the Principal Agent." (Emphasis added.)

Before the construction guarantee was issued, three related companies provided Guarantor with indemnities in the event that it had to pay in terms of the construction guarantee. The first respondent executed a document entitled "RECIPROCAL INDEMNITY AND SURETYSHIP" in favour of Guarantor, in terms of which the respondent undertook to "indemnify and keep indemnified and hold it [the guarantor] harmless from and against all and any claims, losses, demands, liabilities, costs or any other expenses of whatsoever nature ... which [Guarantor] may at any time sustain or incur by reason or in consequence of having executed or hereafter executing any guarantees ...". The 1st Indemnitor also further, undertook and agreed to pay Guarantor on demand any sum which the latter may have been called upon to pay under any guarantee, whether or not Principal of the guarantee admitted the validity of the claim.

The 2nd and 3rd Indemnitor executed two written documents in similar terms in favour of Guarantor. Although both documents had the title "DEED OF SURETYSHIP", they had the following identical feature: The Indemnitors undertook as principal debtors to "indemnify" Guarantor against "any claims of whatsoever nature" which it may incur by reason of it having executed or in the future executing any guarantee.

In 2003, the Principal of the construction guarantee was liquidated. Beneficiary then drew on the guarantee, stating in its demand that Principal had been placed in liquidation, that a final completion certificate had not been issued, and that consequently an amount of ZAR241 429,77 (about US$35,740) was due to it by Guarantor, purportedly the value of work done post the issue of the practical completion certificate.

Guarantor honoured the demand and then turned to the Indemnitors for reimbursement under their indemnities. Indemnitors refused to pay on the basis that the agent who had issued the completion certificates in terms of the construction agreement had perpetrated a fraud in the presentation of the claim. Guarantor then sued Indemnitors for reimbursement in the Western Cape High Court, Cape Town (formerly known as the Cape Provincial Division).

The court of first instance, the Western Cape High Court, Cape Town, decided the matter on the basis that the construction guarantee had to be interpreted in conjunction with the construction contract (underlying transaction). It incorrectly held that Guarantor was only obliged to pay a claim under the construction guarantee if the claim was within the terms of the construction contract. According to the court of first instance, the claim did not fall within that purview and therefore, Guarantor was not obliged to pay and neither was any one of the respondents. Guarantor appealed against this decision. The appeal was granted and the judgment reversed.

Legal Analysis:

1. Independence Principle; Nature and Interpretation of Construction Guarantee and Indemnities; Fraud: The appellate court correctly found that the court of first instance misinterpreted the nature of the construction guarantee and the indemnities provided by Indemnitors. The construction guarantee created an obligation to pay upon the happening of an event. The appellate court pointed out that the construction guarantee itself recorded that the reference in it to the construction contract was solely for the purpose of convenience and that there was no intention to create an accessory obligation or suretyship (see clause 3.1 of the construction guarantee quoted above). The construction guarantee was to protect the beneficiary in the event of default by the principal (the construction company) and it was to the guarantee that one had to look to determine the rights and obligations of the guarantor and the beneficiary (see in para 19).

Regarding the nature of the contraction guarantee the appellate court said the following (in para 20):

"The guarantee by [Guarantor] 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 misrepresents the material facts (Loomcraft Fabrics CC v Nedbank Ltd and another 1996 (1) SA 812 (A) at 815G-816G)."

In terms of the construction guarantee, Guarantor undertook to pay Beneficiary upon Principal being placed in liquidation. Guarantor, it was accepted, did not collude in the fraud and there was no obligation on it to investigate the correctness of the claim. The trigger event in respect of which it granted the guarantee had occurred and the demand was properly made (see para 21). The same applied to the undertakings/indemnities by Indemnitors. They undertook to indemnify the guarantor of the construction guarantee (the appellant) in the event that it paid a claim based on the guarantee provided by it. That event occurred and Indemnitors were, thus, likewise liable.

Comments:

1. As to whether the Court distinguished between whether the undertaking could be drawn on the actual default or liquidation as opposed to a documentary recital of these events, the opinion is not clear. The issue here was whether there was a fraudulent statement in relation to the completion of the underlying contract, rather than focusing on the fact that there was actually a dispute as to the completion of the underlying contract. If the parties had focused on the issue of a dispute as to whether the underlying contract was in fact complete, South African courts would still allow the payment under the Guarantee and the guarantor would be forced to pay and would not be allowed first to investigate the underlying dispute. In principle South African courts only allow for the fraud exception in the narrow sense (on documents only) like the UK (although there are indications that they would accept fraud in the broader sense - ie in the underlying contract itself). The court probably did not really focus on that issue much since the principal of the construction guarantee was in any event placed in liquidation which was a triggering event in itself. They did not focus at all on whether the triggering "event" had to be documentary.

2. The Supreme Court of Appeal correctly acknowledged the autonomy principle of the construction guarantee. A fundamental characteristic of documentary credit law is the autonomy of the credit. The autonomy principle is also fundamental to demand guarantees (i.e., construction guarantees).1 In the United States, Revised Article 5 of the Uniform Commercial Code (UCC) deals with both commercial and standby letters of credit and the principle of autonomy is codified in Section 5- 103(d). The principle of autonomy is also codified in articles 3 and 4 of the 1993 version of the Uniform Customs and Practice for Documentary Credits (UCP500); articles 4 and 5 of the 2007 version of the Uniform Customs and Practice for Documentary Credits (UCP600); article 2(b) of the 1992 Uniform Rules for Demand Guarantees (URDG); and Rules 1.06(a), 1.06(c), and 1.07 of the International Standby Practices (ISP98). The United Nations Convention on Independent Guarantees and the Standby Letters of Credit which applies to an international undertaking such as a demand guarantee or a standby letter of credit, also mentions the autonomy principle applicable to these letters of credit and guarantees in articles 2 and 3.

The first time the South African courts briefly referred to the fraud exception to the autonomy principle in relation to letters of credit/demand guarantees was in 1985 in Phillips v Standard Bank.2 However, it was not until the Loomcraft Fabrics v Nedbank3 case in 1995 that the courts really acknowledged and dealt with the fraud exception in the South African law. The Appellate Division (now the Supreme Court of Appeal) in Loomcraft Fabrics v Nedbank provided merely a basis for the fraud rule and has left many uncertainties regarding, specifically, the concept of fraud and the standard of proof that is required. However, the value of this decision lies in the fact that the Appellate Division did make it clear that:

- South African courts would consider intervening and issue interdicts restraining payment in cases where the fraud was clearly established; and

- South African courts would be willing to enforce the fraud exception where the forgery or falsification concerned the documents (i.e., where there was fraud in the narrow sense).

However, since 1995 there have been no other South African cases specifically dealing with the fraud rule. The South African fraud rule has thus remained stagnant for more than a decade and it is unclear how the courts would apply the fraud rule today. For instance, the courts have not yet indicated that they will not be prepared to interdict a bank from paying in the case of fraud concerning the performance by the beneficiary in terms of the underlying contract (i.e., in cases of fraud in the wide sense).

The court in Union Carriage v Nedcor Bank,4 however, remarked by way of an obiter dictum that had the beneficiary and the applicant entered into an agreement in terms of which the beneficiary undertook not to draw on the letter of credit (i.e., a pactum de non cedendo) and had the beneficiary, nevertheless, sought to extract payment under the letter of credit, it could conceivably have been guilty of fraud. It has been said that although this comment was made obiter, it provides an indication that the South African courts may be willing to look beyond the letter of credit documents in considering whether there was any fraud on the part of the beneficiary. It therefore provides support for the view that fraud justifying interference with the beneficiary's claim to payment is not limited to the so-called documentary fraud. However, from the Lombard case, discussed above, it appears that the Supreme Court seems to support the view that it would only be willing to enforce the fraud exception where the forgery or falsification concerned the documents (i.e., where there was fraud in the narrow sense)

South African law regarding the fraud exception is far from being settled. From the very limited (and old) case law that is available at this time, one can see strong correlations with the English law in South African courts' application of the fraud exception. However, there are still many uncertainties regarding the limits of the fraud rule in South African law and there is much speculation as to how it will be applied by the country's courts. [MKL]

1. See HN Bennett 'Performance bonds and the principle of autonomy' (1994) Journal of Business Law 574; and Raymond Jack, Ali Malek & David Quest Documentary credits: the law and practice of documentary credits including standby credits and demand guarantees (3ed 2001) in par 1.41 at 21. In Union Carriage and Wagon Company Ltd v Nedcor Bank Ltd 1996 CLR 724 (W) at 731-732 it was confirmed that the autonomy principle also applies to standby letters of credit and advance payment guarantees (i.e., demand guarantees).

2. 1985 (3) SA 301 (W).

3. 1996 (1) SA 812 (A).

4. 1996 CLR 724 (W).

* Professor in Banking and Insolvency Law, Department of Mercantile Law, University of South Africa.

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