Article

Factual Summary: Kentz (Pty) Ltd was one of the contractors involved in the construction of a new power generation plant in South Africa. During September 2008, Kentz (beneficiary) entered into a written construction contract (underlying contract) with Brokrew Industrial (Pty) Ltd (applicant) relating to the supply of ducting at the plant. In terms of clause 4.2 of the construction contract, Brokrew (applicant) was obliged, at its own cost, to secure "an irrevocable, on demand bank guarantee or a demand guarantee from a recognised financial institution" for proper performance ("performance guarantee"). The construction contract also called for a similar advance payment guarantee to be secured. The performance guarantee and the advance payment guarantee were both issued by Guardrisk Insurance Company Ltd (guarantor) in favour of Kentz (beneficiary). It was common cause that Kentz (beneficiary) had paid Brokrew (applicant) an amount of ZAR 17 million after the advance payment guarantee had been issued.

It was common cause that Brokrew (applicant) experienced severe financial difficulties which impacted on its ability to perform its obligations under the construction contract. On 24 February 2010, Kentz (beneficiary) addressed a letter to Brokrew (applicant) where it inter alia alleged that it appeared that Brokrew (applicant) had repudiated the construction contract which it (Kentz (beneficiary)) was prepared to accept and that it seemed that Brokrew (applicant) had become insolvent. On 5 March 2010, Brokrew (applicant) advised Kentz (beneficiary) that unless the terms of the construction contract were renegotiated, it would not be in a position to perform its obligations in terms thereof. In a further letter, Kentz (beneficiary) cancelled the contract, with immediate effect. On 3 and 9 March 2010, respectively, Kentz (beneficiary) made demand for payment in terms of the guarantees on Guardrisk (guarantor). Brokrew (applicant) inter alia disputed the beneficiary's entitlement to cancel the contract and argued that beneficiary (Kentz) had in actual fact repudiated the contract. It also alleged that the beneficiary's call on the guarantees was fraudulent given the latter's knowledge that it was not entitled to cancel the contract.

The guarantor (Guardrisk) resisted the beneficiary's demands for payment on the basis that the claims were fraudulent. In April 2010, and in consequence of the non-payment, the beneficiary instituted motion proceedings against the guarantor in the South Gauteng High Court, Johannesburg (court of first instance), in which it claimed payment in terms of the guarantees. In May 2010, Brokrew (applicant) applied for and was granted leave to intervene as a (second) respondent in the proceedings before the court of first instance. The guarantor subsequently issued third party notices against Brokrew (applicant) and Broseal Properties (Pty) Ltd and Kairos Industrial Holdings (Pty) Ltd, respectively. Guardrisk (guarantor) relied upon a counter indemnity in its favour executed by Brokrew (applicant) for its claim against the latter and an indemnity and deed of surety for its claim against Broseal and Kairos. The third party notices were not opposed and Broseal and Kairos were subsequently joined as third parties in the proceedings in the court of first instance.

Before the hearing took place before the court of first instance, Brokrew (applicant) was finally liquidated and at the hearing it was represented by its liquidators. The court of first instance found that the evidence had failed to prove that the beneficiary, in making demand for payment under the guarantees, had acted fraudulently. It further found that the guarantor was obliged to make payment in terms of the guarantees and accordingly granted judgment in favour of the beneficiary. It also made an order in favour of the guarantor in terms of the indemnities and deed of suretyship. The guarantor (appellant) appealed against this order to the South African Supreme Court of Appeal. The liquidators of Brokrew (applicant) also applied to be joined as the fourth appellant in these proceedings. That application was not opposed and was granted.

In the appeal, the first appellant (guarantor) argued that the claims were fraudulent inter alia because the beneficiary had not given the principal (Brokrew (applicant)) adequate notice within which to remedy the breaches alleged. In addition, the second (Broseal), third (Kairos) and fourth appellants (liquidators of Brokrew (applicant)), argued that the two construction guarantees were accessory in nature (thus conditional) and did not constitute independent undertakings ("on demand guarantees"); therefore, the beneficiary had to prove liability on the part of the principal of the guarantees (Brokrew (applicant)) before demands could be make on the construction guarantees.

Legal Analysis:

Relevant to the outcome of the appeal was the correct interpretation of the two construction guarantees that were identical in their material terms.

1. Independent guarantees versus accessory guarantees. Theron JA (with Navsa ADP, Shongwe JA, Saldulker JA and Meyer AJA concurring) referred to Minister of Transport and Public Works, Western Cape, and Another v Zanbuild Construction (Pty) Ltd and Another 2011 (5) SA 528 (SCA) para 13 (discussed in 2012 ANNUAL REVIEW OF INTERNATIONAL BANKING LAW AND PRACTICE 469-472) where the essential difference between accessory (conditional bond) and independent guarantees (on demand bonds) were described as follows:

"... [A] claimant under a conditional bond is required at least to allege and - depending on the terms of the bond - sometimes also to establish liability on the part of the contractor for the same amount. An 'on demand' bond, also referred to as a 'call bond', on the other hand, requires no allegation of liability on the part of the contractor under the construction contracts. All that is required for payment is a demand by the claimant, stated to be on the basis of the event specified in the bond."

Theron JA said in order to determine the nature of the two construction guarantees in the case before her, regard must be had to their terms. The two guarantees were identical in their material provisions. Theron JA stated that in terms of both guarantees, the guarantor (Guardrisk) had bound itself as principal in favour of the beneficiary. She pointed out that the guarantor confirmed that it held the guaranteed sums "at the disposal of the Employer [beneficiary], as security for the proper performance by the Contractor of all its obligations in terms of and arising from the contract". It also undertook to pay to the beneficiary the guaranteed sums, upon demand from the latter. Such demand had to be in writing and contain a statement that the demand amount was payable to the beneficiary in terms of the construction contract and that the contractor (principal of the guarantees) was in breach of its obligations under the construction contract (underlying contract). Theron JA also referred to clause 4 of the construction guarantees which provided:

"4. Notwithstanding the reference herein to the Contract the liability of the Financial Institution in terms hereof is [as] principal and not as surety and the Financial Institution's obligations to make payment:

a) Is and shall be absolute and unconditional in all circumstances; and

b) Is not, and shall not be construed to be, accessory or collateral on any basis whatsoever."

She also stated that clause 5(c) of the guarantees was important because it provided that the compliance by the guarantor with any demand for payment made in terms of the guarantee "shall not be delayed, by the fact that a dispute may exist between the Contractor and the Employer".

Theron JA held that the terms of the guarantees were clear. They created an obligation on the part of the guarantor to pay the beneficiary on the happening of a specified event. It was recorded in the guarantees that notwithstanding the reference to the construction contract (underlying contract), the liability of the guarantor was absolute and unconditional, and could not be construed to create an accessory or collateral obligation. Furthermore, the guarantees specifically stated that the guarantor could not delay making payment in terms of the guarantees by reason of a dispute between the principal (contractor) and the beneficiary. The very purpose of the guarantees was to protect the beneficiary in the event that the principal could not perform its obligations in terms of the construction contract.

Theron JA found that the arguments regarding the conditional nature of the guarantees had to fail. She held that the guarantees were unconditional and had to be paid according to their terms. The only basis upon which the guarantor could escape liability was to show proof of fraud on the part of the beneficiary.

2. Fraud exception. In dealing with the guarantor's contention that the demands were "material, knowingly false and constituted a fraud" on the parties to the underlying contract, Theron JA simply relied and endorsed the Supreme Court of Appeal's earlier views concerning the fraud exception expressed in Loomcraft Fabrics CC v. Nedbank Ltd 1996 (1) SA 812 (A) and Lombard Insurance Co Ltd v. Landmark Holdings (Pty) Ltd 2010 (2) SA 86 (SCA) (discussed in 2010 ANNUAL REVIEW OF INTERNATIONAL BANKING LAW AND PRACTICE 566-570). For example, that the fraud had to be clearly established; the onus of proving the fraud was on the party alleging it; and the onus was the normal civil one which had to be discharged on a balance of probabilities, but would not be inferred lightly. Furthermore, in order to succeed in respect of the fraud exception, a party had to prove that the beneficiary presented the documents to the guarantor knowing that they contained material misrepresentations of fact upon which the guarantor would rely and which it knew were untrue. Mere error, misunderstanding or oversight, however unreasonable, would not amount to fraud. Nor was it enough to show that the beneficiary's contentions were incorrect. A party also had to show that the beneficiary knew it to be incorrect and that the contention was advanced in bad faith. Theron JA, also merely followed (just like the Supreme Court of Appeal had done in its earlier judgment in Lombard) the English case of United City Merchants (Investments) Ltd and Glass Fibres and Equipments Ltd v. Royal Bank Of Canada, Vitrorefuerzos SA and Banco Continental SA (incorporated in Canada) [1983] AC 168 (HL) and seemingly interpreted the fraud rule in the narrow sense (para 17 - footnote omitted from quotation)):

"It would be useful to briefly consider the legal position in relation to the fraud exception. It is trite 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 bank and decline enforcement of the guarantee in question. This fraud exception falls within a narrow compass and applies where:

' ... the seller, for the purpose of drawing on the credit, fraudulently presents to the confirming bank documents that contain, expressly or by implication, material representations of fact that to his (the seller's) knowledge are untrue.'"

Theron JA concluded that the guarantor had failed to prove that the demands were made fraudulently. She pointed out that what the guarantor wanted the court to do was to determine the rights and obligations of the parties in relation to the underlying contract which the court was not permitted to do. She stated that the court of first instance was correct when it had found that the guarantor had not discharged the onus resting on it to establish fraud on the part of the beneficiary. She agreed with the view of the court of first instance that:

"The evidence . . . clearly demonstrates that Kentz [beneficiary] held the view that it was entitled to lawfully pursue its claims under the guarantees. The mere fact that it pressed its claims knowing that Brokrew [principal] held a contrary view about the cancellation with which it disagreed is not fraudulent."

3. Independence (autonomy) principle. Theron JA confirmed the principle that a valid demand on an unconditional performance guarantee created an obligation on the guarantor to make payment in terms of the guarantee. However, despite the independence principle of the construction guarantees, the appellants also urged Theron JA to have regard to the decision of the majority in Dormell Properties 282 CC v. Renasa Insurance Co Ltd and Others NNO 2011 (1) SA 70 (SCA) (discussed in 2012 ANNUAL REVIEW OF INTERNATIONAL BANKING LAW AND PRACTICE 406-410). In Dormell, the majority held that because the dispute between the parties to the underlying contract in that case was finally resolved by arbitration an order to enforce the guarantee in such circumstances would be of no practical effect. In contrast the minority in Dormell was of the view that fraud was the only ground upon which payment could be validly refused and details of the arbitration award were completely irrelevant to the court as the independence principle prohibited such details to be made to the court. The appellants in Guardrisk argued that the principles of practicality enunciated by the majority in Dormell ought to be applied to the matter before Theron JA and the issues concerning the rights and obligations of the parties to the construction contract had to be determined as all the parties were before the court and the disputes between the parties to the construction contract (Kentz (beneficiary) and Brokrew (applicant)) have been crystallised and were capable of being determined.

Theron JA who was also one of the concurring judges in Firstrand Bank Ltd v. Brera Investments CC 2013 (5) SA 556 (SCA) (also discussed in the 2014 ANNUAL REVIEW at 451) said that she agreed with Malan JA's view expressed in Brera that the minority in Dormell was the more appropriate one and that the majority's view was "flawed". She elaborated extensively on why the majority in Dormell was wrong when it had found that ordering the guarantor to honour the demand guarantee in that case (ie, where the dispute between the parties to the underlying contract was finally resolved by arbitration) would amount to an academic exercise without practical effect. She too, just like the minority in Dormell, argued that the majority had misconstrued the passage from Hudson and Wallace Hudson's Building and Engineering Contracts and as was quoted in the English case of Cargill International SA Antigua Geneva Branch v. Bangladesh Sugar and Food Industries Corporation [1996] 2 Lloyd's Rep 524 (QB (Com Ct); and affirmed in [1998] 2 All ER 406 (CA). Theron JA makes the point that in Cargill the English court said that it was implicit in the nature of a guarantee that, if a payment in terms of it had been made, that there would at a later stage be an accounting between the parties to the underlying contract. It, however, did not mean that at the stage when a compliant demand was being made under the guarantee that all the disputes between the parties to the underlying contract were relevant (see also State Trading Corpn of India Ltd v. ED and F Man (Sugar) Ltd and ANR [1981] Com LR 235 (CA)).

Theron JA also stressed the importance of the autonomy principle of construction guarantees (demand guarantees) and pointed out that the principle clearly meant that disputes in the underlying contract were completely irrelevant when a demand for payment was made and, if this principle was ignored, it 'would undermine the efficacy of such guarantees'. She added (para 29):

"In determining whether payment should be made on such a guarantee, accessory obligations are of no consequence. The very purpose of the guarantee is so that the beneficiary can call up the guarantee without having to wait for the final determination of its rights in terms of accessory obligations. To find otherwise, would involve an unjustified paradigm shift and defeat the commercial purpose of performance guarantees."

For the above reasons, the appeal was dismissed with costs, including the costs of two counsel, which costs were to be paid jointly and severally by the appellants, the one paying the others to be absolved.

Text of Guarantees:

"Guardrisk bound itself as principal in favour of the employer (Kentz). It confirmed that it held the guaranteed sums 'at the disposal of the Employer, as security for the proper performance by the Contractor of all its obligations in terms of and arising from the contract'. Guardrisk undertook to pay to Kentz (beneficiary) the guaranteed sums, upon demand from the latter. Such demand had to be in writing and contain a statement that the demand amount was payable to the employer in terms of the contract and that the contractor was in breach of its obligations under the contract. Further relevant terms of the guarantees are the following:

'4. Notwithstanding the reference herein to the Contract the liability of the Financial

Institution in terms hereof is [as] principal and not as surety and the Financial Institution's obligations to make payment:

a) Is and shall be absolute and unconditional in all circumstances; and

b) Is not, and shall not be construed to be, accessory or collateral on any basis whatsoever.'

Clause 5(c) is of importance as it provides that compliance by the Financial Institution with any demand for payment made in terms of the guarantee 'shall not be delayed, by the fact that a dispute may exist between the Contractor and the Employer'."

Text of Opinion:

"[T]he argument advanced by Broseal and Kairos regarding the conditional nature of the guarantees must fail. The guarantees in this matter are unconditional and must be paid according to their terms."

Comments by Prof. Kelly-Louw:

The decision by the Supreme Court of Appeal cannot be faulted. It is clear that the guarantees in this matter were independent guarantees, and not accessory obligations similar to suretyships.

From the South African cases (see, e.g., Loomcraft, Lombard, and Guardrisk) dealing with the fraud exception, it is very easy to make the deduction that the South African courts are willing to enforce the fraud exception only where the forgery or falsification concerns the documents presented in terms of the demand guarantee or letter of credit (i.e., fraud in the narrow sense). Unfortunately the Supreme Court of Appeal in Guardrisk did not elaborate or remove any of the uncertainties surrounding the fraud exception that exist. For example, whether the fraud relates only to fraud in the narrow sense or also includes fraud in the underlying contract (i.e., fraud in the broad sense). However, the South African courts have not yet indicated that they will not be prepared to interdict a guarantor or issuer from paying in the case of fraud concerning the performance by the beneficiary in terms of the underlying contract (fraud in the wide sense).

The views expressed in Brera and Guardrisk eventually caused the Supreme Court of Appeal in Coface South Africa Insurance Co Ltd v. East London Own Haven t/a Own Haven Housing Association (050/13) [2013] ZASCA 202 (02 December 2013) (also discussed in the 2014 ANNUAL REVIEW at 421) to reconsider the majority and minority views that it (the Supreme Court of Appeal) had earlier expressed in the controversial Dormell case and to compare them to the views it had later expressed in subsequent cases. The Brera and Guardrisk cases were the fore-runners for the Supreme Court of Appeal finding in Coface that the majority in Dormell was, in fact, clearly wrong.

[MKL/pt]

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* Professor of Law, Department of Mercantile Law, School of Law, University of South Africa.