Article

Topics: Independent (Demand) Guarantee; Performance Guarantee; Independence (Autonomy) Principle; Exceptions; Unconscionability; Good (Bad) faith; Fraud; Breach of a negative stipulation in the underlying contract; Expiry of Guarantee

Note: Sulzer Pumps (South Africa) (Proprietary) Limited (Applicant/Contractor/Principal of performance (demand) guarantee) applied, on an urgent basis, for an interim interdict (injunction), which was granted. The interim interdict prohibited Covec-MC Joint Venture (Employer/Beneficiary of performance guarantee/Respondent) to demand payment from the guarantor (Nedbank Limited) of the performance guarantee. When the interim interdict was granted, the Beneficiary had already called on Nedbank to make the payment, but the interim interdict prevented the payment from being made. On the return date the matter came before the court (Jansen J) to determine whether the interdict should be made final. The initial application was done on an urgent basis as it was thought, at that stage, that the guarantee would expire in February 2013, but it later transpired that it would actually only expire on 28 February 2015.

The Beneficiary had contracted with Sulzer to perform certain construction work (ie, the Vaal River Eastern Subsystem Augmentation Project). Sulzer provided the Beneficiary with a performance guarantee (silent as to the amount and any governing ICC rules) issued by Nedbank Ltd (guarantor) in respect of the construction contract (underlying contract).

The performance guarantee contained the following clause:

"3. Payment shall be made to the Employer on receipt by the Bank, at the Bank's domicilium citandi et executandi of the Employer's first written demand and which written demand shall be accompanied by this original guarantee as well as the following:

3.1 Written confirmation, signed by the employer, stating that the Contractor is in breach of any contract in terms of which this guarantee was required, or that any event triggering payment in terms of this guarantee has occurred".

During the course of the dealings between the parties various disputes arose regarding an alleged breach of the construction contract by Sulzer. Sulzer claimed ZAR 45 million from the Beneficiary, who in turn, counterclaimed for ZAR178 504 073,16. The parties proceeded with arbitration proceedings regarding the breach of the contract. According to Sulzer the parties had reached an agreement on 29 November 2010 that the performance agreement would not be called upon until the arbitration proceedings were finalised, provided that the guarantee was annually renewed and remained valid until such time as the arbitration proceedings (disputes) were finalised. The Beneficiary denied the existence of such an agreement saying that it had simply indulged Sulzer's request not to call upon the guarantee in an attempt to try and resolve the matter, but that it had never agreed to waive its right to demand payment at any time. However, in a letter dated 12 November 2010 the Beneficiary's attorneys sent to Nedbank (guarantor) the following was stated:

"3.1 we have . . . requested Sulzer's legal representatives . . . on 12 November 2010 to extend the current expiry date of 28 February 2011 of the guarantee to expire only upon the final determination of the disputes between C-MC [Beneficiary] and Sulzer;

3.2 we are currently awaiting a response . . . to our attached letter of 12 November 2010 . . . * Professor of Banking Law, Department of Mercantile Law, School of Law, University of South Africa. 3.3 in the event that Sulzer does not agree to extend the expiry date as indicated in 3.1 above and deliver the original amendment of the guarantee to our offices by no later than . . . Friday 3 December 2010, C-MC shall proceed to demand payment of the guaranteed amount in respect of the guarantee from your offices."

Sulzer's attorneys responded in writing on 25 November 2010 and confirmed that the guarantee would be extended as was requested, but pointed out that Nedbank refused to extend the guarantee for an indefinite period of time and insisted that a date be inserted. They also confirmed that they would supply the Beneficiary with an undertaking that the guarantee would be extended until the final determination of the disputes between the parties.

On 29 November 2010 the bank informed Sulzer as follows:

"1 We refer to the above matter and your attached letter dated 25 November 2010, which we have forwarded to our client for instructions.

2. We are instructed that our client is prepared to accept -

2.1 the extension of the expiry date of the guarantee to 28 February 2012;

2.2 your client's undertaking to further extend the guarantee in the event that the disputes between our respective clients have not been resolved by 28 February 2012,

on the basis that, in the event that it is anticipated by our client that the disputes between our client and your client will not be determined, to finality, within three months before the expiry date of the guarantee, being by 28 November 2011, that your client will proceed to extend the guarantee, by no later than 28 November 2011, for a further period of 12 months and furnish our client with the original amendment to the guarantee reflecting such further extension.

3. In the event that the position referred to in 2 above transpires and your client fails and/or refuses and/or neglects to -

3.1 further extend the expiry date of the guarantee, from 28 February 2012 to 28 February 2013, as referred to in 2 above; and

3.2 deliver the original amendment to the guarantee, reflecting the requested extension, to our offices by no later than . . . on Monday, 28 November 2011, our client shall proceed to demand immediate payment of the guaranteed amount in respect of the guarantee . . .

4. The above position regarding the timeframes and the extension will then also apply in respect of the anniversary of the expiry date of the guarantee in the event that the disputes between our respective clients have not been resolved and been finally determined within a period of three months before the further extended expiry date of the guarantee

5. Kindly confirm your client's agreement and undertakings in respect of the above process".

Sulzer accepted the undertaking in writing. While the matter between the parties remained unresolved the guarantee was extended on various occasions. It appeared that Sulzer did not adhere to the agreed time frames by which the guarantee had to be renewed, namely, prior to or on 28 November of any particular year. The various renewals and extension letters were done after these dates, but at no time did the guarantee lapse and it was still valid until 28 February 2015. This led to the Beneficiary sending various letters to Sulzer concerning Sulzer's "late" renewal of the guarantee and the submission of the relevant extension letters. The Beneficiary pointed out that although it indulged these "late" renewals and receipt of the extension letters it did not waive its rights to demand payment at any time.

Later, while the arbitration proceedings were still pending, it transpired that a substantial dispute between the Beneficiary and a third party (Trans Caledon Tunnel Authority) had arisen which could substantially affect the construction project and also affect the arbitration dealings between the Beneficiary and Sulzer. As a result, the Beneficiary requested Sulzer for a stay of their arbitration proceedings for two years. Sulzer refused which then prompted the Beneficiary to call up the guarantee. Sulzer immediately brought the application for an interim interdict. The interim interdict was granted and Sulzer proceeded with the subsequent application to confirm the interim interdict.

The court (per Jansen J) considered whether there was in fact an agreement reached between the parties that no demand would be made on the guarantee while the arbitration proceedings were still on-going (ie, until the disputes between the parties were finalised). The court found that the Beneficiary's contention that no such agreement existed was inaccurate on its own version. Jansen J found that it was clear from the correspondence exchanged between the parties that such an agreement had been reached by the parties.

Jansen J confirmed the independence principle of performance guarantees and indorsed the view that courts could generally only intervene to prohibit payment from being made in very limited circumstances, for instance, where fraud was involved. She then proceeded to quote from a paper entitled "Calling on a Performance Security: As Good as Cash?" that was presented by Michael Whitten (18 June 2012) to the Commercial Bar Association Construction Law Section (The Victorian Bar) where the presenter/author discusses three specific exceptions to the autonomy principle in the Australian law (para 41). Jansen J particularly referred to the part of Whitten's paper where he states that courts will not intervene to prevent a party from calling upon a bank guarantee, except in cases of: (1) fraud; (2) unconscionability which generally involves "taking advantage of a special disadvantage of another"' or "unconscientious reliance on strict legal rights" or "action showing no regard for conscience, or that are irreconcilable with what is right or reasonable (Whitten also referred to what was held in Olex Focas Pty Ltd v Skodaexport Co Ltd and ACCC v Samton Holdings Pty Ltd (2002) 117 FCR 301 as constituting unconscionability); and (3) breach of a negative stipulation in the underlying contract - where calling on the security would be in breach of an express or implied negative stipulation in the underlying contract. Reference was also made to Whitten's statement that the last listed exception was a common basis for contractors challenging a beneficiary's entitlement to call upon a guarantee. To be successful a contractor needed to prove that there were terms in the contract that restrained the calling of the security. Jansen J, however, pointed out that in the matter before her the agreement not to call upon the guarantee was made separately from the underlying construction contract.

Jansen J stressed that it should be borne in mind that to introduce qualifications on the entitlement of beneficiaries to call up guarantees, will deprive such guarantees of their commercial currency. "As a general rule a court will not prevent a party from calling upon a bank guarantee unless the party calling up the bank guarantee is acting fraudulently or unconscionably or has made a contractual promise not to call upon the guarantee" as was held in Clough Engineering Ltd v Oil and Natural Gas Corporation Ltd [2008] FCAFC 136.

In delivering her judgment, Jansen J carefully considered the conduct of the Beneficiary. She spent a lot of time carefully studying the communication between the parties regarding the various renewals of the guarantee. She pointed out that there were clearly contradictions in the letters and other communications between the parties as to what the Beneficiary had agreed to regarding the calling up of the guarantee. However, on the court's interpretation of the documents and court papers it was clear (also the only reasonable interpretation) that the Beneficiary had, in actual fact, agreed not to make a call on the guarantee while the arbitration was pending, provided that the guarantee remained valid. The court said evidence in support of its view was also found in the fact that when Nedbank agreed to renew the guarantee annually itself had expressly stated that should the beneficiary fail to extend the guarantee it would follow that, then (and clearly only then) the guarantee could be called up (para 99).

Jansen J said that given the emphasis on the actual intention of the parties, there was no doubt in her mind that the agreement between the parties was that the building guarantee could only be called up once the disputes between the parties had been resolved by way of the pending arbitration proceedings (para 108).

She continued and held (paras 115 and 116):

"not only fraud may prohibit the calling up of a construction guarantee, but also unconscionable conduct and also when a contract to the contrary has been entered into between the relevant parties (in this instance, including the bank). . . .

Given the fact that Nedbank . . . was a party to the amended construction guarantees, it is bound by these terms. These terms include the extension of the construction guarantees until the issues have been finally determined by arbitration."

Jansen J applied the general principles of the law of contract to interpret the agreement made between the parties regarding the calling up of the guarantee. She also considered the role that "good faith" played in contracts and how that that has been applied in the South African case law. She highlighted that the recognition of the principle of good faith, has received very mixed reactions in the South African jurisdiction. She also added (para 125)

"Given the interpretation of the agreement between the parties set out above, it is unnecessary to delve further into the thorny issue of the role of good faith in contracts. However, the court holds that it is clear that when it is unconscionable to rely on the literal wording of a contract without reading such wording within the context of the background facts, the surrounding circumstances and the purpose of the agreement, then a construction guarantee cannot be called up."

The court confirmed the interdict prohibiting the beneficiary from calling up the performance guarantee until the final determination of the pending arbitration proceedings between the parties, except if Sulzer (Applicant) failed to extend the guarantee in accordance with the terms of the performance guarantee in its amended format.

Comments

This is not a well-reasoned judgment. It is not clear on which exact ground the court confirmed the interdict. The court simply relied on Australian law as the sole authority to say that a beneficiary could be prevented from calling upon a guarantee where he was acting fraudulently or unconscionably or had made a contractual promise not to call upon the guarantee. There is no indication that the court considered the position as it currently exists under the South African law. From a reading of the judgment it seems that the court was of the view that the conduct by the Beneficiary in Sulzer was unconscionable. The court also seemed adamant that if an agreement had been entered into between the relevant parties not to call upon the guarantee (either in terms of the underlying contract or in a separate agreement) the beneficiary could be prevented from making a call. It is unclear which grounds constituted the main reason for the interdict being confirmed. At some point the court even made reference to the role of good faith in contracts which could create the impression that the court was also of the opinion that the Beneficiary lacked good faith (ie, acted in bad faith) when he made the demand on the guarantee. Although acting in bad faith is somewhat similar to acting unconscionable, it is unclear if the court meant for bad faith to constitute an additional exception to the independence principle. The exact reason for ignoring the independence principle of the demand guarantee in this case is therefore quite blurred.

At present, in South Africa only fraud is accepted as an exception to the independence principle (for a full discussion, see M Kelly-Louw ""Limiting exceptions to the autonomy principle of demand guarantees and letters of credit" in C Visser & JT Pretorius Essays in Honour of Frans Malan (2014) at 197-218). The Sulzer case now seems to imply that there are also various other acceptable exceptions. The closest the South African courts came to expressing its view on whether a contractual promise not to call upon/draw on the guarantee/letter of credit could constitute a valid ground for ignoring these instruments' independence from their underlying contracts was in Union Carriage and Wagon Company Ltd v Nedcor Bank Ltd 1996 CLR 724 (W). In this case the court had simply remarked in passing 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 and had the beneficiary nevertheless sought to extract payment under the letter of credit, the beneficiary could conceivably have been guilty of fraud. Based on the Union Carriage case, it would thus seem that the conduct of the beneficiary in the Sulzer case could easily have been classified as fraudulent and could have been slotted under the existing fraud exception rather than being labelled as "unconscionable" and thereby creating a separate ground for justifying nonpayment. Until now the "unconscionable" and "bad faith" exceptions have not been dealt with or even raised as a possibility in the South African case law. Such exceptions should in any event not be accepted as they seriously undermine the independence of demand guarantees and letters of credit. They also diminish the usefulness of these instruments.

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This article represents the views of the author and not necessarily those of the ICC or any of the other partners in DC-PRO.