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The most commonly used form of guarantee in construction projects is the so called on demand or unconditional guarantee. The fundamental principle of an on demand guarantee is that it is autonomous and independent from the underlying construction contract. On demand guarantees must be honoured, notwithstanding any dispute between the parties i.e. the employer and the contractor to the underlying construction contract. Performance under an on demand guarantee is prompted by written demand made to the guarantor on occurrence of an event specified in the guarantee.
South African law has been influenced by the English law position in relation to the autonomous and independent nature of on demand guarantees. Similar principles have been adopted by other African countries such as Namibia, Kenya, Tanzania and Ghana.
The independent nature of on demand guarantees has resulted in many cases before the courts in South Africa that have challenged the basis and validity of a demand on these guarantees.
There is only one clearly established exception to the autonomous principle of on demand guarantees in South Africa and that is fraud. If there is no fraud, and provided the terms contained in the guarantee itself have been met by the employer, the guarantor must pay out upon the employer's demand in accordance with the terms of the guarantee.
The longstanding autonomy principle was put to the test in a recent case before the Supreme Court of Appeal (SCA) in the matter of Joint Venture between Aveng (Africa) (Pty) Ltd and Strabag International GmbH v South African National Roads Agency Soc Ltd and Another (577/2019)  ZASCA 146; 2021 (2) SA 137 (SCA) (13 November 2020) (saflii.org) (the SANRAL case).
In this case, the contractual relationship between SANRAL (the employer) and the Joint Venture (the contractor) broke down, with each party purporting to terminate the underlying construction contract. The dispute regarding the termination of the underlying construction contract was referred to arbitration pursuant to the dispute resolution procedure. At the time that the appeal was brought before the SCA, the arbitration proceedings had not yet commenced.
An on demand guarantee was issued in favour of SANRAL by the Joint Venture for its performance for the duration of the contract. As a result of the termination of the underlying construction contract, the Joint Venture applied to the Pretoria High Court for an interlocutory interdict restraining SANRAL from calling up the guarantee, pending the outcome of the arbitration.
The High Court did not decide the question of whether SANRAL’s right to call up the guarantee was limited by the underlying contract. Consequently, the Joint Venture appealed to the SCA.
The Joint Venture argued that SANRAL's call on the guarantee would be unlawful, on the basis that it had not met certain conditions in the underlying contract which limited its right to call up the guarantee. The Joint Venture submitted that South African law should be developed to recognise a further exception, other than fraud, so that where the underlying contract restricts a beneficiary's right to call up the guarantee, a contractor is entitled to interdict a beneficiary from doing so until the conditions in the underlying agreement have been met (the ''underlying contract exception'').
The Joint Venture argued that SANRAL had to establish a factual basis for its entitlement to call up on the demand guarantee, and that it should be precluded from demanding payment on the basis that it did not establish any entitlement to make the demand. After examining the relevant provisions of the underlying construction contract and of the guarantee, the SCA held that the Joint Venture failed to prove that the parties intended anything other than that SANRAL would be entitled to payment before any underlying dispute between them was determined, and accordingly dismissed the Joint Venture's appeal.
However, in considering the Joint Venture's submissions, the SCA examined the legal position both in Australia and England and found that in terms of Australian law a contractor may restrain a beneficiary from making a demand on a performance guarantee if the contractor can prove that the beneficiary would breach a term of the construction contract by making a call on the guarantee and therefore the beneficiary’s right to make a call on the guarantee should be restricted. Similarly, the courts in England have held that the underlying contract cannot be disregarded so readily, that it cannot be said that under no circumstances whatsoever, apart from fraud, that the court would restrain a beneficiary from calling up a guarantee.
The underlying contract exception was successfully raised in the English case of Simon Carves Ltd v Ensus UK Ltd  EWHC 657 (TCC) (23 March 2011) (bailii.org). In this case the contractor, Simon Carves Ltd, was employed by Ensus UK Ltd, the employer, to construct a bioethanol plant. The underlying contract provided that the contractor was to provide, as it is referred to in English law, an on demand performance bond (“performance bond”) in favour of the employer for the works and that the performance bond would become null and void once an Acceptance Certificate was issued by the employer to the contractor. Certain disputes arose in respect of alleged defects on site, however notwithstanding this, an Acceptance Certificate was issued to the contractor. The employer sought to call on the performance bond. The contractor argued that the performance bond was null and void on the basis that an Acceptance Certificate was issued and sought an injunction. Akenhead J held that “If the underlying contract…clearly and expressly prevents the beneficiary party from making a demand under the bond, it can be restrained by the court from making a demand under the bond.” The court held that the contractor was entitled to the injunction.
Although, the SCA in the SANRAL case, given the facts of the case and the evidence before it, did not have to make a finding on the underlying exception, the court has shed some light on paving the way for a new exception.
The SCA in passing stated that ''there is room'' in South African law to follow the same path taken in Australian and English law but reiterated the SCA decision of Kwikspace Modular Buildings Ltd v Sabodala Mining Company Sarl and Another (173/09)  ZASCA 15;  3 All SA 467 (SCA) ; 2010 (6) SA 477 (SCA) (18 March 2010) (saflii.org) and emphasized the important caveat that “…a building contractor may, without alleging fraud, restrain the person with whom he had covenanted for the performance of the work, from presenting to the issuer a performance guarantee unconditional in its terms and issued pursuant to the building contract, if the contractor can show that the other party to the building contract would breach a term of the building contract by doing so; but the terms of the building contract should not readily be interpreted as conferring such a right.”
In addition to the above caveat, the SCA also commented that “…given the significance of performance guarantees and letters of credit in international trade and commerce, such claims as are made by the Joint Venture in relation to the underlying contract, should be approached with caution.”
The underlying contract exception is a novel point which has not yet been tested in other African jurisdictions. The judgment could, however, pave the way for this exception being more widely and commonly accepted along with the fraud exception.
The South African courts have shown a resolute resistance to allowing the erosion of the autonomy principle in the context of on demand guarantees. This judgment, however, introduces a new potential exception to the well-established autonomy principle.
Whilst the underlying contract exception has been considered obiter by the SCA, there is no doubt that future litigants will seek to rely on the underlying contract exception in an effort to interdict a beneficiary's call on a guarantee, particularly in the absence of fraud. This exception requires further examination by the courts and will seemingly only be applied by the courts in very narrow circumstances, and within the very strict guidelines and caveats identified by the court. What is likely, however, is that parties will seek to rely on this exception as a defence, now that the door has been opened, even if just a crack.
On demand guarantees are designed to be used by employers to claim payment when a contractor has defaulted on its obligations. However, often so called “soft calls” are made on these guarantees, leading to many disputes regarding the basis and validity of demands. Whilst the judgment does not protect from “soft calls”, what it does allow is for parties to include certain restrictions in their contracts on when a guarantee can be called, thus offering some protection to a contractor. However, and what is important to remember, is that there must be a balancing act between the needs of the employer and protection to the contractor. Importantly, if the contractual terms are too onerous and seek to limit too much when an on demand guarantee can be called upon, it would dilute the very nature of the guarantee and employers will not be willing to accept such contractual terms.
Should you like to discuss this article further, please contact Alon Meyerov.