South Africa: Demand Bonds - A Pound Of Flesh

The good news for the beneficiary of an on-demand bond or guarantee, also known as a performance bond, advance payment bonds, tender bond and letter of credit or irreversible documentary credit¹, is that the surety’s liability is triggered more often than not upon the mere demand or call by the creditor, provided the call is expressed in accordance with any requirements of form which are to be inferred from the wording of the bond.²

In those cases the occurrence of the event or document or the making of the demand in the appropriate form will over-ride any need to establish the accuracy or justification of any facts or alleged facts, such as the failure of due performance under the principal contract on which the bond or guarantee may have been nominally conditioned.³

Demand bonds are forms of guarantees with the distinctive characteristic that the guarantee can be called irrespective of the true state of affairs between the debtor and the creditor, provided a demand which complies with the terms of the bond is made.⁴

Demand bonds are a means of ensuring performance of the contractor’s obligations. Commonly, bonds are now provided at a fixed percentage of the contract price. The employer can then call down the bond by asserting a breach of contract without having to prove the breach to the bank. The bank is then required to pay, apart from fraud, if the demand is in proper form and is not entitled to investigate the true position.

Established fraud on the part of the beneficiary is the exception to the rule that no regard should be had to the underlying transactions.

In such an instance, the fraud must be brought to the attention of the bank before payment to the beneficiary is made.

The beneficiary of credit who is knowingly a party to forged documents or documents that otherwise facilitated the perpetration of a fraud in the transaction, would acquire no rights to any of the future proceeds contemplated by the credit.⁶

The onus of establishing fraud is the ordinary civil one, that is the balance of probabilities, but as in other instances where fraud is alleged, it will not be lightly inferred.⁷

The representation of the irregularity in regard to the transaction continues up to the moment of payment. Accordingly where the beneficiary’s claim against the ultimate debtor is discharged before payment in terms of the documentary credit, the beneficiary is equally guilty of fraud where it persists in its efforts to obtain payment in terms of the documentary credit.

The essential feature of an irrevocable documentary credit is the establishment of a contractual obligation on the part of the bank to pay the beneficiary under the credit ("the seller") which is wholly independent of the underlying contract of sale between the buyer and the seller, and which assures the seller of payment of the purchase price before parting with the goods which form the subject matter of the sale:

Accordingly, much turns on the classification of whether the bond is conditional, on demand or unconditional, since demand bonds can be oppressive documents.

The most notorious or infamous bond was that given by Antonio, the "Merchant of Venice" to Shylock.¹⁰

Demand bonds have been described as "astonishing".¹², and also "virtually the same as a promissory note payable on demand."¹³

The question whether the bond is conditional or absolute is essentially one of interpretation of the instrument. In practice, that often reduces to the question of whether the beneficiary has to establish a valid claim against the ultimate debtor.¹⁴

In July 2007 the Court of Appeal for Botswana was required to determine whether the bond in dispute was conditional or absolute. The beneficiary had been unsuccessful in the trial court in that regard and appealed the judgment.

Both the insurer who issued the bond as well as the sub-contractor was sued.

It was submitted that the performance bond in the case was a demand guarantee.

The bond provided that the insurer is surety

It was common cause that the bond should be read and interpreted in light of a subsequent letter addressed to the insurers by the beneficiary, the main contractor ("the due cause letter"). That letter recorded, inter alia:

It was common cause that the words "due course" should read "due cause".

The contractor subsequently cancelled the sub-contract on the basis of the sub-contractors alleged repudiation of the sub-contract, which letter was followed by a letter of demand by the sub-contractor to the insurer under the performance bond.

The beneficiary argued that the performance bond was a demand guarantee, despite the fact that the due cause letter qualified the performance bond. It was submitted that in order to show due cause under the sub-contract, the contractor was only required to allege that the sub-contractor failed to perform thereunder.

Both the lower and appeal courts disagreed.

The performance bond was not an unconditional undertaking, such that upon mere notification of the sub-contractor’s default the insurer would pay the contractor the pre-determined sum on demand.

To the contrary the court highlighted the wording of the bond "to indemnify the Contractor of any liability or damage resulting from defects or shortcomings of the sub-contractor or the debts it may have incurred …"

While it was correct that the bond did not require proof of the defects, shortcomings or debts, whether actual, estimated or expected, the letter of demand did not even suggest that the sub-contractor’s alleged breach of the contract caused the contractor to suffer any loss or damage for which the insured was liable. Moreover, there was no quantification of the amount which was required "to indemnify the Contractor for any liability or damage resulting from the defects or shortcomings of the Sub-contractor or the debts he may have incurred to any parties involved in the works under the Sub-Contract.", nor was there any indication on what grounds the contractor was claiming payment of the full amount under the performance bond.

The due cause letter made it clear that the performance bond would only be called upon if the contractor has a right of action against the sub-contractor in terms of the sub-contract, which right of action presupposes the contractor having suffered damage as a result of the sub-contractor’s breach of contract. No allegation of loss or damage was made in the letter of demand.

The mere allegation of the sub-contractor’s breach of the sub-contract did not establish due cause.

Accordingly, properly interpreted, the performance bond as read with the due cause letter, was not unconditional and proper demand had not been made under the bond in the letter of demand.

The insurer was entitled to refuse to make payment; no doubt bringing to the insurer’s minds the words of Portia:

Parties who wish to avoid having to depend on the mercy of a court, should carefully consider the wording of any performance bond to determine whether the payment obligation is conditional or absolute.

The principles set out above also apply to the insurance equivalent of a bond, that is a guarantee policy.

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.