Performance Guarantees – Resisting a Demand under FIDIC Contracts

In any economic downturn, there is usually an increase in the number of demands made throughout supply chains and in particular by owners / employers on project securities (e.g. for performance issues, upon termination or following insolvency) and the recent global economic slowdown caused by the coronavirus pandemic is no different. 

Increasingly, we have seen contractors across the globe successfully challenging demands on unconditional security instruments (once seen as being ‘as good as cash’) for a failure to comply with the underlying contract. There is judicial precedent for such action. Over the past 15 years the issue has been considered in several jurisdictions, including England and Australia, where the courts have held that restrictive provisions in the underlying contract can prevent a demand being made on an unconditional security instrument (e.g. Simon Carves Ltd v Ensus UK Ltd [2011] EWHC 657 (TCC), para 33, and Clough Engineering Ltd v Oil and Natural Gas Corporation Ltd [2008] FCAFC 136, para 77). A recent case from the South African Supreme Court of Appeal (SCA) shines a fresh spotlight on this increasingly common, and invariably contentious, issue under the terms of the FIDIC Red Book 1999, commonly used in global projects.

The case before the SCA was between the Aveng-Strabag Joint Venture (contractor) and the South African National Roads Agency (employer) and related to the construction of the Mtentu River Bridge, which was to be the highest bridge ever built in Africa. The brief facts of the case are as follows: (i) the contractor terminated the contract, but this was disputed by the employer who sought to then terminate itself; (ii) the employer threatened to call the performance guarantee (an on-demand and unconditional guarantee); (iii) this led to the contractor seeking to restrain that call – claiming that the employer was not duly entitled under the conditions of the construction contract, notwithstanding that the guarantee was on its face unconditional.

Central to this case was the proper interpretation of the FIDIC Red Book 1999, the general conditions of which formed part of the construction contract and the relevant provisions of which were un-amended by the particular conditions. Specifically, the SCA had to decide on the circumstances in which a performance guarantee may be called by the employer and whether these provisions provided a hurdle, or were otherwise a condition precedent, to entitle the employer to properly make a call on the security. In particular, Sub-Clause 4.2 of the FIDIC Red Book 1999 (the relevant portions of which are substantially similar in the 2017 edition) provides that the employer may not make a claim under the performance guarantee (i) “except for amounts to which the Employer is entitled under the Contract”; and (ii) if one of the four trigger events listed in it occurs. It also provides for an indemnity to the contractor if the employer claims under the performance guarantee when it had no entitlement.

The contractor argued that the employer’s threatened call on the performance guarantee would be deficient on two grounds:

• for purposes of establishing “amounts to which the Employer is entitled under the Contract”, the employer failed to follow the procedure for payment under the contract pursuant to Sub-Clause 2.5; and
• none of the trigger events in Sub-Clause 4.2 had occurred – in particular, sub-paragraph (d), which provided that the employer was entitled to terminate, was not triggered because the contractor had terminated the contract first.

The SCA firstly confirmed the recognition of the autonomy principle, i.e. that a performance guarantee is autonomous from the underlying contract in respect of which the guarantee was issued. Consistent with English and Australian law, the SCA then decided that a contractor may, without alleging fraud, restrain an employer from calling on an unconditional performance guarantee if the contractor can show that the employer would breach a term of the construction contract by doing so. The issue then turned on whether the underlying FIDIC Red Book provisions provided the asserted impediment.

While any such case will turn on the facts, the key points considered by the SCA provide insight into whether the employer must first establish entitlement under the terms of the FIDIC Red Book before it can make a call on a performance guarantee. The SCA decided that it did not for the following reasons:

• The indemnity given by the employer under Sub-Clause 4.2 was an important factor in determining whether there was an impediment – the contract specifically provides for relief where the employer makes a demand to which it was ultimately not entitled. Accordingly, the indemnity showed that the parties contemplated that the employer might make a demand when it might subsequently be found that it had no entitlement.
• The employer does not have to prove its entitlement to make the demand at the time the demand is made and does not need to have first followed the dispute resolution mechanism to establish entitlement. Moreover, the prospects of success in pending dispute resolution proceedings were immaterial.
• However, pursuant to Sub-Clause 2.5, the employer was required to act in a bona fide belief that it was entitled to payment – whether it was in fact entitled at the time of the demand was immaterial.
• The procedure in Sub-Clause 2.5 does not always have to be followed so as to establish “amounts to which the Employer is entitled under the Contract” and to satisfy the trigger events in Sub-Clause 4.2. It only applied where it was specifically referred to, which was sub-paragraph (b) of Sub-Clause 4.2; not sub-paragraph (d) that was in issue.

What is the takeaway from this decision?

This case presents a timely reminder, when negotiating construction contracts and particularly when relying on standard forms, of the importance of ensuring clarity on any impediments to making a demand on otherwise unconditional securities. The contractor’s argument may not have been successful in South Africa in this instance but that might not be the case in other jurisdictions.