Effect on demand guarantees: clause 4.2.2 in FIDIC Red 2017

14 July 2023

In the FIDIC suite of contracts, the contractor is ordinarily required to obtain a performance security within 28 days of receiving the Letter of Acceptance. In terms of the 2017 edition of the FIDIC Conditions of Contract for Construction for Building and Engineering Works Designed by the Employer (more commonly known as the FIDIC “Red Book”), clause 4.2 is the key clause dealing with the contractor’s performance security.

The ‘performance security’ usually takes the form of a performance guarantee, also known as a performance bond, and is arguably the most common type of guarantee in the construction industry. The function of this particular guarantee is to safeguard the employer against non-performance, late performance or insufficient performance by the contractor. 

A performance guarantee may either be conditional or unconditional. The difference manifests in the terms of the guarantee. An unconditional guarantee (also called a ‘demand guarantee’) only requires a notification to the guarantor in accordance with the terms of the guarantee itself. The guarantor must then honour the demand for payment in terms of the guarantee, irrespective of any disputes or obligations arising from the construction contract.

Entitlement to Payment in Terms of Clause 4.2.2

Clause 4.2.2 of the FIDIC Red Book limits the situations in which the employer may make a call on the guarantee to the following:

“[t]he Employer shall not make a claim under the Performance Security, except for amounts to which the Employer is entitled under the Contract in the event of:

(a) failure by the Contractor to extend the validity of the Performance Security…;

(b) failure by the Contractor to pay the Employer an amount due, as agreed or determined…;

(c) failure by the Contractor to remedy a default stated in a Notice given under Sub-Clause 15.1…;

(d) circumstances which entitle the Employer to terminate the Contract under Sub-Clause 15.2…; or

(e) if under Sub-Clause 11.5 [Remedying of Defective Work off Site] the Contractor removes any defective or damaged Plant from the Site, failure by the Contractor to repair such Plant, return it to the Site, reinstall it and retest it by the date of expiry of the relevant duration stated in the Contractor’s Notice…”

The clause furthermore provides contractors with protection against calls on the guarantee which falls outside of the ambit of clause 4.2.2:

“The Employer shall indemnify and hold the Contractor harmless against and from all damages, losses and expenses (including legal fees and expenses) resulting from a claim under the Performance Security to the extent that the Employer was not entitled to make the claim.

South African jurisprudence does not recognise qualifications for payment stemming from the underlying contract but strictly evaluate the terms of the guarantee itself. This leads to further conceptual problems relating to the independent nature of guarantees.

The question to investigate is whether a breach of compliance with the requirements to demand payment in terms of the guarantee would consequently indemnify the contractor against any resultant damages, losses and expenses – as provided for in clause 4.2.2.   

Enforcement of the Guarantee

Given that the demand performance guarantee as envisaged in FIDIC, is generally payable strictly in accordance with its terms, a problem might arise as regards the enforceability of the limitation contained in clause 4.2.2 in the South African legal position. In South African law, unless fraud is present in the documents comprising the guarantee itself such as for example forgery, the guarantee must be honoured. Without the presence of fraud a court may order payment.

The principle of autonomy of a demand guarantee provides that the underlying construction contract and the guarantee are independent from one other and that invalidity of the one contract will not affect the validity of the other. In effect, this has the result that a guarantor, in the event that it wishes to prevent payment to the beneficiary, cannot defend itself with any reference to the underlying contract.

In the matter Joint Venture between Aveng Africa (Pty) Ltd and Strabag International Gmbh v South African National Roads Agency SOC Ltd [2019] 3 All SA 186 (GP) the Court considered, amongst others, how clause 4.2 would affect the enforcement of the performance guarantee and whether the contractor would be entitled to restrict payment thereof, by way of an application for an interdict, when the employer does not comply with the requirements contained in clause 4.2 of the underlying contract.

The court held that if it was necessitated to pronounce on the issue, it would have held that the employer / beneficiary of the guarantee was required to meet the preconditions in clause 4.2 of the contract before its entitlement to demand payment in terms of the guarantee would arise. This pronouncement by the Court is indicative of the more lenient approach being adopted by the Courts as regards the independence of a demand guarantee.

On appeal to the Supreme Court of Appeal in the same matter, it was confirmed that the provision indemnifying the contractor from instances where the employer was not entitled to call upon the demand guarantee remains applicable. The Court held that any other construction of the terms of the contract would render the indemnity provision meaningless. The effect of this important judgment is that when the employer calls upon the guarantee without entitlement as envisaged in FIDIC, it does so at its own risk.

The limitation formed in clause 4.2 creates two competing legal concepts. The first is that it creates an undertaking by the employer/beneficiary in the underlying contract to only call upon the guarantee in strictly specified circumstances, while the second relates to the unconditional right of the employer/beneficiary to obtain payment from the guarantor in terms of the guarantee itself.

The present legal position in South Africa, however, remains that the conditions in clause 4.2 of the FIDIC Red Book will not restrain payment in terms of a guarantee.

By Deonn Fourie | Director

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