Rethinking guarantees and suretyship in lending agreements

May 1st, 2020
x
Bookmark

Picture source: Gallo Images/Getty

The Land and Agricultural Development Bank of South Africa (Land Bank) is a government owned development finance institution tasked with, among others, the facilitation and support of equitable ownership of agricultural land through the increase of ownership of agricultural land by historically disadvantaged persons (s 3(1)(a) of the Land and Agricultural Development Bank Act 15 of 2002 (the Act)). It achieves these objectives through, inter alia, the provision of financial services to historically disadvantaged persons with the aim of promoting access to ownership of land for the development of farming enterprises and for agricultural purposes (s 3(2)(a)).

In the case of Shabangu v Land and Agricultural Development Bank of South Africa 2020 (1) SA 305 (CC), the Land Bank lent and advanced funds to Westside Trading 570 Pty Ltd (Westside Trading) in terms of a written loan agreement for the purposes of developing urban property. Included in the security package for the loan were signed suretyships by Mr Shabangu and eight others (sureties). Following the conclusion of this transaction, it became known by the Land Bank that the loan agreement was invalid as it did not meet the developmental objectives contemplated in s 3 of the Act.

On learning of the invalidity, the Land Bank ceased advancing further funds to Westside Trading and sought to reclaim funds already advanced, plus interest accumulated thereon and fees incurred. Westside Trading disputed the amount so claimed, and accepted liability of a lesser amount in terms of a written acknowledgment of debt for payment in full and final settlement of its indebtedness to the Land Bank.

Unfortunately, Westside Trading failed to make repayments under the signed acknowledgment of debt thus resulting in the Land Bank instituting legal proceedings against it. Westside Trading was liquidated shortly thereafter thus necessitating the Land Bank to amend its claim and sue the sureties under the acknowledgment of debt instead.

The sureties disputed the claim on the grounds that the original debt had been declared invalid, which thus invalidated any further claims under the acknowledgment of debt.

The High Court

The High Court dealt with the validity of a suretyship where the principal debt has been extinguished. Defined, a suretyship is an agreement whereby a third party undertakes to assume liability for the debt obligations of a debtor to a creditor (whether in part or full) in the event of the debtor failing to fulfil its debt obligations. By its very nature, a suretyship is an accessory obligation and there can be no surety if there is no valid principal obligation.

In its arguments, the Land Bank differentiated between the legal terms ‘novation’ (an agreement substituting a new obligation for an existing one, thus extinguishing the old debt entirely) and ‘compromise’ (an agreement in terms of which parties agree to settle a dispute with the effect of discharging the original obligation) arguing that the acknowledgment of debt amounted to a compromise rather than a novation and that the invalidity of the loan agreement did not automatically invalidate the acknowledgment of debt. In arriving at its conclusion, the High Court relied on the findings in Panamo Properties 103 (Pty) Ltd v Land and Agricultural Development Bank of South Africa 2016 (1) SA 202 (SCA) where a loan agreement was subsequently declared invalid and an enrichment claim was instituted against the debtor relying on a covering mortgage bond in place. The court in the Panamo case dealt with a question of whether or not the bond given as security for the loan agreement covered an enrichment claim against the debtor. The court in Panamo found that the scope of the bond extended to debt obligations beyond those outlined in the loan agreement and, therefore, could be extended to include a claim for enrichment. Relying on this, the High Court through Basson J reasoned that ‘the fact that the loan agreement is invalid, does not mean that it necessarily follows that the deed of suretyship, being an ancillary agreement, is likewise invalid’ (Land and Agricultural Development Bank of South Africa v Meisel NO and Others (GP) (unreported case no 23733/12, 6-10-2017) (AC Basson J)). The High Court found that the suretyships granted in favour of the Land Bank in the loan agreement, covered the debt so validly acknowledged under the acknowledgment of debt. The applicants were thus ordered to pay amounts claimed under the acknowledgment of debt.

Constitutional Court (CC)

  • Validity of the acknowledgement of debt

The CC noted with concern that the High Court’s analysis of the Panamo case and its finding that the invalidity of the loan agreement did not invalidate the acknowledgment of debt and missed a crucial step, namely, whether the debt so acknowledged was not tainted by the original loan. This is the crucial difference between the claim under the Panamo case and the present case. The court stated that, as was seen in Panamo, a valid debt is not necessary for an enrichment claim to arise. In Panamo, the court iterated that a mortgage bond can secure more than the obligations contained in a loan agreement, but that it could contain primary obligations (as opposed to accessory obligations) and such primary obligations could, therefore, not be extinguished by the invalidity or voidness of the obligations contained in the loan it secured.

In the present case, however, it was common cause that the acknowledgment of debt only arose as a result of the existing debt and the two could not be separated. Froneman J remarked at para 20 of Shabangu that: ‘At best [the acknowledgement of debt] was about payment of a reduced amount still owing under the invalid loan agreement’. Proceeding with the claim under the acknowledgment of debt would be tantamount to resuscitating an invalid agreement.

The court noted the Land Bank’s comparison of a novation and a compromise in law and remarked that even if the acknowledgment of debt had to be characterised as a compromise, the acknowledgment of debt remained tainted by the invalidity of the original agreement thus resulting in an invalid arrangement.

  • Creating a principal obligation

The court noted that if the acknowledgment of debt had been premised in a way that established a principal obligation such as an enrichment claim or a claim based on a ‘no profit principle’, the acknowledgment of debt could have been valid and enforceable.

Furthermore, the terms of the suretyships were clear and exclusively limited to the extinguishing of the debt obligations as contemplated in the invalid loan agreement. The scope of the suretyships did not extend beyond the loan agreement and could not be said to cover the subsequent acknowledgment of debt.

The court found the acknowledgment of debt to be tainted with the original invalidity of the loan agreement.  The applicants appeal succeeded with costs.

Conclusion

There are important issues, which arise from this judgment (for both debtors and creditors) in the structuring of financing deals.

At the outset, it is important for the parties to a financing transaction such as this matter, to ensure that all requisite corporate and statutory requirements for the conclusion of the transaction have been complied with not only in terms of procedural approvals, but also in terms of the power to assume stated rights and/or obligations. This eliminates potential ultra vires acts and the legal and financial implications that could ensue. More importantly where a government institution is involved, the constitutional invalidity of the loan agreement adds a different and riskier dimension to the powers of the parties to act.

The parties ought to exhaustively consider the nature of the rights they wish to regulate in the security documents. Different rights arise from different forms of security, namely, suretyships, covering mortgage bonds. It is no use to conclude security documents that will not be of much assistance in the event of a default, or worse, a declaration of invalidity of the underlying contract. This case also raises usefulness of capacity, authority, validity and enforceability opinions for transactions of this nature. Usually these related to a borrower, but is it time for lenders to be covered by this too – for their benefit.

Another important issue is the significance of creating primary obligations in security agreements. It is for this reason that in most cases, guarantees are preferred to suretyships. As a general principle, guarantees create principal obligations while suretyships create accessory obligations. It should be noted, however, that it is not what you call your agreement, but rather the nature of the obligations created thereunder. Lenders should be careful in this regard. For example, in Basil Read (Pty) Ltd v Beta Hotels (Pty) Ltd 2001 (2) SA 760 (C) the Cape Provincial Division held that a document that was referred to as a ‘demand construction guarantee’ issued by the Joint Building Contracts Committee was in the nature of a suretyship and that any obligation of the guarantor was accessory to the obligation of the debtor to the creditor. This is because the substance of some guarantees is often worded as suretyships.

On the other hand, in Peter Cooper & Company (Previously Cooper and Ferreira) v De Vos [1998] 2 All SA 237 (E) the court rejected the defendant’s argument that a bank guarantee constituted a suretyship. It is stated in the Peter Cooper case that ‘it is true that the ordinary and usual meaning of the word “guarantee” connotes a surety who promises to saddle himself with an obligation if the principal obligator defaults.’ The court held that ‘the word [guarantee] has several meanings and the sense in which it is used in a particular document would depend on the contents and tenor of that document’.

If one intends to create a guarantee in terms of which the guarantor assumes the principal obligation, then one should consider using language that demonstrates this intention clearly. For example, one may word the agreement to the effect that –

  • the guarantor undertakes as a principal obligation to pay to the lender on the occurrence of specified events, and that the guarantee is not a suretyship or any other form of accessory obligation;
  • the guarantor must waive any defence or reliance on any defect or dispute in the underlying agreement; and
  • any invalidity of the underlying agreement, or any dispute thereunder shall not absolve the guarantor from performing under the guarantee.

Finally, where agreements have been found after the fact to be unenforceable, settlement agreements, be it in the form of acknowledgements of debt or otherwise, should be carefully considered lest they are tainted with the unenforceability that applies to the original agreement.

Nobathembu Dlamini LLB (UKZN) PG Dip (Law) (Wits) and Sandanathi Gwina BProc (Walter Sisulu University) PG Dip (Corporate Law) (Wits) are legal practitioners at Gwina
Attorneys Inc in Johannesburg.

This article was first published in De Rebus in 2020 (May) DR 16.

X