Construction Guarantees: On Demand or Surety?

Construction guarantees (also called ‘performance guarantees’ or ‘performance bonds’) are frequently issued in Construction agreements to ensure that the employer is safeguarded in the event that the contractor causes a delay, or a disruption, in the completion of the works. The JBCC series contract has a standard form of Construction Guarantee- and this can be a part of the agreement. The parties are free however to deviate from the JBCC series contract and construct their own construction guarantee agreement. Case law has shown that construction guarantees may be interpreted as ‘on call’, or ‘on demand’ guarantees, or as a suretyship guarantee, also known as a ‘conditional bond’. It is important to know the difference in interpretation between the two types of construction guarantees, as they are substantially different from one another.

Where a construction guarantee is in place, it presupposes the existence of three separate relationships, that between;

•  The employer and the contractor – governed by the building contract;

•  The employer and the financial institution – which the employer tasked the contractor with approaching for the provision of a construction guarantee, and which will in turn, if the requirement of the guarantee are fulfilled, make payment of the amount as contained in the construction guarantee.

•  The contractor and the financial institution for the provision of a construction guarantee.

I will now discuss relevant case law in which the different interpretations of construction guarantees were considered.

ACCESSORY AGREEMENT

In the matter of Basil Read v Beta Hotels 2001 (2) SA 760 a building contract was entered into between the applicant, Basil Read, as the contractor, and the 1st Respondent, Beta Hotels, as a hotel owner. The 3rd Respondent is the financial institution who provided Basil Read with a construction guarantee. The building contract, and the construction guarantee itself, was based on the 1991 JBCC series contract. The construction guarantee determined that payment would be effected upon the receipt of a written demand from the employer ‘in respect of expenses or loss incurred or to be incurred by virtue of non-performance or breach of the terms of the contract’.

A dispute arose due to the fact that the principal agent, namely the appointed architect (the 3rd Respondent), refused to extend the practical completion date to such a date as was requested by Basil Read. This dispute was referred to arbitration. Upon the interpretation of the construction guarantee the court decided that the arbitration proceedings did not relieve Basil Read of its liability for the ‘due and timeous performance’ of its obligations. The court found that the construction guarantee gave rise to liability on the part of Basil Read on the basis of suretyship. This conclusion was reached due to the fact that upon reading the guarantee it was clear that it intended to ‘indemnify the first Respondent ( Beta Hotels) against such ‘expenses and loss’ – caused by the payment of penalties, etc. The construction guarantee in this matter was in the nature of a suretyship agreement, this being so any obligation of the financial institute to Beta Hotels is accessory to the liability of Basil Read to Beta Hotels.

In the recent Supreme Court of Appeal matter of Minister of Transport and Public Works, Western Cape, and Another v Zanbuild Construction 2011 (5) SA 528 the court also found on interpretation of the construction guarantees that same was construed in the form of a suretyship agreement. The facts of the matter are as follows:

Pursuant to two, but similar, building contracts having been entered into between the contractor, Zanbuild Construction, and the Minister of Transport and Public Works, the employer, Zanbuild approached Absa Bank to secure construction guarantees in favour of the employer. The construction guarantees were not the standard JBCC guarantees, but same was accepted by the employer nonetheless.

The wording of the guarantees provided that Absa reserved the right to withdraw the guarantees after the employer had been given 30 days notice of its intent to do so. In event of this coming to pass the employer reserved the right to recover the amounts outstanding and due to it by Zanbuild as on the date of the expiry of the guarantees.

Absa notified the employer of its intent to withdraw the construction guarantees, and the employer gave notice within the 30 day period of its intent to recover the full amounts of both guarantees. The employer alleged that Zanbuild was in default, but had not yet taken steps to cancel the building agreements between it and Zanbuild. Both the building agreements were indeed cancelled afterwards.

The employer contended that although it had no monetary claims against Zanbuild, the construction guarantees were of such a nature that they stood apart from the principal agreement, and were thus akin to irrevocable letters of credit. This being so, Absa must make immediate payment of the construction guarantees upon a valid claim being submitted.

According to the express wording of a guarantee, it is either a ‘conditional bond’ or an ‘on demand bond’. The difference between the two is that with a conditional bond it is required that liability be established on the part of the contractor, whilst with an ‘on demand bond’ no allegation of liability on the part of the contractor is required. All that is required is a valid demand on the part of the employer to the financial institution.

The court concluded that the wording of the construction guarantees gave rise to liability on the part of Absa akin to suretyship. The indications for this conclusion was that the guarantees themselves stated that ‘security be provided for the compliance of the contractor’s performance of obligations in accordance with the contract’, and the wording indicated that separate claims under the guarantees could be made, which clearly indicated the construction guarantees were referring to a claim in terms of the principal agreement. Lastly, the fact that the guarantees contained the provisions which allowed Absa to withdraw expressly limited the liability of the bank, in accordance with the nature of a suretyship agreement.

What is understood about a suretyship agreement is that it is accessory to a principal agreement, there can be no obligation when the principal obligation it refers to is not valid or effective. A surety agreement needs three relationships in order to be in place, in construction contracts this will be between the contractor and the employer, between the employer and the financial institute, and lastly the relationship between the contractor and the financial institution.

‘ON DEMAND’ CONSTRUCTION GUARANTEE

Two Supreme Court of Appeal matters immediately spring to mind when one considers ‘on demand’ construction guarantees, these being Dormell v Renasa and Lombard v Landmark Holdings.

The matter of Lombard Insurance Co Ltd v Landmark Holdings 2010 (2) SA 96 an insurer, namely Lombard, issued a construction guarantee to the employer,on instruction of the contractor. The guarantee determined that the full amount of the guarantee, or the amount outstanding at the time of the demand, would be payable to the employer on default of the construction company or in the case of its liquidation. The employer found out at some point in time that the contractor had been liquidated, and thus made a claim under the guarantee, which Lombard paid out. Prior to this however Landmark Holdings indemnified Lombard Insurance for any claims under the construction guarantee. The 2nd and 3rd Respondents also indemnified Lombard for any claims arising from the construction guarantee. After the guarantee had been paid out Lombard had reason to suspect that fraud was involved, and approached the court.

The court a quo in this matter interpreted the guarantee in conjunction with the principal agreement and held that Lombard was only obliged to pay a claim under the agreement if the claim was within the terms of the principal agreement. Since the claim did not fall within the contract, Lombard was not obliged to effect payment of the construction guarantee, and could thus not claim indemnity from the Respondents.

The Supreme Court of Appeal however found that the court a quo had erred in its conclusion concerning the construction guarantee and the indemnity agreements. Upon inspection of the construction guarantee the court found that the guarantee created an obligation to pay upon the happening of an event, a trigger. The guarantee provided that any reference to the principal agreement was only for convenience sake, and expressly stated that there is no intent to create an accessory obligation or suretyship.

The guarantee by Lombard is not unlike irrevocable letters of credit issued by banks and used in international trade, the essential feature of which is the establishment of contractual obligation on the part of the bank to pay the beneficiary. This obligation is wholly independent of the underlying contract of sale and assures the seller of payment of the purchase price before he parts with the goods being sold. The bank’s liability to the seller is to honour the credit. The bank undertakes to pay provided only that the conditions specified in the credit are met. The only basis upon which the bank can escape liability is proof of fraud on the part of the beneficiary.

Lombard had undertaken to pay the construction guarantee upon the contractor being put into liquidation, this being the trigger event. This indeed came to pass, and the employer made a valid demand. The same principle applied to the Respondents’ indemnity agreements in favour of Lombard.

The matter of Dormell Properties v Renasa Insurance Company [2010] ZASCA 137 is quite a lengthy one, and the Supreme Court of Appeal had to determine on issues of time, rectification and the validity of a construction guarantee. I will only focus on the court’s discussion with regard to construction guarantees.

Dormell Properties, the employer, concluded a building agreement with Synthesis, the Contractor. Synthesis obtained a construction guarantee from Renasa at the behest of Dormell. The construction guarantee was couched on the standard form of construction guarantee as in the JBCC 2000 contract. This guarantee set out certain requirements to be met in order for the guarantee to be paid out, these being that a proper claim be made by the employer on the grounds that the building contract had been cancelled due to a default of the contractor.

The court a quo had found that the construction guarantee had expired prior to a claim being made, but consented that Dormell may take the matter on appeal.

Prior to the Supreme Court of Appeal hearing the matter the parties to the agreement referred the dispute to arbitration, where the arbitrator made the award that Dormell had repudiated the building contract, thus Synthesis had validly cancelled same.

The majority of the judges of the Supreme Court of Appeal found that due to the fact that Dormell had in effect caused the cancellation of the agreement it would be an academic exercise to enforce the construction guarantee. This despite the fact that they had acknowledged that as an ‘on call’ construction guarantee, the guarantee had to have been honoured as soon as the employer made a proper claim in the happening a specified event. And Dormell had made a proper claim. The majority placed heavy reliance on the award of the arbitrator in making its final decision; Dormell’s repudiation of the building agreement had been unlawful and as a consequence it lost its right to enforce the guarantee.

The minority judgement of Cloete JA was however that the Arbitrator’s award was irrelevant. In terms of the construction guarantee, which was a ‘on demand’ or ‘on call’ guarantee, it was unnecessary for Dormell to allege it had validly cancelled the building agreement due to Synthesis’s default. Dormell had made a valid demand, bona fide, with no question of fraud, thus the construction guarantee should have been paid out within 7 days. The fact that Dormell had unlawfully cancelled the contract affected only Synthesis, and not Renasa at all.

In another Supreme Court of Appeal matter, Compass Insurance Company Ltd v Hospitality Hotel [2011] ZASCA, the court had to make a decision whether the employer had fulfilled the requirements of a ‘performance guarantee’. Compass had issued a performance guarantee in favour of Hospitality for the performance of work undertaken by a subcontractor. The construction guarantee would be payable upon the liquidation of the subcontractor, and in order to make a valid claim the court order of liquidation had to be attached to the claim.

Hospitality made a claim under the construction guarantee, but failed to provide Compass with the court order of liquidation. Hospitality only placed Compass in possession of the court order a while after the performance guarantee had expired. Hospitality argued that the courts do not favour strict compliance with the wording of a performance guarantee, as they do with suretyship agreements, and the court a quo decided in its favour.

The Supreme Court of Appeal however did not agree, as the requirements for the payment of the construction guarantee were absolutely clear, and Hospitality did not comply with them at all.

“There may be cases where what is referred to as a guarantee constitutes no more than an accessory obligation. However, it is the terms of the guarantee itself that will determine its nature. The guarantee in this case is an independent contract that must be fulfilled on its terms. There is no justification for departure and indeed allowing the furnishing of the copy of the court order months after the guarantee had expired would have defeated its very purpose.”

BEWARE THE READER!

After reading the above matters, it should be noted that any person, be it an employer, contractor or a financial institution, must be careful and aware of the agreements they are putting in place. Make sure that you understand the nature of the agreement, and that it is indeed what you wish for. Construction guarantees are strictly interpreted by our courts, thus it is prudent that a party desirous of making a claim thereunder follows the requirements to the very word.