Building Contracts: The Difference Between On-Demand and Conditional Performance Guarantees
In the construction industry, employers require contractors to provide guarantees as security for the fulfilment of their contractual obligations. Contractors, in turn, require their subcontractors to furnish guarantees for their obligations. A legal issue that arises is how to interpret the guarantees and whether the guarantees constitute "on-demand" guarantees or "conditional guarantees”.
On-demand guarantees constitute primary independent obligations placed on a guarantor to make payment of a guaranteed amount. The obligations are independent from the main contract and are usually triggered by a written demand being made on the guarantor. Conditional guarantees, on the other hand, are guarantees only payable on the happening of a specified condition linked mainly to performance of the contractor or sub-contractor.
So, when does a performance guarantee amount to an on-demand guarantee and when does it amount to a conditional guarantee, akin to a suretyship agreement? This is the issue the Supreme Court of Appeal (“SCA”) grappled with in the recent case of Mutual & Federal v KNS Construction (208/15)  ZASCA 87 (31 May 2016).
The background facts were that SANRAL awarded a contractor, KNS Construction, a contract for road works in Ballito. KNS then appointed Aqua Transport & Plant Hire (Pty) Ltd as a sub-contractor to perform surfacing work. Aqua was required to provide a performance guarantee to the value of 15% of the main contract and Mutual & Federal, as guarantor, issued a guarantee of approximately R3.4m on Aqua’s behalf. The wording of the guarantee was:
"Mutual & Federal do hereby hold at your disposal the amount of R3,423,850.49 for the due fulfilment by Aqua Transport of its obligations to KNS in terms of the stated contract" and "The Guarantor renounces the benefits of exceptions non numeratae pecunia, non causa debiti, excussion and division, the meaning and effect whereof we declare ourselves to be fully conversant. The guarantor undertakes to pay KNS the said amount of R3,426,850.49 or such portion as may be demanded on receipt of a written demand from KNS which demand may be made by KNS if (in your opinion and at your sole discretion) the said contractor fails and/or neglects to commence the work as prescribed in the contract or if he fails and/or neglects to proceed therewith or if, for any reason, he fails and/or neglects to complete the services in accordance with the conditions of contract, or if he fails and/or neglects to refund to KNS any amount found to be due and payable to KNS or if his estate is sequestrated or if he surrenders his estate in terms of the insolvency law in force in the Republic of South Africa."
KNS experienced financial difficulties, leading to the company’s voluntary winding up in December 2011. As such, KNS was not able to perform in terms of the main contract, and SANRAL therefore cancelled the contract and issued a new tender. A day after placing itself in liquidation, KNS cancelled the sub-contract with Aqua, giving Aqua 14 days’ notice to rectify its performance and to commence work or face the guarantee being called up. To avoid this, Aqua applied to the South Gauteng High Court to interdict Mutual & Federal from paying under the guarantee and the dispute about the true meaning of the guarantee ultimately found itself in the Supreme Court of Appeal in Bloemfontein.
KNS argued that the guarantee was an on-demand guarantee and it had thus become payable when demand was made. Aqua, on the other hand, contended that the guarantee was a conditional guarantee linked to performance under the contract and the condition for the calling up of the guarantee had not been fulfilled.
To resolve this question, the SCA scrutinized the wording of the guarantee and relied on the recognized rules of interpretation, one of which is to ascertain the intention of the parties from the express wording of the document. In addition, the SCA reviewed past court decisions dealing with guarantees. In the case of Lombard Insurance Co Ltd v Landmark Holdings (Pty) Ltd & others, the SCA was required to interpret a guarantee. The Court found that the guarantee issued by Lombard was:
“…not unlike irrevocable letters of credit issued by banks and used in international trade, the essential feature of which is the establishment of a contractual obligation on the part of a bank to pay the beneficiary (seller). This obligation is wholly independent of the underlying contract of sale…The only basis upon which the bank can escape liability is proof of fraud on the part of the beneficiary. This exception falls within a narrow compass…”
The SCA also reviewed Minister of Transport and Public Works, Western Cape, & another v Zanbuild Construction (Pty) Ltd & another, where the court found that the guarantee gave rise to a liability akin to that of a suretyship. In this judgment, the SCA stated:
“The first indicator in that direction is the assertion at the outset that the guarantee provides “security for the compliance of the contractor’s performance of obligations in accordance with the contract”. And in the body of the document the bank guarantees “the due and faithful performance by the contractor”. This accords with language associated with suretyships."
Ultimately, the SCA found that the language used in the Mutual & Federal guarantee was similar to that in the Zanbuild case, and it revealed that the true intention of the parties was to have a conditional guarantee in place to guarantee the due performance by Aqua of its contractual obligations. In other words, Mutual & Federal was not assuming a primary and independent obligation to pay under the guarantee but only a conditional obligation to pay if there was a breach by Aqua. The SCA also highlighted the fact that although the demand under the guarantee was at the discretion of KNS, this did not change the nature and form of the guarantee, as the discretion by KNS had always to be exercised arbitrio bono viri – which means in good faith.
The SCA concluded that KNS could not and did not perform its obligations in terms of the main agreement and therefore Aqua was not in breach of its obligations under the sub-contract agreement by failing to commence the works; Mutual & Federal did not have to pay under the guarantee as it was a conditional guarantee and the condition had not been met.
What does this mean for the construction industry? In each instance, when a guarantee is handed over, the wording needs to be examined and, if necessary, discussed with the Guarantor – the parties need to understand whether they are contracting to receive an on-demand guarantee as a primary obligation placed on a guarantor or whether the guarantee is akin to a suretyship, which is conditional on underlying performance.
Regrettably, often the wording of the guarantee is not examined at the inception of the contract and the document is filed away with the other contract documents and only emerges when a dispute arises. By then the proverbial horse will have bolted if the wording of the guarantee does not meet the expectations of the contracting parties.