The case of the unconditional guarantee that wasn’t

14 Jul 2016

When the wording of a construction-related guarantee is ambiguous, the intention of the parties involved is key in determining its true nature. This was highlighted in a recent Supreme Court of Appeal (“SCA”) judgment, which found that the best way to determine the parties’ intention was to look at all relevant facts.

The importance of guarantees in construction

In the construction industry, it is common for an employer to require a contractor to provide a guarantee as security for the fulfilment of its obligations under the construction contract, which is usually equivalent to 10% of the contract price. The contractor may, in turn, require a subcontractor to furnish a guarantee as security for proper fulfilment of its obligations under the subcontract.

Guarantees are usually issued by a bank or an insurance company for a specified amount and for a fixed period of time (usually the time the contractor is likely to take to complete the work).

Construction guarantees typically take one of two forms, namely an on-demand or call guarantee, which is unconditional, and a suretyship guarantee, which is conditional. The rights of the holder and the obligations of the guarantor under these two guarantees differ:

  • on-demand guarantees are first primary obligations of the guarantor, equivalent to an indemnity to the employer, and operate independently of the degree of performance or non-performance of the principal contract. They are effectively the equivalent of a promissory note payable on demand.
  • suretyship guarantees are conditional on a particular event (or events), commonly on the satisfactory performance of the contractor. These guarantees are accessory to the principal agreement, and there can be no obligation where the principal obligation they refer to is not valid or effective.

Sometimes it’s not clear from the wording of a guarantee whether it amounts to an on-demand or a suretyship guarantee. This was the case in the recent SCA decision in Mutual & Federal v KNS Construction (case no. 208/15, 31 May 2016).

The Mutual & Federal case

During 2011, KNS Construction (Pty) Ltd (in liquidation) (“KNS”) was awarded a contract for the construction of roadworks in KwaZulu-Natal. KNS appointed Aqua Transport and Plant Hire (Pty) Ltd (“Aqua”) as a subcontractor to apply the prime coat, asphalt base and surfacing. In terms of the subcontract, Aqua had to provide a performance guarantee of a stipulated percentage of the main contract price.

Mutual & Federal (“M&F”) issued the guarantee, with the following terms:

  • M&F held at KNS’ disposal ZAR3.4-million for Aqua’s fulfilment of its obligations to KNS under the subcontract.
  • M&F renounced the benefits of certain exceptions.
  • M&F undertook to pay KNS ZAR3.4-million 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), [Aqua] 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 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 within the Republic of South Africa.”

KNS subsequently experienced financial difficulties and could not perform its obligations under the main contract, including the work it needed to do in order for Aqua to perform under the subcontract.

KNS went into voluntary liquidation (which later became final) and purported to cancel the subcontract with Aqua, giving the latter 14 days’ notice to rectify its performance. Failing this, KNS would call up the guarantee based on Aqua’s alleged failure to commence, proceed with or complete the project.

Aqua launched an application in the high court to interdict M&F from paying out under the guarantee, pending the finalisation of proceedings between KNS and Aqua. KNS also launched an application in the court, contending that the guarantee was an on-demand guarantee and that it had become payable. Aqua, however, contended that the guarantee was conditional, inextricably linked to the subcontract and, as it was not in breach of the subcontract, the guarantee was not due and payable.

The court found in KNS’ favour, holding that M&F was obliged to pay in terms of the guarantee on demand from KNS, provided the latter complied with its terms.

Aqua then approached the SCA, where it maintained that the guarantee was conditional and was inextricably linked to the underlying subcontract, similar to a suretyship and not an on-demand guarantee.

In determining the nature of the guarantee, the SCA considered several of its earlier decisions. The court noted that the guarantee in question recorded that it was issued for Aqua’s fulfilment of its obligations to KNS in terms of the subcontract. Further, the guarantee amount was payable upon written receipt of a demand from KNS where Aqua failed and/or neglected to commence or proceed with the work, or failed to complete the services in accordance with the subcontract.

The SCA found that although the guarantee was payable at KNS’ discretion and payment could be demanded at any stage, its true purpose was to guarantee Aqua’s performance under the subcontract. As such, the amount was only payable if Aqua breached the subcontract as expressly provided for in the guarantee. The fact that KNS could call upon the guarantee did not affect the nature of the guarantee, as KNS’ discretion could only be exercised reasonably, the trigger event being Aqua’s failure to commence, proceed with or complete the subcontracted work. The SCA found that KNS did not – and could not – perform its obligations in terms of the subcontract, and therefore did not meet any of the conditions imposed before payment could be deemed due and payable.

The fact that that the guarantee was not accompanied by any document before payment was demanded, but depended on breach of the subcontract, lent credence to the fact that the guarantee was inextricably linked to the subcontract and was therefore akin to a suretyship, the court found. The inescapable conclusion was that the guarantee was conditional.

Parties’ intention is key

The facts of the M&F matter, more so than the wording of the guarantee, were instrumental in the SCA’s finding. Regardless of the wording of the guarantee, it is likely that the SCA would still have found, on the facts, that the guarantee was conditional and akin to a suretyship. It is highly improbable that, at the time the subcontract was concluded and the guarantee provided, the parties intended that KNS could demand the guarantee in any circumstances other than where Aqua was in breach of the subcontract and that KNS would be entitled to call up the guarantee when it was the one preventing Aqua from performing.

The intention of the parties is thus vital in such a dispute and, in ascertaining what this is, the courts must consider all relevant circumstances surrounding the contract in question.

(This article is provided for informational purposes only and not for the purpose of providing legal advice. For more information on the topic, please contact the author/s or the relevant provider.)

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