Construction guarantees

I have often been critical of the indiscrimate use of construction guarantees without consideration of the cost consequence to employers. Obviously the cost of any guarantee is built into the price by the Contractor and borne by the Employer. Where the Employer is able to be selective in the choice of tenderers incurring additional unnecessary costs, simply because it is the norm to ask for such guarantees, does not seem to make a lot of sense. Furthermore insurance companies and indeed banks who issue such guarantees do not always rush to the assistance of the Employer when demand is made and the Employer may be drawn into expensive litigation even where a guarantee is provided.

However, a recent judgment in 2010 illustrates that one particular insurance company did indeed promptly comply with an Employer’s demand only to be met by the refusal of the sureties themselves to reimburse the insurer after it had paid the Employer. The case is interesting for a number of reasons.

The facts were briefly as follows:
The Employer entered into a JBCC contract for the construction of a two storey training centre for the Employer. The insurer issued a variable construction guarantee in accordance with the wording of the standard JBCC forms in terms of which the insurer, as Principal Debtor, undertook to pay the Employer the guaranteed sum or the full outstanding balance upon the happening of either of two eventualities, being default by the Contractor resulting in cancellation or a liquidation order being granted against the Contractor.
The guarantee included the following words:

“The guarantor hereby acknowledges that: Any reference in this Guarantee to the Agreement is made for the purpose of convenience and shall not be construed as any intention whatsoever to create an accessory obligation or any intention whatsoever to create a suretyship.
Its obligation under this Guarantee is restricted to the payment of money. Reference to a practical completion certificate or to a final completion certificate shall mean such certificate as issued by the Principal Agent”.

A practical completion certificate was indeed issued by the Principal Agent but prior to that the Contractor was placed in liquidation. Some 6 months after the practical completion certificate was issued the Employer called up the guarantee advising that the Contractor had been placed in liquidation and some R241 000.00 was due to the Employer from the insurer, purportedly being the value of remedial work carried out after the issue of the practical completion certificate. The insurer, pursuant to the Employer’s demand, promptly made payment. Thereafter it made demand from the 3 sureties each of whom had undertaken, jointly and severally, to reimburse the insurer in the event that the insurer was called to pay out against a demand by the Employer. The sureties refused to pay the insurer as they contended that the claim that the insurer had paid out was invalid due to fraud by the Principal Agent in that the claim by the Employer against the insurer had included work that went beyond the terms of the construction contract. Although the sureties acknowledged that the Contractor would have been responsible for performing remedial work, it did not have an obligation, in terms of the construction contract, to do work in relation to a change in design specifications ordered by the Principal Agent after the liquidation of the Contractor. In particular the glass and other materials in an atrium which were replaced were originally installed strictly in accordance with the design specifications. The problem was that after the atrium was completed it proved unsuitable in that it was too hot and required additional ventilation. The replacement glass was substantially thicker and other materials were required in order to overcome original design flaws introduced by the Principal Agent together with a further significant design change requiring horizontal sliders to replace vertical sliders to facilitate ventilation. The sureties argued that the re-designing of the atrium with all the additional changes to the constituent materials was beyond the terms of the construction contract and therefore not the Contractor’s responsibility. In order to overcome the design problem introduced by the Principal Agent, the sureties alleged that the Principal Agent appeared to have perpetrated a fraud in order to obtain the benefits of the construction guarantee by claiming against the guarantee for work allegedly of a remedial nature which it clearly was not.

The matter proceeded in the High Court where the insurer argued that the sureties had undertaken to indemnify the insurer in the event that it was obliged to pay out against demand made on the guarantee. The terms of the surety agreement were self contained and created obligations distinct and separate from those created by the construction contract. The insurer argued that in terms of the construction guarantee, the insurer undertook and indeed was obliged to pay out upon the occurrence of one of the named events occurring, namely, the liquidation of the Contractor. The insurer argued that if it was required to pay out then it was in turn entitled to be reimbursed by the 3 sureties.

The High Court decided that the matter must be decided on the basis that the construction guarantee must be interpreted in conjunction with the construction contract. The Court reasoned that the insurer was only obliged to pay a claim under the guarantee if the claim was within the terms of the construction contract and since the claim did not fall within the construction contract, the insurer had not been obliged to pay and consequently had prejudiced the sureties in making payment against a demand which was effectively invalid. Accordingly, said the High Court, the insurer was not entitled to recover anything from the 3 sureties.

The insurer appealed this judgment to the Supreme Court of Appeal (SCA) and the judgement is reported . On appeal the SCA found that the High Court had misconstrued the nature of the guarantee and the indemnities provided by the 3 respondents. The terms of the construction guarantee issued by the insurer were clear. The guarantee created an obligation to pay upon the happening of an event. The fact that the construction guarantee recorded reference to the construction contract was purely for the purpose of convenience and there was no intention to create an accessory obligation or suretyship. The construction guarantee was put in place to protect the Employer in the event of default by the Contractor and it was to the guarantee that one should look to determine the rights and obligations of the Employer and the insurer. The conditions of the guarantee having been fulfilled, namely a liquidation of the Contractor having occurred, the insurer was obliged to make payment which it had done. Accordingly, the sureties were liable to reimburse the insurer in respect of the amount paid out to the Employer. There was no obligation on the insurer to investigate the propriety of the claim. In other words, it might well have been that some form of fraud was perpetrated. That however, insofar as the construction guarantee was concerned, was entirely irrelevant and therefore was also irrelevant insofar as the obligations of the sureties were concerned towards the insurer. The trigger event in respect of which the guarantee protected the Employer had occurred and demand had been properly made. The sureties were accordingly found liable to reimburse the insurer the R241 000.00 that it had paid out to the Employer together with the cost of the 2 court cases in the High Court and the Supreme Court of Appeal including the cost of 2 counsel.

In this instance the guarantee came to the assistance of the Employer who was not subsequently involved in the actions between the insurer and the 3 sureties. At the end of the day, having participated in 2 court cases, even though it was successful on appeal, given the legal cost incurred and the fact that the amounts which can be recovered by a successful party on taxation are only a fraction of the total amount expended by a successful party (frequently less than 40% of the total amount expended), the judgment was probably a hollow success for the insurer.

The judgment is however important in that it establishes that, depending on the wording of the guarantee, construction guarantees will be interpreted usually as stand alone documents independent of the construction contract itself. Of course subtle changes in the wording could have given a different result and there is a world of difference between the wording used in the JBCC variable construction guarantee and, for example, the Form of Guarantee included in the Blue Book for Civil Works, GCC 2004 and the Performance Security required by clause 4.2 of the FIDIC Forms of Contract.
At the end of the day cash is always king but construction contracts have a unique ability to devolve into some form of dispute and interestingly a substantial portion of our common law has evolved from decisions of the Courts concerning construction matters.

Chris Binnington Pr Eng