Understanding construction bonds and guarantees

While bonds are similar to insurance, there are differences – and it pays to know what you’re dealing with.

Bonds and guarantees are used extensively in the construction industry to support projects. These should not be confused with bonds used in capital markets. In the construction industry, bonds and guarantees are instruments used to protect the owner of a project against the risk of default or bad workmanship by the contractor.

Essentially they are contracts of suretyship, which promise the project owner (or principal) that in the event of the construction company defaulting, or failing to complete the project according to contract specifications, the surety (usually a bank or insurance company) will make good the default. This is important because prudence dictates that the project owner takes all reasonable steps to protect funds invested in the project against failure by the contractor.

In a way bonds are similar to insurance, but the two also have fundamental differences. For example, a bond involves three parties – the surety, the contractor and the principal (who is the project owner or sponsor). Insurance involves only two parties – the insured and the insurer.

While bonds and guarantees can play a vital role in supporting construction projects, users must ensure that they understand how these instruments work to avoid unnecessary and often costly disputes.

In this regard, the recent case of Guardrisk Insurance Company Ltd versus Kentz (Pty) Ltd 2013 ZASCA 182 is illustrative. The case started in the South Gauteng High Court in 2010 and later went to the Supreme Court of Appeal. In this case, Guardrisk issued construction bonds in favour of Kentz (Pty) Ltd (the owner of the project) at the request of Brokrew Ltd (the contractor). The bonds issued were of a type called demand guarantee, and advance payment for the proper performance and advance financing of the project, respectively.

Brokrew ran into financial problems and, in March 2010, it advised Kentz (Pty) Ltd that it was unable to perform its obligations under the contract unless terms of the contract were re-negotiated.

As it turned out, Brokrew was later liquidated and was represented in the proceedings by its liquidators. Subsequent to that, Kentz cancelled the contract with Brokrew after realising that the contractor no longer had capacity to see the project through. Kentz then made a demand for payment from Guardrisk in terms of the demand bond. Guardrisk rejected the claim as being fraudulent. Kentz sued Guardrisk in the South Gauteng High Court claiming payment in terms of the bonds that Guardrisk had issued at the request of Brokrew.

The High Court found no evidence of fraud by Kentz when it demanded payment and ruled that Guardrisk was obliged to pay in terms of the bond it had issued. Guardrisk appealed to the Supreme Court of Appeal, arguing that the bonds it issued were conditional and not demand bonds.

The difference between a conditional and a demand (or unconditional) bond lies in what the principal has to prove in order to succeed in a claim for payment.

Conditional bonds require proof of liability on the part of the contractor before the project owner (or principal) can be entitled to payment. By contrast, a demand bond (also known as a “call bond”) places no such obligation on the principal. All the principal needs to do is demand payment on the basis of the event specified in the bond. In this case it was the failure by the contractor, Brokrew, to fulfil its obligations under the contract it entered into with Kentz. That is why this type of bond is called a demand or call bond.

On reading the case, it appears Guardrisk was mistaken about the nature and type of bonds it had issued. It argued they were conditional bonds, but both the High Court and the Supreme Court of Appeal found that they were, in fact, unconditional. How Guardrisk could issue unconditional bonds and later argue that they are conditional is not easy to understand.

However, the fact remains that the Supreme Court of Appeal found the bonds to be unconditional (or demand) bonds, which placed no onus on Kentz to prove liability. The court further ruled that the only way one can avoid payment under an unconditional bond is to show that the demand for payment is fraudulent.

This fraud exception requires the surety to prove that a beneficiary (in this case Kentz) under a demand bond has made a call for payment knowing that it is not entitled to such payment. In such a situation the court is obliged to protect the surety and decline enforcement of the bond. In other words the surety must show that the beneficiary’s claim contains material misrepresentations of fact, which the beneficiary knows to be untrue.

Because the essence of fraud is intentionally making false claims in order to benefit, merely showing that there was a misunderstanding or dispute between the contractor and the principal does not make the beneficiary’s claim fraudulent.

Guardrisk argued that Kentz cancelled its contract with Brokrew prematurely and did not give the contractor adequate notice in terms of that contract. Yet all this, as correctly pointed out by the Supreme Court of Appeal, is of no consequence under a demand (or unconditional) bond. All that matters is: Is the demand for payment being made in accordance with the terms of the bond or guarantee in place? Alternatively, has the event protected by the bond occurred? If the answer is “yes” the principal is entitled to payment.

Underlying contractual disputes that may exist between the principal and the contractor have no bearing on the surety’s obligation to pay once a call has been made. Demand for payment under the bond is, therefore, strict and totally independent of any other issues that may be involved between the principal and the contractor.

The Guardrisk Insurance Co Ltd versus Kentz (Pty) Ltd case brings one fundamental aspect of demand (or unconditional) bonds and guarantees to the fore. These instruments are very risky from the surety’s perspective. They leave the surety with virtually no defence once the beneficiary has made the demand for payment in terms of the bond. It is not unusual to find some banks and insurance companies that, as a matter of principle, refuse to issue unconditional (or demand) bonds.

This begs the question; why do banks and insurance companies agree to issue them? To find the answer, one has to examine the expectations of the surety when it agrees to issue bonds and guarantees in general.

The reality is that the surety will only agree to issue a bond if it expects to pay no claim. Herein is another difference between bonding and insurance. Insurers generally expect to pay some losses on policies they issue, but in bonding no such losses are expected. A bond represents a surety’s confidence in the technical and professional competence of the contractor. Therefore the surety does not expect the bond to be called up, because such a development represents some professional flaw, which ought not to occur.

However, as this case demonstrates, a contractor can fail, resulting in the bonds (issued in favour of the principal by the surety) being called up, and when this happens unconditional bonds reveal their ugly side.

In the final analysis, however, the nature of bonding, as it is commercially practiced, is such that the surety further secures its position by demanding counter-indemnities from the contractor, which are used in the event that the bond is called up.

Further, the surety also has a right of recourse against the contractor if it makes payment under a bond,
but this may not be very helpful in cases where the contractor is insolvent and its liabilities exceed its assets.

Legally Speaking is a regular column by Albert Mushai from the school of Economics and Business Sciences, University of the Witwatersrand. Mushai holds a master’s degree from the City University, London, and was the head of the insurance department at the National University of Science and Technology in Zimbabwe before joining Wits University as a lecturer in insurance.