Allegations of poor workmanship at President Jacob Zuma's Nkandla homestead have recently made headlines again following an official visit to the estate by MPs and members of the media last month.

One wonders how things might have panned out if performance guarantees were called on in this instance.

Bar the political considerations relating to Nkandla, from a legal perspective, the courts have made it clear that such guarantees must be paid on a valid written demand, save in the case where fraud is involved.

Performance guarantees are provided by a bank or an insurer to secure proper performance by a contractor under a construction contract. By providing such a guarantee, the bank or insurer shoulders the employer's risk.

The Coface case – laying down the law

In the case of Coface South Africa Insurance Co Ltd v East London Own Haven t/a Own Haven Housing Association (2014 (2) SA 382 (SCA)), the Supreme Court of Appeal laid down the law on the issue of the enforceability of performance guarantees.

The Coface judgment followed an appeal by Coface South Africa Insurance Co Ltd ("the insurer") against a high court decision in which East London Own Haven t/a Own Haven Housing Association ("ELOH") was awarded over R1-million in terms of a performance guarantee.

Briefly, the facts were that ELOH and Construct Construction (Pty) Ltd ("the contractor") concluded a construction contract in terms of which the contractor needed to obtain an on-demand performance guarantee in favour of ELOH. In terms of the guarantee, the insurer undertook to pay ELOH on receipt of a written demand, which needed to state that the contract had been cancelled due to default by the contractor.

The contract was subsequently cancelled after ELOH accused the contractor of default. However, despite ELOH complying with all of the terms of the guarantee, the insurer refused to pay the guaranteed amount. The insurer denied that the contractor had defaulted on its obligations, instead blaming ELOH for a faulty design, which meant it wasn't entitled to call up the guarantee, it claimed.

The dispute headed to the high court, where ELOH was successful. It later went on appeal to the SCA, which confirmed the high court ruling.

Earlier cases

In reaching its decision in the Coface case, the SCA confirmed the findings in both Guardrisk Insurance Company Ltd v Kentz (Pty) Ltd (94/2013) [2013] ZASCA (29 November 2013) and Lombard Insurance Co Ltd v Landmark Holdings (Pty) Ltd & Others 2010 (2) SA 86 SCA.

The legal position, as set out in the Lombard case, is that an insurer's obligation is independent of the underlying construction contract and that any dispute between the parties to it has no impact on the insurer's obligation. Accordingly, a dispute between an employer and a contractor in terms of the construction contract doesn't provide an insurer with a defence or a basis on which to avoid paying out in terms of the guarantee.

In terms of the Guardrisk case, the fact that a performance guarantee refers to the construction contract doesn't render the guarantee accessory to the construction contract – the performance guarantee remains a principal obligation of the insurer to the person in whose favour the performance guarantee was issued.

If the situation provided for in the guarantee happens (in the Coface case, this was default by the contractor) and a valid, non-fraudulent demand for payment is made, the insurer is obliged to pay the guaranteed sum. The only ground for refusing to do so is that the demand for payment is fraudulent, and the insurer bears the onus of proving this on a balance of probabilities.

Essentially, the insurer must show that the person demanding payment has knowledge that –

  • the information on which the demand is made is incorrect; and
  • the insurer will rely on the information presented on demand.

A spanner in the works – the Dormell case

However, a different view was articulated in Dormell Properties 282 CC v Renasa Insurance Co Ltd and Others NNO 2011 (1) SA 70 (SCA).

In this case, the SCA had to decide many issues, including the validity of a call on a performance guarantee and, if valid, whether it should be upheld or enforced. The SCA found that the appellant in this case had validly demanded payment from the respondent in accordance with the performance guarantee. However, due to a subsequent arbitration award, which held that the appellant had unlawfully repudiated the construction contract between itself and the contractor, there was no longer a legitimate purpose for the amount to be paid, the majority judgment in the SCA found.

The minority judgment in this matter, however, found that the respondent had no defence for failing to pay the guaranteed sum, as the demand had been validly made and there was no suggestion of fraud involved. The arbitration should have no effect on the guarantee, according to the minority judgment.

Finally, much-needed clarity

The SCA in the Coface case preferred the view of the minority judgment in the Dormell case, finding that the majority judgment was "clearly wrong". As Coface had based its case on the Dormell majority judgment, it was bound to fail, the SCA found.

The SCA added that the Dormell decision had led to an increase in litigation in which insurers have attempted to introduce contractual disputes to avoid their obligations under guarantees.

Hopefully these floodgates have now closed following the Coface case, where the court made it clear that the legal position as set out in the Lombard and Guardrisk cases is correct. This means that, other than when a defence of fraud is raised, an insurer is obliged to pay out on a valid on-demand written demand.

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