Finding a fair guarantee for a project

The impact of COVID-19 pandemic has left no African economy unscathed, resulting in a slowdown, which in some sectors, as commentators have predicted, may take years to recover to - what can be termed - ‘normal’ levels. And in the construction sector, this is situation is no exception. It is no longer ‘raining’ projects as before; projects are only coming in dribs and drabs. Thus, this calls for employers (project owners) and contractors involved in complex or major projects to work together in order to deliver on time, within budget and to the expected standards better than ever before.

The need to be clued-up

For contractors who do the actual ‘dirty’ work on site, the stakes could not have been higher. This should prompt them to be more clued up than before on the risks they may face and their implications on the ability to deliver on a project. This is because the reality is that no matter how consistently committed contractors may be to the project, there could be some unforeseen circumstances that could prevent them from performing as expected. For this reason, they have to be very conversant with the scope of the construction guarantees to the owner (employer) guaranteeing the contractor’s performance undertaken in terms of the construction contract or the principal building agreement (PBA). Of course, the dilemma they are likely to face is telling the wheat from the chaff amongst scores of construction guarantee offerings out there, with every service provider proclaiming have ‘the best and proven’ solutions.

At the outset, the need for contractors to be more prudent as they cherry-pick a 'fair' guarantee becomes clear considering the scope of construction guarantees and their contractual implications. Impulsive decisions may leave them very susceptible to being short-changed by employers.

The scope of construction guarantees

Under the PBA, construction guarantees are used to indemnify (cover) the employer against damages suffered in the event of the contractor defaulting. Short-term insurance companies (or guarantors) issue construction guarantees on behalf of contractors to provide a benefit to employers. In South Africa, this governed by terms of the Short-Term Insurance Act, which defines a guarantee policy as “A contract in terms of which a person, other than a bank, in return for a premium, undertakes to provide benefits if an event, contemplated in the policy as a risk

Contractors involved in projects in Africa should apply thorough due diligence when choosing a construction guarantee to cover an employer’s interest in a project, not least in the current economic climate.

Nothing is guaranteed, except a guarantee

Uncertainty about the future has proven the crucial need for construction contractors to provide employers with the security of a performance guarantee.

There have been shockingly hard lessons and knocks for a broad range of contractors over the past five years. For those who survived the pre-COVID-19 economic meltdown, the pandemic may have been the final straw, causing many defaults of contracts relating to construction work. These disruptions have challenged project execution and vastly changed attitudes towards the acquisition of performance guarantees, which have generally been considered a grudge purchase. Clinton Spence, Head of Santam Guarantees, explains: “Unlike with traditional insurance, here, a third party is involved. Construction projects are based on an agreement between a contractor (the principal debtor), working on behalf of a beneficiary (employer/owner/ creditor). Should a contractor fail to meet its obligation in fulfilling that contract, the project is at risk. “This is where a performance guarantee comes in. It indemnifies the beneficiary of the project against a default or non-performance by a contractor, which, in return, puts an obligation on a guarantor (the insurer) to make payment should a specific event occur. But although contractors facilitate and pay for the premium on a guarantee, they do not realise any direct financial benefit should there be a claim.”

The construction sector comprises 90% of Santam Guarantees’ underwriting, 70% of which is performance-based. “It is a highly specialised and extremely technical, risky business,” says Spence. “A guarantee issued today pushes our resources because the underwriting is made far more intensive. For example, we can’t judge how a company will be performing in a year’s time, let alone in six.”

Full-spectrum offering

There are three types of guarantees that together contribute to the majority of business within the Santam Guarantees product suite: Performance, which covers elements of quality, specification, and scheduling; Advance, which covers the expenses incurred to create the facilities that a site requires and addresses initial negative cash flows relating to the procurement of capital goods, and Retention, which comes into play at the end of the construction period, and addresses employer risk associated with defects. “This full-spectrum offering makes it incredibly difficult for underwriters. They have to consider whether the contractor has the financial and technical means to complete a job, and not fail. Ultimately, that’s what we are guaranteeing – non-failure!” says Spence.

Insurance good and proper

Underwriters have to consider an immensely complicated list of checkboxes, including contractor liquidity, performance over the previous five years, application of building standards, risk ratings, and technological and finance audits, to name but a few. Time frames vary, but generally, the process from the day the application is submitted to when the guarantee is issued, can take up to a month. However, this only applies to the local market; foreign clients can expect the process to take up to three months because of the varying security checks and compliances. Currently, 40% of the business Santam Guarantees underwrites is local; the balance is foreign. “At any one time, we have some 30 foreign guarantees in play, and only 25% of those are motivated through SA companies looking for support of their projects in other nations.” Spence concludes: “There is always a point in processing this type of insurance where you hold your breath because the risks are so great and so complicated. But ultimately, we abide by our decadesold mantra: to provide insurance good and proper. And we believe we do that well.”

Call Santam Guarantees on 011 912 8478/8354/812 or send an email to surety@santam.co.za for more information.

relating to the failure of a person to discharge an obligation, occurs.”

Based on information which Construction Review has sourced from some of the leading insurers and brokers in South Africa, mainly members of the South African Insurance Association, insurers cover the eventualities of non-delivery, non-performance and nonpayment through construction guarantees. Generally, the following are the common categories:

• Advance Payment Guarantee: The employer will require an advance payment guarantee where they have made an advance payment to the contractor. • Bid Bonds or Tender Guarantee: In instances where a tendering process was done, all contracts are accompanied with a tender guarantee. This is aimed at covering the employer against costs incurred where the contractor fails to take up the tender. • Performance Guarantee: Should the contractor fail to perform in accordance with the contract, the employer is covered by the performance guarantee. It therefore covers the cost of completion. • Retention Guarantee: The retention guarantee is a form of security against default or defective work. More often than not, there are always problems in the area of retention money guarantees. Certainly, this is one of the areas where contractors should more pay attention to.

Overlooked fine print in retention guarantees

Problems often arise in the area of retention money guarantees, where contractors sign agreements hastily, overlooking reading the fine print.

Retention money is money an employer withholds to protect it from any potential defects that may arise under the maintenance period of the contract. In an instance the contactor reneges on returning to site to repair defects, the money is used to pay an alternative service provider to do the work.

There have been instances where contractors would encounter a challenge after signing an unconditional retention guarantee, which gives away all their rights to the employer. Later, they would have no grounds for legal recourse should they have an objection.

Though this is no cast in stone, the rule of the thumb is: Contractors have to be well-informed about the kind of contract guarantee they are entering into – whether it is a demand or a conditional retention guarantee1.

Demand guarantees (unconditional)

Typically unconditional in form, a demand guarantee is a contract in which the guarantor promises to pay the beneficiary a certain sum of money upon the beneficiary’s first demand alleging a certain event. The event — usually insolvency or breach of contract by the contractor — does not need to be proven by the beneficiary (the contractor’s employer). Upon receipt of a compliant demand from the beneficiary, the guarantor is obliged to pay, irrespective of a dispute relating to the contract between the employer and the contractor.

If there is a claim on a contractor’s guarantee, the guarantee will have a right to claim the full amount from the contractor. Thus, the onus is upon the contractor to provide the guarantor with confidence and security that a full recovery from the contractor with no problem in the event there is a claim a guarantee. The amount of the guarantee that can be covered is dependent on three factors: the risk profile of the industry in which the contractor operates; the risk profile of the contractor; and the specific contract.

Standard forms of contract used in demand guarantees mainly include FIDIC, NEC, JBCC or GCC. However, employers may elect to have their own contract requirements. Risk averse employers are likely to ask for a demand guarantee to be included in tender requirements of complex contracts. More to the point, a guarantor is prohibited from informing the contractor that there has been a claim on a guarantee.

Due to the principle on which they are based, demand guarantees can be abused by an employer to force an outcome that favours them, with contractor getting the short end of the stick. The only area where a contractor may have grounds to dispute a claim is when there is concrete proof that the employer has been involved in some fraudulent activity.

Conditional guarantee or suretyship

A suretyship or a conditional guarantee, due to its accessory nature, places the burden on the guarantor for any failure of the contractor. It is worth highlighting that, due to the accessory nature of the suretyship, the guarantor’s and contractor’s obligations closely correspond. And so, due to this, the guarantor carries the obligations of completing construction works, delivering material and repaying cash in advance. Furthermore, when needs be, the contractor can intervene to resolve a contractual dispute by establishing whether or not the employer is making a valid claim against a guarantee.

A ‘fair’ option

From the foregoing, it clear that conditional guarantees or suretyships would be a ‘fair’ option for a contractor. However, the importance of reading the fine print of guarantee requirements either at the tender or commercial negotiation stage of a contract to prevent does need to be overemphasised. Moreover, onerous demand guarantees have to be avoided as far as possible.

Thorough due diligence

In the current atmosphere of a depression in the construction sector. More often than not, contractors find themselves in a liquidity squeeze. They would be at a receiving end - employers paying late, at best, or not paying at all, are all too common.

Contractors have to engage reputable guarantors with the most convenient packages for their construction projects in Africa. The few types of construction guarantee packaged under names, with seemingly little differentiation. There is no better way than doing the due diligence thoroughly. In this way they would be able to separate the wheat from the chaff.

Credits Information on “Retention guarantees” sourced from “The role of guarantees in contracting”, by Peter Suremann, underwriting manager in the Construction Guarantee business of Lombard Insurance Company, and adapted for Construction Review. The article was published on Civils Online, 9 April 2019