Conditional Bond

Wednesday, September 5th, 2012

Conditional bond

A conditional bond is common within the UK construction industry. Such a bond is usually issued by an insurance company, and payment is usually conditional upon the employer who makes the call providing the amount of loss which he has suffered. In practice, therefore, a conditional bond may require litigation before any payment can be obtained. A conditional bond is also known as a default bond. The guarantor becomes liable upon proof of a breach of the terms of the principal contract by the principal and the beneficiary sustaining loss as a result of such breach. The bond should include within the terms and conditions:

–          A mechanism for calling (so that the bond may be called only if certain procedures have been followed.

–          A requirement for the client to identify the reason for calling (which reason may be questioned and contested.

–          A cooling off period (during which the contractor may remedy the default.

The parties to a bond are:

–          The Principal is the party who requests the surety to issue the bond and whose obligations are guaranteed.

–          The Obligee is the party who requires the principal to obtain the bond and who receives the benefit of the guarantee.

–          The Surety is the party who issues the bond that guarantees the obligations of the principal.

A study of actual cases is always enlightening. We recommend reading Minister of Transport and Public Works, Western Cape and Another v Zanbuild Construction (Pty) Ltd and Another [2011] ZASCA 10; 68/2010 (11 March 2011). This case highlights the interpretation of two construction guarantees that were identical in their material terms. The guarantees were issued by Absa Bank Ltd in favour of the Western Cape Department of Transport and Public Works (DOT). The guarantees were issued with reference to two separate construction contracts entered into between MOT and Zanbuild. The work was to construct pathology laboratories at two hospitals. The guarantees issued by Absa were different from the MOT standard form but were nevertheless binding on the parties. Each guarantee was for an amount equal to 10% of the value of the contract to which they pertained. One of the Absa terms read:

‘The bank reserves the right to withdraw the guarantee after the employer has been given 30 (thirty) days written notice of its intention to do so, provided the employer shall have the right to recover from the bank the amount owing and due to the employer by the contractor on the date the notice period expires.’

Two days before the stipulated expiry date ie on 26 September 2008, the MOT responded to an Absa notice by demanding immediate payment of the full amount of both guarantees. Amongst other things the letter of demand stated that: ‘The contractor has defaulted on both contracts, see Annex “A” but the contracts have not been cancelled yet. … The Department therefore in accordance with the terms of the guarantee which affords us the right to recover this amount from the bank….demands payment of the guaranteed amounts.’

Brand JA in the judgment stated that: ‘In the parlance of the English authorities the dispute can be usefully paraphrased as being whether the guarantees are ‘conditional bonds’ (as suggested by Zanbuild) or ‘on demand bonds’ (as suggested by the department). The essential difference between the two, as appears from these authorities, is that a claimant under a conditional bond is required at least to allege and – depending on the terms of the bond – sometimes also to establish liability on the part of the contractor for the same amount. An ‘on demand’ bond, also referred to as a ‘call bond’ on the other hand, requires no allegation of liability on the part of the contractor under the construction contracts. All that is required for payment is a demand by the claimant, stated to be on the basis of the event specified in the bond’.

The bond issued by Absa included some very important words, namely: ‘Each claim by the employer must be made in writing accompanied by a signed statement that the contractor has failed to fulfil his obligations in terms of the contract and shall be sent to the bank’s domicilium address as indicated below.’

At para 19 of the judgment it states that: ‘Construing the Absa guarantees as a whole, I agree with the view of the High Court that they support the interpretation contended for by Zanbuild. In other words, that they do not constitute ‘on demand’ bonds, but that they give rise to liability on the part of Absa akin to suretyship. The first indicator in that direction is the assertion at the outset that the guarantee ‘provide security for the compliance of the contractor’s performance of obligations in accordance with the contract.’ And in the body of the document the bank guarantees ‘the due and faithful performance by the contractor’. This accords with language associated with suretyships.

At para 20 of the judgment it states that: ‘In argument the department’s answer to this indicator was twofold. First, that the interpretation of guarantees of this kind is often bedevilled by loose language. For the sake of argument, I accept that this is so. The second answer was that the Absa guarantees contain an indicator to the contrary’. This answer relied solely on the stipulation that ‘each claim by the employer must be made in writing accompanied by a signed statement that the contractor has failed to fulfil his obligations in terms of the contract’. What this provision means, so the department contended, was that, in order to obtain payment of the guarantees in full, the department has to do no more that to submit two documents to the bank: a) a claim in writing and (b) a signed statement that the contractor is in default under the construction contract. This, so the department’s argument concluded, renders the guarantee payable on demand whenever the contractor is in default, irrespective of liability on the part of the contractor.’

At para 21 of the judgment it states: ‘What goes against this interpretation is that provision upon which the department relies as the sole basis of its argument, contemplates more than one claim under the guarantee. …. Any breach of contract by the contractor would render the full amount of the guarantee due and payable on demand.’ The illogicality of this argument is explained.

The outcome of the case was that the DOT lost the appeal.

This case illustrates the difficulty of bonds and their interpretation in practice. It clearly demonstrates that this area is not the place for the ill-informed or gifted amateur.

The next article in the series covers Bid Bonds.