In the recent decision of Dormell Properties versus Renasa Insurance Company the joint liquidators of Synthesis Projects Cape (in liquidation) the Supreme Court of Appeal (SCA) dealt with issues concerning liability under construction guarantees.

Renasa had issued a standard JBCC construction guarantee in favour of Dormell in respect of the performance of the works by the contractor Synthesis. The works comprised the construction of a shopping centre in Durbanville Cape Town.The guarantee provided that it expired on 28 February 2008.

Prior to the issue of the guarantee, Dormell had converted from a company to a close corporation. The building agreement reflected the company as the Employer and the guarantee was issued in favour of the company and not the close corporation.

In response to Renasa's refusal to pay the close corporation, Dormell contended that the purpose of the guarantee and the intention of Synthesis, it and Renasa was to secure the position of the Employer engaged on the project in question, i.e. the close corporation and it was therefore entitled to rectification of the guarantee to reflect the close corporation as the Employer.

A dispute arose between Dormell and Synthesis the consequence of which is that Dormell cancelled the building agreement on 28 February 2008. On the same day it called up the guarantee. In doing so, it complied fully with the steps prescribed in the guarantee.

Renasa refused to make payment under the guarantee alleging that:

· Dormell was not the party entitled to payment under the guarantee due to the guarantee being issued in favour of the company, as opposed to the close corporation, and reflecting the company as the Employer therein;

· The guarantee had not been called up timeously and had expired at midnight on 27 February 2008.

In addition, Synthesis alleged that the cancellation by Dormell was unlawful and therefore the calling up of the guarantee was flawed and could not sustain a claim for payment. This issue, as well as several others had been referred to arbitration by Synthesis.

Before the hearing in the SCA, the arbitrator had found that Synthesis was not in breach and that accordingly Dormell's cancellation was indeed unlawful.

The SCA was therefore required to decide:

· Whether Dormell was entitled to rectification of the guarantee so as to reflect it (as opposed to the company) as the party entitled to payment thereunder;

· Whether the guarantee had been called up prior to its expiry;

· Whether the Arbitrator's finding that Dormell's cancellation was unlawful absolved Renasa from liability under the guarantee.

The SCA found unanimously that, in issuing the guarantee, Renasa's intention, as in the case of all guarantees of this nature, was to secure the position of the Employer in fact undertaking the project in question. The fact that this Employer had not been correctly described in the guarantee did not affect this intention and Renasa's liability to such Employer.

The court accordingly upheld Dormell's request for rectification of the guarantee so as to reflect the close corporation as the Employer therein.

The court also unanimously found that the guarantee had been timeously called up and did not expire at midnight on 27 February 2008. Where a guarantee provides that it will expire on a certain day, rather than at the end of a calculated period of time, the right to call up the guarantee may be exercised at any time on that day, i.e until midnight. Accordingly, Dormell's calling up of the guarantee during the course of 28 February 2008 was permissible.

No fault can be found with the court's reasoning and findings thus far. However, the court's unanimous approach ended there and in a 3/2 split decision, it found that Dormell's entitlement to payment under the guarantee had been negated by the Arbitrator's finding that its cancellation of the building agreement was unlawful. It is this aspect of the judgment which we find alarming as it departs from the widely accepted approach, both in South Africa and in the United Kingdom, that a guarantee constitutes a separate, stand-alone agreement between the guarantor and the customer/employer, and is not concerned with the relationship and agreement between the customer/employer and the supplier/contractor, and any disputes arising out of such agreement.

Where the guarantee provides for a set of steps to be taken by the customer/employer in calling up the guarantee and those steps have been taken, the guarantor is obliged to honour the guarantee. To proceed otherwise undermines the commercial veracity of and certainty sought to be created by guarantees of this nature.

Only where the customer/employer acts fraudulently in calling up the guarantee can the guarantor be excused from making payment. There was no finding of fraud on the part of Dormell.

The majority decision of the court was based upon the reasoning that, as a result of the finding that the cancellation of the building agreement was unlawful, Dormell had lost its entitlement to access to the guaranteed funds in order to complete the works. Allied to this reasoning is the view that the guaranteed funds may only be used for this purpose and are not intended to be available to meet any and all claims which the Employer may have against the Contractor arising from the building agreement.

We are in agreement with the minority view that the proceeds of a construction guarantee are not ring-fenced in this way, as this would mean that an Employer who has validly cancelled the building contract could never use the proceeds of the guarantee to satisfy amounts due to it by the Contractor prior to and at the time of cancellation.

The use of construction guarantees is widespread and was intended to and has largely replaced the provision of retention funds in building contracts. Retention funds have habitually been the source of dissention between Employers and Contractors.

We are concerned that the Dormell judgment will disturb the regime of provision of reciprocal guarantees under building contracts, which have become the accepted practice in major construction projects. Developers will be less inclined to rely upon and have confidence in the provision of construction guarantees in the light of the decision which opens the door to the guarantor declining payment despite full compliance by the Employer.

This enables the guarantor to enter into the arena of the performance or otherwise of the Employer's and Contractor's obligations under the building agreement, something very removed from the stand-alone agreement which the guarantee creates between the guarantor and Employer.

For this reason we hope that the SCA will have occasion to reconsider and correct its approach in the not too distant future.

Written by Nick Muller, Director, and Kelly-Anne Ramages, Candidate Attorney, in the Dispute Resolution: Litigation, Arbitration and Mediation Practice at Cliffe Dekker Hofmeyr business law firm.