By Ntupang Magolego
Almost all human actions or activities have the potential to bring about damage and/or loss. In contract law, there are various mechanisms available that serve to reduce the exposure and probability of loss resulting from some of these activities. On a daily basis lawyers are confronted with the task of advising clients on which mechanisms to impose in order to minimise loss. It is important for a lawyer who has been tasked in this way to have a clear understanding of the nature and effect of each risk-mitigating mechanism so that clients are adequately protected against risk. This article aims to elucidate on suretyships, guarantees, warranties, indemnities and insurance as means of mitigating or reallocating risks.
Suretyships
Suretyship is one of the frequently utilised risk-mitigating mechanisms in South Africa. In essence a suretyship contract entails an agreement in which a surety agrees to be bound to a creditor for the obligation of another, being the principal debtor. A suretyship is a contract and therefore the parties to it – the surety and the creditor – must conclude an agreement and the normal requirements for concluding a valid contract must be complied with. In terms of the General Law Amendment Act 50 of 1956, a suretyship contract must be in writing, and further to this, in terms of the National Credit Act 34 of 2005 (NCA) a suretyship agreement, which is referred to as a credit guarantee in the NCA, will be regulated by the NCA, provided the principal agreement to which the suretyship/credit guarantee relates is a credit agreement to which the NCA applies.
Therefore, a written contract where A agrees to be bound to B as surety with C, for the due performance by C of its obligations arising out of C’s agreement with B, will be a valid suretyship contract. The purpose of a suretyship contract is therefore to protect the creditor against the loss associated with the risk of non-performance by the principal debtor.
Once a valid suretyship contract is concluded, there will be two debtors who are liable and bound for the same debt – that is, the principal debtor and the surety – and there will be two separate agreements, namely the main agreement between the creditor and the principal debtor and the suretyship agreement between the creditor and the surety. In practice these two agreements are usually embodied in one document. The validity of a suretyship contract is dependent on the validity of the main agreement between the creditor and the principal debtor, and another characteristic of a suretyship contract is therefore that it has an auxiliary nature.
The principal debtor remains liable for the obligations arising out of the main agreement, and the surety’s obligations kick in when the principal debtor fails to perform his or her obligations under the main agreement.
Guarantees
The words ‘guarantee’ and ‘suretyship’ are constantly used interchangeably, but these two terms are distinct and have different effects. In a legal sense, a guarantee is a form of security in terms of which a guarantor agrees to make payment to a beneficiary –
A typical example of a demand guarantee is a performance guarantee, a practice usually found in the construction industry, in which a guarantor (usually a financial institution) agrees to give security for the due performance of a principal’s obligations under a construction contract between the principal (the financial institution’s client) and the beneficiary, by issuing a guarantee in favour of the beneficiary that will be presented to the guarantor for payment. In other words, A and B enter into a contract in which B must construct a building for A, and as security for the due performance of the building construction by B, C provides A with a guarantee.
At first glance a demand guarantee can be confused with a suretyship, however, a closer examination will reveal that this is not the case. The main difference between this guarantee and a suretyship is that a demand guarantee is a separate and independent contract from the underlying contract between the principal and the beneficiary. The validity of a demand guarantee contract is not affected by the validity or not of the underlying contract between the principal and the beneficiary. In other words, if the construction contract between the principal and the beneficiary is found to be invalid, this will not invalidate the demand guarantee contract as it is a distinct and separate contract.
Another difference between a suretyship and a demand guarantee is that the due performance of the obligations under the underlying contract in case of a suretyship contract (ie, the principal agreement between the principal debtor and the creditor) can be the liability of either the principal debtor or the surety. In other words, a suretyship contract entails that the surety will be held liable for the due performance of the obligations of the principal debtor under the principal agreement. This is not the case with a demand guarantee. A demand guarantee does not entail that the guarantor will be held liable for the due performance of the obligations under the underlying contract between the principal and the beneficiary. Therefore, the principal remains the only party liable to perform under the underlying contract, for example, the principal is the sole party that must perform the obligations under the construction contract; a demand guarantee does not make the guarantor liable for this obligation.
Other examples of demand guarantees are –
A letter of credit is also a guarantee contract, and it is usually employed in international trade transactions. In this case, a purchaser in, for example, South Africa enters into a sale agreement with a seller in Australia, and for payment of the purchase price, bank A (the purchaser’s bank) issues a letter of credit that the seller can present for payment. The seller does not have to demand payment from the purchaser first before presenting the letter of credit for payment. The letter of credit therefore serves as the first mode of payment, as opposed to being accessory or secondary. Again the letter of credit is a separate contract and is not dependent on the underlying sale agreement between the purchaser and the seller.
A guarantor is obliged to perform in terms of the issued guarantee, be it a demand guarantee or a letter of credit, on compliance with all the formalities by the beneficiary. These formalities are usually that the beneficiary must present the guarantee for payment, together with all the required documents.
A guarantee then serves to safeguard the beneficiary against loss associated with the risk of non-performance or improper performance by the principal (in case of a demand guarantee) or the risks of non-payment (in the case of a letter of credit).
Warranties
A warranty is a contractual term in which one party gives an undertaking to another party that specific facts or conditions are true or will happen. Warranties can be contractual – that is, expressly agreed to by the parties to a contract; or implied by law – that is, warranties that form part of a contract, without the parties expressly agreeing thereto, but by virtue of the law (such as those implied by the Consumer Protection Act 68 of 2008).
Warranties can also be either a promissory warranty or an affirmative warranty. A promissory warranty is when one party gives an assurance to the other party that a fact is presently true and will continue to be true. An example of this kind of warranty is when A gives B an undertaking that he or she is in possession of a valid licence to operate a particular business and will throughout the existence of the contract be in possession of the licence. An affirmative warranty is when one party gives an assurance to the other party that a particular statement of fact is true and may be relied on. A typical example of an affirmative warranty is when A gives B an undertaking that he or she has the authority necessary to enter into an agreement with B.
Warranties serve, first, to elicit information from the parties in a contract and, secondly, they serve to reallocate risk between the parties in that the liability of the party giving the warranty is extended beyond what would normally be the case had the warranty not been provided. Non-compliance with a contractual warranty is a breach of contract and the non-defaulting party can cancel the contract, claim specific performance, where possible, or claim damages. The Supreme Court of Appeal in the matter between Mastersspice (Pty) Ltd v Broszeit Investments CC 2006 (6) SA 1 (SCA) held that a breach of a warranty can mean breach of a term that gives rise to a claim for damages, or a term whose material breach gives rise to a right to cancel, and that it is necessary in every case to examine the terms of the contract closely in order to determine whether a breach of a warranty gives rise to a claim for cancellation of a contract or a claim for damages.
Consequences of non-compliance with a warranty implied by law will be governed by that law, for example, in terms of the Consumer Protection Act, non-compliance with a warranty implied by this Act is that a non-defaulting party (a consumer) has a right to return the goods, or a right to have the goods replaced or repaired.
Indemnities
An indemnity agreement can be described as a contractual undertaking between two parties in terms of which one of the parties in a contract is exempted from loss that may occur as a result of a specified event.
Indemnity agreements can be structured in various forms; it can be formulated in a manner in which one party indemnifies another party against losses incurred as a result of the indemnified party’s own acts and/or omissions, or it can be that one party indemnifies another party against losses except those that occur as a result of the indemnified party’s own acts and/or omissions. Indemnities can also come in a form where one party indemnifies another party against liabilities to or claims by a third party. It may also occur that each party to a contract indemnifies the other(s) for losses occasioned by the indemnifier’s breach of the contract. An indemnity may be included as one of the clauses in some or other contract, for example, it may be one of the clauses in a loan or a sales contract, or it may be embodied in a separate contract, known commonly as a hold harmless contract.
Indemnities can be used in circumstances where a breach of warranty may not necessarily give rise to a claim in damages. For example, in a sale of a business, the seller may provide a disclosure letter in terms of which the warranties that the seller has given in the sale agreement are restricted or qualified. In such an event, it would be prudent for the buyer to request an indemnity for loss that the buyer may suffer due to the effect of the qualified or restricted warranty, for example if a seller gives a warranty that there is no litigation pending against the sold business and then, in a disclosure letter, the seller discloses one litigation pending against the sold business, the buyer will not be able to claim damages for losses arising from the disclosed litigation. However, the buyer can safeguard himself or herself against loss as a result of this disclosed litigation by requesting an Indemnity from the seller in this regard.
Another important aspect that needs mentioning with regard to indemnities, is that prescription in relation to the indemnity clause will start to run from the date on which the indemnifier refuses to honour the indemnity and therefore the claim may remain valid for an extended period of time.
Indemnities can be drafted in a general form without specifying the amount to be paid, or it can be drafted with a stated amount. In other words, A may agree to indemnify B for losses that B may suffer as a result of a pending litigation, or A may agree to indemnify B in the amount of, for example, R 500 000 for losses that B may suffer as a result of a pending litigation. This latter indemnity may give rise to a claim for debt, as opposed to a claim for damages, which will be the case under the former indemnity.
Therefore, as stated above, the purpose of an indemnity is to safeguard a party against loss that may occur as a result of a specified event.
Insurance
Insurance contracts should also be mentioned since insurance, by its nature, acts as a risk-transfer mechanism in that the financial risk of the insured is shifted and transferred to the insurer. The insured is covered by contributing a premium to the insurer. Therefore, in the event of a financial loss, the insured is entitled to compensation subject to the terms and conditions that are in place in the particular insurance contract.
Insurance can either be indemnity insurance or non-indemnity insurance. With indemnity insurance the insured will be compensated by the insurer for the damage that the insured may suffer as a result of the occurrence of the event insured against. A typical example of this kind of insurance is insurance against theft of property. With non-indemnity insurance, the insurer will receive a predetermined amount of money from the insurer on the occurrence of the event insured against, an example of this being life cover insurance.
The crux underpinning an insurance contract is that the insured is protected from financial loss associated with the event insured against. An insurance contract might be confused with an indemnity contract/clause discussed above, but the fact that the insured must contribute a premium in order to be protected by insurance, which is not the case with an indemnity, this distinguishes insurance contracts from indemnity contracts/clauses.
Conclusion
The above discussion may be summarised as demonstrated in the table below.
Even though all these mechanisms all serve one purpose, which is to reallocate and/or mitigate risk, they all have different requirements and each with a different effect. These mechanisms are not mutually exclusive and may, where possible, all be utilised in one transaction, thus providing extensive and comprehensive security against risk.
Type of risk-mitigating mechanism | Example | The risk being mitigated | The effect |
Suretyship | A is indebted to B for a loan amount, and C agrees in a written contract to stand surety for the debt in case A does not repay the loan. | The loss that B may suffer as a result of non-payment by A. | In the event of non-payment by A, C will be held liable for the repayment of the loan. |
Guarantee | A and B enter into a building construction contract, and as security for the due performance of B’s obligation under the building construction contract, bank C issues a guarantee in favour of A (demand guarantee). | The loss that A may suffer as a result of non-performance or defective performance by B. | In the event of non-performance or defective performance by B, A can present the guarantee for payment of the amount specified in the guarantee. |
A and B who are in two different countries enter into a sale agreement, and bank C issues a letter of credit in favour of B for the payment of the purchase price by A. | The loss that B may suffer in case A fails to pay the purchase price. | B does not have to demand payment of the purchase price from A, and can simply present the letter of credit for payment. | |
Warranty | A gives B a warranty that A has the required licence to operate a particular business. | The loss that B may suffer should A not be in possession of the required licence. | B may claim damages for the loss suffered or may even cancel the contract under which the warranty was given. |
Indemnity | A agrees to indemnify B in the event that A does not have the licence to operate a particular business. | The loss that B suffers as a result of A not having the licence to operate a particular business. | B may claim the loss as a debt or as damages, depending on the wording of the indemnity. |
Insurance | Insurance company A agrees to compensate B for a financial loss that B may suffer due B’s asset being stolen, against payment by B of regular premiums to insurance company A. | The financial loss that B may suffer as a result of the occurrence of the event insured against, for example; theft of B’s asset. | The insurance company will pay B the amount of financial loss that B proves to have suffered. |
Insurance company A agrees to compensate B with a fixed amount of money on B being disabled, against payment by B of regular premiums to insurance company A. | The non-financial loss that B may suffer as a result of the occurrence of the event insured against (B becoming disabled). | The insurance company will pay B the fixed amount. |
Nthupang Magolego BIur LLB (UP) LLM (Unisa) is an assistant manager: legal and implementation at Gauteng Enterprise Propeller in Johannesburg.
This article was first published in De Rebus in 2013 (Sept) DR 30.