In the mining and construction industries, the non-performance of a contractor or non-payment by a client to a contractor are potential risks that both parties need to consider in the early stages of their relationship, using performance bonds, insurance and various forms of payment security.
Performance bonds, which are issued by a contractor to its contracting client, are in common use in capital projects. However, they can place a significant financial burden on the contractor, especially smaller emerging construction firms, and their call-up by the client can lead to costly and lengthy legal disputes.
For example, in November 2020 the Supreme Court of Appeal ruled on Aveng (Africa) (Pty) Ltd and Strabag International GmbH v South African National Roads Agency SOC Ltd and Another (Case no: 577/2019)  ZASCA when Aveng tried to interdict Sanral from calling on the performance bond, based on alleged force majeure. The SCA upheld Sanral’s right to call in the bond.
In 2018, Group Five failed in its attempt to stop its client, Cenpower Generation in Ghana, from calling up its retention and performance bonds over the contract to construct the Kpone power station. The $106.5 million payment demanded by the client was a major factor pushing Group Five into business rescue in the following year.
While large construction companies take a dim view of the impact of calls on their performance security, smaller businesses, without access to substantial litigation budgets, are even more exposed.
Matters like these are well documented, however it is impossible to know how many smaller operations have quietly collapsed as a result of frequently overly-conservative drawdowns on performance bonds.
It is questionable whether performance bonds, which add to the costs of projects for the client (because the contractor will factor the costs into the tender) are the best way for clients to secure performance. The mining industry, which is required to assist emerging black entrepreneurs, may find that the costs of a performance bond render new entrants less competitive in tendering. A performance bond or guarantee may require the contractor to set aside cash equivalent to 10-20% of the value of the contract, pay high premiums (where cash security is not available) and expose their assets as further security.
As an aside, where the mine has secured traditional bank funding, the rights of the contractor are secured by way of a bank guarantee (as part of the funding package made available to the mine). In return for this “bank guarantee”, all rights to security would be ceded in favour of the bank.
One possible solution is Contractor Default Insurance, which is relatively common in the UK, Europe and other mature markets – but not yet in South Africa.
Contractor default insurance covers the contracting company in the event that the contractor defaults, for any reason. It is a three-way contract between the insurance company, the client and the contractor. The cost is borne by the contracting party, rather than the contractor, but the advantage of this is that the cost of the protection is not a hidden cost in the project and becomes one that the client has more control over.
An alternative approach, which may be more appropriate for large mining companies with strong balance sheets, could be a form of self-insurance. They could set aside a separate fund in the event of default, which could be called upon in the worst-case scenario but, if not called upon, could be rolled over and used for other projects.
Payment security is often a risk for contract miners engaged by junior miners who do not have access to capital or a large balance sheet, particularly when they are in start-up phase and before they have achieved steady state mining and payment via offtake agreements. Often the contract miner will seek security for payments to be made to it by the client. Performance security in the way of a bond is often not feasible as the required capital is simply not available.
Various forms of security are available to a contractor wishing to minimise its exposure. A combination of various forms of security is often necessary. Contractually, the contractor ought to include a right of suspension where payment is not made timeously. Although this is a good stick to have, a contractor is often reluctant to suspend the contract as this may harm the relationship and put the project at risk. Also, the contractor must be mindful of the fact that its exposure can be for a three-month period (or longer, depending on the contractual payment terms) if it begins work in month 1, then renders an invoice at the end of month 1 which is payable at the end of month 2. If payment is not made, the contractor may need to give 30 days to remedy the breach. Usually, it is only then that the contractor would be able to suspend performance.
The contractor should also include as security for the client’s performance the right to a lien over the site where it conducts operations. A right to use the client’s property on site in the event of an exercise of the lien may be specified. This may allow the contractor to exercise its security and continue rendering its services, should it choose to do so. As lien holder, the contractor would need to remain in continuous possession of the site and exercise effective control over it. The lien is a useful tool and, if it is exercised, has the effect of making the contractor a secured creditor. Ultimately, if the client goes into business rescue or liquidation, being a ranked as a secured creditor is preferable to being a contingent creditor.
Cession of payments due to the client under its offtake arrangements as security for the client’s performance of its payment obligations to the contractor can be a useful form of security. This can be coupled with an obligation to pay funds into an escrow account managed by an escrow agent, who can then ensure that the contractor is paid, can help the client to manage its cash flow and provide additional protection for the contractor.
We have also seen contractors taking security in the form of security cessions over the client’s VAT refunds from SARS or over any diesel rebates to be paid to the client by SARS. It is crucial for the client to properly manage the diesel rebate process for primary mining activities and to ensure that the contractual regime provides for a dry rate.
In South Africa, we have seen contractors taking out insurance to cover payment they are due by the client in terms of the contract. Care must be taken to ensure that the insurance is properly crafted. Often this is crafted as trade debt insurance, which is not the most appropriate instrument. Contractor default insurance is required. It is important to ensure that the insurers are wholly apprised of the nature of the contract and the risks associated with it. This is particularly relevant when this type of insurance is not commonplace in the market and the insurers may not be well-versed in the mining industry.
A combination of one or more of these forms of security can help to minimise the contractor’s exposure to non-payment by the client.