Door open for rescission of surety bonds despite potential impact to third parties

November 3, 2022 | Lori Goldberg, Emma L. Johnston, Danielle M. Bouchard

The recent decision of Urban Mechanical Contracting Ltd. et al v Zurich Insurance Company Ltd., 2022 ONCA 589 (“Urban”) has sent waves through the construction industry. In Urban, the Ontario Court of Appeal refused two applications seeking to overturn a lower court decision which permitted a bond issuer, as a matter of law, to rescind a bond agreement on the basis of fraudulent misrepresentations and collusion, even where doing so would affect the rights of innocent third parties claiming against the bonds. While the Urban decision addresses whether such relief could be available to a bond issuer, the decision itself is not a determination of whether Zurich Insurance Company Ltd. (the “Zurich”) will, in fact, be entitled to rescind its bond agreements with Bondfield Construction Company Limited (“Bondfield”) for the St. Michael’s Hospital Redevelopment Project in Toronto, Ontario (the “Project”).

What is a surety bond?

Surety bonds are financial instruments which transfer certain risks associated with a project, such as non-performance or non-payment by a contractor, to a third party surety who guarantees the obligations of the principal (i.e. the contractor) to the bond claimant (i.e. the owner or subcontractor) with respect to that project.[1] Each bond will specify the rights and remedies available to each party as well as the process that a party must follow in order to make a claim for payment under the bond.

The two most common types of surety bonds used in the construction context are performance bonds and labour and material payment bonds. A performance bond guarantees the completion of the project in the event that the principal (i.e. the bonded contractor) defaults on its contractual obligations.[2] Similarly, a labour and materials payment bond guarantees payment to subcontractors who have not been paid by the principal for the labour and materials to a project.

A surety’s decision regarding whether to provide a bond for a contractor is normally predicated on the surety being satisfied that the contractor’s finances and its ability to perform the work required by the contract meet certain financial and risk metrics. Often, most of the information that surety relies upon for such decisions is provided by the contractor seeking bonding.

What is rescission?

Rescission is an equitable remedy available to a party who has been improperly induced into entering into a contract and, if granted, effectively annuls the contract and treats the contract as though it never existed. The goal of the rescission remedy is to restore the parties to the position that they were in prior entering into the rescinded contract.

Urban Mechanical Contracting Ltd. v Zurich, 2022 ONCA 589

In Urban, Zurich issued a performance bond and labour and materials payment bond (the “Bonds”), for the benefit of the owner, lenders, and the subcontractors, which guaranteed Bondfield’s obligations as general contractor. When Bondfield failed to perform its obligations, the Bonds were called upon, and Zurich was required to make payment to certain bond claimants, including lenders and subcontractors, in order to facilitate the completion of the Project.

Zurich later discovered communications between Bondfield and a representative of the Project’s owner, St. Michael’s Hospital, which Zurich alleges disclose improper behavior during the procurement process which contributed to the success of Bondfield’s bid, including fraudulent misrepresentation, collusion, and kick-backs in exchange for information.

Following this discovery, Zurich ceased further payments under the Bonds and commenced an action seeking (a) a declaration that the Bonds were rescinded; (b) a declaration that the calls on the Bonds were invalid; and (c) compensation for the amounts advanced under the Bonds to date. In response to Zurich’s action, several subcontractors and lenders who had received funds under the Bonds (the “Third Parties) brought applications to the Court seeking a declaration that the Bonds could not be rescinded due to its effect on them (the “Applications”).

The Applications were heard by Justice Gilmore at the Ontario Superior Court of Justice. In her decision, Justice Gilmore denied the relief sought by the Third Parties and found that rescission may be an appropriate remedy, notwithstanding the potential impact to innocent third parties. As the parties had only completed some discoveries in Zurich’s action, the Court declined to make a determination as to whether the relief sought by Zurich should be granted in the absence of a full factual record.

The Third Parties appealed to the Ontario Court of Appeal, which dismissed the appeals and confirmed that, as a matter of law, the rights of innocent third parties are not an absolute bar to rescission. In reaching this decision, the Court of Appeal emphasized the Court’s ability to craft remedies that are “practically just”, and which could, in appropriate circumstances, resolve practical issues or prejudice otherwise caused to third parties by a rigid interpretation and application of the rescission remedy.

The Court of Appeal’s decision is of particular note to owners, contractors, and subcontractors who rely on bonds to mitigate the risks associated with a party’s failure to perform its contractual obligations as it undermines the extent to which the stakeholder(s) may rely on protections provided by the bond(s).

While Urban has opened the door for sureties seeking to disavow bonds based on alleged material misrepresentations in a bonded contractor’s disclosures, the onus of proof required to obtain such relief remains high and may not be granted except in clear and compelling circumstances.

If you have any questions, please feel free to reach out to a member Miller Thomson’s Construction Litigation group.

[1] Urban Mechanical Contracting Ltd. et al v Zurich Insurance Company Ltd., 2022 ONCA 589 (“Urban”)  at paras 11-13

[2] Urban at para 12

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