Performance Bonds – What do they really cover?

February 2, 2022 | Charles W. Bois, Andrew Hefford

It is common practice in the construction industry to use contract documents and performance bonds to allocate risk appropriately between owners and contractors. Owners often require that contractors provide a performance bond from a recognized surety as a condition to being awarded the construction contract.  A performance bond provides the owner with a mechanism to mitigate the costs and risk of the contractor defaulting under the construction contract.   If a contractor defaults on its obligations under the construction contract, and there is a performance bond, that bond entitles the owner to call on the surety to complete the contract.

Subject to the express terms of the performance bond, a surety generally has four options under the bond to respond to the owners demand.  The surety can:

  1. remedy the default;
  2. complete the contract in accordance with its terms and conditions;
  3. obtain bids from other contractors for the completion of the contract, in accordance with its terms and conditions;
  4. make a cash payment to the owner and obtain a release.

Generally, option 3 is the one commonly pursued by the surety and owner.  Once the surety and owners have obtained and reviewed the required bids, a decision is made as to the contractor that will complete the contract in accordance with its terms and conditions, and the surety’s obligation is to make sufficient funds to pay the costs of completion (subject to the face value of the bond). But what are the surety’s obligations given the phrase “complete the contract in accordance with its terms and conditions”?

There has been an extensive debate in Canadian Courts regarding the obligations of a surety when it comes to “completing the contract in accordance with its terms and conditions” and what those obligations actually include.  One long line of cases, culminating with the 2004 Saskatchewan Court of Appeal decisionLac La Ronge Indian Band v. Dallas Contracting Ltd.[1](“Lac La Ronge”), adopted a narrow approach, holding that the surety is responsible only for completing the physical construction work (the “Bricks and Mortar Approach”) and is not liable for payment of collateral monetary obligations (such as liquidated damages, delay damages/costs, loss of income) even if such monetary obligations are set out in and payable under the construction contract.  In Lac La Ronge, the Court held that:

A surety’s obligation on this point can be no greater than if it had completed the contract or had found a responsible bidder to complete it. If either of those options had occurred, Western would not be liable to the Band for the extra costs incurred by it. Accordingly, I find that the trial judge erred in holding Western liable for these amounts. (para. 104).[2]

Another line of cases, culminating in the Ontario Court of Appeal in Whitby Landmark Developments Inc. v. Mollenhauer Construction Ltd.[3] (“Whitby”), adopted a broader approach holding that the surety’s obligation is to complete the construction contract in accordance with its terms and conditions, and such obligations are not limited to completion of the physical work under the contract.  In Whitby, the construction contract included terms that the owner and the contractor would share any cost savings.  The contractor defaulted and the owner completed the work and claimed its costs and its share of the cost savings from the surety.  The Court considered the wording of the performance bond and noted that the construction contract documents formed part of the bond and that all obligations under the bond referred to the construction contract.  The Court concluded that the surety’s obligation was not limited to completion of the physical work, but that the surety was obliged to pay the owner’s share of the cost savings. Whitby establishes, at least in Ontario, that the surety’s obligations under a performance bond could include payment of collateral monetary obligations that form part of the construction contract.

The Whitby decision has been criticized for ignoring the long line of authorities which follow the Bricks and Mortar approach adopted in Lac La RongeCourts in British Columbia have largely adopted the Bricks and Mortar approach adopted in Lac La Ronge.[4] However, there are signs that courts may be reconsidering the “bricks and mortar” approach.

Two recent decisions emanating in Alberta have adopted the broader approach established in WhitbyIn 2013, the Court was asked to consider the surety obligation to satisfy the monetary obligations of a defaulting contractor.  In MGN Constructors Inc. v. AXA Pacific Insurance Company.[5](“MGN”), the surety provided a performance bond to a subcontractor of MGN Constructors.  Disputes arose between MGN and the subcontractor and the subcontractor quit working. MGN made a claim under the bond.  The Court recognized that the surety’s obligations depend on the specific wording of the performance bond, and signalled that the Court would adopt the broader approach in Whitby, and stated the following with respect to the surety’s obligations under the standard form contract:

Were it necessary for me to decide the case on this basis, I prefer the reasoning of Justice Lamek at trial and the Ontario Court of Appeal in Whitby Landmark, and the trial judge’s reasoning in Lac La Ronge, to that of the Saskatchewan Court of Appeal. I fail to see how a surety can arrange for completion of the contract in accordance with its terms and conditions unless it is responsible for any acceleration costs to meet the original schedule, and any delay damages the owner is entitled to if the schedule is not met. Otherwise, that would mean in cases where it is not possible, even by herculean acceleration efforts, to complete the work on schedule after the Principal’s default, the blameless owner would be unable to deduct its legitimate delay damages from the amount otherwise owed to the defaulting Principal. That in my view distorts a fair interpretation of “the amount properly paid by the Obligee to the Principal”. (para. 126).[6]

[emphasis added]

In 2017, the Court, in Vermilion & District Housing Foundation v. Binder Construction Limited,[7]was asked to consider whether the surety was responsible for paying the owner’s costs to remedy defects in the flooring work performed by the contractor and for paying the owner’s claim for lost rental income due to the need to relocate the tenant to complete the remedial work. The Court considered the conflicting approaches taken in Whitby and Lac La Ronge  regarding the surety’s obligations, and noted that when interpreting the bond the “Court must consider the terms of the underlying contractual relationship and the degree to which the obligations outlined therein are incorporated into the bond by reference”.[8]  Ultimately, the Court followed the Whitby approach and determined that the owner’s lost rental income was recoverable from the surety:

As for the loss of income claim related to foregone rent, I have found that the approach taken in replacing the flooring was reasonable and that Vermilion suffered loss of income damages directly relating to that work. The damages in that regard are set out previously in these Reasons for Judgment.

In my view, it would have been within the reasonable contemplation of both Vermilion and Guarantee Company that if it was necessary to carry out remedial work in relation to the work of Binder pursuant to the Construction Contract, such remedial work might result in some loss of income to Vermilion. In my view, such losses would fall within the “cost to complete” the work as set out in option 4 of the Performance Bond. Such costs fall within the indemnity obligations of Binder pursuant to General Condition 9.2.1 and the obligation to pay for damage resulting from corrections made during the warranty period pursuant to General Condition 12.3.5. (paras. 314-315).[9]

[emphasis added]

Conclusion

The debate regarding a surety’s obligations under a performance bond continues, and with the recent decisions in Alberta, may set the stage for the Supreme Court of Canada to determine the extent of a surety’s obligation under a performance bond.  The foregoing cases establish that courts will determine the surety’s obligations based on the wording of the performance bond. Absent express provisions in the bond limiting a surety’s obligations, it is possible that more courts may adopt the expanded approach in Whitby and find that surety’s obligations include payment of collateral monetary obligations, such as liquidated damages, delay costs, acceleration costs, and even lost income when the payment of such amounts is a term and condition of the construction contract and become the responsibility of the contractor.

Owners and contractors should read and understand the terms and conditions of their construction contract and the performance bonds.  In addition, in the event of a default and claim under a bond, both owners and contractors must ensure that they comply with their obligations under the construction contract and the performance bond. It is also imperative that owners comply with the notice provisions of their contract and under the bond and deliver notices within the required period.  Defective notices, or late notices to the contractor or the surety could result in an owner losing the ability to recover costs and any collateral monetary obligations from the surety.  Owners faced with a defaulting contractor should notify the surety as soon as possible to mitigate the risk of the surety denying a claim under the bond.


[1] Lac La Ronge Indian Band v Dallas Contracting Ltd., 2004 SKCA 109.

[2] Ibid at 104.

[3] Whitby Landmark Developments Inc. v Mollenhauer Construction Ltd., 2003 CarswellOnt 3968, [2003] O.J. No. 4000.

[4] See for example: Fraser Gate Apartments Ltd. v Western Surety Co., 1998 CarswellBC 1278, [1999] 3 WWR 213; and Cranbrook (City) v Gabriel Construction (Alberta) Ltd., 2014 BCSC 2280.

[5] MGN Constructors Inc. v Axa Pacific Insurance Co., 2013 ABQB 216.

[6] Ibid at 126.

[7] Vermilion & District Housing Foundation v Binder Construction Limited, 2017 ABQB 365.

[8] Ibid at 294.

[9] Ibid at 314-315.

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