Construction Bond Recession: Navigating the Murky Waters of Third-Party Prejudice

In the case of Urban Mechanical Contracting Ltd. V Zurich Insurance Company Ltd., the Court of Appeal was asked to decide if a construction bond can be rescinded due to fraudulent misrepresentation and collusion, even if that would prejudice the rights of innocent third parties. The Court of Appeal ruled that rescission is possible in cases of fraud and that the rights of innocent third parties are not an absolute bar to rescission. The Court stated that rescission is an equitable remedy focused on “practical justice”, not rigid technicalities and that courts have a high degree of flexibility in rescinding contracts particularly in cases of fraud. Even when the parties cannot be restored precisely to the state they were in prior to entering the contract, rescission may be ordered to avoid an injustice between the parties.

Background

In 2011, St. Michael’s Hospital entered into a public-private redevelopment project with Infrastructure Ontario to build a 17-story patient care tower. The project’s construction contract was awarded to a subsidiary of Bondfield Construction Company (hereinafter referred to as “Bondfield”), for a sum of $301,189,863. Bondfield was also responsible for obtaining and maintaining surety bonds, including a performance bond and a labour and material payment bond, as required by both the construction contract and the project lending agreement. Accordingly, Bondfield obtained such bonds from Zurich Insurance Company (“Zurich Insurance”). The project was financed by $230 million loan advanced by a syndicate of lenders including the Bank of Montreal which was named as the administrative agent for the lenders.

As the project unfolded, Bondfield fell into default, therefore inducing the Bank of Montreal to demand payment from Zurich Insurance by invoking the surety bonds. Nevertheless, Zurich Insurance sought to rescind the bonds it had issued due to the discovery of fraudulent misrepresentations and collusion between Bondfield and St. Michael’s Hospital that appeared to have enabled Bondfield to secure the construction contract. Zurich Insurance took the position that it would have never agreed to issue the bonds had it known about the fraud. The Bank of Montreal and certain subcontractors brought two applications seeking a declaration that Zurich may not rescind the bonds because doing so would affect their rights as innocent third parties (ie. they would not get paid as a result of default).

The Court of Appeal Decision

The Court of Appeal asserted that “prejudice to the rights of third parties may be, but is not always, a bar to rescission”. The ONCA dismissed both applications, ruling that the surety bonds may be rescinded despite prejudice to the lenders and subcontractors, and remitted the case to the trial judge to determine whether recession is appropriate in the case at bar based on the factual record.

Implications

This recent court ruling has significant implications for those in the construction industry who use bonds as a safeguard against default. It remains to be seen in this case whether Zurich Insurance will in fact be entitled to rescind its construction bonds. However, it should be noted that burden of proof required to acquire such relief remains high and will only be granted in certain compelling circumstances. Albeit, construction lenders and subcontractors alike, may wish to consider alternative risk mitigation measures in light of this decision.

Co-author: Harjaap Sahota