Court says trial should decide whether surety bonds can be rescinded due to false representation

Construction subcontractors claim rights of innocent third parties harmed if rescission allowed

Court says trial should decide whether surety bonds can be rescinded due to false representation
The Ontario Court of Appeal

The Ontario Court of Appeal has dismissed an application by several construction trade subcontractors who sought to prevent an insurance company from rescinding two surety bonds on the basis of fraudulent misrepresentation when the rights of innocent third parties would be affected.

In a 3-0 decision in Urban Mechanical Contracting Ltd. et al.  v. Zurich Insurance Company Ltd., released on August 17, the court agreed with the application judge’s ruling and decided that the issue of whether the company is entitled to rescind the bonds should be decided at trial on a full factual record and not summarily through an application, since the judge made no error of law.

In appealing the judge’s order issued in Urban Mechanical Contracting Ltd. et al. v. Zurich Insurance Company Ltd., 2021 ONSC 2535, the applicants submitted that, “as a matter of law, rescission is not available where there are innocent third parties.”

The appeal court, however, saw it differently.

The application judge “correctly concluded that, as a matter of law, the rights of innocent third parties are not an absolute bar to rescission in all cases where there is an allegation of fraudulent misrepresentation. The applications were permitted to be brought in the midst of an ongoing action only to determine this narrow issue of law,” Justice Julie Thorburn wrote on behalf of the appeal court.

Matthew Lerner, a partner at Lenczner Slaght in Toronto who represented Zurich Insurance, said: “This is an important decision which confirms that rescission is always a legally viable remedy where fraud has occurred. The Court of Appeal has confirmed that our client is entitled to the opportunity to prove its allegations of fraud at trial, and Zurich looks forward to doing so without further delay.”

Counsel representing some of the applicants were not available for comment.

At the centre of the case is a major public-private redevelopment project involving St. Michael’s Hospital in Toronto and Infrastructure Ontario. Following a bidding process, the construction contract was awarded to 2442931 Ontario Inc., a subsidiary of Bondfield Construction Co. Ltd. Bondfield was named the general construction contractor on the $301-million project.

A group of lenders provided a $230-million loan to the numbered company, and the Bank of Montreal was named in a credit agreement as the administrative agent for the lenders.

Under the construction contract and credit agreement, 2442931 Ontario was required to obtain two surety bonds: a performance bond for the construction and design contract to ensure the project is completed if the contractor defaults on its obligations; and a labour and material payment bond to protect those supplying services and materials if, for example, the general contractor becomes insolvent.

On January 27, 2015, Zurich Insurance issued the performance bond in the amount of about $156 million and the payment bond for about $142 million.

Sometime in 2017, the general contractor, Bondfield, struggled to meet payment deadlines, leading Zurich to keep the project going by paying subcontractors and suppliers, as well as signing ratification agreements with some of the trades. But Bondfield’s difficulties continued through 2017 and 2018.

“On November 2, 2018, the hospital issued a notice of default under the project agreement, which had been entered into by the hospital and [2442931 Ontario] in January 2015 to provide for services, labour and materials in relation to the construction and financing of the project,” the appeal court says. “On November 16, BMO, as the obligee, informed Zurich that Bondfield was in default and demanded payment of the performance bond.

During the dispute, BMO obtained a court order appointing a receiver to make a decision on the performance bond, which Zurich didn’t contest. The insurance company then requested an adjournment until April 2020 to file materials, but in the meantime, Zurich discovered information that led it to take action to rescind its surety bonds.

“In March, 2020, five years after Zurich entered into the agreements to provide bonds, one of its consultants uncovered numerous email communications between Bondfield and hospital representatives disclosing allegedly fraudulent misrepresentations and collusion which appeared to have enabled Bondfield to secure the contract for the project. The evidence spans many years and includes communications among many people,” the appeal court wrote.

A month after the discovery, Zurich stopped paying the trades and started its legal action seeking a declaration that both the performance and payment bonds be rescinded due to fraud in the construction procurement process.

“Zurich claims the fraud occurred prior to the issuance of its bonds and that, by virtue of the fraudulent misrepresentations, it was induced to issue the bonds. It seeks to recover the money paid out under the bonds prior to rescission from the alleged principal fraudsters. Zurich takes the position that, had it known about the fraud, it would never have issued the bonds.”

The trades have unpaid claims under the payment bond and want to stop rescission, while BMO, which represents the lenders who were given guarantees, is seeking a declaration from the courts that Zurich cannot rescind the performance bond.

In addition to Zurich’s rescission application, other legal actions have been launched connected to the delayed hospital project.

The appeal court said that “the central issue” in the case “is whether, as a matter of law, an order for rescission can ever be made where an innocent party was induced to enter a contract by virtue of fraudulent misrepresentation and there are third parties who assert their rights. This is a question of law for which the standard of review is correctness.”

The court also said it must assume that the trades and lenders are “innocent third parties” – a statement at odds with Zurich’s claim “that certain of the trades have participated in the fraud. … If it is established that the trades were party to the fraud, it would be difficult to envisage that the legislature intended … to protect the trades who participated in fraud,” the court said, noting that discoveries in the case are ongoing.

In their appeal, the trades relied on s. 69 of the Construction Lien Act to argue that Zurich is prevented from rescinding the payment bond because they have valid claims. “They claim that equitable remedies such as rescission cannot undermine their statutory right and that, if Zurich’s rescission action is sustained, their right to claim on the payment bond pursuant to s. 69, would be improperly extinguished,” the court said.

“The Construction Lien Act clearly ousts certain equitable rights,” the court said, adding that it’s necessary to examine the situation s. 69 was meant to address.

“At common law, tradespeople could not sue upon a payment bond because they were not parties to the bond and had no privity of contract with the surety. To avoid this problem, modern payment bonds used trust language,” the court said, referring to Valard Construction Ltd. v. Bird Construction Co., 2018 SCC 8, [2018] 1 S.C.R. 224.

“Section 69 was designed to replace the common law actions based on trust bonds with a direct statutory action between the surety and the trades. This served to resolve any potential problem arising from the lack of privity of contract between them.”

The court also referred to a 2016 report to Ontario’s Ministry of the Attorney General called “Striking the Balance: Expert Review of Ontario's Construction Lien Act.” It says, “Surety bonds guarantee, among other things, payment of either 50 percent or 100 percent of the amounts owed by general contractors to the suppliers of labour and materials, and guarantee the owner that, in the event of the insolvency of the general contractor, construction will be completed.”

But the legislation doesn’t address a right of action for the trades when the bond agreement “was founded on fraud,” the court said. “Nor is there anything in the legislative record to show whether the legislature specifically intended s. 69 to sustain the bond even in the face of fraud. And finally, the parties have adduced no cases that specifically address the issue of fraud in the issuance of the bond.”

When it comes to rescission in cases involving innocent third parties, the appeal court wrote, “The jurisprudence and academic literature reflect two concerns about the rights of third parties in rescission cases: first, the impossibility of achieving restitutio in integrum when third parties have acquired an interest in property subject to the contract; and second, unavoidable prejudice to, or adverse effect on, third parties. However, … neither concern presents an absolute bar to rescission.”

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