Financial institutions who lend to clients involved in the construction industry may be familiar with the process of “bonding off” liens under the Construction Lien Act, (Ontario).  If a construction lien is registered on title to the lands upon which construction is taking place, no advances can be made under a construction mortgage while the lien remains on title to the lands. However, by posting a bond as security for the construction lien claim, a party can arrange to have the lien vacated from title to the land, and the bond will instead stand at the ready to pay the claim if it is upheld and the party that posted the bond is liable to the lien claimant. However, as discussed below, there are specific requirements for a Letter of Credit used to bond off a construction lien that may not be readily apparent.

The bonding off process is designed to allow a general contractor or owner to continue to pay for work without first having to pay off the lien. Banks and other lenders likewise can continue to make advances under construction loans without losing priority to lien claimants once the lien is vacated from title to the lands. 

The Ontario Construction Lien Act does not specify the kind of security needed to bond off a construction lien. However, construction litigators who appear regularly in construction lien court in Toronto know well that the court reserves the right to “approve” any security posted to vacate a construction lien.1 And for many years, Toronto Construction Lien Masters have insisted that any letter of credit posted as security must not contain any reference to international commercial conventions concerning letters of credit. Letters of credit are expressly refused approval where international commercial conventions are referred to in their terms.

Duncan Glaholt in his text Conduct of a Lien Action, 2013 writes as follows:

The letter of credit must not be conditional on compliance with the uniform Commercial Code for International Letters of Credit, or any like conditional language.2

This practice is alive and well in the courts.  In Naylor Group Inc. v. Enfinity Canada EPC Inc.3, Enfinity intended to post a Letter of Credit that was “subject to ISP98”. Enfinity’s European parent had arranged for a Letter of Credit from a European bank the beneficiary of which was the Royal Bank of Canada as security for a letter of credit issued by Royal Bank to bond off the construction lien. The motion to vacate the lien and post security was dismissed because, in the words of Master Polika, “by inserting the term, on its face the letter of credit is subject to ICC Publication 590 [sic] and there is potential that the term will be invoked to deny payment.”

Clearly, this practice is at odds with how letters of credit actually work.4 A closer look at the true nature of letters of credit, however, shows that all letters of credit are not in fact “conditional” on any factors that could be relied on to avoid payment. In Bank of Nova Scotia v. Angelica-Whitewear Ltd.,5 Justice LeDain, writing for a unanimous Supreme Court of Canada outlined the key principle behind letters of credit:

The fundamental principle governing documentary letters of credit and the characteristic which gives them their international commercial utility and efficacy is that the obligation of the issuing bank to honour a draft on a credit when it is accompanied by documents which appear on their face to be in accordance with the terms and conditions of the credit is independent of the performance of the underlying contract for which the credit was issued.6

What all this means is that regardless of disputes between the buyer and seller over the goods or their delivery, the seller will receive payment upon presenting the bank with the letter of credit and other required documents. If a letter of credit is immediately enforceable upon presentation to the issuer of the required documents, it is difficult to see how that letter of credit could ever be termed “conditional”. With no contingency (other than presenting the documents) there is no uncertainty in the payment process.

The Court in Angelica-Whitewear noted that there is only one instance in which a bank may refuse to honour a letter of credit, namely fraud by the beneficiary of the letter of credit. However, the standby letters of credit posted with the Superior Court of Justice to bond off construction liens are payable only on court order. (This is the cumulative effect of Rule 72.03 of the Rules of Civil Procedure and the Construction Lien Act.) Since the beneficiary of a standby letter of credit posted to bond off a construction lien is always the Accountant of the Superior Court of Justice, and since the Accountant must always act under court order, fraud by the beneficiary (i.e. the Accountant) simply cannot occur.

However, until a higher court rules on the matter, a Construction Lien Master simply will not allow a Letter of Credit that is subject to an international convention to be posted with the Accountant of the Superior Court to bond off a construction lien.

1 This practice appears to originate from the requirements of s. 29(4) of the old Ontario Mechanics Lien Act, R.S.O. 1970, c. 267, although it is not strictly a requirement of the Ontario Construction Lien Act.
2 Glaholt, p. 142
3 [2012] O.J. No. 3573 (Master),
4 Ironically, Duncan Glaholt has now updated his text to include the following commentary, citing Naylor:
“This point must be stressed. The masters’ office still receives forms of letters of credit that are expressed in conditional language, or incorporating international standards that themselves, arguably, incorporate conditional language and these will be rejected. As one of the masters has put it, “You will not get around us on this one”. By insisting on unconditional language, the masters simply ensure that there is no chance of the Accountant of the Superior Court being embroiled in litigation because of conditional language.” [italics in original]
5 [1987] 1 S.C.R. 87
6 Angelica-Whitewear, at para. 10