The Ontario Court of Appeal sent ripples through the construction industry when it recently ruled in Urban Mechanical Contracting Ltd v Zurich, 2022 ONCA 589, that a bond issuer may rescind a bond agreement on the basis of fraudulent misrepresentations and collusion, even if rescinding the bond agreement would affect the rights of innocent third parties. In determining whether to rescind, the court will determine what is "practically just" in the circumstances, no matter how large or complex the project.

Rescission is an equitable remedy that is meant to put the contracting parties back to the positions they were in before entering into the contract (restitutio in integrum). Rescission is available where a party has been improperly induced to enter a contract.

Surety bonds are financial instruments that transfer project risk to a third-party insurer, providing assurances to lenders, subcontractors, and suppliers. This decision reduces the reliability of surety bonds in an industry that depends on these assurances.

Background

In 2011, St. Michael's Hospital entered into a public-private redevelopment project to build a 17-storey patient care tower. Construction was to be financed and carried out by the private sector. Through Infrastructure Ontario's procurement process, the construction contract was awarded to a wholly owned subsidiary of Bondfield Construction Company Limited. Bondfield was made the general construction contractor of the $301M project.

Under the Construction Contract and the Credit Agreement for the lenders that provided for a $230M loan to finance the project, Bondfield was required to obtain two surety bonds: a performance bond for the construction and design contract, and a payment bond for labour, services and materials.

In 2015, Zurich Insurance Company Ltd. issued a $156M performance bond and a $142M payment bond naming Zurich as surety, Bondfield as principal, and the subsidiary, BMO and the Hospital as obligees. The payment bond creates an express trust for the appellant subcontractors to claim under the bond.

Beginning in 2017, Bondfield struggled to meet payment deadlines. Zurich acted on the bond and paid some of the subcontractors and suppliers. Zurich also signed Ratification Agreements with some of the subcontractors and suppliers. The Ratification Agreements confirmed amounts owing, along with the agreement that subcontractors would recommence work, discharge their lien rights, and that subcontractors agreed to be bound by the subcontract to Zurich as if they had entered into the subcontract with Zurich.  

Bondfield continued to experience financial difficulties. In November 2018, the Bank of Montreal (BMO), the administrative agent for the lenders, obtained a court order appointing a receiver to call on the performance bond. Zurich elected to pay the lesser of the remaining balance of the bond amount or BMO's reasonable estimate of the cost to complete the contract. Zurich requested an adjournment until April 2020 to file materials in the receivership. However, in March 2020, Zurich uncovered communications between Bondfield and hospital representatives disclosing allegedly fraudulent misrepresentations and collusion that appears to have enabled Bondfield to secure the project contract.

After this discovery, Zurich ceased paying subcontractors and suppliers and commenced an action seeking a declaration that both bonds be rescinded due to fraud in the construction procurement process. Zurich takes the position that had it known of the fraud, it would not have issued the bonds and seeks to recover the money paid out under the bonds prior to rescission. The appellant subcontractors and BMO brought two applications seeking a declaration that Zurich may not rescind the bonds because doing so would affect their rights as innocent third parties. The applications were permitted to determine this narrow issue. The application judge ruled that rescission may be possible, but without a full factual record it could not determine at this stage whether the remedy was available to Zurich, and that the issue should be determined at trial on a full factual record.

The Ontario Court of Appeal decision

On appeal, Justice Thorburn dismissed the appeal.  As a matter of law, the rights of innocent third parties are not an absolute bar to rescission, particularly in cases where it may be possible to provide restitution in other ways. As noted by the Court of Appeal, "[e]ven when the parties cannot be restored precisely to the state they were in before the contract was signed, courts may still grant and tailor rescission remedy because rescission is an equitable remedy focused on practical justice, not rigid technicalities".

The Court goes on to state that a flexible approach is required to determine whether restitutio in integrum could be achieved by considering what is "practically just." In the absence of a full factual record, the Court could not determine whether rescission could be tailored to achieve practical justice for the appellants and respondents. The Court of Appeal ruled that determination of the issue should be left to the trial judge to determine what, if any, equitable claims arise in the circumstances.

Impact on the construction industry

The ruling has a significant effect for the construction industry given the importance of bonds in major projects, including complex public infrastructure projects.

Pursuant to statute, in Ontario, surety bonds are required to secure at least 50 per cent of the contract price for public contracts exceeding $500,000 (Construction Act, s. 85.1 and O. Reg. 304/18 s. 12). While Justice Thorburn did not decide whether rescission would achieve practical justice between the parties in the circumstances, the ruling leaves open the unsettling possibility of bonds being rescinded leaving subcontractors, suppliers and lenders vulnerable.

At this time, subcontractors and suppliers have unpaid claims, and lenders who relied on the performance and payment guarantees remain unpaid. The facts and circumstances of the case will determine whether the remedy of rescission is practical and just in these circumstances, but most importantly, the Court's decision will impact the willingness of subcontractors, suppliers and lenders to rely on the assurances of bond insurers in future public infrastructure projects.