Third Party Rights Not Absolute Bar on Rescission of Bonds Issued Due to Fraudulent Misrepresentation

October 06, 2022

Written By Ian Reynolds, Scott Bower, Brian Reid and Peewara Sapsuwan

Bonds are commonly used on construction projects in Canada to provide security for owners, subcontractors and other parties supplying labour and materials in the event of an insolvency or other performance failure. However, in the recent Ontario Court of Appeal decision of Urban Mechanical Contracting Ltd v Zurich Insurance Company Ltd, 2022 ONCA 589 [Urban Mechanical], the ability of an innocent third party to bring a claim under a bond may be called into question.

Urban Mechanical involves a public-private partnership hospital project. Five years after Zurich Insurance Company Ltd., acting as the surety, entered into an agreement to provide bonds, it was discovered that the contractor and representatives of the hospital allegedly committed fraudulent misrepresentations to be awarded the contract. The surety then ceased to pay the subcontractors and sought to rescind both the performance and payment bonds by virtue of the fraudulent misrepresentations. The subcontractors brought applications to declare that the surety may not rescind the bonds because doing so would affect their rights as innocent third parties. In the instant case, the court was asked:

1. whether third-party rights pose an absolute bar to the rescission remedy; and
2. where innocent third parties may suffer unavoidable prejudice because of such rescission, whether such remedy may nonetheless be available.

Rescission is an equitable remedy that is available when a party has done something that is considered to be "against good conscience." However, equitable remedies operate as between parties to an agreement and should not bind a person who does not partake in the violation of good conscience. Such person is called a "bona fide (good faith/innocent) third party without notice".

Invoking the principle of "practical justice," the Court dismissed the appeal brought by the subcontractor appellants on the ground that rescission may be granted to avoid injustice between parties, as for example by unjustifiably making a party (i.e. the surety) worse off. The implication of this reasoning shows that the rights of a third party are not an absolute bar against rescission. This reasoning affects core principals of contract law, the protection of reasonable expectations of contracting parties and the interests of an innocent third party without notice.

Risk Mitigation

Despite Urban Mechanical being sent back for a new trial, the decision reveals that the rescission remedy is not impossible even where third party rights are involved. As such, participants in the construction sector may want to employ measures to mitigate this uncertainty.

Lenders

To mitigate post-Urban Mechanical risks, lenders should ensure that their financing arrangements contain obligations requiring the borrower and its sponsor(s) to provide as much finance documentation as possible to be able to comprehensively analyze the financial risk of the project. Furthermore, to minimize reliance on bonds and guarantees, in addition to having a robust and exhaustive representations and warranties provision, lenders will want to require detailed cash flow projections from the borrower, a direct agreement with the sponsor (where possible) and a statement from the borrower's directors on measures to be taken if there is a risk of the borrower being in default of any of the material project agreements or during financial difficulties.

Project Company/Owner

An important objective of a project company is to ensure that the project meets its commercial operation dates and that its recourses vis-à-vis the contractor commensurate its liabilities in other material project agreements. In light of Urban Mechanical, the project company may want to protect itself by ensuring that the construction contract is easy to terminate and assign, and that any subcontracts and warranties are also easily assignable. As the scope of Urban Mechanical's impact remains unknown, project companies may also want to include a flexible change in law clause in their financing and commercial agreements.

Subcontractors and Suppliers

As obligees to the bond amount, ideally, subcontractors and suppliers (Trades) may want to require the primary contractor to have the guarantor or surety to waive their equitable defenses under the bond. To reduce reliance on bonds, Trades may want to structure payments into phases, with a requirement that the contractor pay for the work performed or materials delivered upfront for each phase.

Furthermore, it is worth noting that the Court in Urban Mechanical takes no view on whether the appellant Trades have "acquired interests under the Bond that they might be entitled to retain by virtue of being purchasers for values or because they acquired a beneficial interest in the Bond Amount"¹. Implicitly, this could mean that although the Trades may not be able to benefit from the express trust as obligees of the bond, they may still have other forms of trust and beneficiary interests such as constructive or resulting trust. Therefore, Trades may also want to make these rights and interests explicit in their agreements.

Conclusion

Although the final words on whether the applicants are entitled to payment remain to be decided, Urban Mechanical reveals that adverse effects on the rights of bona fide third parties without notice are not an absolute bar to rescission. At this stage of the litigation, it is difficult to gauge how far the court is willing to proceed without knowing all of the facts and the full scope and extent of the adverse impacts on the innocent third parties. Nevertheless, market participants in the construction sector should conduct their risk analysis exercise with caution.

Bennett Jones' Construction group will continue to monitor this development and what it means for the sector.

Authors