Can Surety Bonds be Rescinded Due to a Contractor's Fraudulent Conduct?
September 2022 - 4 min read
Surety bonds are commonplace on construction projects across Canada. They provide assurance that if the principal under the bond (usually a general contractor or major subcontractor) defaults, funds will be available to complete the work and/or pay unpaid subcontractors.
But bonds remain, in simple terms, contracts. Can a surety rely on rescission as a means to absolve itself of liability under an otherwise valid bond? A case out of the Ontario Court of Appeal has left this possibility open.
Surety Bonds 101
Bonds are three-party contracts where one party (the surety) guarantees the performance/obligations of a second party (the principal) to a third party (the obligee). Typically, these roles are held as follows:
- Surety: insurance company
- Principal: general contractor
- Obligee: project owner
The two most common bonds are performance bonds and labour and material payment ("L&M") bonds. In a performance bond, the obligee can make a claim if the principal defaults. In an L&M bond, unpaid subcontractors (claimants) can make a claim for their unpaid invoices if the principal fails to pay them.
While these bonds are commonly used in Alberta, they are not mandatory under Alberta's new Prompt Payment and Construction Lien Act or the previous Builders' Lien Act. However, they are mandatory by contract on most major government projects and are commonly used on larger private projects.
Rescission is an extraordinary remedy under contract law. If granted, it puts the parties to a contract back in the positions they were in before contracting – in effect, treating the contract as though it never existed. It is based in equity, requiring some wrongdoing on one party's side, on which its counterparty seeks to rely to rescind the contract. One way to prove rescission is by showing that the misrepresentation was material and relied upon by the party seeking to rescind the contract.
When Worlds Collide: Rescission of a Bond?
In Urban Mechanical Contracting Ltd v Zurich, the insurance company argued that it was entitled to rescind surety bonds based on misrepresentations and collusion of the contractor.
The contractor was hired to construct a hospital. It failed to pay some of its subcontractors, who made claims on the L&M bond. The insurance company paid out some claims but later discovered correspondence which indicated that the contractor may have secured the bonded contract through fraudulent misrepresentations and collusion. The insurance company stopped issuing bond payments and took the position that it would not have issued the bonds had it known about the fraud. They brought an action seeking recovery of the bond money already paid out.
Two applications were brought by innocent third parties, including several subcontractors, to address whether rescission can be ordered when an innocent party (a surety) entered into a contract based on fraudulent misrepresentation, but the rights of third parties (L&M bond claimants) have been asserted.
The Court of Appeal was tasked with balancing the rights of the innocent insurance company with the rights of the innocent L&M bond claimants. Ultimately, the Court concluded that a trial was required to determine whether the insurance company could rescind the bonds in question. But the Court nonetheless commented on whether, in the right circumstances, rescission of surety bonds is permissible at law.
The Court of Appeal stated that "the rights of innocent third parties are not an absolute bar to rescission in all cases where there is an allegation of fraudulent misrepresentation." As such, while the Court did not hold that rescission was available on the facts before it, its reasons suggest that rescission is a remedy available to a surety if the necessary facts are proven.
While this decision may be viewed as a negative for the construction industry, keeping the overall context in mind is important:
- Rescission is a long-standing equitable doctrine and has existed for more than 100 years. The fact that a 2022 decision holds that rescission may apply to surety bonds, which have also existed for many years, shows how infrequently the argument is likely to arise.
- The Court did not find on the facts before it that the insurance company was entitled to rescind the bonds. While it left the possibility open, it will be up to the trial judge to determine the issue. Until then, parties faced with a rescission argument can continue relying on existing case law in any other bond rescission disputes.
One potentially negative impact is that owners may be more hesitant to use surety bonds on future projects. If a bond can be rescinded due to a contractor's wrongdoing, unbeknownst to the owner, then what the owner thought was an effective way to mitigate its risk may become a useless instrument.
It is unlikely that sureties such as insurance companies will actively seek to have bonds rescinded since sureties generate revenue from issuing new bonds and collecting premiums. If the use of bonds declines, the surety industry, and likely the construction industry as a whole, would suffer. Further, the spectre of a bad faith argument looms large when a surety seeks to avoid liability under bonds it issued.
A potentially more problematic negative impact is the loss of a payment remedy for unpaid subcontractors. While subcontractors do not obtain L&M bonds for their protection, a prudent subcontractor will determine whether an L&M bond is in place before bidding or accepting work on a new project. Lien rights (or, in Alberta, the right to a Public Works Act claim) may still exist, but the risk of non-payment is higher without a bond claim remedy.
Navigating bond claims is a complicated task, even without potential rescission arguments. Contact Anthony Burden or Raymond Gallelli in Calgary, Ryan Krushelnitzky in Edmonton, or any member of Field Law's Construction Law Group for assistance with bond claims, whether you are surety, obligee, principal or claimant.
Link to decision: Urban Mechanical Contracting Ltd v Zurich, 2022 ONCA 589