Trial required to assess Zurich’s right to rescind surety bonds: Appeal Court

As a matter of legal principle, Zurich can rescind performance and payments surety bonds based on fraud or misrepresentation, even if that would affect the rights of innocent third parties in a construction dispute, Ontario’s Court for Appeal has ruled.

But whether or not the courts will allow it specifically in the case of Urban Mechanical Contracting Ltd. v. Zurich remains to be seen. The Appeal Court said the ultimate decision about rescinding the surety bonds would require the courts to consider the relevant facts in the case, and the factual record has not yet been established.

As noted in the Appeal Court’s decision, St. Michael’s Hospital in Toronto entered a public-private redevelopment project with Infrastructure Ontario in 2011 to build a new 17-storey patient care tower.

Construction was to be financed and carried out by the private sector. The construction contract was to be awarded to a bidder chosen through Infrastructure Ontario’s procurement process, which was subject to rules designed to ensure a fair, open and transparent process.

The construction contract was ultimately awarded to ProjectCo, a wholly owned single-purpose subsidiary of Bondfield Construction Company Ltd. ProjectCo was responsible for designing, constructing and financing the project for $301.1 million. Bondfield was the general construction contractor.

A syndicate of lenders financed the project via a $230-million loan to ProjectCo. The credit agreement named the Bank of Montreal as the administrative agent for the lenders. The construction contract and credit agreement required ProjectCo to obtain and maintain surety bonds — a performance bond for the construction and design contract, and a labour and material payment bond for labour, services and materials. Zurich provided the bonds.

Bondfield struggled to meet payment deadlines as early as 2017, according to the Appeal Court ruling. Zurich paid the subcontractors and suppliers to keep the project going, based on a claim made against the performance bond. Bondfield continued experiencing difficulties meeting deadlines through 2017 and 2018 until finally, on Nov. 2, 2018, the hospital issued a notice of default under the project agreement.

On Nov. 16, 2018, BMO informed Zurich that Bondfield was in default and demanded payment of the performance bond. After a dispute over whether BMO could demand payment without exercising step-in rights under the construction contract, BMO obtained a court order appointing a receiver to make a call on the performance bond, which Zurich did not dispute.

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 the hospital. The emails disclose what Zurich claims to be fraudulent misrepresentations and collusion that appeared to have enabled Bondfield to secure the contract for the project, the Appeal Court wrote.

In April 2020, Zurich ceased paying the subcontractors under the performance bond and sought a court declaration to rescind both the performance and payment bonds due to fraud in the construction procurement process. Zurich took the position that, had it known about the fraud, it would never have issued the bonds.

BMO went to court saying Zurich did not have any legal basis in law for rescinding the bonds when innocent third parties are involved (i.e., third parties such as the bank and subcontractors relied on the bonds to do their work and make representations to others on the project).

An applications judge decided that, as a matter of legal principle, rescission of the surety bonds may be possible, even if it would affect the rights of these innocent third parties. However, she found the issue of whether Zurich was entitled to rescind its bonds based on fraudulent misrepresentation should be determined at trial on a full factual record, and not disposed of summarily by way of application.

The subcontractors appealed, but Ontario’s Appeal Court upheld the lower court’s decision.

Essentially, the project’s subcontractors said rescinding Zurich’s bonds would mean unavoidable prejudice to them as third parties, since they could not be returned to the state of their original position as if the bonds had never existed. The Appeal Court rejected that line of argument.

“Turning…to the appellants’ ‘prejudice to innocent third parties,’ argument,” the Court of Appeal wrote in a decision released Aug. 17, “Urban Mechanical Contracting et al. and BMO misconstrue the effect of the principle of restitutio in integrum [return to the original position] on third parties.

“Rescission unwinds the contractual relationship between the contracting parties. It does not unwind the contractual relationship with third parties….I take no view on whether rescission would be able to achieve practical justice between the parties in the circumstances. These are fact-laden questions that are more appropriate for trial than an application.”

The Appeal Court thus agreed with the application judge that a trial would be required to determine whether rescinding Zurich’s bonds could be done without doing unavoidable harm to third parties such as the bank and the contractors.

Feature photo courtesy of iStock.com/PixelsEffect