Prejudice to Innocent Third Parties Not an Absolute Bar to Rescission

Published on: September 2022 | What's Trending

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The Ontario Court of Appeal released its decision in Urban Mechanical Contracting Ltd. Et al. v. Zurich Insurance Company Ltd. on August 17th, 2022. It dismissed the appeal and upheld the application judge’s conclusion that prejudice to innocent third parties is not an absolute bar to rescission.

The issue of whether the surety is entitled to exercise this remedy and rescind its bonds cannot be disposed of summarily by way of application but rather must be decided at trial, having regard to all the facts.

In 2011, St. Michael’s Hospital entered into a public-private redevelopment agreement with Infrastructure Ontario to build a patient care tower. The contract was awarded to 2442931 Ontario Inc (“Project Co”). Bondfield Construction Company Limited (“Bondfield”) was the construction contractor.

The appellants are a group of subcontractors (the “Trades”) hired by Bondfield, and Bank of Montreal (“BMO”), Project Co’s lender. The respondent is Zurich Insurance Company Ltd, the surety that issued the Performance Bond and Labour and Material Payment Bond (“Payment Bond”) in connection with the project.

The Trades brought two applications centered on the question of whether rescission is available as a matter of law on a construction bond where there has been fraud and collusion in the procurement process.

Rescission is a common law equitable remedy designed to put the parties back to their pre-contractual positions. It allows a party to cancel, or “unwind” the contract when they have been improperly induced to enter the contract through vitiating means such as fraudulent misrepresentation, mistake, or undue influence. Zurich claimed this remedy.

Zurich alleged that in March 2020, prior to the issuance of its Performance and Payment Bonds, it uncovered expansive evidence of fraud, including emails between Bondfield and the Hospital representatives disclosing fraudulent misrepresentations and collusion which enabled Bondfield to secure the contract for the Project. In April 2020, Zurich ceased paying the Trades pursuant to the Payment Bond and commenced an action. Zurich sought a declaration that both bonds be rescinded due to fraud.

The Trades sought a declaration that Zurich could not rescind the Payment Bond because that would interfere with the Trades’ rights as innocent third parties. BMO sought a declaration that Zurich could not rescind the Performance Bond.

The Trades argued that section 69 of the Construction Lien Act (CLA), as it was then called, barred Zurich from rescinding the Payment Bond. They claimed their statutory rights could not be undermined by equitable remedies such as rescission, seeing as legislation supersedes a common law remedy where it is clear and unambiguous. Zurich claimed the Trades were potentially parties to the alleged fraud which, if proven, would taint their statutory rights.

Section 69 of the CLA provides that:

(1) Where a labour and material payment bond is in effect in respect of an improvement, any person whose payment is guaranteed by that bond has a right of action to recover the amount of the person’s claim, in accordance with the terms and conditions of the bond, against the surety on the bond, where the principal on the bond defaults in making the payment guaranteed by the bond.

(3) The surety, upon satisfaction of its obligation to any person whose payment is guaranteed by the bond, shall be subrogated to all the rights of that person.[1]

The Court of Appeal analyzed the legislative intent of section 69, determining that it was designed to replace common law actions based on trust bonds with a direct statutory action between the surety and the trades. At common law, tradespeople were not able to sue on a payment bond because they lacked privity of contract with the surety.

In enacting the CLA, the legislature would not have intended for a surety to have absolute liability. The application judge wrote in her reasons that “common law and equitable remedies are still available; otherwise, the section would stipulate that the surety’s liability arose upon execution rather than when the Bond is ‘in effect.’”[2] The legislation did not address situations of fraud. “If it is established that the Trades were party to the fraud, it would be difficult to envisage that the legislature intended with ‘irresistible clearness’ to protect the Trades who participated in fraud”.[3]

The appellants further argued that rescission is not available as a matter of law whenever the rights of innocent third parties are engaged. The Court of Appeal addressed two concerns regarding third party rights in rescission cases: 1) the impossibility of restoring the parties to their pre-contractual positions when third parties have acquired a superior interest in some of the property subject to the contract, and 2) unavoidable prejudice/adverse effect on third parties when rescission is granted. While they are legitimate concerns, the Court of Appeal clarified that neither is an absolute bar to rescission. Addressing the first concern, the Court of Appeal noted that parties may be awarded alternative relief aimed at restoring their original position, so the fact that some of the property remains in the hands of third parties is not necessarily determinative of whether rescission can be granted. The Court of Appeal discounted the second concern by explaining that rescission unwinds the contractual relationship between contracting parties, not third parties.

The Court of Appeal reiterated that judges have discretionary power to order rescission depending on the facts of the case and are more likely to do so in cases of fraud than innocent misrepresentation.[4] The Court of Appeal concluded that the bars to rescission are flexible, and given the appropriate factual matrix, rescission may be ordered despite prejudice to third parties. Therefore, Zurich was allowed to continue to seek rescission as a remedy. Whether Zurich is ultimately successful will be up to the trial judge.

[1] Construction Lien Act, RSO 1990, c. C.30, s. 69

[2] Urban Mechanical Contracting Ltd. v. Zurich, 2022 ONCA 589, at para 31

[3] Ibid, at para 51

[4] Ibid, at para 63