Legal Blog

Bond Recovery

A labour and material payment bond provides the deep pocket of a surety to ensure that, for example, a general contractor pays its subcontractors. An owner wants to know that subcontractors are being paid because, if they are not, it reflects badly on the owner and, since the subcontractors actually perform the work on the project, it may adversely affect the project. In effect, the owner is buying peace of mind when it mandates that the general post a labour and material payment bond. We say “buying“ because the cost of this bond is invariably added to the contract price.

When a general is incapable of paying its subs and the surety steps in to pay them, the surety will seek to reduce its losses by collecting any funds that would otherwise be available to the general and then collecting any shortfall from the individuals, usually directors and officers, who guaranteed the general’s obligations to the surety.

A general’s inability to pay its subs points to its financial deterioration and possible insolvency. It is probably also incapable of paying other creditors and, more to the point, its source deduction remittances to CRA. Unfortunately for sureties and subs, CRA has a super priority for unremitted source deductions. This priority, which was settled in a 1993 decision of the Supreme Court of Canada, takes precedence over liens that might arise under the Construction Act and even over secured interests. It is yet another reason why subs and subsubs should know the financial position of the parties with whom they are contracting because the lien rights on which they may be relying may turn out to be no rights at all.

If an owner admittedly owes money to a general, then a priority dispute may arise between the subs or surety and CRA. Such was the case in Manitoba Housing and Renewal Corp v. Able Eavestroughing Ltd., a 2017 decision of the Manitoba Queen’s Bench, appealed to the Manitoba Court of Appeal, and then to the Supreme Court of Canada.

Mess

The usual mess unfolded after a general became insolvent. The surety under a labour and material payment bond paid subs and took an assignment of their claims for lien. The surety had a claim for $610,000. CRA delivered to the owner a requirement to pay (something like a garnishment)  the general’s unpaid source deductions of $712,000. The owner owed the general $463,000 by way of statutory and notice holdbacks and was content to pay those funds to whichever of the competing interests was the proper payee. Accordingly, either the surety or CRA was to be paid the owner’s holdback, but, regardless who received the money, neither would be paid in full.

The surety had to demonstrate that the owner had a separate duty in law to pay the disputed funds either to the subs from whom it took its assignments or to the surety itself. If it could not do so, the surety would lose.

Mitigation

Mitigation is a concept by which a party who suffers a loss is under a duty to attempt to reduce (i.e. mitigate) its damages before it claims those damages against the person who caused the loss.

The surety argued that, under the laws of guarantee, once the surety’s obligation was triggered, the owner was obliged to pay funds to the surety to mitigate the surety’s exposure under the bond. This obligation, the surety argued, was owed to the surety in its own capacity.

The judge noted that this argument might make some sense if the surety’s claim were under a performance bond (i.e. if the owner is going to insist that the surety complete the project, then the owner has to pay the remaining funds under the contract to the surety). However, this argument made no sense, and was not supported by any jurisprudence, in the context of a labour and material payment bond. The true purpose of this bond is to ensure that the subcontractors get paid. That would not engage a duty of the owner to pay money directly to the subcontractors or the surety; that was the very purpose of the bond, for which, you will remember, the owner paid.

Direct to Subs

 The prime contract had a provision that allowed the owner to pay the subs upon the general’s default. This is not an unusual provision. Accordingly, the surety argued that, since the owner was entitled to pay the subs, the owner somehow had a duty to pay the subs and, through them, the surety. This argument, which the judge did not accept, attempted to turn the owner’s discretion into an obligation.

The surety also argued that the owner had a duty to pay the subs as third party beneficiaries under the prime contract. For this argument to succeed, the surety had to prove that the parties to the prime contract intended to extend the benefit of its payment provisions to the subs.

The judge held that there was no evidence that the owner intended to extend the ability to sue on the prime contract to unpaid subs. “To the contrary, the requirement it imposed upon the (general) to obtain a labour and material payment bond confirms that (the owner) was attempting to avoid being involved in any dispute with an unpaid contractor, or any lawsuit started by one.”

The judge also noted that private arrangements between the owner and the general in the prime contract could not adversely affect the rights of CRA.

Subrogation

 The surety then argued, based on the doctrine of equitable subrogation, that it was subrogated to the position of the owner (i.e. the surety stands in the shoes of the owner so that whatever claim the owner might have against the general, the surety had against the general). Further, as a consequence of this subrogation, the surety was entitled under the prime contract to pay the funds as it saw fit and it saw fit to pay all of the funds to itself.

The judge rejected this argument in one sentence. She merely stated that she could not accept the concept that the surety could be, at the same time, both the assignee of the subs and subrogated to the position of the owner.

Inevitable Result

The parties had agreed (or conceded) that, if the owner only had an obligation to pay the funds to the general and had no obligation to pay the funds directly to the surety or the subs, then CRA had priority to those funds. Accordingly, CRA got everything (although not enough to satisfy its claim) and the surety and the subs received nothing.

The surety was not pleased with the decision of the motion judge and appealed to the Manitoba Court of Appeal. In a short 2018 decision, the Court agreed with every reason for decision that the motion judge made and dismissed the appeal. The surety then moved for leave to appeal the decision of the Court of Appeal to the Supreme Court of Canada. Leave was denied.

We assume that, because of the general’s insolvency, any claim of the surety against the general would be futile. Accordingly, the surety’s only remaining possibility to recoup its losses – remember that a bond is not an insurance policy – is to claim against the individual guarantors of the general’s obligations to the surety, assuming there were some.

 

Image courtesy of finance.

Written by Jonathan Speigel, the founding partner of Speigel Nichols Fox LLP, leads the litigation and construction practices.