By Roy Nieuwenburg QC and Manveer Sall

Can a surety / bond issuer (in this case Zurich Insurance Company) rescind performance and payment bonds, based on fraudulent misrepresentation and collusion of the contractor and hospital obligee, when doing so would affect the rights of innocent third parties? This case is causing consternation in construction and lending circles. Zurich Insurance is seeking, on a $301 million hospital project, to rescind the 50% bonds its issued on the basis of fraudulent misrepresentations and collusion. Third parties, including Bank of Montreal on behalf of a syndicate of lenders, have relied on the existence of the bonds. The facts of the case are more fully summarized in the Ontario Court of Appeal decision released August 17, 2022:

[7] In 2011, St. Michael’s Hospital (the “Hospital”) entered into a public-private redevelopment project with Infrastructure Ontario to build a new 17-storey patient care tower (the “Project”). 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 that were designed to ensure a fair, open and transparent process.

[8] The Construction Contract was ultimately awarded to 2442931 Ontario Inc., a.k.a. “ProjectCo”, a wholly owned single-purpose subsidiary of Bondfield Construction Company Limited. ProjectCo was responsible for designing, constructing and financing the Project for the sum of $301,189,863. Bondfield was made the general construction contractor.

[9] A syndicate of lenders financed the Project by way of a $230 million loan to ProjectCo as memorialized in the Credit Agreement. The Credit Agreement named the appellant Bank of Montreal (“BMO”) administrative agent for the Lenders.

[10] Both 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 (“Payment Bond”) for labour, services and materials (collectively, the “Bonds”).

…

[22] 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 Hospital representatives disclosing allegedly fraudulent misrepresentations and collusion which appeared to have enabled Bondfield to secure the contract for the Project. The evidence spans many years and includes communications among many people.

…

[24] Zurich takes the position that, had it known about the fraud, it would never have issued the Bonds.

Bank of Montreal, as administrative agent for the syndicate of lenders, appealed to the Ontario Court of Appeal for a declaration that as a matter of law rescission is not available where there are innocent third parties.

Briefly stated, the Ontario Court of Appeal held:

[5] Prejudice to the rights of third parties may be, but is not always, a bar to rescission. This is particularly true in the case of fraudulent misrepresentation and in cases where it is possible to provide restitution in other ways.

If you are a lender such as Bank of Montreal in this case, or a subcontractor that has relied on the existence of a labour and material payment bond, this case is cause for concern. But as between the obligee of the bond (in this case the hospital alleged to have taken part in fraudulent misrepresentations and collusion) and Zurich Insurance, it would appear that the angels would be on the side of Zurich Insurance. At this point, all the Ontario Court of Appeal has decided is that they would not rule out the possibility that Zurich Insurance would be successful not only as against the hospital but possibly also as against innocent third parties.

Think about this – in the context of insurance on a residential or commercial mortgage loan, the long standing practice is that a lender will require a standard mortgage clause for the insurance policy on a loan secured by the property. The standard mortgage clause basically says that if there is a misrepresentation made by the applicant insured on the insurance application, the insurance company would be liable to pay out to the mortgagee regardless. This Zurich Insurance case raises the question of whether we also need to start getting a standard clause in the bonding context, with the surety for a performance bond (or a dual obligee or multiple obligee rider, suitably drafted similar to the standard mortgage clause).

It will be interesting to follow this case as it works its way through the Courts.