Performance bonds are used in construction contracts to provide the owner with security that the contractor will perform all of its obligations under the contract. The surety for the performance bond provides a guarantee to the obligee (owner) that, if the contractor (principal) defaults in performance of a contract, then the surety will be obliged to remedy the default (by completing the contract, putting out bids for completion of the contract, or by other means). The bond will have certain conditions on which the surety’s obligations will be triggered, including that the obligee/owner must perform all of its obligations under the contract.

An owner that requires a performance bond may assume that in any instance of a contractor’s breach, the bond will be triggered and the surety will step in to complete performance and make the owner whole in respect of all costs incurred in connection with the breach. However, this is not always the case.

In order for a performance bond to be triggered, the contractor’s breach must be of such a serious nature that the owner deems it appropriate to make a declaration of default under the bond. However, after the performance bond is called on, the surety may look to take steps to avoid payment or liability under the bond, including by alleging that the owner is also in default of the construction contract or the bond itself.

Whether or not an owner is in breach of a construction contract or performance bond is dependent on the facts. In some circumstances, the fact that the owner has refused to pay project funds may be a contractual breach. In other circumstances, the fact that the owner continues to pay project funds may limit its ability to recover on a performance bond.

Refusal to Pay Construction Funds may be a Breach of Contract

This dichotomy was recently discussed by the Court of Appeal of Newfoundland and Labrador in RJG Construction Limited v. Marine Atlantic Inc., 2019 NLCA 51, leave to appeal refused 2020 CanLII 17601 (SCC). In this case, the contractor, RJG Construction Limited (“RJG”), entered into a contract with Marine Atlantic Inc. (“Marine Atlantic”) for the construction of a ferry wharf. RJG was obliged to provide a performance bond.

The project was delayed and Marine Atlantic stopped payments.  RJG continued to perform work. Marine Atlantic ultimately gave notice to both RJG and the surety on the performance bond that it was freezing all project funds until the delay issues were resolved. Ultimately, the surety determined that RJG was not in default under the bond. RJG gave notice that it was terminating the contract because of Marine Atlantic’s refusal to pay for work performed. In response, Marine Atlantic issued its own notice terminating the contract, citing RJG’s failures to meet the construction timeline. Eventually, the dispute culminated in a claim and counterclaim for damages arising out of the competing claims for breach of contract. The surety was not named in the action.

Marine Atlantic argued that it was required or entitled to freeze funds in order to comply with its obligations under the performance bond.  The trial judge agreed finding that at common law Marine Atlantic had an obligation to maintain the funds payable under the contract, in order to avoid potential prejudice to itself or the surety.  Marine Atlantic was successful at trial and was awarded $1,300,000 for additional costs it paid to complete the project using a different contractor. This award was overturned by the Court of Appeal.

The Court of Appeal disagreed with Marine Atlantic’s position that it was entitled to freeze the project funds pursuant to either the terms of the construction contract or the performance bond. The Court of Appeal noted that there was no language in the contract or bond that contemplated such a freeze.  Further, by freezing “any and all funds related to the project”, Marine Atlantic had repudiated its contract with RJG, entitling RJG to terminate the contract and seek damages for breach. The trial judge’s findings were set aside and RJG’s appeal and claim for damages was allowed.

The funds in issue in this case had become due and owing to RJG and Marine Atlantic could not freeze project funds under these circumstances.  Where there are project funds that have not become due and owing in respect of work performed under the contract, the owner may be required to stop all further payments in order to recover pursuant to the performance bond.

That was the circumstance before the British Columbia Court of Appeal in Fraser Gate Apartment Ltd. v. Western Surety Co., 1998 CanLII 6532 (BCCA). In that case, after the contractor breached the terms of its contract, the owner called on the surety to complete the work pursuant to the performance bond. After calling on the bond, however, the owner continued to pay certain trades working on the project. The surety took the position that, as it was given the authority under the performance bond to elect how to remedy the contractor’s default, the owner’s continued payment of trades was itself an act of default. The Court of Appeal found that the owner’s actions did not wholly exclude the surety from its obligations under the performance bond. However, the owner was not entitled to recover any funds it paid to the trades after calling on the performance bond.

Accordingly, whenever an owner is faced with a potential breach by a contractor on a bonded contract, it must carefully consider what funds may be due and owing to the contractor at the time. Release of funds that become due and owing after a contractor’s default and call on the performance bond may prejudice the surety, while a failure to release funds that are due and owing prior to the breach may prejudice the contractor and give it a right to terminate the construction contract before a call on the performance bond can be made by the owner.

Conclusion

An owner seeking to call on a performance bond must be aware of all conditions of the bond, as well as its obligations under the construction contract that may continue even after it has alleged that a contractor/principal has breached the construction contract. As the actions taken by an owner/obligee after calling on the performance bond may impact the surety’s position under the bond, or otherwise put the owner/obligee in a position of default itself in respect of the construction contract, care should be taken to ensure that all requirements of the bond and all contractual obligations are properly complied with.