In the recent decision of Urban Mechanical Contracting Ltd. v. Zurich, 2022 ONCA 589 (“Urban Mechanical”), the Ontario Court of Appeal unanimously held that it is possible for a bond issuer to rescind performance and labour and material bonds on the basis of fraudulent misrepresentations and collusion, even if the recission impacts the rights of innocent third parties. Although the rescission of the bond agreements are possible, the Court of Appeal in Urban Mechanical concluded that a trial was required for a court to ultimately decide whether Zurich could rescind the bond in question.
Urban Mechanical involves a 2011 private-public redevelopment project entered into by St. Michael’s Hospital and Infrastructure Ontario for the construction of a new 17-storey patient care tower. The construction contract was eventually awarded to ProjectCo., a subsidiary of Bondfield Construction Company Limited. Being a private-public project, the redevelopment was financed by a syndicate of lenders by way of a $230 million loan to ProjectCo. Pursuant to the credit agreement, the Bank of Montreal was named the administrative agent for the lenders.
The construction contract and credit agreement required ProjectCo. to obtain two surety bonds. Namely, a performance bond and a labour and material payment bond. In 2015, Zurich issued both bonds in the amounts of approximately $156 million and $142 million, respectively. By early 2017 through to 2018, Bondfield struggled to meet payment deadlines. As such, Zurich paid the subcontractors and suppliers to continue construction of the project. Eventually, Bondfield was in default and BMO as obligee of the bonds, demanded Zurich issue payments under the performance bond, which it did until 2020. In March 2020, five years after Zurich entered into the agreements to provide the bonds, it discovered several years-worth of email correspondence between Bondfield and St. Michaels which consists of allegedly fraudulent misrepresentations that enabled Bondfield to secure the construction contract. Soon after, Zurich stopped issuing payments towards the subcontractors on the basis of fraud during the procurement phase. Zurich’s position was that it would not have issued the bonds had it known about the alleged fraud. In response, BMO brought two applications seeking declarations that Zurich may not rescind the Bonds as doing so would affect their rights as innocent third parties.
In the lower court decision Urban Mechanical Contracting Ltd. et al. v. Zurich Insurance Company Ltd., 2021 ONSC 2535, the application judge concluded that, as a matter of law, the rights of innocent third parties are not an absolute bar to rescission in all cases where there is an allegation of fraudulent misrepresentation. However, the Court held that it is unable to determine whether recission is available to Zurich as this matter must be decided on a complete factual record at trial.
On appeal, the application judge’s decision was upheld and the appeal was dismissed. Upon rendering its decision, the Court of Appeal rejected BMO’s arguments that rescission is impossible. BMO had argued that recission should not be allowed where: 1) third parties have acquired an interest in property subject to the contract; and, 2) where there is unavoidable prejudice to, or adverse effect on, third parties. In addition, the Court of Appeal emphasized the necessity of the full factual context to enable it to make a determination as to whether Zurich is permitted to rescind the bonds. Some facts and circumstances of the case to be considered include when Zurich knew or ought to have known of the fraud, and what knowledge, if any, BMO and the other appellants had of possible fraud. Writing for the Court of Appeal, J.A. Thoburn explained:
 Before a court can determine what the rescission remedy would unwind, the possible interconnections among the various agreements must be explored. This is an issue of mixed fact and law that can only be determined by a trial judge upon consideration of the factual matrix and the parties’ intentions: De Molestina & Ors v Ponton & Ors,  E.W.H.C. 521 (Comm) (U.K.).
In sum, Urban Mechanical stands for the proposition that as a matter of law, rescission may be available where the bond issuer was induced to enter a contract by virtue of fraudulent misrepresentation even when the recission would have significant adverse consequences for innocent third parties. However, we will need to wait until the trial decision to find out whether a court will permit rescission in this scenario.
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