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May 12, 2006
Developments in the area of the law regarding surety do not happen every day. Until recently, the single most significant decision which impacted the liability of a surety was the decision of the Supreme Court of Canada in Citadel General Assurance Co. v. Johns-Manville Canada Inc.  1 S.C.R. 513.
The Citadel case was significant in that it distinguished between compensated and accommodation sureties and introduced the concept of prejudice which is now a cornerstone of the consideration of whether a surety will be released from its obligations under the bond.
Following the Citadel case, there were other cases (See Frasergate Apartments Ltd. v. Western Surety Company (1998), 38 C.L.R. (2d) 199 (B.C.C.A.)) that dealt with significant concepts of importance to legal practitioners in the area of surety. However, until recently, there has not been a decision of any controversy. Recently, two cases have set up what will surely be an issue to be considered by the Supreme Court of Canada. The two cases in issue are:
(a) Whitby Landmark Development Inc. v. Mollenhauer Construction Limited  O.J. No. 4000 (“Whitby”); and
(b) Lac La Ronge Indian Band v. Dallas Contracting Ltd.  S.J. No. 531 (“Lac La Ronge”).
The stage is set for the Supreme Court of Canada to decide whether a bonding company’s liability under a performance bond is limited to the “bricks and mortar” of physical construction or whether that liability extends further.
There are two “competing” views, one espoused by the Ontario Court of Appeal in the Whitby case and the other by the Saskatchewan Court of Appeal in the Lac La Ronge case.
When one examines the “timeline” it is clear that the Saskatchewan Court of Appeal had the benefit of the Ontario Court of Appeal’s view before it ruled (against the reasoning in Whitby) that amounts owing by the contractor to the owner at the time of default do not include amounts that become owing after default.
After a careful consideration of the Whitby case and a number of U.S. cases, the Saskatchewan Court of Appeal based its conclusion on the basic principles of contractual interpretation. In the end, the Court found the words “complete the contract” can be more easily interpreted as “complete the work” than as “perform all obligations under the contract”. The decision of the Saskatchewan Court of Appeal is consistent with a number of earlier cases prior to Whitby.
Prior to the Whitby decision, the conventional wisdom had been that performance bonds secured only the physical construction of the building in question. However, Whitby provided the Ontario Court of Appeal with the opportunity to find that the standard North American construction Performance Bond guaranteed the contractor’s obligation to remit its share of project cost savings – a non-brick-and-mortar item – to the owner.
In Whitby, the owner/developer entered into a contract with the contractor for the construction of a building. Under the contract’s terms, the owner was entitled to 75% of the savings if the cost of the work came in below the contract price. The contract, however, made no provision for the actual payment of such savings to the owner.
The contractor obtained a standard performance bond from the bonding company. Accordingly, if the contractor was “in default under the contract,” the bonding company was bound to “complete the contract in accordance with its terms and conditions.”
Early in the project, it became apparent that the work would cost less than the price stipulated in the contract. By agreement, the owner deducted its share of the savings from the monthly progress payments to the contractor.
As the project progressed, it became clear that the owner would be entitled to yet further savings on a final accounting. The monthly deductions, however, were not adjusted to take the further savings into account. As time passed, the contractor encountered financial difficulties and opted not to pay the balance of the $600,000 owing to the owner relating to the savings.
As a result, the owner took the position that the $600,000 was recoverable from the bonding company under the Performance Bond. The bonding company responded that its obligations were limited to the terms of the Bond itself, and did not include duties or obligations set out in the underlying contract between the owner and contractor.
On October 17, 2003, the Ontario Court of Appeal held that the wording of the Bond was broad enough to include all issues relating to the underlying contract. The terms of the construction contract, the Court ruled, were expressly incorporated into the Bond, which had the effect of requiring the bonding company to respond to all defaults in the construction contract. This included the contractor’s obligation to issue the cost savings report and to provide compensation for the owner’s share of the savings.
Whitby is an example of the propensity of the courts to hold sureties liable for the contractual obligations of principals beyond the physical construction of the work, and the case serves as an impetus for bonding companies to revise the standard form Bond to limit their liability in this area. The standard form Performance Bond, according to the Ontario Court of Appeal, is not limited to securing the physical construction, or “bricks and mortar,” of a project, but will respond to claims for the collateral contractual obligations of the principal. Whitby determined that bonding companies’ obligations to owners under Performance Bonds were co-extensive with that of the contractor.
While many legal observers construed Whitby as opening the door to making bonding companies liable for contractors’ “collateral obligations,” Lac La Ronge appears to have shut that door.
In the face of what was a rather clear decision in Whitby, the Saskatchewan Court of Appeal in Lac La Ronge held that the Performance Bond was not intended to respond to the owner’s claim for liquidated damages and engineering costs incurred by the owner in completing the abandoned contract in issue. Both items were collateral obligations, as they were not in the “bricks and mortar” category.
In Lac La Ronge, the bonding company provided a Performance Bond to secure the performance of a contract to build a sewage lagoon. The contractor did not complete the contract on time. Eventually, the owner tendered for a new contract, which ended up costing the owner about $600,000 more than the original contract.
In the first instance, the trial judge found that the Bond required the surety to “complete the contract in accordance with its terms and conditions”. These conditions included the payment of liquidated damages to cover late completion of the contract, and the payment of extra engineering and supervision costs that the owner had incurred.
However, the Saskatchewan Court of Appeal disagreed with the trial judge, stating that:
There is no authority in the Contract to set off these amounts against the funds available to complete the contract. Once one reaches that conclusion, on what basis can the surety be made liable for these costs? They are costs incurred by the owner to "complete the Contract" but neither the original contractor nor the surety contracts to pay the owner's costs. A surety is not liable for all costs to complete the contract. A surety is only liable for those costs contemplated by the bond (Lac La Ronge, para. 102).
The Supreme Court of Canada will have to decide whether the Whitby or the Lac La Ronge case is correct on the issue of collateral damages.
In reaching its conclusion, the Saskatchewan Court of Appeal had the benefit of the Ontario Court of Appeal’s views in the Whitby case. In addition, the Saskatchewan Court was influenced in part by the decision in Saskatchewan Housing Corp. v. Canadian Surety Co. (1988), 64 Sask. R. 158 which was a decision where an owner sought to recover damages for delay from a surety. The Court concluded that such damages would not automatically be the surety’s responsibility. Instead, the Court insisted upon a causal relationship between the contractor’s default and any damages suffered by the owner. At trial, the Judge distinguished Saskatchewan Housing Corp. on the basis that it dealt with delay damages rather than liquidated damages. However, the Court of Appeal rightly concluded that liquidated damages are merely a pre-estimate of delay damages and declined to distinguish the Saskatchewan Housing Corp. decision on that basis.
Obviously the Lac La Ronge decision is an important case from the perspective of collateral damages but it also makes a number of important pronouncements on other issues which are of significance to the law of surety. Some of these other important concepts will be reviewed here.
The surety will not be required to perform to the schedule set out in the contract if such performance is impossible.
In the situation at hand in the Lac La Ronge case, by the time the contractor was declared to be in default no work could be done on the project because of winter freeze up. The work could only be recommenced in the following Spring. In reliance on the Saskatchewan Housing Corp. case, the Court concluded that the surety should not be held to the scheduling requirements of the contract.
When a default occurs, the obligee under the bond will want the surety to act promptly and with a view to minimizing the negative consequences of the default. Apart from the fact that an early investigation is desirable from the surety’s perspective, the bond contains an obligation to act “promptly”.
In the Frasergate Apartments Ltd. (supra, para. 2) case, the Court reviewed the obligation of a surety to act promptly. The particular facts of that case are important to the issue of a “prompt” response. In Frasergate Apartments Ltd., the work was substantially complete, and the Court was concerned with warranty obligations. In that context, promptness was not as significant a concern as when a default occurs during a critical phase of the work. Likewise, in the Lac La Ronge case, due to the weather conditions in Northern Saskatchewan, it was not possible to resume work until the spring and therefore, the obligation to act “promptly” had to be viewed with regard to the circumstances of the case. On a review of the surety’s conduct in Lac La Ronge, the Saskatchewan Court of Appeal came to the conclusion that it had acted promptly in all of the circumstances.
Accordingly, and viewed in total, the obligation to act promptly has to be viewed in the context of the progress of the work and with regard to the impact of a delay in all the circumstances.
One of the options open to the surety in the case of the default is to obtain a bid or bids for submission to the obligee for completion of the contract in accordance with its terms.
Usually, the obligee is reluctant to deal with the contractor that has just gone into default and in some circumstances, the obligee may refuse to accept a bid from that contractor.
In the Lac La Ronge case, Western Surety submitted a bid which involved its defaulting contractor, Dallas Contracting Ltd., to complete the work in conjunction with Golder & Associates.
While it did not factor in the Court’s conclusion either at trial or on appeal, the Court seems to be content that the use of a defaulting contractor in the completion of the work will not in and of itself be objectionable.
This opens up the door for a surety to use the defaulting contractor provided that there is no loss of confidence. In summary, a surety may be able to rectify the issue that caused the default in the first place or may be able to initiate a joint venture of the defaulting contractor with another reputable contractor to complete the work.
While the Court of Appeal’s ruling on this issue was consistent with the Court’s conclusion on liquidated damages, the issue is often brought up by owners who seek to recover the costs associated with engineering services used to supervise the work of the new contractor. In reverting to the language of the bond, the Court came to the conclusion that the surety’s obligation can be no greater than if it had completed the contract or had found a responsible bidder to complete the contract. In either case, the surety would not be liable for the extra costs incurred by the owner.
The Ontario Court of Appeal recently extended the liability of a surety to include the contractor’s obligation to issue a cost savings report and to provide compensation to the owner for its share of the savings. This represented a departure from previous cases which held that the surety’s obligation was to “complete the work”.
The Saskatchewan Court of Appeal appears to have retreated from the position in Whitby and, following its own decision in the case of the Saskatchewan Housing Corp., has reaffirmed that the obligation of a surety is “completion of the work”.
This is a significant issue for owners and sureties. With two provincial Court of Appeal decisions which are inconsistent, the stage is set for the issue to be resolved by the Supreme Court of Canada.
Lyle E. Braaten