Urban Mechanical Contracting Ltd. V. Zurich, 2022 ONCA 589
Rescission is an equitable remedy meant to return contracting parties to pre-contract conditions. It may be invoked where a party has been improperly induced to enter into a contract. In Urban Mechanical Contracting Ltd. v. Zurich, 2022 ONCA 589 (Urban Mechanical), the Ontario Court of Appeal unanimously held that the rights of innocent third parties are not an absolute bar to rescission in all cases where there is an allegation of fraudulent misrepresentation. In Urban Mechanical, the Ontario Court of Appeal refused two applications brought to overturn a lower court decision, which allowed the bond issuer to rescind a bond agreement, as a matter of law, on the basis of fraudulent misrepresentation and collusion, even though the rights of innocent third parties claiming against the bonds would be impacted.
In 2011, St. Michael’s Hospital (the Hospital) (the Owner) entered into a public-private redevelopment project with Infrastructure Ontario for the construction of a new patient care tower (Project). Construction was to be financed and carried out by the private sector. 2442931 Ontario Inc. (ProjectCo) was awarded with the contract to design, build and finance the Project. ProjectCo was a special purpose entity related to Bondfield Construction Company Limited (Bondfield).
Under the contract with the Owner and pursuant to its credit agreement, ProjectCo was obligated to secure a performance bond and a labor and material payment bond (collectively, the Bonds). In January 2015, Zurich Insurance Company Ltd. (Zurich) issued the performance bond in the amount of approximately CA$156 million, or half the contract price; and the labor and material payment bond in the amount of approximately CA$142 million.
The Bonds named Bondfield as principal, Zurich as surety, and ProjectCo, the lender and the Hospital as the obligees. ProjectCo held the rights to claim on the payment bond in trust for various subcontractors (collectively, the Trades), including the applicant in this case, Urban Mechanical Contracting Ltd. (Urban).
Bondfield failed to meet payment commitments to the Trades and, in 2017, Zurich began paying the Trades to keep the Project moving. In November 2018, the Hospital issued a Notice of Default to Bondfield. The lender thereafter applied to the court for the appointment of a receiver to make a call on the performance bond. Before Zurich filed responding materials, however, it discovered email communications between Bondfield and Hospital representatives suggesting that alleged fraudulent misrepresentation and collusion was used to enable ProjectCo to secure the Project. These communications spanned many years and were between many people. Zurich ceased payment of the Trades under the Bonds and initiated an action for rescission of the Bonds, claiming that since the fraud occurred prior to the issuance of the Bonds, and by virtue of the fraudulent misrepresentations, it was induced to issue the Bonds. Zurich sought recovery of the funds paid out to date under the Bonds from the fraudsters. It took the position that had it known about the fraud, it never would have issued the Bonds.
The Trades brought an application seeking a declaration that, as a matter of law, Zurich may not rescind the Bonds on grounds of fraud and collusion, because doing so would, in part, affect their rights as innocent third parties. The lender also brought an application seeking a declaration that Zurich cannot rescind the performance bond.
In the two application before the court, the application judge found that “[t]he Legislature [in enacting the Construction Lien Act] cannot have intended that the liability of a surety be absolute.” Highlighting the need for a complete factual record to reach any further findings, the application judge dismissed both applications. The Trades and the lender appealed.
Court of Appeal emphasizes equitable rescission as a flexible remedy
The Court of Appeal upheld the application judge’s finding that innocent third party rights are not an absolute bar to rescission in cases of alleged fraudulent misrepresentation. The Court left all remaining issues to the trial judge to assess the availability of rescission on a complete record, taking into account all facts, circumstances and findings.
The Trades had initially argued that section 69 of the Construction Act prevents Zurich from rescinding the payment bond because they have a valid claims against Zurich, and equitable remedies such as rescission cannot undermine their statutory right. The Court of Appeal rejected this argument, noting that while legislation supersedes common law and equity, legislation only does so where it expresses an intention to do so “clearly and unambiguously.” The Court stated that section 69 of the Construction Act was designed to explicitly permit tradespeople to sue on a payment bond, but the statute and its legislative history is silent on rights of action in the face of fraud, and no party presented cases on this issue.
The Court of Appeal then assessed whether risks to innocent third party rights are an absolute bar to the rescission remedy. The Court identified two common concerns about the rescission remedy when innocent third party rights are engaged: (1) the concern that rescission as restitution is technically “impossible” when property subject to contract is purchased by an innocent third party purchaser for value without notice of pre-existing interests, and (2) the concern that rescission is impermissible where it causes unavoidable prejudice to innocent third parties. The Court held that neither concern posed an absolute bar to granting rescission where third party interests are engaged.
First, the Court found that a technical “impossibility” argument presumes an overly restrictive interpretation of rescission. Though an innocent third party purchaser of property for value without notice generally is entitled to retain the property at the expense of pre-existing equitable interests, the Court emphasized that equitable rescission is “focused on practical justice, not rigid technicalities.” That is, the rescission remedy may be granted in modified forms, such as monetary compensation, in order to do what is just when it is impossible to technically restore pre-contract circumstances. The Court stressed that determining whether rescission could be tailored to achieve practical justice on particular facts requires a full factual record.
Second, the Court noted that concern over alleged unavoidable prejudice to third parties does not form an absolute bar to rescission, but is rather “flexible criteria” in a court’s determination to grant and/or modify a rescission remedy. Such concern also implicates a number of determinations as to whether any risk of prejudice is in fact unavoidable, and the Court declined to make further findings or assess the intersecting contractual relationships in the absence of a complete factual record.
Of note is the fact that the Court’s analysis did not address the issue of who is in the best position to avoid a loss when Bonds have been issued in circumstances where it is later determined that fraudulent and collusive conduct occurred without the knowledge of the bond issuer. The surety industry has tools available to assess those contractors who apply for and are determined to meet the eligibility criteria for such Bonds. Innocent third parties who seek to rely on such Bonds inevitably take the position that the bond issuer is in the best position to assess the risk and uncover a “fraudulent contractor.” It will be interesting to see whether or not this issue is addressed in the subsequent proceedings taken in the Urban Mechanical proceedings.
By way of contrast, the standard mortgage clause in many property insurance policies provides coverage to the mortgagee regardless of whether or not the owner or mortgagor engaged in conduct that would otherwise materially alter the risk for the insurer. The Supreme Court of Canada in National Bank of Greece (Canada) v. Katsikonouris considered the following standard mortgage clause contained in the property insurance policy at issue:
IT IS HEREBY PROVIDED AND AGREED THAT:
1. This insurance and every documented renewal thereof -‑ AS TO THE INTEREST OF THE MORTGAGEE ONLY THEREIN -‑ is and shall be in force notwithstanding any act, neglect, omission or misrepresentation attributable to the mortgagor, owner or occupant of the property insured, including transfer of interest, any vacancy or non‑occupancy, or the occupation of the property for purposes more hazardous than specified in the description of the risk. 
The Supreme Court of Canada went on to observe that:
It defies rational explanation to suppose that the insurer would agree not to invalidate coverage of the mortgagee with respect to the very omissions and misrepresentations of the mortgagor that stand to affect most radically the risk it has agreed to assume, while at the same time reserving to itself the right to invalidate coverage in respect of the omissions and misrepresentations it had a reasonable opportunity to investigate before agreeing to issue a policy.
Such provisions do not currently exist in standard surety Bonds and would no doubt be viewed as materially increasing the risk to the surety in the face of the Urban Mechanical decision.
The decision in Urban Mechanical may prove to be worrisome to project stakeholders in the construction industry where surety bonds provide a common and vital means of mitigating the risks associated with a party’s failure to perform by providing a form of guarantee for non-performance or non-payment by a defaulting contractor where the conditions for payment under the Bonds are met. Lenders, owners, subcontractors and suppliers alike may need to exercise greater caution and scrutiny for risks of fraud in the construction projects they participate in, as statutory claim protections may not be fool-proof against a court’s inherent equitable discretion.
 2022 ONCA 589 at para 31.
 2022 ONCA 589 at paras 43-44.
 2022 ONCA 589 at para 61.
 2022 ONCA 589 at para 71.
 2022 ONCA 589 at para 82.
 National Bank of Greece (Canada) v. Katsikonouris,  2 SCR 1029.
 With special thanks to Hannah Bourgeois for her assistance with this article.