Canada: Scope of Performance Bonds as Contract Security

In Canada, owners often utilize performance bonds in the construction industry as a form of security to ensure that the general contractor performs its obligations under the construction contract. Provided the general contractor performs all of its obligations, the bond is returned to the surety for cancellation. If the general contractor ("Principal") defaults, then the owner ("Obligee") can exercise its rights under the performance bond.

The terms of the bond usually provide that, once the Principal is declared to be in default, the surety is entitled to proceed with the options available to it as provided by the performance bond.

However, two competing appeal court cases in different provinces call into question the scope of the bond and the obligations of the bonding company once the general contractor is declared to be in default.

In Lac La Ronge Indian Band v. Dallas Contracting Ltd., [2004] S.J. No. 531 (Sask. C.A.) ("Lac La Ronge") the Saskatchewan Court of Appeal considered the obligations and responsibilities of the surety once the contractor is declared in default.

The contractor had failed to complete its contract on time and the owner terminated the contractor’s contract. Upon declaring the contractor in default, the owner invited tenders for the completion of the work and a claim was made under the terms of the general contractor’s performance bond.

The construction contract contained a clause which, in the event that the general contractor did not complete its work by the completion date, would oblige the contractor to pay certain liquidated damages to the owner. The owner wanted to offset this amount against the balance of the contract funds, thereby decreasing the available balance of contract funds and ultimately increasing the amount for which the surety would be responsible. The surety objected to this on the basis that a claim for liquidated damages was not within the scope of the performance bond.

The specific terms of the performance bond in Lac La Ronge gave the surety the following options in the event of default by the general contractor:

• Remedy the default;
• Complete the contract in accordance with its terms and conditions; or
• Obtain bids for submission to the owner for completion of the contract and ensure sufficient funds were available to pay the cost of completion, less the balance of the contract price.

The third option provided by the performance bond defined the ‘balance of contract price’ as being the total amount payable by the Obligee to the Principal under the contract, less the amount properly paid by the Obligee to the Principal.

The court examined the language of these options in order better to understand the scope of the surety’s obligations and liabilities to the owner. After analyzing the various provisions of the bond, including the surety’s obligations under each option, the court concluded that the surety’s exposure under the bond was not to be any greater regardless of the option chosen by the bonding company. Therefore, the court held that each option must be read and interpreted in the context of the other options, ensuring that, in choosing one option over another, the surety was not subject to a greater liability.

In determining the extent of the surety’s obligation with regard to completing the work, the court stated:

Furthermore, the Saskatchewan Court of Appeal, in reviewing the language contained in the performance bond, determined that a standard form agreement, such as the performance bond, must be read in the ordinary manner and not strictly construed against either party. The court acknowledged that the surety’s responsibility under the performance bond was to guarantee the completion of the construction contract, rather than assume all of the contractor’s responsibilities and obligations under the terms of the contract.

In reviewing the owner’s ability to deduct liquidated damages, the court determined that the owner was only permitted to deduct liquidated damages only from any payment "which becomes due and payable" to the general contractor. However, the court held that, subsequent to the general contractor’s default, no further monies were due and payable to the general contractor, and the owner was not entitled to payment of the liquidated damages. Therefore, such a claim for liquidated damages could not be included in the calculation to determine the balance owing under the contract when establishing the amount for which the surety could be liable under option three of the bond.

The Ontario Court of Appeal adopted a broader approach to the surety’s obligations when assessing the obligations under a performance bond. In Whitby Landmark Development Inc v. Mollenhauer Construction Limited (2003), 67 O.R. (3rd) 628 (C.A.) ("Whitby") the owner and the general contractor agreed to a cost-savings arrangement whereby the owner would receive 75% and the general contractor 25% of any cost savings on the project. The general contractor failed to complete its work under the contract and ultimately ceased to carry on business. The owner completed the work on its own and subsequently made a claim under the general contractor’s performance bond for an amount that included the balance of its share of the cost savings under the construction contract. The surety objected to the cost-savings claim on the basis that the performance bond did not extend to costs beyond those of completing the physical work.

In interpreting the provisions of the performance bond, the Court of Appeal concluded that where there is ambiguity in the wording of the bond, the principle of contra proferentum applies so that the ambiguity is construed against the bonding company which chose the form of the performance bond (an approach that contrasts with Lac La Ronge).

As in Lac La Ronge, the Court of Appeal also examined the scope of the three options available to the surety under the performance bond once the contractor is declared in default. In particular, the court attempted to discern the intended scope of the surety’s obligations under the performance bond and whether these extended beyond the costs of physically completing the work.

The court concluded that it was necessary to look at the underlying construction contract and that, without specific wording in the bond limiting the surety’s obligations, the surety was obligated to "complete the contract or act under the default under the Contract."

The Court of Appeal stated:

The court further concluded that there was no language in the performance bond that "limits in any way the references to the construction contract or the obligations to complete the contract or act on a default under the contract", thereby potentially expanding the scope of the surety’s responsibilities and liabilities to the owner once the general contractor is declared to be in default.

In addition, in examining the language of the third option the court determined that, where the contract contains a cost-savings arrangement, the balance of the ‘contract price’ (as that term is used in the wording of option three of the performance bond) could be reduced by the amount that may be owing by the contractor at the time of the default. Therefore, the amount the surety may ultimately be obliged to pay to complete the work would be greater than it would have paid had there not been such a cost-savings provision in the contract. In making such a determination, the court was prepared to acknowledge that the surety might be responsible for costs other than those associated with the completion of the physical work.

Examining Lac La Ronge alongside Whitby, it is clear that the courts, faced with a similar issue, took different approaches, resulting in different outcomes.

The Saskatchewan Court of Appeal accepted the surety’s argument that its obligations were limited to completing the work rather than performing all of the obligations under the contract. However, the Ontario Court of Appeal concluded that the surety’s obligations may extend beyond simply completing the work and may result in the surety being responsible for damages beyond the completion of the physical work.

The analyses of the performance bonds’ terms were affected in both cases by the manner in which the balance of contract price was calculated. In Whitby, the Ontario Court of Appeal opened the door to a more expansive interpretation of the surety’s obligation based on an acceptance that the balance of contract price calculation could include a deduction for amounts owing and payable to the owner by the general contractor at the time of the default. In Lac La Ronge, the Saskatchewan Court of Appeal determined that, once the general contractor had defaulted, it was owed no further amounts by the owner and as such, the owner was not entitled to deduct any further amounts from the contract price.

The Saskatchewan Court of Appeal did not apply the principle of contra proferentum and, in fact, determined that the performance bond should not be strictly construed against either party, as it was a standard form document used throughout the construction industry and should be given its ordinary meaning. However, the Ontario Court of Appeal applied this principle.

Finally, while the Ontario Court of Appeal did not find any ambiguity on the face of the performance bond and further determined that the bond’s language did not limit the surety’s obligations to complete the contract beyond completion of the physical work, the Saskatchewan Court of Appeal adopted a much narrower interpretation of the scope of the surety’s obligations.

Until this issue is reviewed by the Canadian Supreme Court, it is clear that those relying on surety bonds as security will look to the decision that most favours their position in either responding to or making a claim under a performance bond.