Defence & Indemnity - August 2017: V. SURETY AND BOND ISSUES: Manitoba Housing and Renewal Corp. v. Able Eavestroughing Ltd., 2017 MBQB 27 per Simonsen, J. [4237]

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V. SURETY AND BOND ISSUES

A. Manitoba Court of Queen’s Bench finds CRA entitled to priority to “earned but unpaid” contract funds held by obligee (over the surety who had paid out labour and material payment bond claims after principal’s default)

Manitoba Housing and Renewal Corp. v. Able Eavestroughing Ltd., 2017 MBQB 27 per Simonsen, J. [4237]

I. FACTS AND ISSUES
In May 2010, Falcon Creek Industries Inc. ("Falcon"), as general contractor, entered into a construction contract (the “Contract”) with Manitoba Housing and Renewal Corp. ("MHRC") which required Falcon to obtain a Performance Bond and a Labour and Material Payment Bond (the "L&M Bond") with respect to the Contract. The Guarantee Company of North America ("GCNA"), as surety, issued the L&M Bond, with Falcon, as principal, and MHRC, as obligee.

In the summer and fall of 2011, various subcontractors and suppliers of Falcon registered builders’ liens against the project, preventing further payments from being made to Falcon. Despite non-payment, it appears Falcon then completed its work on the project with substantial performance being achieved in April 2012. MHRC ended up holding the sum of approximately $433,000 (the "Funds"), which in the normal course would have been payable to Falcon, consisting of approximately $147,000 representing the builders’ lien holdback and approximately $286,000 in further earned but unpaid amounts which had not been paid to Falcon as a result of the liens being registered.

In August 2012, CRA issued a Requirement to Pay (“RTP”) to MHRC requiring MHRC to pay all amounts it owed to Falcon up to a sum which was well in excess of the Funds.

In addition to making lien claims, certain unpaid subcontractors and suppliers also made claims against the L&M Bond. GCNA then paid approximately $611,000 to Falcon’s unpaid subcontractors and suppliers pursuant to its obligations under the L&M Bond. As is normally done, in exchange for payment, GCNA received an assignment of the unpaid subcontractors’ and suppliers’ lien claims and then stood in their position with respect to the Funds. No claim was made by MHRC on the Performance Bond.

MHRC filed an interpleader application seeking to pay the Funds into court and sought confirmation that upon payment of the Funds into court, any and all liability it may have with respect to paying the Funds was extinguished. Essentially, MHRC wanted to wash its hands of the Funds and let CRA and GCNA (in the shoes of the lien claimants) fight over their respective claims.

GCNA resisted this application instead, arguing that MHRC had a positive legal obligation to pay the Funds to GCNA and therefore the interpleader order, and the extinguishment order sought, was inappropriate. Taking this position was consistent with GCNA’s overall argument that the Funds were not payable to Falcon (and therefore should not be payable to CRA as CRA’s claim to the Funds arose only if the funds were payable to Falcon).

The Manitoba Court of Queen’s Bench had to then decide whether MHRC had a positive legal obligation to pay the Funds to GCNA; a question which if answered in the negative, would ultimately see the Funds paid to CRA and not GCNA.
II. HELD: MHRC, as obligee, had no legal duty to pay the Funds to GCNA, notwithstanding GCNA had made payments in excess of the amount of the Funds to claimants under the L&M Bond

GCNA made four arguments in support of its position, three of which are considered below:
 
1.   Pursuant to the first principles of the law of guarantee, MHRC had an obligation to pay the Funds to GCNA to mitigate the exposure of GCNA under the L&M Bond;
 
2.   Pursuant to the terms of the Contract and the L&M Bond, MHRC was obligated to pay the unpaid subcontractors and suppliers, which included GCNA as a result of the assignments made by those subcontractors and suppliers in favour of GCNA;
 
3.   The principles of equitable subrogation under the law of guarantee provide that when GCNA was called upon under the L&M Bond, it became subrogated to the position of MHRC. In this subrogated position, it could choose to pay itself and the unpaid subcontractors (likely pro-rata);
 
MHRC and CRA both argued that MHRC had no legal obligation to pay the Funds to the unpaid subcontractors or GCNA. They argued the Funds, payable to Falcon, should instead be paid to CRA as result of its RTP and its corresponding legislated superiority.
 
If the Funds were payable to Falcon (which GCNA denied), then all parties agreed that CRA’s RTP takes priority over the lien and trust claims made by the unpaid subcontractors, and GCNA as assignee, to the extent any such rights arose under the Manitoba Builders’ Lien Act.
 
With respect to the first argument, GCNA could not point to any Canadian authority where an obligee on a construction project was liable to a surety on the basis of an alleged duty to mitigate the surety’s exposure under a bond. The Court distinguished the textbook passages relied on by GCNA, noting that these were passages discussing performance bonds not labour and material payment bonds. For the Court, this distinction was critical:
 
23   …The objectives of the two are very different. A performance bond requires a guarantee company to arrange for completion of a project in the event the general contractor fails to do so and to pay any additional costs associated with completion. A labour and material payment bond, on the other hand, provides financial security to subcontractors, to ensure that they are paid. Although counsel for Guarantee Company points to evidence of Linda Cook, Contract Administrator for MHRC, on cross-examination on her affidavit in which she agreed that the Bond is “really for [MHRC’s] benefit to make sure that the subs get paid”, that is simply her own view. And the Bond does benefit MHRC by ensuring that the trades on its Project are paid. With this background, it seems to make little sense that there would be a general duty to mitigate on the part of MHRC in the context of a labour and material payment bond that would require it to pay subcontractors when that is the very purpose of the Bond…
 
With respect to the second argument, the Court reviewed the terms of the Contract and noted that upon an event of default (which Falcon’s non-payment to its subcontractors would have been), MHRC was entitled to withhold further payment and had the discretion to then use withheld funds to pay unpaid subcontractors. The discretion being the key point – as nothing in the Contract itself created any obligation on MHRC to pay unpaid subcontractors. The Court also cited the Alberta Court of Appeal decision in Iona Contractors Ltd. (Receiver of) v. Guarantee Co. of North America 2015 ABCA 240 where that Court rejected the argument that a similarly worded contract could be read together with a labour and material payment bond to create an obligation on an obligee to pay its contractor’s subcontractors:
 
31   Although the factual matrix in Iona is different in that the party claiming entitlement to the funds was a trustee in bankruptcy pursuant to the Bankruptcy and Insolvency Act, R.S.C. 1985, c. B-3, rather than CRA pursuant to the Income Tax Act, I am satisfied that the conclusion that the contract and Bond do not create an obligation on the part of MHRC to pay subcontractors is applicable to the case before me. That is, the private arrangements between MHRC, Falcon Creek and Guarantee Company cannot affect the rights of the Crown under s. 224(1.2). The Crown acquired those rights by operation of law and the issuance of a Requirement to Pay; its rights too cannot be displaced by private arrangements.
 
With respect to the third argument, GCNA was unable to point to any Canadian legal authority where the principle of equitable subrogation had been applied as requested in the context of a labour and material payment bond. The Court rejected the American authorities provided by GCNA and adopted a passage from the Justice Paperny’s dissent in Iona, supra, at para 88 of that case:

88   Those authorities are not persuasive given that existing Canadian authority deals with the issue. The equitable doctrine of subrogation described by the British Columbia Court of Appeal in Canadian Indemnity Company v. British Columbia Hydro and Power Authority, 1976 CarswellBC 1227 at para 15; [1976] BCJ No. 815 (QL) (CA) (also relied upon by GCNA) is said to entitle a surety, who carries out its obligations to pay or perform what a contractor has failed to pay or perform, to the rights of the person to whom the surety was obligated. In this case, those rights would include the right to use retained funds to complete the project, as was done. The chambers judge relied on the reasoning in Canadian Indemnity to include in that amount the cost of paying an electrical subcontractor to return to finish its work, and I would not interfere with that conclusion. It is clear from this Court’s decision in Horizon Earthworks, however, that the surety’s subrogated rights would not include repayment for fulfilling the contractor’s obligation to pay the subcontractors. The Airport has no corresponding obligation to make those payments under the Contract and importantly, under the law as set out in Horizon Earthworks and A.N. Bail, the Airport had no ability to use the Funds to make voluntary payments to subcontractors in priority to other creditors, in the face of Iona’s bankruptcy. I also note the decision of St. Paul v Genereux Workshop (Bonnyville) Ltd. (1984), 12 DLR (4th) 238 (ABCA), where this Court declined to follow the American authorities relied upon by GCNA.
 
As the Court rejected all of GCNA’s arguments, it found the Funds were not payable to GCNA in its own capacity or as assignee of the lien claimants’ claims. Rather, the Funds were held to be payable to Falcon, pursuant to the Contract, as Falcon completed the work for which it contracted. The Funds payable to Falcon were subject to the lien and trust claims of the unpaid subcontractors which included GCNA as assignee, however, there was no dispute that CRA’s RTP took priority over those claims. There was no argument that any distinction should be drawn between the portion of the Funds held back pursuant the Manitoba Builders’ Lien Act and the portion of the Funds held back by MHRC as a result of Falcon failing to pay its subcontractors. As a result, CRA was entitled to funds paid into Court by MHRC.   

III. COMMENTARY
“The tax man always gets his due” rings true here once again. The legislated “super-priorities” given to CRA are powerful tools that create a difficult challenge for any party seeking priority to funds also claimed by CRA. While the specific facts certainly matter, in Alberta, Courts have given priority to CRA over lien claimants’ claims to lien fund monies (Japan Oil Sands Ltd. v. Stoney Mountain Steel Corp. (2001), 290 AR 251, 93 Alta LR (3d) 54) and security paid into court by a tax debtor to remove a builders’ lien (Canadian Western Bank v. 702348 Alberta Ltd., 2012 ABQB 89 and supplemental reasons at 2012 ABQB 305).
 
In Alberta (and other provinces), when a surety makes payments to unpaid subcontractors pursuant to its obligations under a labour and material payment bond, the surety is subrogated to the rights of the unpaid subcontractors. In Iona, that subrogated position entitled GCNA to receive amounts held back by an owner, as a result being subrogated to the lien claimants’ trust claims. However, the Iona decision was in the context of a priority dispute with Iona’s bank (Iona being the principal under the bonds in that case) and not CRA.
 
The Manitoba Builders’ Lien Act’s trust provisions are much more robust than those found in Alberta’s Builders’ Lien Act. However, it does not appear that trust claims under either Act would survive a priority battle with CRA, given the breadth of ss. 224 and 227 of the Income Tax Act RSC 1985, c. 1 (5th Supp) (and no such priority arguments were advanced in this case).
 
Similarly, it would very likely have been futile to try and argue that MHRC was in any different position with respect to the portion of the Funds held back pursuant the Manitoba Builders’ Lien Act and the portion of the Funds held back by MHRC as a result of Falcon failing to pay its subcontractors.
 
Finally, this case is example of the type of risk faced by surety in any financing or "quasi" default situation (i.e. if a bonded contractor continues to do the work and "earn" contract funds, those contract funds are subject to claims of other creditors of contractor, not just CRA, in priority to the surety). The exposure to such risks underscores the surety’s need to properly secure its position before entering into any such arrangements. Similarly, it is important that any completion agreement expressly addresses the matter of the contractor’s default and who is entitled to the contract funds to be earned going forward.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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