When a contractor goes bankrupt and the bonding company pays the subcontractors, who is entitled to the holdback funds in the owner’s hands: the contractor’s trustee in bankruptcy or the bonding company? In Iona Contractors Ltd. (Receiver of) v. Guarantee Co. of North America, the Alberta Court of Appeal recently held that the bonding company is entitled to the funds.

This decision raises an important issue with respect to the constitutional enforcement of the provincial lien legislation in light of the federal bankruptcy legislation. The majority of the Court of Appeal held that, when the holdback is in the owner’s hands, the trust fund provisions of the Alberta Builders’ Lien Act are enforceable as against the contractor’s trustee in bankruptcy and the holdback funds are payable to the subcontractors, or the bonding company which has paid those subcontractors. The minority judge held that those provisions are not constitutionally enforceable and that the holdback funds are payable to the contractor’s trustee in bankruptcy.

Background

Iona Contractors and the Calgary Airport Authority entered into a contract for the construction of improvements to the airport. Under the contract, Iona was required to deliver a Performance Bond, and a Labour and Material Payment Bond to guarantee payment to the suppliers of materials and labour. Guarantee Company of North America was the surety under both bonds.

When the work under the contract was substantially complete, the contractor went into bankruptcy and some of the subcontractors remained unpaid. The Airport Authority used $182,869 to complete deficiencies in the contract work, which left $997,715.83 still in the Airport Authority’s hands (the “holdback”). Guarantee paid out $1.48 million under the Payment Bond to settle the outstanding accounts of Iona’s subcontractors. It claimed the holdback to recoup these payments. At the same time, the trustee in bankruptcy of the contractor also claimed the holdback.

The Alberta Court of Queen’s Bench held that contractor’s trustee in bankruptcy was entitled the holdback. This decision was reversed by the Alberta Court of Appeal, which held that Guarantee was entitled to those monies.

Decision of the Alberta Court of Appeal

There were two issues in this case:

  1. First, the contract issue. Were there any monies owing by the owner to the contractor at the time the contractor went bankrupt?
  2. Second, the trust fund issue. If there were monies owing to the contractor, were those monies “trust funds” which were being held in trust for the sub-contractors?

Were there monies owning to the contractor when it went bankrupt?

Guarantee argued that, under the terms of the contract between the owner and the contractor and the definition of “Work” in that contract, there was no money owing to the contractor. Guarantee submitted that, because the subcontractors were not paid, the “Work” was not complete. The owner was entitled to take the payment to the subcontractors out of the contractor’s hands, and once this occurred then there was nothing owing to the contractor.

The contractor’s trustee in bankruptcy asserted that, since there was no contractual relationship between the owner and the subcontractors, there was no “obligation” on the owner to pay subcontractors. The Court of Appeal held that the issue at this stage was not whether the owner had an “obligation” to pay the subcontractors but whether it has the “right” to do so under the prime contract with the contractor. The Court of Appeal held that, even if payment by the owner to the subcontractors was permitted under the provisions of that contract, those provisions became inoperative after the contractor’s bankruptcy. The Court of Appeal said:

“There is nothing objectionable about a provision in a contract allowing the owner to complete work that was not performed by a bankrupt contractor, and to deduct the amount from what was otherwise owing to the contractor. Section 97(3) of the Bankruptcy and Insolvency Act allows such set-offs. After a bankruptcy, however, no such clause is effective to the extent that it gives a discretion to the owner to pay creditors of the bankrupt contractor otherwise than as authorized in the Bankruptcy and Insolvency Act…..The appellant argues that when the construction contract and the bond are read together, they disclose an obligation on the part of the Airport Authority to “mitigate” the exposure of the surety, which includes using the holdback funds to pay the subcontractors. Even if the agreements, when read together, disclose some intention to minimize the exposure of the surety, the private arrangements between the owner, the contractor, and the bonding company cannot affect the rights of third parties like the Trustee in bankruptcy and the secured creditor. Whatever rights the appellant may have were not registered at the Personal Property Registry, and cannot displace the rights of the secured party….It follows that the appellant is unable to succeed based on its argument that no money was due to Iona under the contract.”

Were the holdback funds trust funds to which the subcontractors or bonding company were entitled?

The majority of the Alberta Court of Appeal held that the holdback funds were impressed with a trust under the provisions of the Alberta Builders’ Lien Act (the “BLA”) that the subcontractors were entitled to those funds by reason of that trust, and that the bonding company was subrogated to those rights of the subcontractors since it had paid the subcontractors’ claims. The logic of its decision was as follows:

  1. The Alberta BLA creates a “comprehensive, integrated system that provides some assurance to subcontractors that they will get paid for improving land” and the trust fund provisions are part of that system.
  2. These trust provisions apply when a certificate of substantial performance is issued, as had occurred in this case. The Act “effectively uses the mechanism of a trust to avoid the diversion of the holdback funds, after the issue of the certificate of substantial completion, but before the funds actually reach the unpaid subcontractors. If, in this situation, the [holdback] had been paid by the Airport Authority to Iona or the Trustee, under the statute the recipient would have held the funds in trust for the subcontractors.”
  3. While the owner was an airport falling under federal legislative jurisdiction, so that its lands could not be liened, the trust fund provisions applied to the holdback funds.
  4. There is a constitutional issue as to whether the federal The Bankruptcy and Insolvency Act (the “federal bankruptcy Act”) or the provincial BLA On the one hand, the federal bankruptcy Act takes effect in the context of, and subject to, the general provincial law of property, including trust law. On the other hand, the provinces cannot enact legislation to contradict the priority regime in the federal Act. In each case it is a question of which side of the line the provincial legislation falls. The majority of the Alberta Court of Appeal held that the statutory trust created by the Alberta BLA fell on the valid and enforceable side of the line, for the following reasons:
    1. The trust provisions are part of the basic provincial law. They were not designed to frustrate the priorities in the federal bankruptcy Act or to use “form over substance” in that process.
    2. The trust fund provisions satisfied the “three certainties” required for a valid trust: certainty of intention, certainty of objects and certainty of subject matter.
    3. So far as the certainty of subject matter, the statutory trust met the required degree of certainty:

      “…there is certainty of subject matter. Section 22 provides that once a certificate of substantial completion is issued, any “payment by the owner” is subject to the trust. At this stage the owner’s primarily obligation will be to pay out the holdback, and its obligation to do so represents a discrete chose in action. That chose in action is the subject matter of the trust. If, as the Trustee postulates, the Airport Authority had written a cheque for $997,716 to Iona, that bill of exchange and those funds would have been trust assets in Iona’s hands.

    4. There may be an issue as to whether a trust which only comes into existence after bankruptcy can ever be asserted against the priority regime set forth in the federal bankruptcy Act. However, that issue did not have to be decided in this case: “The lien rights arise the minute the work is done, and the funds which are captured by the trust were quantified in the hands of the Airport Authority on the date of bankruptcy…: Nothing in this case about the timing of the formation of the trust or the bankruptcy would render the statutory trust invalid or inoperative.’
    5. Guarantee was subrogated to the rights of the unpaid subcontractors. Once it paid the subcontractors, it became entitled to enforce all of the subcontractors’ rights under the BLA.

The dissenting judge, Justice Paperny, agreed with all of the conclusions of the majority, except for one. She found that there was no certainty of subject matter with respect to the statutory trust created under the provincial Act. Accordingly, that trust did not prevail over the federal bankruptcy Act.

Justice Paperny arrived at this conclusion for the following reasons:

  1. Establishing certainty of subject matter depends upon the facts of each particular case, not upon a rule of law. For certainty of subject matter to exist, there must be a “specific, identifiable res that forms the subject matter of the trust.”
  2. The Alberta BLA is different from some other provincial BLAs. Under the Alberta Act, no trust comes into existence until payment is made to the contractor, whereas under the Saskatchewan BLA, the owner and the contractor are trustees of all funds in the owner’s hands that are payable to the contractor.
  3. On the evidence, there was no sufficient certainty of subject matter:

    “The chambers judge reviewed the evidence and submissions of counsel and concluded that, once the funds in the hands of the Airport were paid to Iona they would be immediately commingled with funds from other sources and any certainty of subject matter lost. That conclusion is supported by the language of s. 22 of the BLA, which does not obligate a contractor who receives payment to segregate the funds….There is no basis to interfere with her conclusion on the point.”

Comment

This decision raises an issue of great importance to construction law, namely, the enforceability of the trusteeship provisions of provincial lien legislation in the face of federal bankruptcy legislation. The majority and minority arrived at opposite conclusions on this issue, leaving uncertainty as to which result will be arrived at by other provincial courts. It is surprising that this constitutional issue is still outstanding having regard to the long history of lien legislation in Canada.

This decision raises the following issues:

  1. The minority decision turns, in part, upon the fact that the Alberta BLA does not expressly create a trust in respect of funds held by the owner, but only over funds once paid to the contractor. The lien Acts in Alberta, British Columbia and New Brunswick are similar in this respect. In Ontario, Nova Scotia, Manitoba and Saskatchewan, the trust starts at the owner’s level. If the constitutional enforceability – or certainty of enforceability – of the trust provision depends upon the legislation starting the trust at the owner’s level, then provinces like Alberta may want to consider amending their lien legislation to start the trust provision at the owner’s level.
  2. It is difficult to see how much more certain the subject matter of the trust –if there then was a trust – could be when the funds were in the owner’s hands. If the funds had been paid into court, it would seem that certainty of subject matter would exist. The mere fact that they could be paid to the contractor and co-mingled with the contractor’s other funds does not seem to alter the conclusion that, in the owner’s hands, the funds are specific and certain. If the funds while in the owner’s hands are not trust funds at that point, then their status at the time they are paid to the contractor – which had not happened – seems irrelevant.
  3. The fact that the contractor might co-mingle the funds received by the owner with other funds seems to be an unsatisfactory basis for finding uncertainty of subject matter. If the contractor in fact receives money from the owner in respect of the particular project, the case law imposes a heavy onus on the contractor to explain what has become of the money and to account for it, and to demonstrate that payments out of those funds were properly made. It seems contrary to the policy behind the trust fund provision to put forth the possible co-mingling of those funds as a ground for holding that the provision is constitutionally unenforceable.
  4. A key ingredient in the analysis is whether the right of the contractor to payment of the holdback funds is subject to trust law. Is that right – or chose in action– the subject matter of a trust claim? The majority appears to have said yes. The minority judge does not focus on that issue, but rather on the holdback funds as funds. There is a considerable appellate law in Canada dealing with whether contract claims can be the subject matter of the trust provisions of the provincial lien statutes. In this appeal, the majority held that this law meant that the contractor’s right to the holdback was subject to the statutory trust in favour of the subcontractors, and the minority held that it did not.

It is to be hoped that this decision will be reviewed by the Supreme Court of Canada so that it may finally determine the constitutionality of the trust fund section of the Alberta lien legislation.

See Heintzman and Goldsmith on Canadian Building Contracts, 5th ed., chapter 16, part 6.

Iona Contractors Ltd. (Receiver of) v. Guarantee Co. of North America, 2015 CarswellAlta 1286, 2015 ABCA 240

Building contracts – Construction and Builders’ Liens – Trust Fund Provisions – Constitutionality

Thomas G. Heintzman O.C., Q.C., FCIArb                                                                                                August 11, 2015

www.heintzmanadr.com

www.constructionlawcanada.com