CRA Entitled To Priority Over Subcontractors To Trust Funds In Owner’s Hands

The Manitoba Court of Queen’s Bench recently held that the Canadian Revenue Agency (CRA) has priority over subcontractors and the bonding company in respect of holdback funds held by the owner in trust for the contractor. The decision in Manitoba Housing and Renewal Corp. v. Able Eavestroughing Ltd., once again underlines the impact of federal legislation on the holdback and trust fund sections of construction and builders’ lien legislation.

This decision raises questions about the scope of the subrogation rights of a bonding company under a labour and materials payment bond, and public policy issues about lien statutes being used for the purpose of collecting taxes.

Background

The Manitoba Housing and Renewal Corporation (MHRC) was the owner on a project In Brandon, Manitoba and Falcon Creek was the general contractor. The bonding company issued performance and labour and materials payment bonds in respect of Falcon Creek’s obligations under the general contract and the subcontracts. MHRC held back 7.5% of the amounts payable to Falcon Creek as mandated by the Manitoba Builders’ Lien Act (BLA). Unpaid subcontractors, and the bonding company which had paid over $600,000 to other lien claimants/subcontractors under the payment bond, asserted that they were entitled to the holdback funds under the payment bond and the BLA.

The Canadian Revenue Agency (CRA) asserted that it was entitled to the funds under s. 224(1.2) of the Income Tax Act of Canada (ITA). That section effectively provides that, once the section is triggered by the CRA, monies owing to a person who is liable to pay an assessment under the ITA (in this case, Falcon Creek) become the property of the CRA in priority to any other interest.

The bonding company and subcontractors asserted that MHRC had the legal right or privilege to pay the trust funds to the subcontractors holding liens, rather than to Falcon Creek. The bonding company asserted that, pursuant to the payment bond and the subrogation principles of the law of guarantee, it entitled to be recompensed out of the holdback funds for the monies it had paid to subcontractors. They argued that MHRC was not obliged to pay Falcon Creek and was entitled to pay the holdback funds to the subcontractors. Accordingly, MHRC was not “liable” to the contractor, Falcon Creek, in respect of those funds and therefore section 224(1.2) of the ITA did not apply.

Decision of the Manitoba Court of Queen’s Bench

The judge of the Manitoba Court of Queen’s Bench held that nothing in the arrangements between the owner, general contractor and bonding company could or did displace the effect of section 224 of the ITA. The court held:

“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….. There are important policy considerations involved in the collection of withholding tax and source deductions. The Income Tax Act entrusts employers with the duty of deducting income tax from the wages of employees and remitting it on their behalf. Employers’ withholding tax or source deductions is at the heart of the collection procedures for personal income taxation in Canada…. Private arrangements between MHRC, Falcon Creek and Guarantee Company cannot interfere with this. (underlining added)

So far as the submissions of the bonding company and subcontractors relating to subrogation and assignment, the Manitoba court held that, while MHRC may have had the right or privilege to pay subcontractors, MHRC had no obligation to do so, and therefore the bonding company or subcontractors did not obtain, by subrogation or assignment, any rights of MHRC to pay the subcontractors. Accordingly, the bonding company and the subcontractors could not interfere with MJRC’s entitlement to pay the monies in it hands to the CRA.   In this respect, the Manitoba court appears to have differentiated between a performance bond, in which a subrogation right might arise compelling the owner to pay the subcontractors and bonding company, and a payment bond, in which case the court says no such subrogation rights arise.

The Manitoba court also rejected the argument that the subcontractors had a right to sue on the general contract as third party beneficiaries of that contract. There was no evidence that MHRC intended to extend the ability to sue on the contract to unpaid subcontractors. In addition, the third-party beneficiary exception to privity of contract is only a shield and not a sword.

In arriving at these conclusion the Manitoba court relied upon the decision of the Alberta Court of Appeal in Iona Contractors Ltd. (Receiver of) v. Guarantee Co. of North America, 2015 ABCA 240, 19 Alta. L.R. (6th) 87 (Alta. C.A.), leave denied (2016), [2015] S.C.C.A. No. 404 (S.C.C.)). In that case, the contest was between a bonding company and the contractor’s trustee in bankruptcy pursuant to the Bankruptcy and Insolvency Act.

Discussion

At one level, this decision raises an important issue about subrogation. The court has held that while the bonding company may be subrogated to the position of the owner under a payment bond, it does not acquire any rights to compel payment of the holdback to the subcontractors rather than the contractor. In this respect, the court appears to differentiate between a performance bond – which might permit the bonding company to compel such payment – and a payment bond – which apparently does not. The court also appears to differentiate between the exercise of subrogation rights in relation to a contractual obligation – in this case payment to the contractor – and the exercise of subrogation rights in relation to a contractual or statutory right or privilege – in this case, the owner’s right to pay the subcontractors.

The right of the owner to pay a liening subcontractor directly is so important that it is enshrined in section 30 of the Manitoba Act, as it is in other provincial lien statutes. Courts have previously recognized that a right – such as the right to settle a claim, or to complete the building – falls within the ambit of subrogation. Indeed, the failure by the obligee to properly exercise its rights and privileges may discharge the bonding company from its obligations under the bond. Yet, in this case, the court seems to say that the subrogation rights of the bonding company under a payment bond do not include the right to be subrogated to the right or privilege of the owner to pay the subcontractors.

It is to be hoped that this issue is addressed by an appellate court. There seems to be no dispute in the decision that, generally speaking, a bonding company is subrogated to the obligee’s right’s (that is, the owner MHRC’s rights) under the building contract (with Falcon Creek in this case). That seems to be black letter law. The Manitoba court did not provide a good rationale as to why those subrogation rights would not include all the rights of the owner, including the right to pay the subcontractors directly, and why subrogation should not apply to that right under a payment bond as well as a performance bond. If the efficacy of the holdback system under the builders’ and construction lien statutes is to be maintained, if the statutory right of the owner to pay subcontractors is to be fully recognized, and if bonding companies are to be encouraged to issue bonds on the basis that they are fully subrogated to the rights of the obligee, then there seem to be good arguments in favour of a bonding company being allowed to exercise the owner’s right to pay the subcontractors, or the bonding company itself if it has paid subcontractors.

At a second level, this decision raises issues of fairness about the purposes of the respective statutes, and in particular the purpose behind builders’ and construction lien statutes.

The purpose behind the holdback and trust fund provisions of those statues is to require the owner (and others down the pyramid scheme) to withhold monies for the purpose of having them paid to the subcontractors and suppliers who are not paid by the contractor. Without those holdback and trust fund provisions of the lien statutes, the owner (and others down the payment chain) would go ahead and pay the contractor. In effect, this case means that the whole scheme of the builders’ and construction lien statues can be used as a tax collection scheme. The tax authorities can wait until the end of the project and scoop up the holdback, a holdback which would not have been there except for the builders’ and construction lien regime.

While the Manitoba judge emphasized the public purpose behind tax statutes, it is arguable that the purpose behind the builders’ and construction lien statutes deserves at least as high a recognition. The taking of the holdback moneys for tax purposes removes those moneys from the payment chain that produced them in the first place through the construction of the building, and takes them from the payment chain that caused them to be preserved. It is only because the builders’ and construction lien statute mandates the holdback that those monies are there in the first place. The taking of those monies for tax purposes impairs the very structure of the lien statutes. Compared to the tax department, contractors and suppliers have few, if any, means to protect themselves from the failure of contractors to pay their taxes. Should the subcontractors suffer when a contractor doesn’t pay its taxes? And will bonding companies provide bonds to the construction industry at the same cost if those bonds can be undermined by the tax authorities? Some might argue that this example of the government preferring itself over the ”little guy” shows why there is angst among some citizens across the western world, who see governments as more the problem than the solution for small businesses.

This decision did not consider the succession-of trust-funds and “no leak” principles in the BLA. The Manitoba Act, like the lien statues in Saskatchewan, Ontario and Nova Scotia starts the trust fund obligation at the owner’s level, and the beneficiary of the trust fund at that level is the contractor which has contracted with the owner. In other provinces, the trust fund starts at the contractor level. In all these provinces, the trust fund provisions apply at the contractor level and below. So in Manitoba, the owner holds the funds payable to the contractor in trust for the contractor, and once the contractor receives the funds, the contractor then holds those monies in trust for the unpaid subcontractors. What is the purpose of the trust fund at the owner’s level? Surely, to ensure that those funds are passed down to the trust fund at the next lower lever, the contractor level. There is no other reason for the trust fund provision at the owner level. It is not to allow the contractor or another person or authority to come in and scoop the funds. The holdback and trust fund provisions do not envision any leakage in the payment scheme.

In the present case and those which it followed, the courts do not apply the second part of the “no-leak” principle, namely, that the monies paid by the owner to the contractor are held in trust by the contractor for the subcontractors.

In this circumstance, the wording in section 224. (1.2) of the ITA may require some re-visiting. That section applies if the recipient of the CRA’s notice is “liable to make a payment …(a) to another person…” In the present case, the Manitoba judge held that MHRC was liable to make a payment to Falcon Creek, so the section applied. But if “another person”, like Falcon Creek, is obliged to hold those funds in trust for others, the subcontractors, can the ITA interfere with the application of trust principles, and has it done so clearly? The Manitoba court has effectively answered Yes to this question, but it deserves consideration at the appellate level.

The drafters of the provincial lien statutes may wish to consider amendments that will address this situation. One way may be to provide that the subcontractors and other person improving the lands are beneficiaries of the trust at the owner level, and similarly at the contractor level, that sub-subcontractors and other persons improving the lands are beneficiaries of the trust at that level. This is what the New Brunswick statute states at the contractor level and below. However, most provinces have amended their lien statues to limit the trust fund obligation to the next lowest level (that is, to the contractor in the case of trust funds held by the owner) and may be unwilling to re-open the scope of the trust fund obligation.

Lastly, while the Manitoba court did appear to hold that the ITA applies no matter what the bonding contract says, the judge did go on to consider the contractual environment, as did the Alberta courts in the Iona case. That being so, it may be that creative drafters of guarantee bonds will go back to the drafting table. If the contracts can change this result, there appear to be several elements to be addressed.

First, the bonding company may have to ensure that the owner is party to the bond, which will normally be the case for a payment or performance bond at the contractor level.

Second, the bond may have to expressly state that the bonding company is subrogated to the owner’s rights and privileges, including the right to pay subcontractors and suppliers (or the bonding company after it pays the subcontractors or suppliers) , and that those rights of the bonding company become effective at some point before the CRA delivers its notice to the owner, perhaps at the time that the first lien arises although not exercisable until, and to the extent that, the bonding company pays the subcontractors or suppliers.

Third, the bond may have to ensure that the holdback monies are beneficially owned by the bonding company once, and to the extent that, it pays subcontractors and suppliers.

Whether provisions such as these could properly be included in a bond and would be effective against the ITA or in light of the builder’s or construction lien statutes, time, future case law and creative drafting may tell.

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

Manitoba Housing and Renewal Corp. v. Able Eavestroughing Ltd., 2017 CarswellMan 56, 2017 MBQB 27

Builders’ and construction liens – holdback – trust fund – bonds- income tax

Thomas G. Heintzman O.C., Q.C., LLD (Hon.), FCIArb                 February 19, 2017

www.heintzmanadr.com

www.constructionlawcanada.caom

This article contains Mr. Heintzman’s personal views and does not constitute legal advice. For legal advice, legal counsel should be consulted.

 

 

Is A Trustee Under Payment Bond Obliged To Advise Potential Beneficiaries Of The Existence Of The Bond?

The Alberta Court of Queen’s Bench recently considered an interesting issue relating to labour and material payment bonds. When a contractor requires a subcontractor to obtain such a bond, does the contractor have a duty to tell the subcontractors about the existence of the bond so that they can make a timely claim under it, particularly when the contractor is shown in the bond to be a trustee for those subcontractors? In Valard Construction Ltd. v. Bird Construction Co., the court said No. Is this the just result?

Background

Bird was the general contractor and Langford was the subcontractor on a construction project. Bird required Langford to provide a CCDC 222-2002 payment bond. Valard was an unpaid sub-sub-contractor of Langford. It was unaware of the existence of the payment bond until after the notice period in the bond had expired, and its claim was accordingly rejected by the bonding company. It submitted that Bird, as trustee under the bond, had a duty to inform it of the bond’s existence within the relevant notice period in the bond.

Decision of the Application Judge

The judge hearing the application held that the trusteeship wording in the bond was solely for the purpose of avoiding the rule in contract law that third parties cannot sue on a contract and to enable the sub-subcontractors to sue on the bond even though they were not parties to it. The trusteeship wording did not create a fiduciary duty toward Valard obliging Bird to tell Valard of the existence of the bond. The judge noted as follows:

“In order to avoid the application of the third party beneficiary rule, the standard bond wording provided, and still provides, that the obligee is “trustee” for the benefit of all beneficiaries/claimants. Significantly, the bond expressly states that the obligee is not obliged to do or take any act, action or proceeding against the surety on behalf of any of the claimants to enforce the provisions of the bond. It provides, however, that claimants may use the name of the obligee to sue on and enforce the provisions of the bond….The express negation of any requirement on the part of the trustee to take action on behalf of the beneficiaries, combined with the ability of claimants to sue in the name of the trustee support the conclusion that the trustee wording is used in the Bond in order to avoid the obstacle raised by the third party beneficiary rule.

The court noted that this issue had been addressed by the Ontario county court some 45 years ago in Dominion Bridge Co v Marla Construction Co, [1970] 3 OR 125. In that case, Judge Grossberg asked the following questions:

“I asked in argument: when did the duty arise? At what point of time? What exactly was that duty? Must Sun Oil embark upon inquiries who were the labourers? Who were the creditors? Who were the suppliers? Must Sun Oil seek out the creditors and suppliers? If the contention of counsel for the plaintiff be upheld, Sun Oil would be obliged to acquire knowledge of all materials purchased, all labourers on the job from day to day and to keep a constant surveillance. The consequence of the submission must be that Sun Oil must seek out material, men, suppliers, labourers, subcontractors, etc., of Marla and acquaint each that there was a bond in existence. No such duty is imposed by the bond itself…”

In the Valard case, the court concluded that “the sole purpose of the trust wording in the Bond is to address the difficulties that the identities of the claimants cannot be ascertained at the time the bond is entered into, and that the third party beneficiary rule would otherwise prevent a claimant from suing the surety.”

The application judge was not impressed with the equities of the situation from the standpoint of Valard, the sub-subcontractor. He said:

“In any event, a simple standard inquiry by Valard would be a more reliable means of obtaining the information. While it may be that employees of subcontractors may not always be aware of the possibility of a bond, this does not explain why a large and sophisticated entity such as Valard would not have in place a mandatory protocol under which bond information is requested on all subcontracts, especially given the state of the law on the issue. In this case, we are not dealing with the disadvantaged and infirm, but rather with a large sophisticated company with five or six hundred employees in Canada which has its own surety or bonding company.”

Accordingly, the court held that Bird had no duty to advise the sub-subcontractors of the bond.

Valard had originally sought relief from forfeiture in respect of its claim against the bonding company. But during the application, that claim was withdrawn since the bonding company was able to establish actual prejudice arising from the delay in making the claim.

Discussion

The court seems to have been heavily influenced by the long period of time since the Dominion Bridge case was decided and the apparent acceptance of that decision in the construction industry. Yet, this decision seems hard to reconcile with the trustee obligations which contractors assume when they require a payment bond to be obtained by the subcontractor.

Which is the greater burden: if there is a payment bond, for the contractor to find out which sub-subcontractors are beneficiaries of the bond and notify them of the bond; or for every sub-subcontractor on every construction project to ask whether there is a payment bond?

Even though the latter seems to be the more burdensome approach, it seems to be the law based on the Dominion Bridge and Valard decisions.

See Heintzman and Goldsmith on Canadian Building Contracts (5th ed.), chapter 15, part 10

Valard Construction Ltd. v. Bird Construction Co., 2015 CarswellAlta 342, 2015 ABQB 141

Building Contracts – Bonds – Payment Bonds – Duties of Trustee – Rights of Subcontractors

Thomas G. Heintzman O.C., Q.C., FCIArb                                             April 15, 2015

www.heintzmanadr.com

www.constructionlawcanada.com

 

Can A Payment Bond Impose Double Payments On A Contractor?

Payment bonds come in various shapes and sizes and it is important to read them carefully before concluding what they bond. They may not just bond the payment obligation of the party obtaining the bond. They may also bond the payment obligations of all persons on the project.  If they do the latter, then the bond may expose the party which obtained the bond to more than one payment obligation.  That was the conclusion in Nova Scotia Court of Appeal in the recent case of APM Construction Services Inc. v. Caribou Island Electric Ltd.

 Background

ACS was an unpaid sub-sub-contractor on a building project of the province of Nova Scotia.  It sought payment under a bond obtained by the general contractor, APM, from Travelers Insurance. The bond stated as follows:

 NOW, THEREFORE, THE CONDITION OF THIS OBLIGATION is such that if the Principal shall at all times promptly make payment to all Claimants for all work, materials or services used or reasonably required for use in performance of the Contract, or as the same be changed, altered or varied, to the satisfaction of the Obligee, then this obligation shall be void.

. . .

IN THIS BOND where there is a reference to Claimant it shall mean any person, firm or corporation doing or performing any work or service or placing or furnishing any materials, or both, for any purpose related to the performance of the Contract:  work, service and materials being constructed to include all water, gas, power, light, heat, oil, gasoline, service or rental equipment which is supplied or used for or in connection with the performance of the Contract.   (underlining by the court)

APM’s subcontractor was Caribou Island Electric which had in turn subcontractred work to ACS, but had not paid ACS in full. Caribou owed taxes to the Canadian Revenue Agency and CRA made demand on APM for payment in full of the amounts owed by APM to Caribou.  The obligation of APM to pay CRA was undisputed, and the issue was whether, upon payment of those monies, Travelers had any fuher obligation to ACS and the other contractors or suppliers on the project.

ACS acknowledged that the payment by APM to CRA discharged APM’s payment obligation to Caribou under the subcontract and discharged the lien registered by ACS. Indeed, ACS acknowledged that this payment also discharged APM’s trust fund obligation, and in light of that admission the Court of Appeal said that the present case did not decide that issue.

However, ACS asserted that, even though APM’s contractual and lien obligations may have been discharged, the bond was not discharged.  It asserted that the bond was a separate and self-standing obligation which remained in effect, and Travelers was obliged to pay it under the bond.

APM and Travelers asserted that this interpretation of the bond was absurd, and that if Travelers was obliged to pay ACS’s claim, then APM would be obliged to recompense Travelers under the bond.  Effectively, APM would be obliged to pay monies twice, once to CRA and again to ACS. APM and Travelers said that that could not be the proper interpretation of the bond.

The Decision

 The Nova Scotia Court of Appeal helpfully stated the following principles applicable to the interpretation of a bond:

 

“1. The bond is a freestanding contract and its terms ultimately govern the interpretation exercise. The wording of the bond’s terms must be given its ordinary and literal meaning. The words cannot be interpreted in isolation but must be looked at in the context of the bond as a whole.

2. The court will look to the intentions of the parties and, in so doing, will try to give commercial efficacy to the agreement. However, the court will not replace the parties’ agreement with its own. Thus, if the wording of the agreement is clear and unambiguous, parties will be held to their agreement, even where the results appear to be draconian or absurd….

3. Where the disputed contract is part of a series of contracts, the court will look to the surrounding contracts as well. However, in the context of surety bonds, the terms of the bond ultimately govern; while the underlying contract may be considered, it will only be determinative if the specific obligations contained within it are incorporated by reference into the bond.

4. Contra proferentemis available but only where there is an ambiguity that cannot be resolved through other principles of contractual interpretation.”

The Court then considered the form of other bonds. The standard form CCDC bond says:

  “…A Claimant for the purpose of this Bond is defined as one having a direct contract with the Principal for labour, material, or both, used or reasonably required for use in the performance of the Contract….”  (underlining added)

 The bond required by the federal government says:

 “For the purpose of this Bond, a Claimant is defined as one having a direct contract with the Principal or any Sub-Contractor of the Principal for labour, material, or both, used or reasonably required for use in the performance of the Contract …”  (underlining added)

 The Court noted that in the CCDC form, only subcontractors were protected by the bond, while in the federal form, contractors and subcontractors are protected.  The bond in the present case protected any person providing work or materials to the project.

Discussion

If a payment bond taken out by the contractor is premised on payment, not just of subcontractors by the contractor, but payment of any person performing work or service or placing or furnishing any materials, or for any purpose related to the performance of the main contract, then the bond will not be discharged by payment by the contractor to the subcontractor nor by the discharge of the contractor’s obligations under construction or builders lien legislation.

Rather, if so expressed, then the bond is a self-standing independent obligation to pay all persons performing work on the project which, if not fulfilled, may be called upon by any of those persons. Accordingly, if the contractor is obliged to pay a taxation authority which claims unpaid taxes against the subcontractor and therefore has a claim to the monies due by the contractor to the subcontractor, that payment may discharge the contractor’s liability under the subcontract with the subcontractor and under construction and builders lien legislation, but it will not discharge the bond, and the contractor may be liable a second time to recompense the bonding company.

Construction liens  –  bonds  –  priorities  –  subcontractors  –  interpretation

APM Construction Services Inc. v. Caribou Island Electric Ltd.,  2013 CarswellNS 291, 2013 NSCA 62, 21 C.L.R. (4th) 106

Thomas G. Heintzman O.C., Q.C., FCIArb                                                                                                        September 9, 2013

 www.heintzmanadr.com

www.constructionlawcanada.com

Is The Person Who Ultimately Pays A Guarantor Entitled To The Securities Held By The Guarantor?

Bonds and other forms of guarantees and indemnities are commonly used on construction projects. If a contractor applies for a performance bond, the bonding company will require the contractor to indemnify the bonding company. The bonding company may also require the principal shareholder of the contractor to guarantee the contractor’s obligation and to directly indemnify the bonding company. The bonding company may also take security over the contractor’s assets as a further condition of providing the bond. If the principal shareholder of the contractor is required to indemnify the bonding company, is that shareholder entitled to the security obtained by the bonding company over the contractor’s assets?

Normally speaking, one would think so. By indemnifying the bonding company, the indemnifying party should be subrogated to all the rights of the bonding company, including the security held by the bonding company.

But the English Court of Appeal held to the contrary recently in Ibrahim v. Barclays Bank Plc. There were two significant features of the indemnity and guarantee documents in that case, and they resulted in Mr. Ibrahim not being entitled to exercise rights under the securities which were originally available to the guarantor.

Those features of the Ibrahim decision must be carefully scrutinized by any persons about to give or to guarantee a bond. A bonding company, or a person holding competing security to the bonding company, may want to duplicate the features found in the documents in the Ibrahim case in order to avoid those securities passing to the third party which agreed to indemnify the bonding company. On the other hand, a third party who is indemnifying the bonding company may want to avoid those features in order to obtain the securities held by the bonding company.

Factual Background

LDV was an English van manufacturer. In 2008, it was in severe financial condition. Weststar was interested in purchasing the shares of LDV, but it needed a due diligence period to examine LDV’s affairs. Barclays was LDV’s banker. It was agreeable to advance further moneys to LDV during the due diligence period provided that the repayment of its further loan to LDV was guaranteed by a department of the British government, BERR. As a condition of providing its guarantee of LDV’s obligation, BERR demanded a letter of credit from a bank, UBS. UBS in turn demanded a guarantee from the principal shareholder of Weststar, Mr. Ibrahim. These arrangements were put in place.

The agreement between Barclays and BERR provided that “unless and until the Guarantor Liabilities have been paid and discharged in full and [BERR] has no further actual or contingent liability under or in respect of the Guarantee”, Barclays and BERR were to share in the recovery from the assets of LDV under the security which Barclays held over LDV’s assets. USB and Mr Ibrahim were not parties to those arrangements.

As a result of the due diligence conducted by Weststar, it decided not to proceed with the purchase of the shares of LDV and LDV went into insolvency. Barclays called on BERR ‘s guarantee of LDV’s obligation to repay the monies it had advanced to LDV. BERR in turn called upon UBS to pay under its letter of credit, and UBS demanded the Mr. Ibrahim pay under his guarantee. Having paid UBS, Mr Ibrahim asserted the right to exercise the rights accorded to BERR under its agreement with Barclays and to share in the recovery which Barclays had made under the security it held over LDV’s assets.

At trial, Mr. Ibrahim asserted his claim by way of subrogation to BERR’s rights. By the time the appeal was heard, Mr. Ibrahim had obtained an assignment of BERR’s rights under its arrangement with Barclays and asserted that BERR had a right, and that he had the same right by way of assignment, to share in the recovery from LDV’s assets.

The Decision

The English trial division and Court of Appeal held that Mr. Ibrahim had no right to share in the recovery made by Barclays from the assets of LDV, for two reasons.

First, they held the effect of the payment by UBS to BERR was that BERR was paid in full in respect of the obligation of LDV. Under the wording of the Barclays-BERR agreement, that payment discharged the obligation of LDV even though the proceeds came from UBS, and not LDV. Therefore, under the Barclays-BERR agreement, BERR’s rights to share in LDV’s assets had come to an end.

Second, the Court of Appeal held that the letter of credit given by UBS to BERR was an “autonomous instrument” which stated that the obligation to pay accrued when the Secretary of State certified that amounts were due in respect of the LDV debt and that it would discharge the LDV debt. Therefore, the payment by UBS to BERR under that letter of credit did discharge the LDV debt to BERR, and under the Barclays-BERR arrangement BERR had no further right to share in Barclays’ recovery from LDV’s assets.

Mr. Ibrahim argued that the payment by UBS did not discharge LDV’s obligation to BERR. He argued that a payment by a third party of a debtor’s obligation to the creditor does not discharge the debt, that the debt remains alive and that the third party can assert the creditor’s rights against the debtor by way of subrogation or assignment.

A considerable amount of old English legal authority was reviewed by the court. The point of the review was to determine the circumstance in which a debt is considered to be discharged by a payment made by a third party. Having reviewed those cases, the Court of Appeal concluded that when the third party has an obligation to pay the debtor’s obligation by reason of some outstanding obligation to do so, then the debtor’s obligation to the creditor is discharged but the third party has a direct right to recover from the debtor.

In the second situation, when the third party has no such obligation and makes the payment voluntarily, the debt is not discharged unless the payment is made as agent for the debtor, and the third party can bring a subrogated claim against the debtor based on the continued existence of the debt.

Since UBS’s payment was made under an obligation to do so contained in the letter of credit, and in any event UBS’s payment was not made as an agent for LDV, the English Court of Appeal held LDV’s obligation to BERR had been satisfied. Therefore, under the particular wording of the Barclays-BERR agreement, BERR had no further right to share in Barclays’ recovery from LDV’s assets.

Discussion

This decision has a number of lessons for those using bonds, guarantees and indemnities.

First, a third party who is providing a guarantee to the bonding company should examine the securities which the bonding company is taking. If those securities provide that upon payment to the bonding company the loan is effectively discharged, then that is not a good provision so far as the third party is concerned. Or if upon payment by the third party to the bonding company, the bonding company loses its security or its security is in any way impaired, the guaranteeing party will want to change that wording to ensure that its payment does not discharge the debt or impair the security which the bonding company is holding. Indeed, the third party may want to require the bonding company not to impair any securities obtained by it and to ensure that any securities held by it shall remain in effect and be transferred to the third party guarantor.

The time to do so is, of course, at the time of the initial guarantee. Mr Ibrahim may have been in a position at the outset to insist that Barclays agree that he would share in the LDV asset recovery if, through UBS, he effectively paid LDV’s obligation to BERR. If Barclays was willing to make that arrangement with BERR, it may have made that arrangement with Mr. Ibrahim who was the principal in Weststar and was providing the guarantee which supported the loan arrangement.

Similarly, when a shareholder of a contractor is asked to give a guarantee for the contractor’s performance bond, and the bonding company also asks for security over the contractor’s assets, the time when the application for the bond is made is the time for the shareholder to examine that security The guaranteeing shareholder will want to ensure that, if the guarantee is called upon and paid by the shareholder and not the contractor, the contractor’s debt will not be considered to have been paid or the security impaired, and that the security will be available to the shareholder who pays the bonding company. On the other hand, the contracting company itself, or those with a financial interest in that company including its other secured creditors, may have an opposite interest and may wish the security to terminate if the bond is paid by the guaranteeing shareholder.

Second, the Ibrahim decision may suggest that a letter or credit or negotiable instrument has an independent role which can nullify or impair the rights of the ultimate third party guarantor.

This suggestion could be supported from the absolute nature of these instruments. A guarantor such as BERR may wish to have the certainty of an unconditional promise to pay without any requirement to account for securities to which it is entitled. BERR may not have wanted any obligation on its part to bargain with Barclays to retain rights to a continued share in LDV’s asset after it was paid. If this is so, then bonding companies may wish to use these sorts of instruments and third party guarantors will want to avoid them.

However, others may argue that this suggestion is based on an incorrect reading of the Ibrahim decision. It can be argued that the wording of the particular letter of credit, when combined with the particular wording of the Barclays-BERR agreement, simply led to the conclusion that, once BERR was paid by UBS, BERR had no further rights under that agreement and therefore neither did Mr. Ibrahim either by way of subrogation or assignment. If so, then a third party guarantor will want to avoid the particular wording of the documents in the Ibrahim case, while a bonding company may want to use that wording as a useful precedent.

Whichever way one reads the Ibrahim decision, it serves as a warning to all those involved in bonds and other sorts of indemnities and guarantees. If the bonding company holds securities for the bonded obligation, then the parties should clearly understand the rights of a third party in that security if the third party has the ultimate obligation to indemnify the bonding company.

See Heintzman and Goldsmith on Canadian Building Contracts, 4th ed., chapter 9

Ibrahim v. Barclays Bank Plc., [2012} EWCA Civ 640

Building Contracts – Bonds – Remedies

Thomas G. Heintzman O.C., Q.C., FCIArb                                                                                                         November 11, 2012

www.heintzmanadr.com
www.constructionlawcanada.com

Andrews v ANZ: What Are The Consequences For Building Contracts?

The recent decision of the Australia High Court in Andrews v. Australia and New Zealand Banking Group Ltd. is important for the building industry.  While it dealt with a banking contract, the principles it applied are directly relevant to building contracts.

The central decision in Andrews v. ANZ is that the doctrine prohibiting contractual penalties applies both to conduct which is a breach of contract and conduct which is permitted under the contract.  But in its review of the whole history of the law of penalties, the court draws conclusions which are of much wider consequence.  The court explains that non-monetary consequences of a contract are included in the doctrine against penalties.  That conclusion could have a dramatic impact on building contracts.  The court also clarifies the difference between a “condition” in a contract and a “condition” in a bond, and decides that these words do not have the same meaning in both settings.  Since bonds are an essential element in building projects, this decision should be well understood by those engaged in those projects.

Factual Background

The decision in Andrews v. ANZ arose from a motion to strike out certain claims in a class action relating to banking contracts.  The contracts permitted, but did not require, the bank to impose certain fees if the customer undertook, or asked the bank to undertake, various transactions. The transactions included:

  • requesting the bank to consider a withdrawal or payment which would result in an overdraft in the account; or
  • requesting the bank to honour a transaction that resulted in an overdraft.

The transactions were not contrary to the banking contract.  The fees might be payable by the customer if the bank considered the requested transaction, even if the request was denied.

In its motion to strike, the bank argued that the rule against penalties did not apply to these amounts on the ground that the rule against penalties did not apply when, as in this case, the triggering conduct was not a breach of contracts.  The Court of Appeal agreed.  The High Court reversed that decision, holding that the fact that these fees “were not charged by the respondent upon breach of contract by its customers and that the customers had no responsibility or obligation to avoid the occurrence of events upon which these fees were charged, do not render the fees incapable of characterisation as penalties.”

The High Court also held that the doctrine against penalties applies to non-monetary conduct.  The contract may state that a party will do something (the primary event) and then stipulate a further event if the primary event does not occur (the secondary obligation).  Neither event need be a monetary one for the doctrine against penalties to apply. Thus if the primary event is the transfer property, the doctrine can apply.  If the secondary event is the transfer of property, likewise the doctrine can apply.  In either situation, if the secondary event is totally disproportionate to the real consequences of the failure to perform the primary event, the secondary event can be examined to determine if it is really a penalty.  If it is, then it is unlawful.

The Consequences of Andrews v. ANZ  for Building Contracts

There are four important consequences of the decision in Andrews v. ANZ.

1.      Doctrine Against Penalties applies to more than Breaches of Contract

The central conclusion in Andrews v. ANZ is, of itself, extremely important for the law relating to building contracts.  All the clauses in a building contract which provide for monetary payments should be closely examined to see if they impose unlawful penalties. Even those clauses which do not give rise to a breach of contract should be examined.  If those payments are out of line with the actual detriment arising from the relevant conduct, potentially they are penalties and unlawful, whether or not they are in relation to a breach of contract.

2.      Doctrine Against Penalties applies to Non-Monetary Conduct

According to Andrews v. ANZ, this principle applies to any provision in a contract, not just those which involve monetary payments.  In the context of building contracts, this approach could have a wide and uncertain application. What sort of non-monetary consequences fall within it?  If a bidder submits an erroneous bid (the primary event), could a court hold that disqualifying the bidder (the secondary event) is unlawful as a penalty if it is shown that the error in the bid caused little harm to the owner and the disqualification of the bidder is a disproportionate “penalty”?  If an owner gives a “cure notice” and then terminates the contract, could the termination amount to a penalty if it was disproportionate to the damage suffered by the owner?  It may seem ridiculous to include those examples within the doctrine against penalties, but it is difficult to draw a clear line between what non-monetary consequences fall within that doctrine in the construction setting.

3.      Doctrine Against Penalties may not apply to Additional Obligations

The High Court expressly recognized that there may be an exception to the penalty doctrine arising from what it called a consensual “additional obligation.”  The High Court said that if the amount which the party must pay (or other secondary event) as a consequence of the conduct in question is really the result of a new contract, then the penalty doctrine may not be engaged.

Thus, the fee for the overdraft to the banking customer might be seen as really arising from a new contract and a new and additional privilege purchased by the customer.  Similarly, a distributor of films to a theatre owner might stipulate that the theatre owner would pay four times the original single-screening fee for extra showings of the film. The High Court said that those extra fees might amount to the purchase of additional privileges which fall outside the doctrine against penalties. It did not decide whether the banking fees in question fell within this exception and left that issue to the trial judge.

How would this exception apply to building contracts? If the building contract said that for every day of delay by a contractor, the contractor shall pay the owner $500,000, is that provision a penalty or an “additional obligation.”  If instead, the contract stated that if the contractor wished to extend the period of completion, then he may apply to the owner for permission to extend, and the parties agree that a new contract containing any such permission shall be made at a cost of $500,000 per day, would that be a penalty or an additional obligation?

4.      “Conditions” in Contracts and Bonds are Different

There is a further aspect of the decision in Andrews v. ANZ which is of interest to the building industry, and that is its discussion of “conditions” in contracts and bonds. The High Court pointed out that the word has an entirely different meaning in a contract than in a bond.

As the court said, in a contract the word “condition” refers to a term of the contract which is “vital, important or material.”  By using this word, the parties have agreed that the breach of this term amounts to a repudiation and permits the other party to accept the repudiation and terminate the contract.  In other words, in a contract conduct which does not comply with a “condition” is necessarily a breach of contract, and indeed a serious one.

In a bond, however, the word “condition” performs another function.  Like a contract, the bond seeks to “secure performance of the condition, but instead of attempting to secure this result by exacting a promise from the obligor to perform the condition, there is an acknowledgment of indebtedness –in effect a promise.” In Roman and early English law, a bond might be payable in full, no matter what damages the obligee might really suffer. That result was later modified by equity, through decisions which evolved into the doctrine against penalties, to ensure that the payment under a bond could be no more than the real loss of the obligee.

In addition, the High Court noted that the “condition in the bond may be any occurrence or event which need not be some act or omission of the obligor, analogous to a contractual promise by the obligor.” Moreover, the condition in the bond need not be the payment of money, and could relate to the transfer or vesting of interests in land. Indeed, “the cases do not establish any general proposition as to the contractual character of the condition in a bond.”

This discussion of bonds supported the High Court’s conclusion that the doctrine against penalties relates to conduct which does not necessarily amount to a breach of contract and to consequences that do not necessarily involve monetary payments.

In the result, the decision in Andrews v. ANZ provides a good review of the law of bonds and the use of the word “condition” in bonds.  That word designates a circumstance which is the basis for the obligation in the bond. That circumstance need not be a breach of a contract.  It can be whatever conduct the bond is intended to secure.

Conclusion:

Andrew V. ANZ results in a sweeping application of the equitable doctrine against penalties. The decision holds that the doctrine applies to all contractual conduct, including both breaches and permitted conduct and both monetary and non-monetary consequences. Whether this approach will be followed in Canada is uncertain. As a matter of logic and principle, it makes sense.  But the decision raises challenges when applied to building contracts.  And it raises difficult questions about where the boundary line is between conduct which falls within the doctrine against penalties and conduct which does not.

See Heintzman and Goldsmith on Canadian Building Contracts (4th ed.) at Chapter 6, para 2(b)(i)(B) and Chapter 9

Andrews v. Australia and New Zealand Banking Group Ltd., [2012] HCA 30

Building Contracts  –  Bonds  –  Penalties  –  Damages  –  Remedies for Breach of Contract

Thomas G. Heintzman O.C., Q.C., FCIArb                                                                  October 20, 2012

www.heintzmanadr.com

www.constructionlawcanada.com

 

Incorporation By Reference In Building Contracts

Incorporation by reference in building contracts

By Thomas G. Heintzman and Julie Parla1

A common clause in a building contract is one which incorporates the terms of another contract or document into the building contract in issue. The effect of such a clause is referred to as “Incorporation by Reference”. These clauses are common in building contracts because the various contracts necessary for a building project are often cross-referenced and their performance are inter-related.

Thus, the main contract between the owner and the general contractor is inter-related with the subcontract between the contractor and the sub-contractor. The tender or other pre-contractual documents are inter-related to the contracts later entered into. The payment or performance bonds are related to the contracts for which they provide financial guarantees. The contracts between the consultants are related to the building contracts themselves. To a great extent, all of these contracts are part of the same package. Whether the object is to save drafting time or to ensure absolute consistency, or laziness, one of these contracts may state that the terms of another document or contract are incorporated into it.

While an Incorporation by Reference clause may provide a useful correlation of one contract to a second contract, they also open up dangers when the clauses are arguably unsuitable for inclusion in the second contract. This paper will examine the circumstances in which Incorporation by Reference clauses have been used and the potential problems they raise.

Uses of Incorporation by Reference Clauses

Incorporation by Reference clauses have been used in a wide variety of circumstances in building contracts. Here are some of the circumstances in which they have been used and applied:

  • (a)  Specifications:  A specification list prepared by the owner was incorporated by reference into the contract ultimately entered into with the contractor, rather than attaching a specification list physically to the actual contract.2
  •  
  • (b)  Specific work and Best Practices:  A term in the main contract specifying the work to be carried out and stating the obligation to use “best trace practices” was incorporated by reference into the subcontract.3 In another case, the measurement and price to be paid for concrete work in the main contract was incorporated into the subcontract.4
  •  
  • (c)  Force Majeure and Claim period:  A force majeure clause and a clause stating the period in which a claim must be made, contained in the main contract, was incorporated by reference into the sub-contract.5
  •  
  • (d)  Profit Sharing:  A contractor’s obligation in the main contract to pay the owner 75% of savings from the contract price was enforceable against the bonding company. While there was no Incorporation by Reference clause in the bond, the Ontario Court of Appeal applied principles that related both to Incorporation by Reference and to contractual interpretation.6
  •  
  • (e)  Tender Conditions – GST:  The term of a tender, requiring the tender price to include GST, was incorporated into the contract ultimately entered into.7
  •  
  • (f)  Performance Bond:  A provision in the main contract requiring the contractor to post a performance and materials bond for 50% of the contract price was incorporated into the subcontract and precluded the contractor from requiring the subcontractor to post a 100% bond.8
  •  
  • (g)  Letter of Intent:  A letter of intent was incorporated by reference into the subsequent contract, thereby creating contractual representations.9

On the other hand, Incorporation by Reference clauses have not been applied in many cases to incorporate the provisions of another contract or document. Thus,

  • (a)  Liquidated Damages: A liquidated damages clause in the main contract was not incorporated by reference into the sub-contract.10 A bond which contained a clause incorporating the building contract between the owner and the contractor was held not to impose on the surety the obligation to pay the liquidated damages referred to in the building contract between the owner and the contractor.11
  •  
  • (b)  Lien Security:  The obligation to post security for lien claims contained in the main contract was held not to be incorporated into the subcontract.12
  •  
  • (c)  Guarantee Period:  A two-year guarantee given by the contractor to the owner in the main contract was not incorporated by reference into the subcontract.13
  •  
  • (d)  Insurance:  An obligation to obtain insurance was not incorporated into the subcontract because, although there was an Incorporation by Reference clause in that subcontract, there had been no main contract in fact entered into.14
  •  
  • (e)  Inconsistency:  A Term in a building contract was not incorporated into a bond because it was inconsistent with the limited liability of the surety stated in the Bond.15
  •  
  • (f)  Additional Terms:  The subcontractor understood that the main contract between the owner and contractor was the standard CCDC 2 contract. In fact the owner and contractor negotiated additional terms which were unknown to the subcontractor. It was held that those additional terms were not incorporated by reference into the subcontract.16
  •  
  • (g)  Dispute Resolution:  In Canada, courts have generally held that an arbitration clause in the main contract is not incorporated by reference into the subcontract without specific incorporation.17

The courts in other common law jurisdictions have also considered the incorporation of arbitration clauses from one contract to another. Their decisions illustrate the nuances of this practice, especially when those clauses affect rights and obligations outside of the project work per se. The incorporation by reference of arbitration clauses from one contract to another has been the subject of a number of cases in the United Kingdom and Australia.18 The general trend is that an arbitration clause in one contract is only incorporated into the other contract if the arbitration clause in the first contract is specifically referred to in the second agreement. This rule is sometimes referred to as the “rule in Aughton” after the decision in Aughton Ltd. v. M.F. Kent Services Ltd.19 The rule was effectively applied 100 years ago by the House of Lords in TW Thomas & Co. Ltd v. Portsea Steamship Co Ltd (The Portsmouth).20 While the rule is more or less settled in the UK, there are cases in which the rule was not applied on the particular facts.21

Two commentators have recently reviewed the law in the UK and Australia. Their view is that, in Australia, the pendulum is swinging from requiring express reference to an arbitration clause in order to validly uphold an incorporation by reference, to more flexibility allowing arbitration clauses to be incorporated by general reference to a contract which contains an arbitration clause, provided doing so can be supported on a proper construction of the contract. This shift is generally credited to a more pro-arbitration policy of the courts, and may provide insight as to the direction other common law jurisdictions will ultimately take.22

Incorporation by reference of arbitration clauses may also be subject to the governing arbitration statute. Thus, the UNCITRAL Model Law, which is incorporated into the various provincial and federal statutes applicable to international commercial arbitrations23, states as follows:

“The reference in a contract to any document containing an arbitration clause constitutes an arbitration agreement in writing, provided that the reference is such as to make that clause part of the contract.” (underlining added)

It is arguable that the proviso to this provision was intended to require specific reference to the arbitration clause in the other contract before incorporation of it into the second contract occurs. But the opinions of commentators and the decided cases do not necessarily demonstrate this point of view.24

In light of these apparently inconsistent decisions, one might wonder why any subcontractor would agree to an Incorporation by Reference clause in the subcontract. Since the provisions of the main contract are drafted to suit the circumstances of the owner and the contractor, there is every reason for the subcontractor not to agree, holus bolus, to the terms of the main contract being incorporated into the subcontract. This is especially so where the main contract may contain provisions such as liquidated damages, an arbitration clause and other specific provisions with respect to security, insurance and removal of liens which may be wholly suitable to the owner and contractor, but totally unsuitable to the subcontractor.

Some examples from the cases referred to above make this point clear. For example, in Q.Q.R. Mechanical Contracting Ltd. v. Panther Controls Ltd., the contractor had given the owner a specific two-year guarantee. There does not seem to be much reason why the subcontractor should be bound by that guarantee. In Litchfield Bulldozing Ltd. v. PCL Construction Ltd., the owner was a municipality. While a municipality may need a specific force majeure clause, it is not evident that the same force majeure clause is suitable to the subcontract.

Similarly, in Niagara Structural Steel v. LaFlamme, the liquidated damages clause stated a specific per diem amount which was based upon the owner’s particular circumstances and was set to cover the owner’s supervisory cost. Those costs would have no bearing upon the costs incurred by the contractor or subcontractor. In the result, that liquidated damages clause had no relationship to the subcontract. Similarly, in Lac La Ronge Indian Band v. Dallas Contracting Ltd., a bond was interpreted as not including on obligation upon the surety to pay the liquidated damages due by the contractor under its contract with the owner, because that obligation was contrary to the specific terms of the bond.

There may be a total disconnect between the necessity and rationale for terms in the main contract as opposed to the necessity or rationale for the same terms in the subcontract.

Nevertheless, standard form contracts in the Canadian building industry continue to contain Incorporation by Reference clauses. General condition 3.7.1 of the CCDC 2 Stipulated Price Contract between the owner and the contractor requires the contractor to “incorporate the terms and conditions of the Contract Documents into all contracts or written agreements with subcontractors and suppliers.” The wisdom of this requirement is questionable particularly when, as noted above, courts have found that the Incorporation by Reference will not necessarily occur even in the presence of such a clause.25

In these circumstances, it seems more advisable for the Incorporation by Reference clause to state that “the following provisions of the Contract Documents are to be incorporated into the subcontracts”, and then list them specifically, rather than incorporating each and every portion of the Contract Documents into the subcontract. This is particularly so in circumstances where the owner and the contractor have negotiated provisions which are peculiar to their relationship and which may have no place in the subcontract document.

Application of Contract Interpretation Principles

It should be kept in mind that the determination by the Courts of when a term will be found to have been incorporated by reference, will be subject to the general principles of contract interpretation as applicable to any contract.

First and foremost the court will look to the words of the contract, understood with reference to the “factual matrix”, that is, the circumstances and context surrounding contract formation.26 The factual matrix will include the purpose of the second contract to the overall project, in informing how to interpret the agreement.

Second, determining the intention of the parties is an objective exercise; the court does not look to the subjective intent of the parties, but rather presumes that the parties intended the legal consequences of their words.27

Third, the contract must be interpreted as a whole, such that meaning is given to all of the terms agreed to between the parties, without conflict.28

Finally, the contract is to be interpreted consistent with “sound commercial principles and good business sense” and in a way that is commercially reasonable.29

These principles guide how a court may treat terms incorporated into a contract by reference. So, for example, the court will look first to the words that the parties have used, and the subjective intent of one party to incorporate all terms of the incorporated contract (or to not do so) will not be determinative in interpreting what was intended to be incorporated. As discussed below, if a term makes little sense in governing the relationship between the parties who incorporate another contract, it may be inapplicable for failing to result in being commercially reasonable – for example an onerous liquidated damages term as applied to a relatively discrete subcontract, the value of which is far less than the purported liability, may be found to be inapplicable. Where the express terms of the contract appear to be in conflict with the terms of the contract purported to be incorporated, the incorporated terms may also fail to apply.

An Attempt to Draw General Principles

So long as Incorporation by Reference clauses are included in building contracts, can we derive any principles from the case law? To the extent that it is possible to do so, the following are general principles which, in our view, should be applied by the courts, based upon the decided cases, and the principles of contract interpretation:

1.   Incorporation by Reference will only occur if the objective intention of the parties was to incorporate one document into another. While this principle is sometimes stated to be based on the subjective intention of the parties, that approach is contrary to the fundamental principle of contract law that intention is to be objectively determined.30 The mere existence of Incorporation by Reference clause in a subcontract will not demonstrate such an objective intention in relation to matters which do not concern the coordination and undertaking of the physical work.

2.   Some of objective circumstances which may arguably demonstrate an objective intention not to include terms of one contract into another were discussed in the Dynatec Mining deicison, being: lengthy negotiation of the latter contract during which the terms proposed to be incorporated were never discussed; an entire agreement clause in the latter contract; and a comprehensive scheme (such as a dispute resolution procedure) in the latter contract which does not mention or is inconsistent with the term in the other contract (such as an agreement to arbitrate).

3.   Conflict between the provisions in the latter contract and the term sought to be imported from the other contract will in all likelihood preclude incorporation. In fact, the latter contract may directly address this conflict issue. Thus, the subcontract may well state, and should state, that if there is any conflict between the subcontract and the main contract, then the provisions of the subcontract apply.

4.   A conflict does not require an absolute conflict in wording. Indeed, the failure to provide for the matter in, say, the subcontract may itself preclude the importation of a term from the main contract, because to do so would be in conflict with the subcontract.

5.   If the parties are in a direct relationship with each other, then Incorporation by Reference will be more sustainable. Hence, if it is a question of incorporating a letter of intent or the terms of a tender into the contract which is ultimately made by the same parties who exchanged the letter of intent or participated in the tender, or incorporating the terms of a contract into a performance or payment bond relating to that contract, then a court will be much more likely to hold that the Incorporation by Reference clause is effective to bring all of the material portion of the other document into the contract.31

6.  The obligation in the main contract in respect of the actual physical work to be undertaken will likely be incorporated into the subcontract by virtue of the Incorporation by Reference clause.32 The courts view the purpose of an Incorporation by Reference clause in a subcontract to be for co-ordinating the prosecution of the actual physical project, and not for the purposes of subjecting the subcontractor to the same insurance, dispute resolution and similar regimes adopted by the owner and the contractor, absent the clear intention by the contractor and subcontractor to import into their contract the terms of the main contract.

For this reason, terms relating to liquidated damages, the obligation to obtain insurance, the provision for security for lien in the main contract will not likely be incorporated into the subcontract in the absence of a specifically articulated intention to do so.

7.   Similarly, arbitration clauses and other clauses relating to dispute resolution will not usually be imported from the main contract into the subcontract by virtue of a general Incorporation by Reference clause in the latter contract. However, the general principles of interpretation and the facts of the particular case may result in a general incorporation clause having that effect. Consideration must also be given to the specific arbitral statute governing the contract because it may favour or contradict such incorporation. In addition, the trend toward a more arbitration-friendly approach by courts may increase the likelihood of such general incorporation in the future.

Conclusion

Even though standard form building contracts contain Incorporation by Reference clauses, courts may not find that such incorporation has actually occurred. Incorporation by Reference will more likely be found to occur if the parties are in a direct relationship with each other or engaged in the preparation of, or exchanged, both documents, or if the document sought to be incorporated relates to the physical construction of the project. Otherwise, terms such as arbitration clauses, lien security, insurance and liquidated damages clauses will not likely be imported from one contractual regime into another. The interpretation of the contract as a whole, being the contract and the terms Incorporated by Reference, will be subject to the established principles of contract interpretation.

In these circumstances, the drafters of standard building contract might well revisit the Incorporation by Reference clauses contained in those contracts, and particularly in main contracts and subcontracts, and encourage the parties to direct their minds to which specific provisions of one contract they wish to be incorporated into the other contract.

[This article first appeared in Skylines – Newsletter of the CBA National Construction Law Section – July 2012]

  • 1 Thomas G. Heintzman OC, QC, FCIArb is counsel and Julie Parla is a partner in the Toronto office of McCarthy Tétrault LLP.
  • 2 Pozzebon v. Lamantea, 1988 Carswell Ont. 759 at para. 4
  • 3 Kor-Ban Inc. v. Pigott Construction Ltd. (1993), 11 C.L.R. (2d) 160 at para 529(Ont. S.C.J.)
  • 4 Online Constructors Ltd. v. Speers Construction Inc. 2011 CarswellAlta 104 at paras 17-20.
  • 5 Litchfield Bulldozing Ltd. v. PCL Construction Ltd. (1985) 14 C.L.R. 287(B.C. Co. Ct.)
  • 6 Whitby Landmark Developments Inc. v. Mollenhauer Construction Ltd., (2003) 26 C.L.R. (3d) 161 at para. 9-16 (Ont. C.A.)
  • 7 Ecozone Engineering Ltd. v. Grand Falls – Windsor (Town) (1995), 30 C.L.R. (2d) 277, (2000) 5 C.L.R. (3d) 55 (N.L.C.A.)
  • 8 Schaible Electric Ltd. v. Melloul – Blaney Construction Inc. (2005) 45 C.L.R. (3d) 41 (Ont. C.A.)
  • 9 Foundation Co. of Canada Ltd. v. United Green Growers Ltd. (1997), 33 C.L.R. (2d) 159 at para. 27 (B.C.C.A.)
  • 10 Niagara Structural Steel v. LaFlamme (1985), 14 C.L.R. 70 at para 28-32; aff’d (1987) 58 O.R. (2d) 773 (C.A.)
  • 11 Lac La Ronge Indian Band v. Dallas Contracting Ltd. (2004), 35 C.L.R. (3d) 236 at para 70, 82-95 (Sask. C.A.)
  • 12 1510610 Ontario Inc. v. Man-Shield (NOW) Construction Inc., 2010 Carswell Ont. 1395
  • 13 Q.Q.R. Mechanical Contracting Ltd. v. Panther Controls Ltd. (2005), 40 C.L.R. (3d) 154 at para 16-31 (Alta. Q.B.)
  • 14 529198 Alberta Ltd. v. Thibeault Masonry Ltd. (2001), 19 C.L.R. (3d) 63 (Alta. Q.B.)
  • 15 Lac La Rouge Indian Band v. Dallas Construction Ltd., (2004) 35 C.L.R. (3d) 236 (Sask. C.A.)
  • 16 Daiwood Construction Co. v. Wright Schuchart Construction Ltd. (1992), 3 C.L.R. (2d) 144.
  • 17 Dynatec Mining Ltd. v. PCL Civil Constructors (Canada) Inc. (1995), 25 C.L.R. (2d) 259 (Ont. Gen. Div.); Sunny Corner Enterprises Inc. v. Dustex Corp., (2011), 1 C.L.R. (4th) 281 (N.S.C.A.)
  • 18 Rebecca James and Michael Schoenberg, “Incorporating an Arbitration Clause “By Reference”: Reconciling Model Law Article VII and Australian Common Law in Light of Recent Developments”, (2011) 77 Arbitration, Issue I, 84. (“James and Schoenberg”)
  • 19 (1991), 57 B.L.R. 1; 31 Con. L.R. 60 CA.
  • 20 [1912] A.C. 1 HL.
  • 21 Modern Buildings (Waltes) Ltd. v. Limmer & Trinidad Co. Ltd. [ 1975], 1 W.L.R. 1281; [1975] 2 All E.R. 549 CA; Owners of the Annefield v. Owners of Cargo Lately Laden on Board the Annefieldl, [1971] P. 168; [1971] 2W.L.R. 320 CA
  • 22 James and Schoenberg, above.
  • 23 See, for instance, the Ontario International Commercial Arbitration Act, R.S.O. 1990, c. I.9, Article 7(2) of the Model Law attached to that Act The domestic Ontario Act, the Arbitration Act, 1991 ,S.O. 1991, c. 17 does not contain a provision that directly deals with incorporation by reference of an arbitration clause from one contract or document into a second contract. Section 5(1) does say that an arbitration agreement “may be an independent agreement or part of another agreement”.
  • 24 See James and Schoenberg, above, at footnotes 15 and 16.
  • 25 Dynatec Mining Ltd. v. PCL Civil Constructors (Canada) Inc., (1996), 25 C.L.R. (2d) 259; Daiwood Construction Co. v. Wright Schuchart Construction Ltd. (1992), 3 C.L.R. (2d) 144.
  • 26 SimEx Inc. v. IMAX Corp., [2005] O.J. No. 5389 (Ont. C.A.) at para. 23
  • 27 Eli Lilly & Co. v. Novopharm Ltd., [1998] 2 S.C.R. 129 at para. 56; SimEx, supra at para. 23; Drumbrell v. Regional Group of Cos. 2007 CarswellOn 407 (Ont. C.A.) at paras. 48-51.
  • 28 Ventas, Inc. v. Sunrise Senior Living Real Estate Investment Trust (2007), 85 O.R. (3d) 254 at para. 24; 3869130 Canada Inc. v. I.C.B. Distribution Inc. (2008) ONCA 396 (Canlii) at para. 31.
  • 29 Ibid.
  • 30 Heintzman and Goldsmith on Canadian Building Contracts, Chapter 1, Part 1(b)
  • 31 Foundation Co. of Canada v. United Green Growers Ltd. (1997), 33 C.L.R. (2d) 159 (B.C.C.A.); Pozzebon v. Lamantea, 1988 Carswell Ont. 759 at para. 4; Whitby Landmark Developments Inc. v. Mollenhauer Construction Ltd., (2003) 26 C.L.R. (3d) 161 (Ont. C.A.)
  • 32 Dynatec Mining Ltd. v. PCL Civil Constructors (Canada) Inc., (1996), 25 C.L.R. (2d) 259; Kor-ban Inc v. Pigott Construction Ltd, 1993 Carswell Ont. 825 at para 529.

www.constructionlawcanada.com                                                                                                                               July 25, 2012

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Remember Rainy Sky: The Commercially Sensible Interpretation Prevails

Every once in a while, an important decision comes along which should be put in your hip pocket so that it can be pulled out when needed.  Rainy Sky S.A. v. Kookmin Bank is such a decision.  In this decision, the U.K. Supreme Court (formerly the House of Lords) recently held that if there is a choice between interpretations of an agreement, the commercially sensible one should be adopted.

That principle may not be rocket science, but it is crucially important for two reasons.

First, the Supreme Court held this principle applies even if another interpretation is arguable.  The more commercially sensible interpretation will be selected whenever there is a contest over the meaning of a contract.

Second, this approach may make it more important to lay the groundwork for a sensible interpretation in the evidence.

Rainy Sky is an easy case to remember:  whenever the sky looks gloomy in a dispute, think of Rainy Sky!  It concerned a bond given by the Koomin Bank in relation to a shipbuilding construction contract.  The bond was given to protect the buyer in the event of the builder’s/seller’s default under the contract and obliged Koomin to pay “all such sums due to you under the Contract, between the buyer and the seller.”

The question was:   what “such sums” did the bond cover?  Did it cover only events such as the rejection by the buyer of the vessel, the cancellation or rescission of the contract by the buyer or the total loss of the vessel, all of which were specifically mentioned in the bond as events obliging the seller to repay the buyer?  Or did the bond also cover the insolvency of the seller?

In fact, the seller went bankrupt and failed to refund the advances paid by the buyer to the seller, and that event triggered Rainy Sky’s claim on the bond.  Rainy Sky asserted that the return of the advances was included as an obligation of Koomin under the bond.  Koomin asserted that the bond did not cover the seller’s insolvency, and that it covered only the specifically mentioned obligations of repayment contained in the construction contract.

The trial judge held that the bond covered the insolvency of the seller.  The Court of Appeal held that it did not, and that only the events of repayment specifically mentioned in the bond were covered by it. The UK Supreme Court restored the trial judgment.

The Supreme Court’s decision is a ringing endorsement of the reliability of commercial common sense as a touchstone to contract interpretation.  The Court adopted the following statement by the dissenting judge in the Court of Appeal:

“As the [trial] judge said, insolvency of the Builder was the situation for which the security of an advance payment bond was most likely to be needed….It defies commercial common sense to think that this, among all other such obligations, was the only one which the parties intended should not be secured.  Had the parties intended this surprising result I would have expected the contracts and the bonds to have spelt this out clearly but they do not do so.”

The Supreme Court re-iterated the principle stated by Lord Justice Hoffman in another case to the effect that “if the language is capable of more than one construction, it is not necessary to conclude that a particular construction would produce an absurd or irrational result before having regard to the commercial purpose of the agreement.”

The Court also referred to a previous decision of Lord Justice Longmore to the effect that “if a clause is capable of two meanings, it is quite possible that neither meaning will flout common sense, but that, in such a case, it is much more appropriate to adopt the more, rather than the less, commercial construction.”

The Supreme Court ended its judgment with the following statement:

“..the omission of the obligation to make such re-payment from the Bonds would flout common sense but it is not necessary to go so far…..of the two arguable constructions of paragraph (3) of the Bonds, the Buyers’ construction is to be preferred because it is consistent with the commercial purpose of the Bonds in a way in which the Bank’s construction is not.”

The court did not limit this principle to contracts in the nature of bonds and indemnities.  Rather, its pronouncement was clearly intended to relate to the general interpretation of contracts.  As such, it is of the highest persuasive authority in all common law countries.

The face of the judgment does not indicate that there was any expert or other evidence demonstrating the commercial common sense that the Supreme Court adopted.  So that sense of commercial reasonableness had to be derived from other sources.

In the Rainy Sky case, a primary source was the commercial skill and experience of the U.K. Supreme Court.  A court with that experience can make that judgment which other courts, even of high authority, may not be able to make if composed of judges who have not had extensive commercial experience.

If a judge or court does not have commercial experience, then that experience may have to be provided by expert or other testimony.  That circumstance may result in an unfortunate dispute between expert witnesses about what is “commercially sensible”.  That is a dispute which the Court of Appeal may have felt was undesirable.  The Court of Appeal also seemed unwilling to be the judge of what result amounted to commercial common sense when sophisticated parties had not themselves expressly stated that result in their contract.

In any event, we now have a judgment that we can rely upon for a crucial principle:  the commercially sensible interpretation of a contract prevails, even if another interpretation is arguable.

Construction Law  –  Interpretation of Building Contracts  –  Bonds:

Rainy Sky S.A. v. Kookmin Bank, [2011] UKSC 50

Thomas G. Heintzman O.C., Q.C.                                                                                                            December 3, 2011

www.heintzmanadr.com
www.constructionlawcanada.com

Building Contracts – Tenders – Bonds

Building Contracts – Tenders – Bonds

Today we will examine a recent decision of the Court of Appeal of Ontario which dealt with Tenders for construction contracts.

In Bois A. Lachance Lumber Limited v. Conseil Scolaire Catholique de District des Grandes Rivieres, the tender documents required the bidders to obtain performance bonds “upon acceptance” of a bid.  The Court of Appeal held that the successful bidder did not have to provide a performance bond with its bid, but only after acceptance of its bid.

The Court of Appeal went on to hold that, once the successful bid was accepted, then all owner’s tender duties owed to the other bidders were terminated, applying the rational of the Supreme Court of Canada in Double N Earthmovers Ltd. v. Edmonton (City), 2077 SCC .  Accordingly, the owner could then wave or vary any term of the bid and enter into whatever contract it liked with the successful bidder, and substitute a letter of credit for the performance bond.

This decision is a reminder of the difference between the contract formed by the tender process (Contract A) and the contract between the owner and a bidder arising from the tender process (Contract B).  While Contract A contains a duty of fairness and a duty not to accept a non-compliant bid, once Contract A is completed and those duties are fulfilled, and the owner selected a bidder that meets the criteria of the tender documents, then the owner can enter into a Contract B which is different than the tender terms of Contract A.

The law entitles the owner to enter into a Contract B which is different from the terms set out in the tender documents because the law expects the owner to act in its own economic self-interest and not give up economic value to the contractor, and because the law wishes to leave the owner an contractor with the flexibility to enter into the best deal.

However, what has not been explored in this case is the degree to which the owner can influence the tender process.  Can the owner put terms into the tender, and thus into Contract A, which it knows that it will not insist upon, and which it knows that certain bidders cannot meet?  Can the owner stipulate that the successful bidder must provide a performance bond, well knowing from the beginning that certain bidders cannot provide such a bond and that it will waive that requirement or accept security of an entirely different nature?  Can the owner stipulate a particular building material in the tender, intending from the outset to waive that requirement and accept another material?  At what point does that sort of conduct amount to bad faith and a breach of Contract A? And at what point does Contract B become an entirely untendered contract?  In the case of a public authority required to contract by tender, at some point does that conduct fall outside that requirement?  These are unanswered questions which are raised by decisions such as that in Bois.

Building Contracts – Tender – Bonds:  Bois A. Lachance Lumber Limited v. Conseil Scolaire Catholique de District des Grandes Rivieres, 2010 ONCA 694 (CanLII)  https://bit.ly/fpSaaM