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When do the terms of a surety bond allow a construction project owner to withhold payments to a contractor?

This question could go to the Supreme Court of Canada, which recently announced a federal crown corporation wants to appeal a Newfoundland court decision resulting from a $2.3-million ferry wharf construction project that did not get finished on time and spawned a lawsuit.

In 2013, Western Surety Company wrote a $1.6-million performance bond for RJG Construction Limited in connection with a ferry wharf construction project in Argentia, Nfld. for Marine Atlantic Inc., which operates ferry service between North Sydney, N.S. and Argentia.

After delays in the work and delays in payments, Marine Atlantic and RJG Construction sued one another, each claiming the other was in breach of contract. Western Surety is not a party to the lawsuit.

In RJG Construction Limited v. Marine Atlantic, released Feb. 23, 2018, Justice James Adams of the Supreme Court of Newfoundland and Labrador awarded Marine Atlantic $1.3 million for the extra money Marine Atlantic said it had to pay to complete the project using a different contractor

That was overturned in 2019, with the Court of Appeal for Newfoundland and Labrador quashing the damage award and remitting the matter back to the Supreme Court, General Division, to assess damages owed by Marine Atlantic to RJG.

Marine Atlantic is applying for leave to appeal that ruling, the Supreme Court of Canada announced Nov. 29. The top court could dismiss the leave application – in which case, the appeal court ruling stands – or decide to hear an appeal.

A surety bond – which construction firms often must obtain before being awarded contracts – is a three-way contract for the benefit of the client’s clients. The insurer (the surety) writes a bond for its customer (the principal). If the principal fails to fulfill the terms of its contract, a surety bond could be payable to an obligee (such as a construction project owner) which is the principal’s customer.

A performance bond in intended to provide assurance to a project owner that a project will actually get done.

In the case of Marine Atlantic, the contract it awarded to RJG required RJG to complete the wharf project by June 15, 2013. But by October the wharf project was still not done. In January, 2014, RJG and Marine Atlantic both purported to terminate the contract, after Marine Atlantic froze some payments to RJG. Rather than pay the entire cost of the project when it was completed, the contract provided for the owner to make several progress payments after portions of work were done.

In December, 2013, Marine Atlantic refused to release the fifth progress payment. Marine Atlantic was seeking a remediation agreement and had told RJG if no agreement was reached then funds that Marine Atlantic owed to RJG would be withheld to cover any additional costs incurred by Marine Atlantic in completing the project.

Initially in 2018, Justice Adams ruled that Marine Atlantic was entitled to freeze payments to RJG in order to protect itself under the performance bond – which is a separate contract from the construction project. The construction contract gave Marine Atlantic the right to use any payments due to RJG to pay the cost of correcting RJG’s default, Justice Adams reasoned.

That finding was overturned on appeal.

Marine Atlantic told both Western Surety and RJG that, in Marine Atlantic’s view, RJG was in default by not meeting the construction schedule. At that point, Western Surety had four options: remedy the default; complete the contract in accordance with its terms and conditions; obtain a bid from other contractors to complete the contract; or pay the project owner (Marine Atlantic) the amount of the bid bond (or the owners’ proposed cost of completion) less the balance of the contract price.

The construction contract between Marine Atlantic and RJG gives the owner the right to take possession of the work if the owner terminates the contract. Under that clause, the owner could withhold payments if it terminates the contract and charge the contractor the extra cost for the owner to continue the work. But that can only happen if the owner actually terminates the contract, Justice Francis O’Brien wrote on behalf of the appeal court in its unanimous ruling.

The contract does not permit Marine Atlantic to freeze funds while the contract is ongoing, noted Justice O’Brien.

Marine Atlantic did not actually correct a default at the time it was withholding payments, Justice O’Brien added. Therefore, Marine Atlantic did not incur any costs for which it would need to withhold funds from the contractor.

“The fact that Western Surety had various options under the performance bond contract, and the fact that Marine Atlantic was waiting for Western Surety to select an option, did not entitle Marine Atlantic to freeze ‘any and all funds’ until an option had been chosen and acted upon by the surety,” Justice O’Brien wrote in the ruling against Marine Atlantic. “The language of the performance bond contract simply does not support such an interpretation.”

Ultimately, the appeal court ruled that by freezing funds, Marine Atlantic repudiated the contract, meaning RJG was entitled to terminate the contract and seek damages.

Citing previous court decisions involving surety bonds, Justice O’Brien wrote that if a contractor earns money and is not paid for that work, that money cannot be retained for the benefit of the obligee (in this case Marine Atlantic) or the surety (Western Surety) because to do so would mean the oblige or surety is enriched by RJG’s unpaid work under the contract.

“Significantly, there is nothing in the record to indicate that the bondholder, Western Surety, agreed with the position taken by Marine Atlantic’s counsel,” wrote Justice O’Brien. “There is no evidence that Western Surety suggested or directed that Marine Atlantic freeze these funds. At no time did Western Surety indicate that payment of these funds to RJG could contravene Marine Atlantic’s obligations to Western Surety or cause prejudice which might void the performance bond.”

https://www.canadianunderwriter.ca/claims/how-this-surety-bond-could-be-examined-by-supreme-court-of-canada-1004171604/

How this surety bond could be examined by Supreme Court of Canada