Projects often involve various different lending and security groups that sometimes (perhaps without realizing it) include the contracting parties’ own balance sheets. These groups include lenders/balance sheets for contractors, contract managers, subcontractors, equipment suppliers and other vendors, all of whom may have separate interests and separate security agreements with their respective borrowers and among themselves. A specific subset of these lenders are sureties who are engaged on the theory that, for a premium, in the event a general contractor defaults on its contractual obligations, usually to pay its subcontractors, then the surety will satisfy that obligation and subsequently both step into the general contractor’s shoes to be entitled to payments from the owner and to be able to look directly to the general contractor’s balance sheet for satisfaction of the amounts it had to pay out to subcontractors. That sounds simple enough, but what happens to secured creditors? What if there is a bankruptcy involved? Who is left holding the bag? In theory, a secured creditor should have a pretty solid interest and high likelihood of getting paid out in the event of a debtor insolvency, usually at the cost of all of those unsecured creditors and unpaid vendors and subcontractors down the credit line. A recent Alberta Court of Appeal case, Iona Contractors Ltd. (Receiver Of) v. Guarantee Co. of North America, 2015 ABCA 240 (“Iona”) discussed who gets what and who has a priority claim against amounts held back by owners under the Builders Lien Act. Iona involved a contractor that went bankrupt (Iona) who contracted with the Calgary Airport Authority to make improvements to the Calgary Airport, a bonding company that provided a performance bond and a labour and materials bond on behalf of Iona, a group of unpaid subcontractors that had performed work under a contract with Iona and a treasury branch that had a prior secured interest against all of Iona’s assets. Over the project, the owner Airport Authority had withheld 10% and had holdback funds of just over $1 mil at substantial completion, at which time many Iona subcontractors had not been paid for work performed. The surety company later ended up paying about $1.5 mil to the subcontractors as required under an L&M bond and Iona entered into bankruptcy. The question became: who gets the funds being held by the owner - the surety company (through its right of subrogation for funds paid to the subcontractors) or the Trustee of Iona because the holdback funds were amounts due to Iona under the Iona - owner contract? Underlying these questions, the dispute really involved the priority of interests under the Federal Bankruptcy and Insolvency Act on the one hand and the Provincial Builders’ Lien Act and existing contracts between the parties on the other. The surety ultimately failed in its argument that the contract allowed the owner to remedy Iona’s defaults to its subcontractors and make payments directly because such an action would alter the statutory priority given to secured creditors once bankruptcy had occurred; because the contract language was permissive and granted discretion, but not obligation to the owner, the owner (and by extension, the surety) could not pay subcontractors ahead of secured creditors once Iona was in bankruptcy proceedings and by doing so the owner (and surety by extension) lost its right to use the amounts the owner still held as compensation for Iona’s payment defaults. Of note was that the surety’s obligation to pay the subcontractors was not sufficient to bridge the gap between permissive and mandatory mentioned above. Rather, the surety’s obligation was a separate and private agreement between the contractor, owner and surety that could not affect other parties’ rights, i.e.: the secured creditor and the Trustee. However, the surety was successful on appeal: the Builders’ Lien Act impresses on holdback funds a trust designation once a certificate of substantial performance has been issued. In this case, the substantial completion certificate had been issued and the holdback funds were trust funds held on behalf of the subcontractors. The surety paid out funds owed to subcontractors from Iona pursuant to the bond and, in doing so, stepped into the shoes of Iona to the extent Iona had a right to be paid the holdback funds. The surety was entitled to receive the remaining holdback funds from the Airport Authority as compensation for the amounts the surety paid to Ioan’s subcontractors. A few points to take away from Iona:
Once a substantial completion certificate is issued, holdback funds are not a general contractor’s “accounts receivable” available to secured creditors – a surety could minimize exposure to loss by having strict and tightly controlled requirements around the issuing of a substantial completion certificate;
When there is not enough money to go around, the money has to come out of someone’s pocket. In this instance it was the Trustee’s (and the end result would have been the secured creditor’s) instead of the surety or the subcontractors. The facts of when/if a substantial completion certificate was issued and whether certain contract language is permissive or mandatory could have a very different result;
As an owner or prime contractor, it is very important to be diligent in your holdback amounts and ensuring you are in compliance with the Builders Lien Act, otherwise you could end up paying twice for work or paying 110% of the cost you bargained for on your project – tight administration around meeting the Builders Lien Act requirements could go a long way in cost control;
Do not pay out holdback funds to a creditor of the party with whom you have contracted unless you are very clear about the facts and circumstances of the funds being paid out and to what they relate;
If you are going to or think you might want to take over the flow of payments to contractors, subcontractors, suppliers, vendors etc. as a mechanism to control performance of your contractor, make sure your contract says you can in certain instances and will or shall in other instances (obviously with a right of recovery against the other contracting party);
A bond security instrument cannot, by itself, create an obligation on the part of the owner to pay subcontractors; a bond does not create a contractual or trust relationship between an owner and a subcontractor and the surety will have to look to the rights and obligations of its bonded contractor to recover any required payouts under the bond;
An owner that promises to pay subcontractors existing money already owed to them by the general contractor from holdback might not be able to do this (or at least might end up paying twice) if a substantial completion certificate doesn’t exist.
Sandquist Law & Construction Project Consulting can assist in drafting payment, performance and project security clauses to meet your goals. We understand the implications of financing and cash flows on your operations and offer a practical approach to these issues.
I'm busy working on my blog posts. Watch this space!