In Westport Insurance v. BDA Inc.1, the Ontario Superior Court of Justice was tasked with resolving a novel issue regarding a conflict between adjudication awards under the Construction Act and the enforcement of surety rights under an indemnity agreement, along with the subsequent interpleader action regarding the priority of claims over funds held in trust. While this decision provides valuable lessons for contractors and sureties involved in overlapping adjudications and bond claims, it also provides insight as to how the tension between these two subjects can be resolved.
Background
Westport involved a project in Bronte, Ontario for the construction of a commercial facility, in respect of which the relevant parties were the electrical subcontractor, High-Tech Power Inc. ("High Tech"), High-Tech's surety, Westport Insurance Corporation ("Westport"), and BDA Inc. ("BDA"), the general contractor.
High Tech entered into a written subcontract with BDA on May 18, 2022, to supply electrical supplies and installation services (the "Subcontract"). Not atypically, BDA required High Tech to provide security in the form of both a performance bond and a labour and material payment bond. On July 12, 2022, Westport issued these bonds, with BDA as the obligee and High Tech as the principal.2
As is customary, in order to obtain these bonds, Westport entered into an indemnity agreement (the "Indemnity Agreement") with High Tech and its principal, Benyamin Mehraban, under which High Tech and Mr. Mehraban agreed to indemnify Westport for any losses, costs, or liabilities that Westport might incur under the bonds. In that regard, the Indemnity Agreement contained what appeared to be market standard terms, making High Tech and Mr. Mehraban responsible for a wide range of potential and actual claims and obligations arising under or relating to the bonds.3
A dispute arose between BDA and High Tech during the project. By mid-2022, BDA claimed that High Tech had not completed its work in a timely manner – particularly the demolition work required by the Subcontract. BDA also claimed that High Tech failed to submit necessary documentation, delayed the submission of change order quotations, and failed to pay certain suppliers and workers. In response to these alleged breaches, BDA issued a formal notice of breach to High Tech on July 28, 2022. This ultimately led to BDA terminating the Subcontract and making a claim on the performance bond issued by Westport.4
Following the termination, Westport entered into a Mitigation Agreement with BDA before completing its investigation of the claim. The Mitigation Agreement permitted BDA to continue work on the project using other contractors, and allowed Westport to provide interim advances to keep the project moving. By the time this matter came before the Superior Court, Westport had advanced approximately $340,000 to BDA under this agreement. The Mitigation Agreement was entered into on a without prejudice basis, such that Westport reserved all rights to deny liability and seek reimbursement for the advances it had made if it later determined that High Tech was not in default.5
While Westport was conducting its investigation and providing advances, High Tech initiated an adjudication under Part II.1 of the Construction Act. On March 2, 2023, the adjudicator issued a determination which found that BDA owed High Tech $316,960 for unpaid invoices under the Subcontract. The adjudicator did not address whether BDA had properly terminated the Subcontract, focusing only on the unpaid invoices.6
When Westport became aware of the determination, it took the position that High Tech was not in default, that BDA had not properly performed its obligations under the Subcontract, and that BDA's claim under the bonds was therefore unfounded. Westport wrote to BDA, advising that it would no longer make payments under the Mitigation Agreement and requesting reimbursement for the funds it had already advanced to BDA. At the same time, BDA, in response to the adjudication determination, refused to release the awarded funds to High Tech, citing Westport's competing claim and the Indemnity Agreement's provisions.7
The funds at issue, approximately $316,960, were initially held by BDA's counsel in trust. Through subsequent negotiations, $161,037 was released to subtrades, leaving $155,882 in dispute (the "Disputed Funds"). Westport sought a court order to have these funds paid directly to it or, alternatively, paid into court pending further proceedings.8
The case before the Superior Court thus centered on whether Westport, as surety, had a valid security interest in the Disputed Funds, and whether it was entitled to the immediate release of these funds, notwithstanding the adjudication award in High Tech's favour.9
Legal Issues
The Court was presented with several legal issues in this case, each of which required the Court to examine the intersection of the Construction Act's prompt payment and adjudication provisions and the rights and obligations of a surety under a performance bond and indemnity agreement.
- Was there a procedural defect in Westport's claim
for a summary determination? High Tech argued that
Westport's motion for summary determination was procedurally
defective. The argument centered around whether Westport could
bring such a motion under the Rules of Civil Procedure,
and particularly whether the motion could proceed under the
interpleader rules without BDA, the holder of the funds, delivering
its own notice of motion.10
- Did High Tech commit an Event of Default under the
Indemnity Agreement? Central to the dispute was whether
High Tech's alleged failures under the Subcontract,
particularly its failure to complete demolition work on time and to
pay certain workers, constituted an "Event of Default"
under the Indemnity Agreement with Westport. Westport relied on
several categories of Events of Default under the Indemnity
Agreement, including any breach or alleged breach of the
Subcontract or any failure to pay debts that could expose Westport
to loss.11
- Did Westport have a security interest or trust claim
over the Disputed Funds? Westport claimed that the funds
awarded by the adjudicator were subject to a security interest and
impressed with a trust in favour of Westport. This claim was based
on the terms of the Indemnity Agreement, which provided Westport
with a broad assignment of rights over any funds or payments due to
High Tech under the Subcontract.12
- Did High Tech have priority over Westport for the
Disputed Funds by virtue of the Construction Act? High
Tech argued that the adjudication determination, made pursuant to
the provisions of the Construction Act, gave it priority
over Westport's security interest. On this issue, High Tech
relied on the policy objectives of the Construction Act,
which are designed to ensure prompt payment and the continuous flow
of funds for projects within the construction
industry.13
- Had Westport proven an indemnity loss such that it is entitled to immediate payment of the Disputed Funds? Westport sought the immediate release of the Disputed Funds on the grounds that it had suffered Indemnity Losses (a defined term under the Indemnity Agreement), including the advances it had made to BDA under the Mitigation Agreement. Here, the issue was whether Westport had established an immediate right to these funds, given the ongoing litigation between BDA and High Tech.14
The Superior Court's Decision
The Court considered each issue in turn, noting that because there is no case law that specifically addresses the issue as to whether a surety may assert a security interest over funds awarded pursuant to an adjudication determination, the parties were therefore required to advance both legal and policy arguments. Accordingly, the Court's decision largely required a balancing of the rights and obligations under the Construction Act, the Indemnity Agreement, and the performance bond.
Procedural Defects in the Motion
High Tech's argument regarding procedural defects was rejected. The Court found that, while BDA technically did not deliver its own Notice of Motion for an interpleader order, all parties had agreed to proceed in this manner, and BDA had actively participated in the proceedings. Any procedural irregularities were immaterial, and the case could proceed as an interpleader motion, where the Court would resolve the competing claims to the Disputed Funds.15
Event of Default by High Tech
The Court determined that High Tech had indeed committed an Event of Default under the Indemnity Agreement. The Court examined the broad scope of an Event of Default under the Indemnity Agreement, which included, among other things, (1) any breach or alleged breach of any covenants and agreements, (2) any failure or inability by High Tech to pay its debts, and (3) any other occurrence, condition or circumstance which might expose Westport to loss, cost or expense. (All of these terms are relatively standard in the Ontario surety industry.) The Court found that an Event of Default had occurred on the following bases:
- High Tech's failure to pay its union labour, which had resulted in judgments and garnishments, constituted a clear breach of its obligations;
- BDA's delivery to High Tech of a notice of breach of the Subcontract (i.e. in which BDA alleged that High Tech had breached that agreement);16 and
- The subsequent claim on the performance bond exposed Westport to potential losses.
Furthermore, Westport had acted in accordance with the Indemnity Agreement by investigating the claim and entering into the Mitigation Agreement on a without-prejudice basis.17
The Disputed Funds
The Indemnity Agreement clearly provided that all funds due (or which become due) to High Tech under the Subcontract, or awarded or allowed in connection with the Subcontract were subject to Westport's security interest, including funds awarded pursuant to the adjudication determination. The language of the Indemnity Agreement was broad and unambiguous in this regard, covering all payments, whether from progress claims, retained percentages, or otherwise.18 Furthermore, the Indemnity Agreement was equally clear that all funds due or to become due under the Subcontract, whether in the possession of High Tech or BDA, constituted trust funds for the benefit of Westport.
Finally, Westport had also registered its security interest under Ontario's PPSA, further solidifying its claim to the Disputed Funds. The Court emphasized that, while the adjudication provisions of the Construction Act are intended to facilitate the prompt flow of funds, they do not override the valid security interests held by a surety under a pre-existing indemnity agreement.19
Priority of Claims
The Court also rejected High Tech's argument that the adjudication award gave it priority over Westport's security interest, finding that the Construction Act's adjudication provisions do not confer priority over a surety's security interest. The adjudication process is designed to provide interim determinations and payments to ensure that construction projects continue, but it does not alter the pre-existing contractual rights of parties, including the rights of a surety under an indemnity agreement.20
The Court also noted that the policy objectives of the Construction Act are not defeated by upholding a surety's security interest. In this case, the funds had already flowed to downstream subcontractors and union employees, leaving only the competing claims between High Tech and Westport.21
Indemnity Losses and Immediate Payment
Conversely, the Court nevertheless denied Westport's claim for immediate payment of the Disputed Funds. While the Court acknowledged that Westport had suffered losses under the Mitigation Agreement, including the advance of $340,000 to BDA, it found that the ongoing litigation between BDA and High Tech could affect Westport's ultimate entitlement to these funds.22 In that regard, it was premature to order the immediate release of the Disputed Funds to Westport, given the unresolved claims between the parties. Instead, the Court directed that the Disputed Funds be paid into court pending the outcome of the related proceedings, including Westport's action against High Tech and BDA.23
Commentary
As noted by the Court itself, Westport represented a novel dispute at the intersection of a surety's rights of indemnity and the Construction Act's adjudication and prompt payment regime. Westport is therefore necessary reading for practitioners in either area.
In that regard, Westport highlights a tension between the Construction Act's adjudication and prompt payment regime, on the one hand, and the rights of sureties under indemnity agreements, on the other. Adjudication, by design, was always intended to provide a rapid resolution to payment disputes, ensuring that funds flow down the construction pyramid; put simply, the animating theory was intended to be "pay now, argue later". However, Westport up-ends this theory in demonstrating that adjudication funds are not immune to competing claims, particularly when a surety has a pre-existing security interest in those funds. Here, "pay now, argue later" was certainly not a dominant consideration, as the adjudicator's determination was issued 19 months before the Court's decision and yet High Tech had not received the funds in question. It is unclear at what point this matter will proceed to trial, but it appears safe to say that by the time a trial judgment is rendered, it will have been at least 2-3 years since the adjudicator's determination was issued.
In that regard, Westport has the potential to create further challenges to the efficacy of Ontario's adjudication and prompt payment regime. As readers will appreciate, the terms of the Indemnity Agreement in Westport – although they were not quoted at length by the Court – appear to have been consistent with the market standard in Ontario. As the Court itself observed, indemnity agreements are required in order to obtain surety bonds that will in turn grant contractors greater ability to bid on projects; as a result, indemnity agreements with the terms at issue in Westport are widely used in Ontario. If adjudication can effectively be neutralized by a surety's recourse to an indemnity agreement, then from a policy perspective, it may be less likely that parties will resort to adjudication when it cannot deliver on the promise of prompt payment and the funds in question instead remain in limbo for years.
This is particularly problematic insofar as it reintroduces cashflow concerns for those deprived of prompt payment, as they are instead left to dispute for years over funds that could otherwise be put towards paying subtrades and suppliers. To the parties' credit in this case, they saw to the prompt payment of High Tech's union labour such that the remaining amount was only contested as between High Tech and BDA; in that regard, it is possible for reasonable parties to craft a workaround.
That being said, it is easy to envision a scenario in which an obstinate counterparty refuses such a compromise, and instead uses the subtrade's liability to its sub-subtrades and suppliers as leverage to attempt to secure advantageous arrangement. Similarly, payment of subordinate trades and suppliers does not resolve the issue of the adjudicating subcontractor being deprived of funds for years, which might again result in financial difficulties (up to and including insolvency) – which, ironically, is precisely the scenario that sureties typically wish to avoid. In that regard, we respectfully disagree with the Court in its conclusion that the policy of the Construction Act of prompt payment and adjudication – to ensure that funds flow down the construction pyramid – was not at least partially defeated here.
On the other hand, however, it is difficult to suggest that the Court's decision is incorrect insofar as the relevant language of the Indemnity Agreement was relatively unambiguous: High Tech assigned to Westport (as collateral), High Tech's right and interest to all funds due or which become due under the Subcontractor or in connection with the Subcontract work, and all funds due or to become due under the Subcontract, whether in possession of High Tech or BDA, constituted trust funds for Westport's benefit. Thus, it seems clear that High Tech's contractual entitlement to the adjudication determination funds was subordinated to Westport's security interest.
Contractors and subcontractors must therefore be aware that even if they obtain a favourable adjudication determination, their ability to access funds may be constrained by their surety's security interest(s). This is particularly true where their indemnity agreement grants the surety priority over funds payable pursuant to the underlying contract in dispute, which is typically the case in indemnity agreements in Ontario.
It therefore appears that Westport exposes a tension between the policy goals of adjudication and prompt payment versus the legal framework of surety law. Fortunately, it is reasonable to assume that in most circumstances, the surety will remain on good terms with its principal so long as the principal is solvent, and therefore favour the prompt flow of funds from an adjudicator's determination – facilitating the continued performance of the bonded project and reducing the surety's exposure under its L&M bond.
For a surety to attempt to intervene is this manner is undoubtedly an extreme step. Further, if the determination had been honoured within the timelines established under the Construction Act, i.e. if Hi-Tech had been paid within 10 days of the determination being communicated to the parties, then the funds might not have been exposed to the surety. Accordingly, while it may be the case that legislative clarification is necessary with respect to the interaction between the determinations of adjudicators and a sureties' rights of indemnity, perhaps industry consultation as to the proper allocation of rights and risks under standard form indemnity agreements may be in order. We await with interest to see how this issue develops.
Footnotes
1. 2024 ONSC 5450 [Westport Insurance].
2. Ibid at para 2-3.
3. Ibid at para 4.
4. Ibid at para 5.
5. Ibid at para 5-6.
6. Ibid at para 7-10.
7. Ibid at para 11-12.
8. Ibid at para 12-14.
9. Ibid at para 15.
10. Ibid at para 21-30.
11. Ibid at para 32-46.
12. Ibid at para 47-55.
13. Ibid at para 56-71.
14. Ibid at para 85-103.
15. Ibid at para 21-31.
16. Ibid at para 32-45.
17. Ibid at para 37-39, 45.
18. Ibid at para 47-49.
19. Ibid at para 50-55.
20. Ibid at para 56-68
21. Ibid at para 71-72.
22. Ibid at para 95-91
23. Ibid at para 103-105
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
