Vexing questions

Over the past year or so, like most people, we have been preoccupied with the Covid-19 pandemic. Unsurprisingly, most of our contributions over this period focused on this subject, and rightly so. The pandemic brought to the fore the good and the bad sides of government and society at large. Now that the pandemic has shown strong signs of easing, it is perhaps an opportune moment to comment on other subjects of interest as we recover from this global shock.

Some time back we wrote about bonds and guarantees and the important role they play in facilitating commercial and other business transactions. These are essentially instruments used to protect project owners against the risk of default by contractors. We pointed out that if bonds and guarantees are to be effective in performing this role, they must be (and indeed, are) issued as non-cancellable instruments.

Without this requirement, it would be very difficult to implement projects because owners or funders of projects require bonds and guarantees for risk management purposes in case the contractor defaults for any reason. If the issuer can cancel a bond at any time of their choosing, it implies that the project must stop while new bonds are sought. If projects are interrupted the implications are serious; budget overruns, for example, are an obvious consequence. That does not augur well for trade and commerce.

Furthermore, it is quite common for third parties to have interests in the project that are directly or indirectly dependent on the bond’s existence, even though they are not party to the bonding contract itself. Consequently, if the bond on which their interests depend is cancelled, they too will be harmed in various ways, depending on what they leverage on the bond. However, it is important to point out that these third parties are not involved in the information exchange that determines whether or not the bond is issued. That information exchange happens between the contractor and the guarantor or bond issuer.

In spite of this, the very feature of bonds and guarantees as non-cancellable instruments has brought an important question before the appeal court in Canada’s Ontario province. The court is deliberating over whether an issuer of a bond or guarantee (such as a bank or insurance company) can cancel it upon discovering that it was issued based on fraudulent misrepresentation and other malfeasance by the contractor making the application, even if doing so would harm the interests of innocent third parties.

In the case, an insurance company had issued a performance bond in favour of a contractor for the construction of a hospital. After the bond issue, the insurer discovered that the information on which it had relied was false and, to a large extent, fraudulent. The insurer argued that had it known the true information at the time, it would not have issued the bond.

As is usually the case in such transactions, third parties have relied on the existence of this bond to conclude other incidental transactions involving the contractor and other parties. Consequently, cancellation of the bond will harm the interests of these third parties, whose dealings with the contractor centred on the existence of the bond.

On the other hand, the insurer’s argument is straightforward. It relied on the truthfulness of representations made by the contractor to issue the bond. Once the information they relied on was found to be untrue and laced with fraud, they could not continue to uphold their commitment to such an instrument. Doing so would promote perverse incentives where applicants for these instruments would provide false information knowing that, once the bond is issued, the issuer cannot rescind it until the project is complete. If the bond cannot be cancelled once issued, what incentives are there for contractors to provide truthful and accurate information when applying for bonding?

An alternative way of looking at the insurer’s (bond issuer’s) position is to use principles of insurance. Technically, the bond issuer provides insurance protection to the contractor in the event the contractor defaults and is sued by the project owner.

Insurance depends on an honest exchange of information. More importantly, the information being exchanged must be accurate. Failure to disclose relevant information or misrepresenting such information has a mortal impact on the traction and the business of risk trading in general. The very fact that the contract of insurance is built around the disclosure of true and accurate information implies that if this does not happen, the insurer has the remedy of rescinding the contract that resulted from false and misleading information.

If this remedy is removed, it implies that the insurer is bound regardless of the accuracy or otherwise of the information provided by those who seek its protection. On the other hand, the insurer’s reliance on fraudulent information may be indicative of deficiencies in its information gathering and processing systems. This argument is weakened, however, when one considers that not all information can be verified for its truthfulness at the point of receiving it. In other words, the ability to verify the authenticity of information may be time sensitive.

If every decision-maker waited until they were sure that the information given to them was true and accurate, commercial tractions would take forever to conclude. In most cases decision-makers rely on undertakings made by the other party to decide if a business venture is worth concluding.

So, what has the Ontario Court of Appeal decided on the matter? Unfortunately, it has avoided answering the question of whether the insurer can cancel the bond where its issuing was based on misrepresentation and fraud, even if doing so means harming the interests of third parties. Therefore, the matter is still to be decided.

Nevertheless, there are some pointers made by the court that could be useful to those bent on speculating. Of particular interest in this regard is the court’s observation that as prejudiced as it may be to third parties, their interests are not always a bar to rescission. The court emphasised that this observation is more likely to be important where fraudulent misrepresentation is involved.

Another point that the court made, which might represent a way to resolve this issue, is the availability of other avenues for providing restitution. It is not clear if this is referring to providing restitution to the issuer of the bond, or to third parties who may be harmed should the issuer of the bond opt to rescind it.

One is inclined to argue that it is difficult to determine what restitution the issuer of the bond might be seeking. For them, the crux of the matter is that they were misled by the contractor into a contractual arrangement they would not have entered if supplied with the correct information.

For innocent third parties, on the other hand, restitution is easier to envisage because their argument is basically that if the bond is cancelled, they will be financially prejudiced. Therefore, restitution implies that they would be reimbursed for losses arising from the cancellation of the bond.

This matter is still winding up in the Canadian courts. If the court rules that the issuer of the bond cannot cancel it – notwithstanding the contractor supplying misleading and fraudulent information – one can only hypothesise that the insurance companies and banks dominating the bond market will have to overhaul their assessment procedures. At present, the rule that a bond cannot be cancelled once issued is a blanket decree that has hardly been tested. This case will provide important insights regarding the parameters of this principle, and only time will tell.