Canada: British Columbia Court Of Appeal Provides Guidance On How The Holdback Obligation Applies To Direct Payment Arrangements

Introduction

Holdback obligations are an integral part of every Builders Lien Act in Western Canada. The holdback is the statutorily mandated percentage of any payment made pursuant to a contract, or of the value of a contract, which the payor must withhold as a fund to satisfy the claims of those further down the construction pyramid. Its purpose is to provide a level of security to subcontractors for the payment of their invoices. Owners are also protected by the holdback. A lien filed against an owner's interest is a charge against the holdback, and the owner is protected from lien enforcement against his proprietary interest to the extent the holdback is properly maintained and not released until permitted by the legislation.

The holdback obligation varies from province to province in such things as percentage that must be withheld (10% in most provinces), for whom the obligation arises, how it arises and when it can be released. In some provinces, it applies solely to owners. In other provinces, it applies to everyone in the construction pyramid who is a payor. It also goes by different names, like "lien fund" in Alberta. Generally, the obligation to maintain a holdback is triggered by, and applies to, every payment made on account of a contract (or subcontract).

Direct Payments to Lower Subcontractors

A question which has received little judicial attention until now is how the holdback obligation of a paying contractor is affected when they skip over their own subcontractor to pay lower subcontractors directly ("Direct Payments"). The Saskatchewan Builders' Lien Act contains a unique provision at section 47(3) which provides that a payment directly to lower subcontractors does not reduce the holdback obligation of the paying contractor. Legislation from other provinces appears to be more or less silent on this question.

In Iberdrola Energy Projects Canada Corporation v. Factory Sales & Engineering Inc. d.b.a. FSE Energy (2018), 2018 BCCA 272, the courts of British Columbia had to address the issue of Direct Payments. The plaintiff, Iberdrola, was the general contractor in the construction of two biomass plants. It had subcontracted with the defendant ("FSE") for the supply and installation of a boiler in both plants (the "FSE Contract"). FSE incurred financial problems and was unable to pay its subcontractors. Iberdrola learned about this issue and sought various methods of injecting funds into the project in order to keep FSE's subcontractors working.

Iberdrola first sought to pay FSE's subcontractors directly through tripartite "Settlement Agreements" with FSE and its subcontractors. It thus acquired the right to set off payments to FSE's subcontractors against amounts that became payable to FSE under the FSE Contract. As the number of unpaid subcontractors grew and making these individual settlement agreements proved to be onerous, Iberdrola entered into "Payment Agreements" with FSE whereby it made payment advances to FSE for the payment of FSE's subcontractors. By far, the bulk of the money paid to FSE's subcontractors was advanced in this way. The payments were made into a jointly controlled bank account, which could only be used to pay FSE's subcontractors. In total, Iberdrola entered into three Payment Agreements. Under the first Payment Agreement, FSE had to provide the subcontractors' invoices to Iberdrola for approval. This step was not required for the later Payment Agreements.

FSE ultimately went into bankruptcy and its subcontractors filed liens. Iberdrola applied to the court to have the liens vacated on payment of the holdback and the other statutory amounts into court. The subcontractors took the position that the holdback amount proposed by Iberdrola was insufficient because it did not include funds that should have been held back from payments under the Settlement Agreements and the Payment Agreements. Iberdrola argued that since these payments were not made pursuant to the FSE Contract per se, the holdback obligation did not apply.

The Supreme Court of British Columbia treated the Settlement Agreements and Payment Agreements as though they were identical. After examining section 4(1)(b) of the Act, which requires a holdback of 10% of "the amount of any payment made on account of the contract or subcontract price," Justice Dley found that the payments were ultimately payments made because of the FSE Contract and the holdback obligation therefore applied.

The sole issue before the Court of Appeal was whether Justice Dley properly interpreted section 4(1)(b) of the Act. Iberdrola argued that since the Builders Lien Act derogates from contractual freedom, it ought to be narrowly interpreted and the holdback obligation should only apply to payments which were required by the FSE Contract when they were made and not to payments made because of other agreements to keep the project moving along. The Court of Appeal noted that the legislation was not so narrowly worded. The Court, therefore, looked beyond the technical question of which agreement legally required the payment and rather sought to determine whether the payments had, in fact, been made "on account of the [FSE Contract] price."

The Court first looked at the Settlement Agreements, which directly payed FSE's subcontractors in exchange for their promise to keep working. Nothing in the FSE Contract obligated Iberdrola to pay FSE's subcontractors directly. The Court, therefore, found that these payments had not been made on account of the FSE Contract price. The holdback obligation did not apply to Iberdrola. The Court rather found that the holdback obligation for these payments applied to FSE, since Iberdrola had made these payments on its behalf. There was therefore a holdback obligation for FSE arising for each payment to FSE's subcontractors – but only for the benefit of those who had provided services or materials for the specific subcontractor to which the payments had been made. Since none of the lien claimants claimed to have worked or provided materials for those subcontractors, they could not claim the benefit of the holdback obligation for these payments, and Iberdrola's holdback obligation was accordingly reduced.

The Court then looked at the payment advances made pursuant to the Payment Agreements. It found that these payments, even though they had been made ahead of schedule, were nevertheless payments made "on account of" the FSE Contract price. This conclusion was easily reached in regards to the first Payment Agreement. However, the second and third Payment Agreements were entered into after it had become apparent that the fixed FSE Contract price had to be increased. They provided that Iberdrola could seek repayment of these advances from FSE. These payments could, therefore, not as easily be classified as payments made on account of the FSE Contract price. They looked a lot more like loans to FSE to get the work done, albeit with little realistic expectation of repayment. The Court got around this problem by interpreting the FSE Contract as having been simultaneously amended by the Payment Agreements. The result was that all the payments made under the Payment Agreements were payments made on account of the FSE Contract price and triggered Iberdrola's holdback obligation.

Conclusion

The key takeaway is that paying subcontractors directly may in some provinces, other than Saskatchewan, be an effective way to reduce one's holdback obligation. However, if the money goes through the payer's own subcontractor, it will likely trigger the holdback provisions.

It remains an open question whether and to what extend the holdback obligation can be reduced through loan agreements. Courts will look beyond the wording of the agreement to the actual facts on the ground. British Columbia Court of Appeal clearly went out of its way to find that the second and third Payment Agreements were not really loans even though they provided for repayment of the advanced funds. To the extent the courts will look to the actual prospects of repayment and other facts on the ground to determine whether a payment is in fact a loan, one cannot be certain how other arrangements which are more clearly worded will be treated. It does appear that loan agreements which provide for repayment through work performed on the project may not be seen as true loan agreements.

As this case illustrates, courts will jealously guard the holdback obligation any way they can and trying to circumvent it will often prove unsuccessful. A construction lawyer should be consulted prior to entering into any Direct Payment arrangements as there could be a number of implications that are not discussed here.

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.