Managing Long-Tail Risk: Latent Defects, The Limitations Of Warranties, And Protecting Against Insolvent And Bankrupt Counterparties

Latent defects are hidden within the fabric of a building. As such, they are often discovered well after construction is complete and sometimes expensive to fix. Allocating the risks for latent defects is accordingly a key consideration for effective warranties. Owners want protection from unexpected repair bills for defective work completed years earlier and those who provided the warranty want certainty about when their repair obligations and liability end. An effective warranty balances these competing interests.

A generic clause warranting workmanship and materials for one or two years from substantial completion or another agreed milestone will not, on its own, cap the warranty provider’s liability for latent defects at the expiry of that period.¹ Courts have consistently held that clear and specific language is required to exclude a warranty provider’s liability for latent defects, and that exclusionary clauses will be scrutinized closely.²

Equally important, a warranty is only as good as the warranty provider’s ability and willingness to honour it. If the provider becomes insolvent or bankrupt, the beneficiary of the warranty is left with no practical means of enforcing it.

Managing such long-tail risks has become increasingly important to consider in today’s challenging financial climate where numerous construction companies continue to face insolvency and bankruptcy proceedings.

In what follows, we provide guidance on how to manage (i) liability for latent defects through warranties; and (ii) the risk of a warranty provider becoming unable to respond.

A) Don’t Mistake Expiry of a Warranty Period for Protection Against Latent Defects

Courts have defined a latent defect as one that an ordinary purchaser would not be expected to uncover in a routine inspection by ordinary vigilance.³ It could be cracks in concrete foundations or fractures in the underground sewer lines that remain hidden until they manifest themselves or are revealed by some intervening event.⁴ For a warranty provider, latent defects are a classic example of long-tail risks, as there will invariably be unexpected claims when defects emerge years after the work is completed and parties have moved on.

One important distinction must be made upfront – a warranty obligation to ensure the quality of work and services is interrelated with, but distinct from, an obligation to remedy defects.⁵ This distinction is essential to understanding the courts’ approach to liability for latent defects.

In a standard clause warranting the quality of work and materials for a fixed number of years, only the obligation to remedy defects at the warrantor’s sole cost is tied to the warranty period. Without language expressly limiting available remedies or excluding other sources of liability, the warranty period alone will not cap the warranty provider’s exposure for other risks such as, (i) damages arising from or related to the defective work identified in the warranty period; and (ii) defects that have not yet manifested and may survive the warranty period, whether that liability is contractual, statutory or tortious in nature.⁶

B) Excluding Liability for Latent Defects in Contract and Tort: A Tale of Two Standards

Depending on the nature and severity of the defect, liability may arise in contract, for breach of express or implied terms, and/or in tort, for negligent and dangerous construction.

A defect in workmanship in work found not to have been constructed in accordance with drawings and specifications could amount to a breach of an express term of the contract and also a breach of an implied contractual duty if the work was not performed with the skill and care of a reasonably competent contractor. Tort liability for negligent construction, on the other hand, can arise where the defect creates a real and substantial danger to health and safety (whether imminent or not)⁷ or where the defect causes actual property damage or injury.

Contractual liability for latent defects that emerge outside the warranty period may be excluded. Courts have provided clear directions that very specific and unambiguous language to that effect is required.⁸ A clause that merely limits the contractor’s liability to correction of defects appearing within one year of substantial completion likely falls short of effective protection for latent defects discovered after the expiry of the warranty period. Courts have found that such clauses leave the management of defects discovered after the warranty period expires unresolved.⁹ Instead, courts look for language that unequivocally establishes the written fixed-term warranty as the sole and exclusive remedy – one that expressly references and captures latent defects even where they do not manifest until well after completion.¹⁰

Tort liability may be managed in the same way, but the waiver for such liability must be made explicit.¹¹ Courts have ruled that a blanket exclusion clause – even one barring all “representations, warranties, guarantees, promises or agreements other than those set out in [the contract]” – is insufficient to exclude tort liability, as it arises independently of contractual duty.¹²

Courts generally give parties considerable latitude to negotiate and tailor the components of a construction warranty, including the scope of workmanship and materials covered, available remedies, notice procedures, and the warranty period. However, excluding warranties implied by law or statutory conditions attracts closer, case-by-case scrutiny. For example, a generic clause purporting to be the only warranty made “in lieu of all other warranties express or implied and of all other obligations and liability” is insufficient to displace the implied warranty that premises will be fit for habitation and completed in a workmanlike manner.¹³ More precise language excluding the specific obligation, particularly where the obligation is one that parties would generally expect to apply, would be required. Where it is not unconscionable or contrary to public policy¹⁴, courts have upheld clauses that exclude a defined set of implied warranties as valid and enforceable.¹⁵

C) Protecting Against an Insolvent or Bankrupt Warranty Provider

However strong a warranty may be on paper, it is only as good as the warranty provider’s ability and willingness to honour the obligation. Experience in the construction industry consistently shows that such a circumstance cannot be taken for granted.

When a warranty provider becomes insolvent or bankrupt, and thereby unable to fulfill their obligation to remedy defects, the beneficiary of the warranty is left with a contractual claim. In most cases, that claim will be converted into an unsecured damages claim ranking behind preferred and secured creditors, yielding little to no practical recovery. This reality exposes the inherent limits of contractual warranties and underscores the importance of considering protections that remain effective notwithstanding the warranty provider’s inability to perform.

Upstream parties like owners and/or general contractors commonly rely on four types of insolvency‑resistant instruments to supplement and strengthen their contractual warranties. Each instrument operates independently of the warranty provider’s performance or financial position and can provide a source of recovery when a warranty is no longer effective in practice.

(1) Warranty or Maintenance Bond

A warranty or maintenance bond is a surety-backed instrument that gives the owner a creditworthy third party to turn to for remediation of defects emerging during the warranty period. When called upon, the surety steps into the shoes of the insolvent warranty provider to fund or procure remediation. The bond is calibrated specifically to the post-completion period and is distinct from a performance bond in both size and coverage period. It may be structured as (i) a standalone instrument, (ii) an express warranty-period extension endorsed onto a performance bond, or (iii) combined with a performance bond under one instrument. In light of the relatively recent decision in Re Earth Boring Co. Ltd., where calls against performance bonds were stayed as part of an initial order under the Companies’ Creditors Arrangement Act, the prudent approach may be to negotiate a warranty or maintenance bond as a separate deliverable at contract execution, with a term matching the warranty period and insolvency named as an explicit trigger.

(2) Irrevocable Standby Letter of Credit

An irrevocable standby letter of credit (LoC) is a direct obligation of the issuing bank. The insolvency of the warranty provider does not impair the beneficiary’s ability to draw on it. Because a letter of credit has a fixed expiry date, careful structuring is required to preserve its effectiveness throughout the warranty period. Owners or general contractors typically negotiate an auto-renewal or evergreen clause aligning the letter of credit’s term with the warranty period, and also a tail period of 30 to 60 days providing sufficient operational runway to act on a defect discovered close to the instrument’s expiry.

(3) Latent Defect Insurance

Latent defect insurance can be placed on major projects for a defined coverage period that aligns with or outlasts the contractual warranty period. Like an LoC, this instrument is a direct obligation of a creditworthy third party, the insurer, and is entirely independent of the warranty provider’s financial position. The insurance policy is typically placed in the name of the owner and/or the building and runs with the property.

(4) Contractual Warranty Holdback in Escrow

Construction contracts increasingly provide for contractual holdbacks tied specifically to warranty performance and to be released at the end of the warranty period upon confirmation that no outstanding defects remain. The contractual holdback must be treated as legally distinct from the statutory holdback, with separate documentation and release conditions. To prevent it from being characterized as a deferred payment of the contract price (i.e., statutory holdback), and therefore captured as a receivable of the bankrupt estate, the holdback should be placed in a third-party escrow account at contract execution, with the escrow agreement expressly stating that the funds are held for warranty remediation purposes and are not available to the contractor’s creditors.

(5) Final Considerations

The structure of the construction pyramid – with the general contractor sitting between the owner and the trades – creates complexity as to who holds the warranty and who bears the insolvency risks. Whether the arrangement involves: (i) direct warranty from suppliers and manufacturers, (ii) back-to-back warranty requiring the general contractor to step in when a trade becomes insolvent, or (iii) hybrid warranty with assignment of downstream warranties as security against upstream default, the owner inevitably bears some degree of insolvency risk when one or both levels of the contracting chain become insolvent. No contractual arrangement fully eliminates that exposure. In an industry where insolvency risk is an ever-present reality, prudent owners should pair their contractual warranties with independent, third‑party–backed security that remains practically enforceable regardless of the warranty provider’s insolvency.

Footnotes

1. Phillip J Scheibel, “Understanding Construction Warranties in Canada“, 2015 J Can C Construction Law 137 at 6.3 Callback Remedy and also 5.1 Overview.

2. Carleton Condominium Corp No 21 v. Minto Construction Ltd, 2001 CarswellOnt 4558 at paras 223-230, aff’d 2004 CarswellOnt 583 (CA) [Minto]. Winnipeg Condominium Corporation No. 36 v. Bird Construction Co., 1995 CanLII 146 (SCC) at para 47 [Bird]; see also Coglon v. Ergas, 2009 BCSC 1170 at para 155 [Coglon].

3. Scheibel, supra note 1 at 6.3 Callback Remedy.

4. Kingspan Insulated Panels Ltd. v. Brantford (City), 2010 ONSC 4610 at para 56; Costa v. Wimalasekera, 2012 CarswellOnt 13889 at para 21.

5. Scheibel, supra note 1 at 6.3 Callback Remedy.

6. Ibid; Minto at paras 225-226; see also Dominion Chain Co. Ltd. v. Eastern Construction Co. Ltd. et al., 1974 CanLII 648 (ON SC) at para 40.

7. Bird at para 21.

8. Minto at paras 223-230: the warranty clause seeking to limit a developer’s liability to defects becoming apparent within one year from registration of the condo declaration was found to be unenforceable because it was capable of more than one interpretation .

9. Simpsons Ltd. v. Pigott Construction Co. Ltd., 1973 CanLII 626 (ON CA) at paras 6, 11-12; see also Vanir Construction Services Ltd. v. Field Aviation Co., 1988 CanLII 3845 (AB KB) at paras 80, 84-85. Where the contractual warranty clause stipulates that the contractor is only liable to correct defects that appeared within one year after substantial completion, and nothing more, courts have held that such wording was not adequate or clear enough to absolve the contractor of liability for defects discovered outside the warranty period

10. Minto at paras 227-229.

11. We would, however, note that excluding tort liability for dangerous defects may be more challenging as exclusions relating to such liability start to bump up against overriding public policy concerns.

12. Coglon at paras 154-156; see also BG Checo International Ltd. v. British Columbia Hydro and Power Authority, 1993 CanLII 145 (SCC) at para 21.

13. Carleton Condominium Corp. No. 11 v. Shenkman Corp., 1985 CanLII 2056 (ON SC) at paras 24-26 [Carleton No.11]; Carleton Condominium Corp. No. 97 v. Coscan Development Corp., 1996 CarswellOnt 3282 at paras 28-29.

14. Earthco Soil Mixtures Inc. v. Pine Valley Enterprises Inc., 2024 SCC 20 at para 71.

15. York Condominium Corp. No. 76 v. Rose Park Wellesley Investments Ltd. et al., 1984 CanLII 1865 (ON SC) at paras 44-47, 49; Gulf Helicopters Ltd. v. Bell Helicopter Textron Canada Ltd., 2005 CanLII 10542 (ON SC) at paras 27-29; Although not a consideration generally in play with commercial construction contracts, courts scrutinize exclusionary clauses more closely where one party is in a weaker bargaining position (Carleton No.11 at para 25).