In its most recent decision, Chandos Construction Ltd v Deloitte Restructuring Inc.1, the Supreme Court of Canada (the "SCC") reaffirmed the existence of the common law anti-deprivation rule in Canada. The anti-deprivation rule provides that a contractual provision is void if it removes an asset upon insolvency that would otherwise be available for the bankrupt's creditors. This case sheds light on important aspects of the enforceability of certain contract provisions in an insolvency context and confirms that contract provisions that have the effect of depriving the insolvent debtor's estate of value are unenforceable.
Chandos Construction Ltd. ("Chandos"), a general construction contractor, entered into a construction contract ("Subcontract") with Capital Steel Inc. ("Capital Steel"), a subcontractor. The Subcontract contained a provision that entitled Chandos to 10% of the contract price in the event of Capital Steel's bankruptcy. Pursuant to the Subcontract, this sum would be forfeited "as a fee for the inconvenience of completing the work using alternative means and/or for monitoring the work during the warranty period" (the "Insolvency Clause").
Prior to completing its obligations under the Subcontract, Capital Steel filed an assignment in bankruptcy. At that date of bankruptcy, Chandos owed Capital Steel $149,618.39 under the Subcontract. Chandos argued that the cost of completing the work should be set-off against what it owed since Chandos completed the balance of the work at its own expense. Chandos also argued that it was owed 10% of the contract price based on the Insolvency Clause and that this amount should also be set-off against the amount Chandos owed to Capital Steel. If valid and enforceable, the Insolvency Clause would result in Chandos no longer owing any amounts to Capital Steel and in Chandos instead having a claim against the Capital Steel estate for approximately $10,000.
Deloitte Restructuring Inc., trustee in bankruptcy for Capital Steel (the "Trustee"), applied to the Court for advice and directions on whether the Insolvency Clause was valid and enforceable. The application judge found the provision to be valid on the basis that the Insolvency Clause validly imposed a liquidated damages claim and did not operate to avoid the effect of bankruptcy laws.2 The Alberta Court of Appeal reversed the decision, finding the Insolvency Clause to be invalid based on the common law anti-deprivation rule.3
On final appeal, the SCC distilled the legal issues of this case into three parts:
- whether the anti-deprivation rule exists at common law;
- the content of the anti-deprivation rule; and
- the effect of set-off on the application of the anti-deprivation rule.
Does the anti-deprivation rule exist at common law?
The SCC reaffirmed the Alberta Court of Appeal decision and found that the anti-deprivation rule exists at common law and had not been eliminated by the SCC or by Parliament, despite statutory changes in Federal bankruptcy legislation. The anti-deprivation rule was found to exist since before the existence of federal bankruptcy legislation and the SCC determined that no decision it made or act of Parliament, including any changes to the Bankruptcy and Insolvency Act R.S.C., 1985, c.B-3 ("BIA"), ousted the anti-deprivation rule.
What is the content of the anti-deprivation rule?
The SCC clarified that the anti-deprivation rule is to be applied using an effects-based test. The test for invalidating a contractual provision based on this rule has two parts: (a) the relevant contractual provision must be triggered by an event of insolvency or bankruptcy; and (b) the effect of the provision must be to remove value from the insolvent's estate.
Chandos argued that rather than an effects based approach, the Court should adopt a purpose-based test as was applied in the U.K. in Belmont Park.4 In that case, the U.K. Supreme Court concluded that the English anti-deprivation rule does not apply to "bona fide commercial transactions which do not have as their predominant purpose.the deprivation of the property of one of the parties on bankruptcy."5
The SCC explicitly rejected the purpose-based test applied in Belmont Park, which would have required an inquiry into the intentions of the parties at the time they entered into the contract. Such a test would detract from the efficient administration of corporate bankruptcies, since courts would have to determine (sometimes years after the fact) whether the parties had entered into an agreement for bona fide commercial reasons. Moreover, an intention-based test would encourage parties to pretend to have bona fide intentions and would render the rule ineffectual except in the most extreme circumstances. The SCC also rejected the principles of contractual freedom to support an intention-based test finding that parties don't negotiate with a view to protecting their creditors in an insolvency. The effects-based test simply requires that the effect of the provision be a deprivation of the bankrupt estate.
What is the effect of set-off on the application of the anti-deprivation rule?
The SCC also addressed the impact of set-off on the application of the anti-deprivation rule. Set-off allows a creditor who is also a debtor to recover ahead of their priority i.e. by reducing the amount it owes to the bankrupt by the amount it is owed by the bankrupt. The SCC noted that set-off was noted as not incompatible with the anti-deprivation rule. It found that, while set-off had the impact of reducing the value of assets that are transferred to the Trustee for distribution to the bankrupt's creditors, it is applicable only to enforceable debts or claims. In contrast, the anti-deprivation rule makes deprivations triggered by insolvency invalid. As a result, set-off is applicable as a defence to debts owed by bankrupt as long as the debt is not triggered by the bankruptcy itself.
Applying the anti-deprivation rule to the Insolvency Clause, the majority at the SCC held that the clause had the effect of depriving and prejudicing Capital Steel's creditors, and was invalid and unenforceable and therefore could not be set-off against the amount that Chandos owed Capital Steel.
The policy goal behind the anti-deprivation rule is necessary: parties should not be able to opt-out of bankruptcy laws that govern the distribution of the debtor's estate. A clause that has the effect of allowing a party to alter the scheme of distribution directly undermines the purpose of bankruptcy legislation and the foundational rule that unsecured creditors rank pari passu.
Parties entering into commercial contracts should be careful in drafting clauses that are triggered on the insolvency of the counterparty and have the effect of removing value from the insolvent estate that would otherwise have vested in the trustee on bankruptcy. To maintain the integrity of the scheme of distribution outlined in bankruptcy laws, such provisions, if scrutinized, will likely be found to be invalid and unenforceable. The intentions of the parties at the time of contracting are not relevant. Given the clear guidance from the SCC, trustees are likely to be looking more closely at claims and the underlying basis for set-off defences to ensure that the contractual provisions supporting the claims or set-off do not violate the anti-deprivation rule.
1. 2020 SCC 25 Chandos v Deloitte..
2. Alta. Q.B., Edmonton, 242169632, 17 March 2017.
3. 2019 ABCA 32, 438 D.L.R (4th) 195.
4. Belmont Park Investments Pty Ltd v BNY Corporate Trustee Services Ltd, 2011. UKSC 38 Belmont Park..
5. Ibid at para 104.
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.