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Protecting or preserving assets during a time of insolvency is a natural temptation of debtors. Some even take a proactive approach and design contractual terms that aim to do much the same should insolvency ever arise in the future. However, when such terms are exercised, they run into possibly infringing the “anti-deprivation” rule.

What is the Anti-Deprivation Rule?

Part of the common law doctrine of “fraud on the bankruptcy law”, the rule renders void any contractual provision that is intended or designed to remove some value from the estate of the bankrupt which would otherwise be available to the insolvency creditors. The reason for doing so is that such clauses violate the public policy of an equitable and fair distribution of assets following a bankruptcy.

The rule applies to both personal and corporate bankruptcies based on principles established in the 1995 decision Canadian Imperial Bank of Commerce v. Bramalea (“CIBC”).

The Leading Anti-Deprivation Case in Ontario

The Ontario Court of Appeal decision in Aircell Communications Inc. v. Bell Mobility Cellular Inc. is the leading decision on this issue.

At issue in the case was a term in an agreement between a dealer in telecommunications products, Bell Mobility (“Bell”), and one of its licensed distributors, Aircell. Aircell owed Bell Mobility roughly $64,000 for equipment purchased under an agreement between the parties. At the same time, Aircell had earned commissions from past sales of products and was owed $189,000. Bell was pushing for payment of the equipment debt before paying the commissions.

Bell learned that Aircell was considering restructuring its struggling business, including seeking out insolvency protection. Bell did not know that Aircell had already instituted a proposal under the Bankruptcy and Insolvency Act. As a result, Bell did not elect to terminate the agreement, as it was entitled to if Aircell commenced bankruptcy proceedings. Instead, it gave notice to Aircell that, pursuant to another clause in the agreement, it was now demanding that the product debt be retired within 30 days or the agreement would be terminated. Aircell was however adjudged a bankrupt before the 30 days expired, meaning during the tenure of the agreement.

The clause in dispute provided that upon the expiry of the agreement, or where Bell terminates the agreement as a result of Aircell’s failure to remedy a default in payment within 30 days after notice of default, all of  Bell’s obligations to pay commissions “shall cease immediately”.  

Bell relied on this clause to withhold payment of commissions to Aircell’s trustee in bankruptcy.  The trustee brought an action to recover the amount by which the commissions owing by Bell exceeded the amounts owing to Bell with respect to the inventory.

The trustee was successful based on the principle that the clause in question, when exercised, commits a fraud on the bankruptcy. The debtor was insolvent at the time of the exercise both in law and in fact. The clause was invalidated because otherwise it would have created a situation in which funds that should have been available to all of Aircell’s creditors would have been withheld.

Anti-Deprivation: What Determines the Validity of a Clause?

In the CIBC case linked above, the offending clause was one that would only be triggered by a bankruptcy. Since the clause was designed to divert value to an unsecured creditor in the event of an insolvency, therefore depriving other creditors of that value, the clause was invalidated. In the Bell case, the clause could be triggered by multiple factors. However, the court found that since one possibility was that it would deprive creditors in the event of a bankruptcy, the clause could not stand:

While the clause at issue in this case is triggered upon termination of the agreement for any number of reasons, and not only upon insolvency or bankruptcy, it was in fact triggered as a consequence of Aircell’s insolvency.  The clause provides a windfall to one of Aircell’s creditors:  Bell.  In the context of an insolvency, the clause is inequitable.  We agree with the trial judge that the principle in CIBC v. Bramalea should be extended to declare the clause unenforceable as against Aircell’s trustee in bankruptcy as contrary to the overriding public policy that requires equitable and fair distribution among a bankrupt’s creditors.

In our next blog, we will look at a recent Supreme Court of Canada decision that weighs in on the test for anti-deprivation.

If you find yourself in a contractual dispute relating to bankruptcy and insolvency, fraud or otherwise, and require legal representation, contact the highly skilled  Toronto litigators at Milosevic Fiske LLP.  Our team of exceptional Toronto business law lawyers provide both proactive contract review and drafting services, as well as skillful representation of clients involved in all types of contractual disputes. We have helped businesses of all sizes across various sectors manage potential pitfalls and address them through litigation where necessary. We are the lawyers other lawyers turn to for complex commercial litigation. Call us at 416-916-1387 or contact us online for a consultation.