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Last week we visited the primary legal authorities in Ontario on fraud in the event of a bankruptcy, and the anti-deprivation rule. Recently the Supreme Court of Canada (SCC), in Chandos Construction Ltd. v. Deloitte Restructuring Inc., 2020, confirmed the reasoning of those cases.

Did an Insolvency Penalty Clause Contradict the Anti-Deprivation Rule?

A general contractor, Chandos, signed a construction subcontract with Capital Steel, which obligated the latter to pay Chandos 10 percent of their subcontract price as a fee for the extra work and inconvenience in the event Capital Steel went bankrupt. When the subcontractor did file for bankruptcy, it had not yet finished its work under the subcontract. This created extra work and expense for Chandos. It sought to set off those expenses against what it owed to Capital Steel and to further deduct the ten percent as set out in the subcontract.

As a result, the Trustee in bankruptcy sought guidance from the Court as to the validity of the 10% penalty cause. At first instance, the clause was held to be a valid liquidated damages clause. The Alberta Court of Appeal (ABCA) reversed the decision and allowed the appeal. Chandos then sought and was granted leave to appeal to the (SCC).

The court dismissed the appeal by a vote of 8 to 1. At issue was the common law anti-deprivation rule. As discussed last week, its purpose is to prevent any diminishment of the assets available to creditors on a bankruptcy. In this way, it prevents a party from skirting their responsibilities under the Bankruptcy Act. Is this rule a valid one?

The SCC concluded that it was a valid rule and supported the reasoning of the ABCA. The rule was well established in the common law and has not been altered or impacted by any statute or decision of this court. The Court stated:

As this Court has repeatedly observed, Parliament is presumed to intend not to change the existing common law unless it does so clearly and unambiguously.

S. 71 of the Bankruptcy and Insolvency Act

The SCC held that the most relevant section of the Bankruptcy and Insolvency Act was section 71. This section provides for the vesting of title to the assets of the bankrupt in the trustee upon making an assignment. This is done to ensure that all the property of the bankrupt is available for distribution to the creditors in accordance with the priorities set out in the Act.

The anti-deprivation rule renders void contractual provisions that would prevent any property from passing to the trustee, thus frustrating s. 71. This in turn maximizes the assets that are available for the trustee to pass on to creditors.

Test is Based on the Effect of a Clause, Rather Than the Purpose: SCC

This test that determines whether the rule is invoked is a two-part, effects-based, test, set out as follows:

  1. the relevant clause must be triggered by an event of insolvency or bankruptcy; and 
  2. the effect of the clause must be to remove value from the insolvent estate.

In the case at hand, Chandos argued that the test should be purpose-based instead of effects-based. Presumably, if the purpose of the clause was a reasonable one that would then allow the penalty clause to operate. The SCC did not accept this argument, finding that such a change would create more confusion and difficulty. 

The SCC did recognize that there are some clauses that may escape the rule. For example, in an instance where the clause eliminates property but no value is lost then the rule may not apply. Another example would be an instance in which such clauses are triggered by some event other than one of insolvency or bankruptcy.

Thirdly, and most importantly, the SCC told us that the anti-deprivation rule is not offended when commercial parties protect themselves against a contracting counterparty’s insolvency by taking security, acquiring insurance, or requiring a third-party guarantee. This clearly was a hint thrown by the Court on how to solve Chandos’s problem and the worry of other such contractors.

Set-Off Claims

The set-off claim was allowed as it was called for in the Act. The set-off provisions and the anti-deprivation rule can live together. Set-off allows for the deduction of debts owed by the bankrupt at the time of their bankruptcy. The rule makes any deprivations triggered by insolvency unenforceable. 

In sum, the Court of Appeal was correct to consider whether the effect of the contractual provision was to deprive the estate of assets upon bankruptcy rather than whether the intention of the contracting parties was commercially reasonable.

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.