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Contractual Terms and Insolvency: The Supreme Court Reviews the Anti-Deprivation Rule

24-Jan-20

By Christopher Green

One of the primary goals of insolvency law is to ensure fair distribution among creditors. In order to fulfill the goal, the law restricts certain contractual provisions that trigger upon insolvency (known as ipso facto clauses). One of these restrictions is the anti-deprivation rule, which holds that ipso facto clauses that deprive the debtor’s creditors of assets they are entitled to in insolvency are void.

This week, the Supreme Court of Canada heard the appeal of Chandos to determine whether the anti-deprivation rule is still applicable in Canadian common-law and, if it is applicable, how the courts ought to apply it.[1] In this article, we will review the decision and discuss its commercial implications.

Background

Chandos was the general contractor for a condominium project and subcontracted Capital Steel to provide $1.3 million worth of steel work. In the subcontract, Capital Steel agreed that if it entered into insolvency, Chandos was entitled to all costs arising from the suspension of the contract and it would forfeit 10% of the total subcontract price “as a fee for the inconvenience”.[2]

Capital Steel performed most of its obligations, however it filed for an assignment into bankruptcy before full performance of the contract. As a result, Chandos was forced to complete the remaining work at an estimated cost of $22,800. Up until that point, Chandos owed Capital Steel $149,618 in outstanding invoices for the work it had performed.

At the bankruptcy proceedings, Chandos relied on the contract to argue it was entitled to deduct its costs of completing the work plus 10% of the total subcontract price from the balance owing. Given the price of the subcontract, the 10% deduction eliminated Chandos outstanding balance owing and awarded them a $10,511 claim in future bankruptcy proceedings. Subsequently, the trustee brought an application to render the clause in the contract void pursuant to the anti-deprivation rule in common-law.

When addressing the anti-deprivation rule, the chambers judge cited a rule from the United Kingdom case Belmont which found the anti-deprivation rule does not apply in "bona fide commercial transactions which do not have as their predominant purpose, or one of their main purposes, the deprivation of the property of one of the parties on bankruptcy".[3] Finding the contract had a bona fide commercial purpose and was not intended to merely avoid insolvency consequences, the chambers judge refused the application and found Chandos could enforce the clause.

Decision from the Alberta Court of Appeal

On appeal, Justice Rowbotham held on behalf of the majority that the purpose based test from Belmont was inconsistent with Canada’s interpretation of the anti-deprivation rule and overturned the decision. The anti-deprivation rule is meant to protect creditors’ entitlements within insolvency law; it would be inequitable to creditors if parties could contract out of the bankruptcy scheme. Using the purpose based approach in Belmont, creditors may still be deprived of their entitlement to fair distribution on account of a contractual agreement. As such, an effects based approach is more appropriate for determining whether an ipso facto clause offends the anti-deprivation rule.

The court held the appropriate test to determine an ipso facto clauses’ validity is whether it would “remove value from a bankrupt’s estate to the prejudice of the bankrupt’s creditors”.[4]

Applying this test to the circumstances, Justice Rowbotham found the contract effectively allowed Chandos to avoid paying the outstanding balance owed to Capital Steel and prejudiced the creditors' entitlements. The clause in the contract was then void in accordance with the anti-deprivation rule.

Wakelings’ Dissent

In a lengthy dissent, Justice Wakeling found that the anti-deprivation rule “is not now and likely never has been part of the common law of Canada”. [5] He first noted that there was no Canadian case-law that directly addresses the anti-deprivation rule in detail. Further, he stated that any common-law rule preventing ipso facto clauses from being enforced was removed from Canadian common-law after Parliament made amendments expressly prohibiting ipso facto clauses within insolvency legislation.

In the alternative, if there was an anti-deprivation rule in Canadian common-law, the clause did not offend it. The appropriate test for determining whether a contract provision offended the anti-deprivation rule was the Belmont test the chambers judge relied upon; the court should determine whether an ipso facto term is enforceable if its primary purpose is the advancement of a reasonable and defensible commercial purpose.

Analysis

The SCC’s decision will be significant for both creditors and contractors, since the differing opinions weigh freedom of contract against fair distribution for creditors. If the SCC rules with the majority from the Alberta Court of Appeal, it will be virtually impossible for contractors to enforce terms that oust a creditors' entitlement to an insolvent debtors assets. Conversely, if the SCC sides with Justice Wakeling, the anti-deprivation rule will either be non-existent or significantly weakened under the purpose based test. This will impact creditors ability to rely on the insolvency system during corporate bankruptcies and undermine one of the key purposes of insolvency law.

No matter the outcome, this decision will be an important development in Canadian insolvency law.

McLennan Ross LLP has years of experience in insolvency proceedings and is confident in representing clients with insolvency issues. Please do not hesitate to contact our office if you have any insolvency concerns.

 

[1]Captial Steel Inc v. Chandos Construction Ltd., 2019 ABCA 32

[2]Chandos at para 148

[3]Belmont Park Investments Pty Ltd. v. BNY Corporate Trustee Services Ltd. (2011), [2011] UKSC 38 see Chandos at para 46

[4]Chandos at para 52

[5]Chandos at para 116

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