Test for application of the rule is effects-based and not purpose-based, majority finds
The anti-deprivation rule is valid under Canadian common law and has not been eliminated, the Supreme Court of Canada found today in dismissing an appeal in a corporate bankruptcy case.
In Chandos Construction Ltd. v. Deloitte Restructuring Inc., the court found that a clause in a construction contract contravened the anti-deprivation rule under the common law of bankruptcy. The clause would have required a steel company to forfeit a percentage of the total contract price to a general contractor in the event that the steel company became insolvent.
“It’s the first time the Supreme Court has considered the anti-deprivation rule,” Darren Bieganek, a partner at Duncan & Craig LLP in Edmonton and counsel for the appellant in the case, told Canadian Lawyer.
“They confirm that it does exist in Canada, it’s a common law rule that hasn’t been ousted, and that the test for its application is effects-based and not purpose-based.”
At common law the court affords a good deal of weight to freedom of contract between parties, and in the absence of bankruptcy this contractual provision to forfeit a percentage of the total contract price would likely have been upheld, says Bieganek.
“However, in the bankruptcy context, that common law interest in affording great weight … as Justice [Suzanne] Côté in dissent noted, to freedom of contract, is effectively displaced in favour of the interest of creditors, where the effect of applying that contractual provision would remove value from the estate.”
In the case under appeal, Chandos Construction Ltd., a general contractor, had entered into a construction subcontract with Capital Steel Inc. for a total value of $1.37 million. A clause in the subcontract provided that Capital Steel had to pay Chandos 10 per cent of the contract value if Capital Steel went bankrupt; so, $137,000. Capital Steel did become insolvent and filed for bankruptcy protection before the subject of the contact could be completed; Deloitte Restructuring was named the trustee in the bankruptcy proceedings.
At the time that Capital Steel declared bankruptcy Chandos owed Capital Steel nearly $150,000. Now responsible for finishing the project, Chandos -- relying on the ordinary common law rules relating to damages for breach of contract and the law of set-off -- argued that it was entitled to set off nearly $23,000, reducing its debt to Capital Steel to $127,000.
Chandos also argued it should be allowed to set off the amount triggered by the bankruptcy according to clause VII Q(d) of its construction subcontract, under which Capital Steel agreed to forfeit 10 per cent of the subcontract price in the event of insolvency. The result would be that instead of a debt owing to Capital Steel, Chandos had $10,000 as a claim provable in bankruptcy proceedings against Deloitte.
In today’s judgment the Supreme Court found that the Alberta Court of Appeal was correct in finding that Chandos could not rely on or invoke the clause in its contract pertaining to the 10-per-cent- forfeiture, as the clause ran afoul of the anti-deprivation rule at common law. The anti-deprivation rule provides that a person cannot make it a part of a contract that, in the event of bankruptcy, he or she is then to get an additional advantage that prevents the property being distributed under bankruptcy laws.
“No decision of this Court has eliminated the anti-deprivation rule,” wrote Justice Malcolm Rowe in his reasons for the majority. “Nor has Parliament eliminated the anti-deprivation rule. As [Alberta’s] Rowbotham J.A. observed, Parliament did not implement ss. 65.1 , 66.34 , or 84.2 of the BIA so as to eliminate the anti-deprivation rule: the anti-deprivation rule protects third party creditors, whereas Parliament’s changes were directed toward protecting debtors. …
The effect of the provision in the subcontract was to create a debt from Capital Steel to Chandos “that would not exist but for the insolvency,” Justice Rowe wrote. “It is this ‘debt’ created by Clause VII Q(d) because of the insolvency that Chandos seeks to ‘set off’ against the amount it owed to Capital Steel. One can hardly imagine a more direct and blatant violation of the anti-deprivation rule.”
“One of the broader implications on contracts generally is that liquidated damages provisions in contracts, particularly in a bankruptcy context, will now be subject to closer scrutiny if one of the triggering events is a bankruptcy,” says Bieganek, or “if liquidated damages are triggered by business failure [which] happens to be a bankruptcy or insolvency, those provisions could equally be affected adversely by this decision.”
In dissenting reasons, Justice Côté agreed that the anti-deprivation rule exists in common law and has not been eliminated; however, she found that the anti-deprivation rule should not apply to contracts or transactions that serve a bona fide commercial purpose, as the Chandos-Capital Steel contract did.
Further, she found that the pari passu rule -- that all unsecured creditors in insolvency processes must share equally any available assets or proceeds from the sale of those assets, in proportion to the debts due to each creditor – “is based on an implied prohibition in the [Bankruptcy and Insolvency Act] that operates regardless of the parties’ intentions, whereas the anti-deprivation rule has its origins in the common law public policy against agreements entered into for an unlawful purpose.”
The clause in the Chandos-Capital Steel subcontract was not for the purpose of “defrauding or otherwise injuring third parties,” Justice Côté found.
“We argued that the purpose test was an appropriate test to apply,” says Bieganek, “and was consistent with decisions previously made. … The dissent agreed with that assessment, and took a view that was consistent with upholding, in the commercial context, the parties’ general right to have their intentions enforced based on the freedom of contract.”
