In a split decision issued earlier today, the Supreme Court of Canada (SCC) upheld the Alberta Court of Appeal’s majority decision in Chandos Construction Ltd. v. Deloitte Restructuring Inc. in its capacity as Trustee in Bankruptcy of Capital Steel Inc., a bankrupt (Chandos).
The practical effect of today’s decision is that, in the context of insolvency proceedings, certain contractual clauses triggered by a contracting party’s insolvency that remove value from the debtor’s estate are void and will not be given effect by Canadian courts.
As general contractor, Chandos subcontracted a project’s steel work to Capital Steel. The subcontract included a term pursuant to which Capital Steel agreed to forfeit 10 percent of the contract price if it became insolvent “as a fee for the inconvenience of [Chandos] completing the work using alternate means and/or for monitoring the work”, referred to here as the insolvency clause.
Capital Steel completed most of its work under its subcontract with Chandos before making an assignment in bankruptcy. Chandos then had to complete the project’s steel work at its own expense. Deloitte was appointed as Capital Steel’s trustee in bankruptcy. Even after the costs of completion were accounted for, Chandos owed a balance to the estate of Capital Steel; however, Chandos relied on the insolvency clause and took the position that it could deduct 10 percent of the contract price against what it owed. On that basis, Chandos maintained that it owed nothing to Capital Steel. The trustee brought an application seeking a judicial determination of whether the insolvency clause was enforceable.
The lower court decisions
At first instance, the chambers judge ruled in favour of Chandos. He held that the insolvency clause was akin to a liquidated damages clause and was enforceable as part of a bona fide commercial transaction.
The trustee appealed.
A majority of the Court of Appeal held that the insolvency clause violated the “fraud on the bankruptcy law” principle; specifically, the “anti-deprivation rule” which prevents creditors from contracting for the removal of property from a bankruptcy estate to the prejudice of the body of creditors generally.
The dissenting judge at the Court of Appeal wrote lengthy reasons in which he accepted the insolvency clause as being consistent with “freedom of contract” principles. He would have enforced the insolvency clause.
The SCC decision
A majority panel of eight judges who heard the SCC appeal upheld the Alberta Court of Appeal’s decision. It concluded that the insolvency clause was void and therefore unenforceable.
The following determinations were key to the analysis of the SCC majority:
- The anti-deprivation rule continues to exist at common law, even though it is not fully codified in the Bankruptcy and Insolvency Act (BIA);
- The anti-deprivation rule operates by voiding contractual terms that prevent property from passing to the bankruptcy trustee; and
- The anti-deprivation rule is triggered upon satisfaction of a two-part test: (1) the clause must be triggered by an event of insolvency or bankruptcy, and (2) the effect of the clause (irrespective of its purpose) is to remove value from the estate.
The SCC majority characterized the insolvency clause in the subcontract between Chandos and Capital Steel as a “direct and blatant violation of the anti-deprivation rule” – thereby rendering it void.
One SCC judge dissented in lengthy reasons, principally on the basis that the anti-deprivation rule should not apply if a contractual term is serving a bona fide commercial purpose.
The SCC majority decision confirms that contracting parties will not aid themselves by drafting insolvency clause-like terms in their agreements that remove monetary value from the estate upon or because of a counter-party’s insolvency.
With that said, some contracts include clauses that are triggered by a party’s insolvency but do not clearly remove monetary value from the estate; for example, where a party’s insolvency alters responsibility for the operatorship of jointly owned property. This issue was not addressed by the SCC and it remains to be seen whether (or how) today’s decision will apply to such contracts.