Chandos upheld by Supreme Court of Canada: the anti-deprivation rule in Canada

In a split decision issued on October 2, 2020, 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 the Chandos decision is that, if a contracting party enters insolvency proceedings, certain contractual clauses that are triggered by insolvency and remove value from the debtor’s estate are void and will not be given effect by Canadian courts. The SCC rejected the United Kingdom’s more lenient view of the anti-deprivation rule and aligned more closely to the policy underlying the anti-ipso facto clause provisions in the United States Bankruptcy Code. 

Background

Case facts

As general contractor, Chandos subcontracted a project’s steel work to Capital Steel. The subcontract included a term under which Capital Steel agreed to forfeit ten 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” (the Insolvency Clause).

Capital Steel completed most of its work under its subcontract with Chandos before making an assignment in bankruptcy. Deloitte was appointed as trustee of the estate of Capital Steel and Capital Steel ceased operations at that time. As a result, Chandos had to complete the steel work at its own cost. Even after costs of completion were accounted for, Chandos owed a balance to the estate of Capital Steel based on the remaining unpaid contract price. However, Chandos took the position that it could rely on the Insolvency Clause to deduct ten percent of the contract price and that, once deducted, Chandos 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. It was enforceable as part of a bona fide commercial transaction.

The trustee appealed

A majority of the Alberta Court of Appeal held that the Insolvency Clause violated the “anti-deprivation rule,” which prevents parties from agreeing to remove property from a bankrupt’s estate that would otherwise have vested in the trustee for distribution amounts creditors. It invalidates provisions that are “engaged by a debtor’s insolvency and remove value from the debtor’s estate to the prejudice of creditors.”

The Insolvency Clause was also held by the Alberta Court of Appeal majority to constitute an unenforceable “penalty” clause because ten percent of the contract price did not reflect a genuine pre-estimate of Chandos’s damages.

The dissenting judge at the Alberta 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 international context

Courts in the US and the UK had ruled on the “anti-deprivation rule” in the context of the Lehman Brothers bankruptcy before Chandos was heard by the Alberta Court of Appeal. The US Bankruptcy Court and the Supreme Court of the UK came to opposite conclusions about the enforceability of “flip” or ipso facto clauses. In Chandos, the general contractor urged the courts to adopt the UK precedent, which recognized such clauses as enforceable.

The UK Supreme Court held in Belmont Park Investments Pty Ltd. v. BNY Corporate Trustee Services Ltd. that the anti-deprivation rule does not apply to “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.”  The Court adopted a purpose-based test pursuant to which a clause will only be rendered unenforceable by the anti-deprivation rule if it has a predominant or main purpose of depriving the estate in the event of a bankruptcy. The disputed clause in Belmont was recognized as enforceable.

In Lehman Brothers Special Financing Inc. v. BNY Corporate Trustee Services Limited, which ran in parallel to Belmont and dealt with the same agreement, the US Bankruptcy Court made a broad pronouncement about the invalidity of ipso facto clauses under the US Bankruptcy Code. In so doing, the Court applied a statutory effects-based test to arrive at the opposite conclusion to that of the UK Supreme Court.

In Chandos, the majority of two judges from the Alberta Court of Appeal declined to adopt the precedent set by the UK Supreme Court in Belmont on the basis that a purpose-based test was contrary to established Canadian jurisprudence. The majority observed how British legal scholars had questioned whether a purpose-based test would defeat the purpose of the anti-deprivation rule.

The SCC decision

A majority panel of eight judges who heard the SCC appeal upheld the Alberta Court of Appeal majority 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 in Canada, it is not fully codified in the Bankruptcy and Insolvency Act.
• The anti-deprivation rule operates by voiding contractual terms that prevent property from passing to the bankruptcy trustee.
• 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.

In so holding, the SCC, like the Alberta Court of Appeal, did not adopt the precedent set by the UK Supreme Court in Belmont. The SCC majority instead preferred to adopt an effects-based test. Looking at the clause through this lens, the SCC majority concluded that the Insolvency Clause in the subcontract between Chandos and Capital Steel was a “direct and blatant violation of the anti-deprivation rule,” thereby rendering it void.

The SCC majority declined to analyze whether the Insolvency Clause was also unenforceable as a penalty clause.

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.

Implications

The SCC majority decision in Chandos confirms that, in Canada, contracting parties will not aid themselves by drafting terms into their agreements that remove monetary value upon or because of a counter-party’s insolvency. 

With that said, there are contracts whereby contractual rights are altered by one party’s insolvency that 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 how Chandos will apply to such contracts.

In reaching its conclusion, the SCC majority adopted an effects-based analytical approach to the anti-deprivation rule that is substantially aligned with the analytical approach used in the US, but deviates from purpose-based analytical approach used in the UK.