By Danielle Maksimow and Hansik Ha, Norton Rose Fulbright Canada LLP
On October 2, 2020, the Supreme Court of Canada (the “SCC”) confirmed the existence of the common law anti-deprivation rule in Canada with its majority decision in Chandos Construction Ltd. v Deloitte Restructuring Inc., 2020 SCC 25. The anti-deprivation rule operates to invalidate any contractual provisions that would remove monetary value otherwise available to the creditors from the debtor’s estate in an insolvency or a bankruptcy. This rule is an important common law contract principle, particularly as a mechanism for protecting creditors’ interests in insolvency or bankruptcy proceedings.
The anti-deprivation rule has been a well-established common law contract principle. However, this is the first time the SCC affirmed the rule’s existence and provided a clear guiding framework for its application in Canada.
A general contractor, Chandos Construction Ltd., subcontracted with Capital Steel Inc. for certain steel work. The subcontract contained a provision whereby Capital Steel agreed to forfeit 10 percent of the contract price to Chandos if it became insolvent or bankrupt (the “Clause”). The Clause was intended to compensate Chandos for the cost of seeking alternative means or other subcontractors to complete the work.
Prior to completing its work under the subcontract, Capital Steel filed for an assignment in bankruptcy and Deloitte Restructuring Inc. was appointed as its trustee. Chandos still owed Capital Steel a certain balance for the work completed. Chandos claimed that it was entitled to apply, among others, a forfeiture of 10 percent of the contract price to that balance pursuant to the Clause. Deloitte applied to the Alberta courts seeking direction on the validity of the Clause, which eventually arrived at the SCC on appeal.
The Ruling and the Canadian Approach
In a majority decision, the SCC found that the anti-deprivation rule exists in Canada and has not been struck down by the SCC or by Parliament, notwithstanding the introduction of the federal bankruptcy and insolvency legislation and subsequent amendments thereto. As such, the Clause violated the anti-deprivation rule and was therefore void. The SCC affirmed the principle that contract provisions cannot remove value from the estate of a debtor upon insolvency or bankruptcy. Accordingly, Chandos could not deduct the 10 percent forfeiture from the amount owed to Capital Steel, as this would deprive Capital Steel’s creditors of the amount owed under the contract as a receivable, which would form part of Capital Steel’s value.
According to the SCC, the policy rationale behind this rule is to firmly protect creditors’ interests. The SCC reasoned that contracting parties generally do not negotiate with a view to protect the interest of their creditors. Without protection of the anti-deprivation rule, contracting parties would be encouraged to create certain preferences or advantages over third-party creditors. The anti-deprivation rule works to supplement the federal bankruptcy and insolvency legislation in this regard.
Furthermore, Chandos offers a distinctly Canadian perspective on the common law anti-deprivation rule. Specifically, the SCC declined to follow the Supreme Court of the United Kingdom’s approach, which prefers to prioritize the intention of the contracting parties. Under the United Kingdom’s approach, the anti-deprivation rule does not apply to bona fide commercial transactions where its predominant purpose is not the deprivation of property. By contrast, the SCC’s approach is to exclusively examine the effect of a contractual provision. Under this approach, the anti-deprivation rule applies if the effect of the contract is to remove value from the insolvent debtor’s property, regardless of whether the intention of the parties is commercially reasonable.
The SCC’s approach is designed to prevent contracting parties from giving themselves preference over creditors under the guise of reasonable commercial intentions. It is also a more expedient and efficient approach to administer corporate insolvencies. Determining the intent of the contracting parties, often many years later, is often an arduous and difficult process and thus will create additional commercial uncertainties as the contracting parties cannot know at the time of contracting whether a court will find their contract had been entered into for bona fide commercial reasons. By contrast, examining a contractual provision’s effect provides greater certainty and is less time consuming.
Common law generally places great weight on contractual freedom and the pursuit of individual self-interest. However, the SCC stated that the need for contractual freedom cannot support an intention-based approach to interpreting contracts in the context of insolvencies. The assignment in bankruptcy effectively strips the insolvent party of its interest. Accordingly, a party who might become insolvent has no incentive to resist a clause that deprives its estate of value upon bankruptcy. Parties do not negotiate with a view to protecting their creditors’ interests in the event of their bankruptcy and the costs of accepting such clause become borne solely by the creditors. The SCC considered this a misallocation of risk, and the effect-based approach addresses this issue.
The anti-deprivation rule pre-dates Canadian federal bankruptcy and insolvency legislation and was generally recognized as a common law contract principle. Chandos not only confirmed the rule’s existence, but also provided clear guidance on the enforceability of such contractual provisions upon insolvency. It further provided a glimpse into how the SCC considers it of great importance to protect the rights of creditors in bankruptcy and insolvency processes.
In short, the implications of Chandos are twofold:
- if a contractual provision triggered upon insolvency or bankruptcy removes monetary value from the bankrupt’s estate that would otherwise be available to the creditors, such provision is not enforceable; and
- the intentions of the contracting parties are irrelevant to determining enforceability for such contractual provision.
With Chandos, contracting parties can reliably determine whether certain entitlement provisions will be enforceable in the event of insolvency or bankruptcy. As well, creditors can be assured that third-party contracts which includes such provisions will not unexpectedly detract from their entitlement to the debtor’s estate upon insolvency or bankruptcy.
While certain rights to set-off will still be available to creditors as long as the debt or claim is not solely triggered by an insolvency or a bankruptcy, it will be important for investors to avoid finding false comfort by including otherwise unenforceable entitlement provisions that may offend the anti-deprivation rule. Investors should continue to utilize taking security, acquiring insurance, or requiring a third-party guarantee, as means to protect their interest.