The Anti-Deprivation Rule in Canadian Common Law

An analysis of the Canadian case "Chandos Construction Ltd. v. Deloitte Restructuring" which should be of interest to U.S. and other global commercial actors who plan to do business in Canada and need to structure their transactions and contracts in accordance with what is now the new law of the land.

Reprinted with permission from the December 14, 2020 edition of the New York Law Journal© 2020 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com. 

In a recent 8-1 decision, the Supreme Court of Canada upheld a majority court of appeal decision and invalidated a semi-ipso facto clause providing that a company’s bankruptcy filing triggers a payment of 10% of the contract price to its counterparty. See Chandos Construction Ltd. v. Deloitte Restructuring, 2020 SCC 25 (Oct. 2, 2020). Resolving an unsettled issue, the Supreme Court of Canada found that the clause violated the Canadian common law “anti-deprivation rule,” which the court held renders void any provision in an agreement which provides that upon bankruptcy, value is to be removed from the reach of creditors and handed to others parties. What does this mean for U.S. and other global commercial actors doing business in Canada? 

The Facts

Chandos, a general construction contractor, entered into an agreement with Capital Steel, as a subcontractor, to perform certain structural steel work on a condominium project in Alberta, Canada. The contract contained a clause (referred to hereinafter as the “Insolvency Clause”) enumerating four consequences to be triggered in the event Capital Steel files for bankruptcy or takes certain insolvency-related actions: (1) the contract will be “suspended,” (2) Capital Steel shall bear the costs of such suspension, (3) Chandos could withhold certain funds from Capital Steel until the applicable warranty and guarantee periods run out, and (4) Capital Steel will pay Chandos 10% of the contract price, which amounted to about CAD$137,000.

Before completing its contract with Chandos, Capital Steel filed an “assignment in bankruptcy,” which is a voluntary bankruptcy assignment by a debtor to a trustee under the Canadian Bankruptcy and Insolvency Act (or BIA). Deloitte Restructuring was appointed as the Trustee. At the time of the filing, Chandos owed Capital Steel CAD$149,618 under the contract, and argued that it was entitled to setoff the costs it had incurred to complete Capital Steel’s work. Chandos further argued that it was entitled to setoff the amount triggered by the bankruptcy in accordance with the Insolvency Clause, under which Capital Steel forfeits 10% of the contract price in the event of insolvency.

Faced with these arguments, the Trustee applied for advice and directions from the Court of Queen’s Bench as to whether the Insolvency Clause was valid in light of the Canadian common law “anti-deprivation rule.”

Insolvency Clause Upheld

Under Canadian common law, the “anti-deprivation rule” renders void contractual provisions that, upon insolvency, remove value that would otherwise have been available to the bankrupt’s creditors. In other words, this rule prevents parties from agreeing to remove property from a bankrupt’s estate that would otherwise vest in the trustee. Here, the Court of Queen’s Bench found the Insolvency Clause to be valid, concluding that, so long as the provision was not an attempt to circumvent bankruptcy law, the “anti-deprivation rule” does not prevent contracting parties from agreeing that upon the insolvency of one party, the other party can make a liquidated damages claim. The court found that Chandos had not attempted to circumvent bankruptcy law, and that the Insolvency Clause was a valid liquidated damages clause, not an invalid penalty clause.

Alberta Court of Appeal Reverses

On appeal, the majority of the Court of Appeal reversed the lower court’s decision, holding that the Insolvency Clause was invalid. The court identified the long history of the anti-deprivation rule in Canadian jurisprudence, and found that the rule has not been eliminated by either subsequent decisions or by statutory amendments. In an interesting comparative common law exercise, the court determined that Canadian jurisprudence controls the construction of the anti-deprivation rule and declined to adopt the approach taken by the United Kingdom Supreme Court, which concluded 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.” This purpose-based test, the Court of Appeal found, was contrary to the effects-based test applied by Canadian courts.

The court noted that the British approach should be denied for the additional reason that an insolvent party has no incentive to challenge a clause that directs property out of its estate upon insolvency, since it will no longer have an interest in that property; a view that seems somewhat perplexing and unusual in the context of U.S. reorganizations. In sum, analyzing the common law anti-deprivation rule through effects-based lens, the Court of Appeal concluded that since the Insolvency Clause is triggered upon insolvency and aims to remove value from the debtor’s estate to the detriment of creditors, it is invalid.

Canadian Supreme Court Upholds Rule

The Canadian Supreme Court agreed with the Court of Appeal’s conclusion that the Canadian common law anti-deprivation rule has not been eliminated by either subsequent decisions or by statutory amendments. The court explained that the anti-deprivation rule renders void contractual provisions that would prevent property from passing to the trustee, thereby frustrating Canadian bankruptcy law. By doing so, the court noted, the rule maximizes the assets that are available for distribution to creditors.

The court held that the test under the anti-deprivation rule is “effects based,” and rejected the English (and the dissenting justice’s) view applying the purpose-based test. The court emphasized that “[w]hat should be considered is whether the effect of the contractual provision was to deprive the estate of assets upon bankruptcy, not whether the intention of the contracting parties was commercially reasonable.” To hold otherwise, the court explained, would impair commercial certainty because it would “require courts to determine the intention of contracting parties long after the fact and it would detract from the efficient administration of corporate bankruptcies.”

Under the effects-based test, the anti-deprivation inquiry is two-pronged: first, the court has to determine whether or not the relevant clause is triggered by an event of insolvency or bankruptcy. Second, the court must decide whether the effect (not the intention) of the clause is to remove value from the estate. If the answer to both inquiries is “yes,” the clause should be invalidated. Here, since the Insolvency Clause was triggered by a bankruptcy filing and removed value from the trustee, it was rendered void. The court similarly denied Chandos’ argument that it was entitled to setoff, explaining that while “set-off and the anti-deprivation rule are not incompatible,” setoff is impermissible where the underlying debt “would not exist but for the insolvency.”

Artful Drafting

Yet, even though the court favored an effects-based approach, it left room for artful drafting. It noted, for example, that contractual provisions that eliminate property from the estate, but do not eliminate value, “may not offend the anti-deprivation rule.” The court also made clear that the anti-deprivation rule is not offended when commercial parties protect themselves against a contracting counterparty’s insolvency by taking security, acquiring insurance, or requiring a third-party guarantee. And provisions that are triggered by events other than bankruptcy survive the anti-deprivation rule. Here, the court noted, whether the Insolvency Clause would have been enforceable if Capital Steel had stopped operations in other circumstances was “not before us and not relevant here.”

Implications

The Supreme Court of Canada has spoken clearly and determined unequivocally that under Canadian common law, the anti-deprivation rule is not a creature of the past. The opinion resolves an unsettled issue and provides needed guidance as to the scope and application of the anti-deprivation rule. It provides a roadmap for commercial actors engaging in activities subject to the jurisdiction of Canadian courts. Drafters should start by asking themselves two basic questions: (1) is the relevant clause triggered by an event of insolvency or bankruptcy and (2) is the effect of the clause to remove value from the (future) estate.

But this two-pronged test remains multi-dimensional. While holding that the anti-deprivation rule voids contract provisions which clearly seek to remove value from the estate upon an unquestionable “bankruptcy event,” the court acknowledged several commercial nuances. The opinion invited sophisticated contract design that provides valuable protection but avoids the anti-deprivation pitfalls. For example, the court made clear that its decision does not necessarily apply to insolvency-related events less distinct than an actual bankruptcy filing.

U.S. and other global commercial actors who plan to do business in Canada should structure their transactions and contracts in accordance with what is now the law of the land. When crafting contractual protections, drafters should be vigilant and consider whether their event-triggered clauses are likely to survive an anti-deprivation attack. Moreover, among the possibilities available to parties transacting in Canada notwithstanding the anti-deprivation rule are taking security, acquiring insurance, or requiring a third-party guarantee, as well as drafting provisions that remove property but not value from the (future) estate. That said, it remains to be seen which contractual provisions qualify as ones that eliminate property but not value in the context of the Canadian anti-deprivation rule.

Read the opinion >>