On October 2, 2020, the Supreme Court of Canada clarified the existence and application of the anti-deprivation rule in Canadian bankruptcy law. In Chandos Construction Ltd. v. Deloitte Restructuring Inc., the Court firmly established that any contractual provision that removes value from a bankrupt’s estate upon an insolvency (or bankruptcy) is unenforceable. In essence, the common law anti-deprivation rule prohibits parties from contracting in a manner that circumvents the operation of bankruptcy laws. The rule aims to prevent unsecured creditors from taking property directly from the bankrupt upon a bankruptcy. Instead, this property must be remitted to the bankrupt’s estate and divided amongst all creditors. The Court’s decision is significant because it provides parties with clear guidance on the enforceability of contractual clauses triggered by insolvency:

• If a provision in a contract is triggered by bankruptcy or insolvency and removes assets from the bankrupt’s estate that would otherwise vest in the trustee, the clause is not enforceable.

• The intentions of the contracting parties and whether the clause had a bona fide commercial purpose is not a relevant consideration to its enforceability.

As a result of this decision, parties are wise to consider taking security, acquiring insurance or requiring a third-party guarantee instead of relying on contractual provisions as protection from risk of counterparty insolvency.

Background. The general contractor on a condominium project, Chandos, subcontracted certain work on the project to Capital Steel. The subcontract agreement between the parties contained a clause that 10% of the subcontract price would be forfeited if the subcontractor became insolvent, bankrupt or ceased operations “as a fee for the inconvenience of completing the work using alternate means and/or for monitoring the work during the warranty period.” The enforceability of the clause took centre stage when Capital Steel filed an assignment in bankruptcy prior to completing the subcontract. When Chandos sought to rely on the clause, Deloitte, as trustee, made a court application for a determination of whether it would offend the common law anti-deprivation rule. The application judge determined the clause was enforceable as a bona fide commercial transaction that was not predominately designed to deprive the subcontractor’s property in bankruptcy. In January 2019, a majority of the Alberta Court of Appeal reversed the application judge’s decision, holding the provision conflicted with the operation of bankruptcy legislation by removing assets that would otherwise form part of the bankrupt’s estate and was unenforceable.

Supreme Court of Canada. A majority of the Supreme Court of Canada upheld the Alberta Court of Appeal’s ruling that the clause was unenforceable for violating the anti-deprivation rule. The Court provided four important insights into the existence and application of the common law anti-deprivation rule:

• Existence of the Anti-Deprivation Rule. The anti-deprivation rule is a long established common law principle. Its origin dates as far back as 1876, and it has never been extinguished by a subsequent decision.

• Co-Existence with Federal Bankruptcy Legislation. The anti-deprivation rule does not contradict federal bankruptcy provisions. Sections 65.1, 66.34, and 84.2 of the Bankruptcy and Insolvency Act all regulate the enforceability of contracts in a bankruptcy; however, they are not intended to be a full codification of the matter. These provisions aim to protect the debtor, whereas the anti-deprivation rule protects unsecured creditors. The Court determined it was not Parliament’s intention to occupy the whole field with these provisions or to eliminate the anti-deprivation rule. The legislation and common law anti-deprivation rule exist simultaneously in Canadian law.

• Effects-Based Test. Having established the existence of the anti-deprivation rule, the Court also confirmed its proper application. The court adopted an effects based test:
  • (1) The relevant clause must be triggered by an event of insolvency or bankruptcy; and
  • (2) The effect of the clause must be to remove value from the insolvent’s estate.

• Scope of the Anti-Deprivation Rule. The Court also provided guidance on the types of clauses that would not violate the anti-deprivation rule. First, the rule would not be violated where property removed from the bankrupt’s estate has no value. Second, it would not be violated where the clause is triggered by some event other than insolvency or bankruptcy. Finally, it would not be triggered if a party sought protection against the risk of counterparty insolvency by taking security, acquiring insurance or requiring a third-party guarantee.

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Please contact your McInnes Cooper lawyer or any member of the Bankruptcy & Insolvency Law Team @ McInnes Cooper to discuss this topic or any other legal issue.

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