Written by Scott Bower, Preet Bell, Russell Kruger and Emmett Larsen
The common law anti-deprivation rule is alive and well in Canada, the Supreme Court of Canada held in an 8-1 decision in Chandos Construction Ltd. v Deloitte Restructuring Inc., 2020 SCC 25 [Chandos]. Under the rule, parties cannot enforce contractual provisions, triggered on the insolvency or bankruptcy of a party, which purport to remove value that would otherwise be available to that party's creditors.
On the facts of Chandos, the Supreme Court refused to uphold a contractual provision stipulating, among other things, that the subcontractor Capital Steel forfeit 10 percent of the contract price if Capital Steel became insolvent or bankrupt. Capital Steel did eventually become bankrupt, and its assets vested in Deloitte Restructuring Inc. as trustee for distribution to creditors. Deloitte turned to the courts to determine the validity of the clause.
The Supreme Court found the clause violated the common law anti-deprivation rule. The rule prevents any value from being removed from the estate of a bankrupt upon their insolvency, protecting the interests of the bankrupt's creditors. The Court held the rule was not ousted by the federal bankruptcy regime under the Bankruptcy and Insolvency Act, RSC 1985, c B-3 (BIA). The rule has an ancient origin, predating the legislation, and in fact bolsters the scheme of the BIA. In particular, section 71 of the BIA stipulates that property of a bankrupt "passes to and vests in the trustee", and the rule works in harmony with this provision, voiding contractual provisions that would prevent property from passing to the trustee and frustrating the scheme of the BIA.
The test for the rule is two-fold:
- the relevant clause is triggered by an event of insolvency or bankruptcy, and
- the effect of the clause is to remove value from the insolvent's estate.
If both these branches are satisfied, the clause is void.
The Supreme Court held that the test is effects-based, not purpose-based. While Chandos petitioned the Court to follow English common law, whose courts have held that the rule will not invalidate bona fide commercial transactions which lack the primary purpose of depriving the bankrupt's estate of its property, the Supreme Court declined to do so. Instead, the Court held that the test turns on whether the effect, not the purpose or intention, of a contractual clause is to deprive the bankrupt's estate of assets upon insolvency. The intentions of the contracting parties are irrelevant, even if commercially reasonable. The scope of examination is exclusively the clause's effect. The goal of public policy in this instance has been established in the legislation. Through section 71 of the BIA, Parliament has made it clear that all property of the bankrupt is to be vested in the trustee. It is then the duty of the common law to choose the "means that best gives effect to the statutory scheme" which in this case is the effects-based approach. A purpose-based rule would also run contrary to commercial certainty, as courts would be tasked with the assessment of the parties' intent long after the fact, and no party could know when contracting whether a court would find their provision to be bona fide. Focusing on the intent of the parties could also lead to parties plausibly pretending to have bona fide intentions to give themselves preference over the bankrupt's creditors.
Despite Chandos' reliance on the principles of contractual freedom and self-interest, the Supreme Court reiterated that "bankruptcy strips the insolvent party of their [self] interest." The bankrupt party may not care that a clause will deprive its estate in bankruptcy of value since that cost is borne by its unsecured creditors rather than itself.
The Supreme Court recognized that there are nuances with the anti-deprivation rule; for example, "contractual provisions that eliminate property from the estate, but do not eliminate value, may not offend the anti-deprivation rule", and the rule is not offended when parties "protect themselves against a contracting counterparty's insolvency by taking security, acquiring insurance, or requiring a third-party guarantee."
Having found the clause was void under operation of the anti-deprivation rule, the Court had no need—and did not—address the penalty clause rule raised in the lower Court.
In dissent, Côté J. agreed with much of the majority but disagreed that the rule should apply to transactions or provisions with a bona fide commercial purpose. She held, first, that courts applying the rule have not rested their decisions solely on the effect of the provision depriving an estate of value, but rather have looked past the effect and inquired into the bona fide purpose. Second, the rule at common law requires an objective assessment of the parties' bona fide commercial purposes. Third, as a matter of public policy, the considerations cited by the majority in support of an effects-based test cannot "override the otherwise strong countervailing public interest in the enforcement of contracts."
The Supreme Court's decision in Chandos reiterates that the protection of creditors is a paramount concern for the federal bankruptcy regime and that common law rules, such as the anti-deprivation rule, may still be applied in harmony with that regime in appropriate circumstances. The decision also provides some guidance on what parties should expect when drafting clauses contingent on the bankruptcy of one party, while also recognizing the nuances and potential ways in which parties can protect themselves without offending the anti-deprivation rule.