The Anti-Deprivation Rule and its Implications for Construction Contracts: Chandos Construction v Deloitte

In Chandos Construction v Deloitte Restructuring, the Supreme Court clarified one aspect of bankruptcy law – the scope and application of the anti-deprivation rule – while leaving an unsettled area of contract law – the penalty doctrine – to be resolved for another day. Here, we consider the implications of the newly-clarified anti-deprivation rule as it applies to the construction industry.

Background

Chandos Construction Ltd (“Chandos”) was the general contractor on a condominium project in Alberta. Chandos entered into a subcontract with Capital Steel Inc. (“Capital Steel”) for structural steel work (the “Subcontract”). The Subcontract provided for a series of consequences should Capital Steel commit any act of bankruptcy or insolvency, including that:

• Capital Steel would pay Chandos’ costs of having to complete Capital Steel’s work, plus a “reasonable allowance” for overhead and profit;
• Chandos would be entitled to withhold up to 20% of the Subcontract price until the warranty and guarantee periods expired; and
• Capital Steel would forfeit 10% of the Subcontract price as a fee for Chandos completing Capital Steel’s work and/or for monitoring the work during the warranty period. (collectively, these are the “Bankruptcy Clause”)

Capital Steel filed an assignment in bankruptcy prior to completing its work. At that time, Chandos owed Capital Steel $149,618.39. Chandos argued that it was entitled to set off the costs it had incurred to complete Capital Steel’s work, relying on the common law of set-off, which persists in bankruptcy pursuant to s. 97(3) of the Bankruptcy and Insolvency Act (the “BIA”). Chandos also argued it was entitled to set off the 10% of the Subcontract price that Capital Steel had forfeited.

Capital Steel’s trustee in bankruptcy, Deloitte, applied for advice as to whether the Bankruptcy Clause was contrary to the anti-deprivation rule, which rule voids any contractual term stipulating that upon an insolvency or bankruptcy, property is removed from the bankrupt’s estate and placed in the hands of a third party who is not the trustee in bankruptcy. The anti-deprivation rule is intended to avoid depriving the trustee in bankruptcy of the opportunity to realize upon the property in question, and to thereby avoid prejudicing creditors.

Decisions of the Courts Below

The Alberta Court of Queen’s Bench found the Bankruptcy Clause to be valid, concluding that so long as it was not an attempt to avoid the effect of bankruptcy laws, the anti-deprivation rule does not prevent parties from agreeing that upon one party’s insolvency, the other party can make a liquidated damages claim. Chandos had not attempted to avoid the effect of bankruptcy laws. Furthermore, the provision was a (valid) liquidated damages clause, not an (invalid) penalty clause.

The Alberta Court of Appeal overturned the decision. The majority found that the anti-deprivation rule does not rely upon a purpose-based test whereby an impugned clause is valid if it is a “bona fide commercial transaction” whose predominant purpose is not the deprivation of property in case of bankruptcy. Instead, Canadian law has adopted an effects-based test whereby the parties’ intent is irrelevant, and an impugned clause may violate the rule even if the parties did not intend to deprive the bankrupt party’s property.

In dissent, Wakeling JA concluded that the anti-deprivation rule never existed in Canadian common law or, in the alternative, ceased to exist after the 2009 amendments to the BIA and CCAA. In the further alternative, Wakeling JA concluded that the purpose-based test was the appropriate test for the anti-deprivation rule. Finally, Wakeling JA concluded that the Bankruptcy Clause was not a penalty clause, and therefore valid as a matter of contract law as well.

The Supreme Court’s Decision

Writing for an eight-judge majority, Rowe J concluded that the anti-deprivation rule existed in Canadian common law since before federal bankruptcy legislation existed, and was not eliminated by either legislation or the common law. In addition, the proper test for the application of the anti-deprivation rule is the effects-based test, rather than the purpose-based test.

Turning first to whether the anti-deprivation rule exists at common law, the majority observed that no decision from the Supreme Court ever eliminated the rule, nor did any legislation. In particular, federal bankruptcy legislation is better understood as gradually codifying limited parts of the common law, rather than seeking to oust all related common law. Parliament is presumed to intend not to change the existing common law unless it does so clearly and unambiguously.

The majority observed that the effects-based test is preferable to the purpose-based test for several reasons. As a matter of public policy, all of a bankrupt’s property is to be collected by the trustee; accordingly, any avoidance, whether intentional or inevitable, would be a fraud on the statute. In this regard, the majority observed that the public policy objective in this case was established by legislation, and as such it is not open for the court to substitute a competing objective; rather, the role of the common law is to provide the means that best gives effect to the statutory scheme.

In addition, an effects-based test would offer greater commercial certainty as compared to a purpose-based test. The latter would require courts to determine parties’ intent long after contract formation, which would in turn encourage parties to come up with a plausible bona fide purpose after the fact in order to satisfy a purpose-based test. In the majority’s view, it would be unduly easy to posit a plausible bona fide purpose in all but the most flagrant instances of attempts to circumvent bankruptcy legislation, which would render the anti-deprivation rule ineffective.

Relatedly, the majority observed that an effects-based test would promote the efficient administration of bankruptcies, given that it would be consistent with the effects-based tests that already exist for the pari passu rule and other provisions of the BIA. Consistency in this regard would prevent duplicative proceedings and avoid disputes over whether the pari passu rule or the anti-deprivation rule is engaged by a particular contractual provision.

Finally, the majority rejected the general appeal to freedom of contract as a basis for a purpose-based test, observing that the costs of accepting an impugned clause are borne solely by the bankrupt’s creditors, given that the bankrupt/insolvent company no longer has any interest given its bankrupt/insolvent status. Meanwhile, any benefits of the impugned clause are enjoyed solely by the company while it remains solvent.

On the issue of set-off, the majority observed that the application of the anti-deprivation rule means that set-off applies to debts owed by the bankrupt that were not triggered by the bankruptcy. In the present case, Capital Steel’s debt to Chandos only came into existence as a result of the Bankruptcy Clause, which was itself only triggered as a result of Capital Steel’s bankruptcy. Accordingly, set-off did not apply in this case.

In dissent, Côté J concluded that the appropriate test for the anti-deprivation rule is the purpose-based test, which stipulates that the anti-deprivation rule does not apply to transactions or contractual provisions which serve a bona fide commercial purpose. In a detailed review of the case law, Côté J concluded that “the golden thread weaving its way through the jurisprudence is the presence or absence of a bona fide commercial purpose behind the deprivation”, such that a purpose-based test already has a strong basis in existing case law.

Second, Côté J observed that there was a principled basis for the purpose-based test, given that the anti‑deprivation rule is based on the common law public policy against agreements entered for the purpose of defrauding third parties. With that in mind, an analysis of the parties’ intentions is consistent with the policy underlying the rule. By contrast, the pari passu rule and other relevant BIA provisions have different policy considerations that require an effects-based test, such that there is a valid reason for a different test to apply to the anti-deprivation rule.

Third, Côté J observed that in considering the anti-deprivation rule, it was important given its status as a common-law rule that the court balance the objectives of the BIA against other policy interests including freedom of contract. While a purely effects-based test would give too little weight to freedom of contract, a subjective, intention-based test would give too little weight to the legislative objective of protecting creditors. Instead, the appropriate test would be an objective, purpose-based test that asks whether the parties had a bona fide commercial purpose in respect of an impugned clause. In this regard, Côté J concluded that this test would not require a significantly more onerous analysis into the parties’ intentions than that entailed by an effects‑based test.

Analysis

The majority’s decision provides a simple rule that is easily applied, and thus lands squarely in favour of commercial certainty. Contracting parties will be able to determine straightforwardly at the time of contract formation whether a given clause will run afoul of the anti-deprivation rule. In our view, the majority expressed a well-founded concern regarding the problem of parties advancing plausible bona fide purposes after the fact in order circumvent the anti-deprivation rule, and indeed, it would have come as no surprise if parties had resorted to too-clever contract drafting (in other words, contract drafting ripe for litigation) had Chandos been decided differently.

More fundamentally, the majority’s subordination of freedom of contract highlights an important distinction between bankruptcy and contract law. As the majority observed, the effect of a clause that violates the anti-deprivation rule is not confined to the parties to that contract. Rather, the costs of accepting an impugned clause are borne solely by creditors, who have no seat at the bargaining table, while the bankrupt/insolvent company no longer has any interest given its bankrupt/insolvent status. Of the same token, creditors gain no benefit from the impugned provision.

Put differently, the anti-deprivation rule only engages freedom of contract tangentially since effectively, the bankrupt/insolvent party bargained away the rights of third parties uninvolved in the bargaining. Since freedom of contract is meant to protect contracting parties’ freedom to dispose of their own commercial rights, it stands to reason that bargaining away third parties’ rights should not receive the same level of protection. In this sense, Chandos identifies an important limit on the general principle of freedom of contract, particularly as it applies in the bankruptcy context.

Finally, we note that the Court’s decision not to address the issue of whether the Bankruptcy Clause was a penalty clause leaves unanswered an area of significant uncertainty in Canadian contract law, and in our view, represents a missed opportunity. Readers will be well aware of the uncertainty that exists with respect to determining whether a given clause is a valid liquidated damages clause or whether it is a penalty clause (and therefore void). It appears that this uncertainty will persist for the foreseeable future.

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