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The Anti-Deprivation Rule finds its way to the SCC in Chandos Construction Limited v Deloitte Restructuring Inc

Chandos Construction Ltd v Deloitte Restructuring Inc 2020 SCC 25 (“Chandos”) explores a number of issues but the main one addresses the anti-deprivation rule and whether its application requires an effects-based test or a purpose-based test. In essence, the anti-deprivation rule does not allow contracting parties to include contractual provisions where, if one party declares bankruptcy or insolvency, the other party can take value from the bankrupt’s estate. This rule supports the Bankruptcy and Insolvency Act’s (“BIA”) core principle that creditors are to find recovery from the bankrupt. The anti-deprivation rule thereby prevents contracting parties from circumventing this principle. The anti-deprivation rule works in tandem with another common law rule, pari passu. The majority and the dissent refer to this rule in their respective decisions. Pari passu requires that creditors only get their fair share of the bankrupt’s estate. In Justice Rowbotham’s decision for the Alberta Court of Appeal (“ABCA”), she states that “anti-deprivation is concerned about the size of the proverbial pie and pari passu is the slicing of the pie” (para 12). While it is acknowledged that the anti-deprivation rule relates in some way to the “pie,” it is not entirely clear how it applies. In Chandos, the SCC finally made a determination.

This case concerns the validity of clause VII Q(d) of the subcontract between Chandos Construction Ltd, a general contractor, and Capital Steel, a subcontractor, which stipulates that if Captial Steel commits acts of bankruptcy and insolvency, it must forfeit 10% of the subcontract price. The SCC considers if the anti-deprivation rule exists and, if it does, whether it is applied through an effects-based test or a purpose-based test. The effects-based test finds that regardless of the purpose, if a contractual provision has the effect of moving property from the bankrupt and out of reach of creditors, the anti-deprivation rule applies, and the provision is invalid. On the other hand, the purpose-based test finds that the anti-deprivation rule applies will only when the intended purpose of the contractual provision is to circumvent the bankruptcy and insolvency statutory regime. If the contract is a bona fide commercial transaction, a contractual clause that removes property from the bankrupt is unlikely to have such a purpose, and thus, the anti-deprivation rule is less likely to apply.

Chandos comes to the SCC almost ten years after the Supreme Court of the United Kingdom (“UKSC”) heard Belmont Park Investments PYT Limited v BNY Corporate Trustee Services Limited and Lehman Brothers Special Financing Inc. [2011] UKSC 38 (“Belmont”). In that case, the UKSC found that the anti-deprivation rule required a purpose-based test. Since the parties in Belmont had a bona fide commercial transaction, the anti-deprivation rule did not apply and the contractual provision was valid. In light of this decision, there was interest as to how the SCC would define the application of anti-deprivation within the Canadian context. 

The Facts

Chandos Construction Ltd entered into a $1,313,300.47 subcontract with Capital Steel to complete structural steelwork on a condominium project in Alberta. As per clause VII Q of the subcontract, Capital Steel would face four consequences if they committed acts of bankruptcy or insolvency:

  • The contract will be suspended
  • Capital Steel would pay costs arising from the suspension of the contract and any reasonable overhead costs
  • Chandos Construction will withhold 20% of the cost of the subcontract until the end of a warranty period and,
  • Capital Steel forfeits 10% of the subcontract price as an inconvenience fee.

Evidently, Capital Steel filed for bankruptcy and as a result, clause VII Q and its subclauses were initiated. At the time of Capital Steel’s filing, Chandos Construction still owed $149,618.39 on the subcontract with $22,800 available to be “set-off” in accordance with the rules in s. 97(3) of the BIA. However, Chandos Construction hoped to rely on clause VII Q(d) which would have required Capital Steel to forfeit 10% of the subcontract price. As a result, rather than owe Capital Steel $126,818.39, Capital Steel would owe Chandos Construction $10,511.66. Acting as a trustee for Capital Steel, Deloitte Reconstructing Inc. asked an application judge if the clause was valid.

Brief Procedural History

In assessing the validity of clause VII Q(d), the application judge considered whether or not the anti-deprivation rule applied. The judge found that while the anti-deprivation rule applied to Canadian law, it did not apply to contracts in a bona fide commercial transaction. Deloitte appealed to the ABCA and the application judge’s decision was overturned. Writing for the majority, Justice Rowbotham rejected the purpose-based understanding of anti-deprivation, arguing that there is a long history of the rule in Canadian jurisprudence and that it has always been applied through an effects-based test. Regardless of the intent of the contracting parties, if a contractual clause has the effect of preventing creditors from accessing what they are entitled to, it is invalid as per the anti-deprivation rule. More broadly, she stated that common law rules help to govern the bankruptcy and insolvency regime in Canada, making note of pari passu. These rules work together with the anti-deprivation rule to protect creditors and to prevent fraud. Disrupting the understanding of anti-deprivation disrupts the function of these rules. For these reasons, the ABCA allowed the appeal.

The Majority Agrees with the ABCA’s Effects-Based Test Finding

Chandos Construction appealed to the SCC to reverse the ABCA’s decision citing five errors in Justice Rowbotham’s decision, most pertinently, the finding that the anti-deprivation rule exists in Canadian jurisprudence and its application is an effects-based test as opposed to a purpose-based test. In an 8-1 decision, the SCC agreed with ABCA’s decision in its entirety.

Writing for the majority, Justice Rowe finds that the anti-deprivation law does exist in Canadian law, adding it to the list of case law that Justice Rowbotham cited as evidence. Supported by testimony from the Attorney General of Canada, Justice Rowe further reasoned that the anti-deprivation rule was not extinguished by the Court or by Parliament and that codifying some common law rules into the BIA does not thereby eliminate all other common law rules. In fact, any changes to the BIA were about the condition of the debtor, never the creditor whom the anti-deprivation rule protects. As a final note on this point, Justice Rowe also finds that the anti-deprivation rule has statutory footing in s. 71 of the BIA. This section “provides that the property of a bankrupt passes to and vests in the trust” so as to enable global recovery for all creditors (para 44). Not recognizing the anti-deprivation rule frustrates s. 71 and the BIA regime more broadly.

As for the application of the anti-deprivation rule, Justice Rowe states that Canadian jurisprudence requires an effects-based test to determine if the rule applies to contractual provisions. The effects-based test has two parts: 1) the relevant clause must be triggered in the event of insolvency and bankruptcy, and, upon triggering, the relevant clause 2) removes value from the insolvent’s estate. Justice Rowe argues that a purpose-based test would require the courts to examine the intentions of the contracting parties, making business administration less efficient. Moreover, a purpose-based test is inconsistent with other common law rules around bankruptcy and insolvency, most notably pari passu, which requires an effects-based test. All that said, Justice Rowe does acknowledge that the anti-deprivation rule is nuanced and there are occasions where it may not apply, namely where property moves from the bankrupt to the other contracted party but does not eliminate estate value; where there are similar consequences that are not triggered by bankruptcy or insolvency; or where contracting commercial parties, for example, take out insurance to protect themselves from the other party’s bankruptcy.

Justice Rowe acknowledged that there are other pressing policy considerations involved. However, he states that it is not the role of the common law to act as a policy goal, but rather, to fill in the gaps of a statutory scheme. The effects-based approach to the anti-deprivation rule is what is required to accomplish this task. For these reasons, the SCC dismissed Chandos Construction’s appeal.

Justice Coté Dissents, Finds a Purpose-Based Test

The lone dissenting opinion in this case was provided by Justice Coté. Though she agreed with the majority that the anti-deprivation rule exists in Canadian jurisprudence, Justice Coté argued that it did not apply to the case at hand for three reasons. First, the anti-deprivation rule is not an effects-based test, rather a purpose-based test. Thus, if there is no intent to evade the bankruptcy and insolvency regime, it should not apply to bona fide commercial transactions. She argued that her extensive examination of the case law provides substantial evidence that Canadian and English courts have inquired as to whether a contract in question is a bona fide commercial transaction when considering the anti-deprivation rule. This strongly suggests that a distinction needs to be made between bona fide commercial transactions and all other contracts and it is relevant to the application of the anti-deprivation rule. She further states that the anti-deprivation rule has a purpose – to prevent fraudulent or injurious contractual provisions against creditors. Therefore, intent to evade bankruptcy and insolvency laws are necessary.

Second, there is a “principled legal basis” for having a purpose-based test to the anti-deprivation rule. Justice Coté concluded that the anti-deprivation rule is grounded in common law public policy, meaning that it is a judicially derived rule with no footing in statute. This contrasts from pari passu which developed from an implied purpose derived from the BIA. Therefore, the argument that the application of the anti-deprivation rule must be consistent with pari passu ignores this fundamental difference between the two rules. Justice Rowe’s attempt to find a similar statutory footing for the anti-deprivation rule in s. 71 of the BIA did not convince her.

Finally, Justice Coté acknowledges the policy considerations at play. For her, policy interests in the enforcement of contracts should not be outweighed by the policy interests of a purely effects-based test. Moreover, the rigidity of the effects-based test does not give enough weight to the pressing concerns of freedom of contract and autonomy. To best balance these competing policy considerations, Justice Coté calls for a purpose-based test that would apply only to bona fide commercial transactions. Applying this test to the case at hand, Justice Coté would find clause VII Q(d) to be valid and overturn the ABCA’s decision.

Though the SCC decided for the respondent in an 8-1 decision, Justice Coté’s position was a persuasive one. That said, accepting a purpose-based test would seemingly disrupt Canadian norms of bankruptcy and insolvency. For now, the preferred policy choice for the anti-deprivation rule is an effects-based test which is the decision that was affirmed by the SCC.

Some Comparative Reflection

As previously discussed, the UKSC decision in Belmont found that the anti-deprivation rule did not apply to bona fide commercial transactions. What was not emphasized is that the case involved the 2008 bankruptcy of the Lehman Brothers, an event that continues to be litigated. Another case involving the Lehman Brothers, Lehman BrothersSpecial Financing, Inc v Ballyrock ABS CDO 2007-1 Limited (In re Lehman Brothers Holdings, Inc.), Adv. P. No. 09-01032 (JMP) (Bankr. S.D.N.Y. May 12, 2011) (“Ballyrock”), was heard in New York around the same time as Belmont, but the US Bankruptcy Court decided not to follow the UKSC’s direction. That is because the United States Bankruptcy Code (“the Code”) statutorily eliminates what they call “ipso facto” clauses, which are similar in nature to clause VII Q(d) in Chandos [s. 541 (c)(1)(B), see also: ss. 362 and 365(e)(1)]. Since Ballyrock, American legislators have relaxed the rigidity of the Code to allow for recovery by a contracting party in limited, mainly financial, circumstances. In August 2020, an Appeal Court did not invalidate an “ipso facto” clause in Lehman Brothers Special Financing Inc v Bank of America N.A., No. 18-1079 (2nd Cir. 2020) as per the recently added s. 560 of the Code.

All this is to say that the broader bankruptcy and insolvency legal landscape is responsive and, as such, ever-evolving. The Lehman Brothers bankruptcy, and the 2008 Financial Crisis more broadly, was a major, complex event with effects that seems to have forced legislators and the courts in the United Kingdom and the United States to reconsider what justice looks like in bankruptcy and insolvency today. Chandos, however, was not the case for such a departure in Canada. It remains to be seen if the COVID-19 pandemic will usher in bankruptcy and insolvency changes as the 2008 Financial Crisis did for the protection of contracting parties. If there is a need for such change, the SCC has put the ball in Parliament’s court.

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