Earlier this month in Chandos Construction Ltd. v. Deloitte Restructuring Inc., 2020 SCC 25, the Supreme Court of Canada (the “SCC”) signaled that a contracting party cannot enforce any clause that charges a fee to its counterparty if the counterparty goes insolvent or bankrupt. The SCC held that this was because the anti-deprivation rule applies to prevent any contract clause from removing value from the reach of an insolvent person’s creditors that would otherwise have been available to them.
The practical effect of the SCC’s decision is that parties to a construction contract must find other ways to protect themselves from their counterparty’s insolvency or bankruptcy than to charge a fee through their agreement in the event of insolvency.
Chandos Construction Ltd. was the general contractor on a condominium project and subcontracted the steel work to Capital Steel Inc. The subcontract had a value $1,373,300.47 and it provided for a number of consequences if Capital Steel went insolvent, bankrupt, or otherwise ceased business. One of those consequences was that Capital Steel would forfeit 10% of the subcontract price as a fee for the inconvenience of completing work and/or for monitoring the work during the warranty period (the “Insolvency Clause”).
Capital Steel filed for bankruptcy before completing the work. Deloitte Restructuring Inc. was appointed as the trustee in bankruptcy. At the time, Chandos owed Capital Steel $149,618.39 on the subcontract.
Chandos successfully argued that it was entitled to set off from this amount for the cost of completing Capital Steel’s work. Chandos did not rely on the subcontract for this amount as common law rules for breach of contract and setoff entitled it to this amount.
The real issue was over the Insolvency Clause. The Insolvency Clause would have charged a 10% fee on the subcontract price and this would have given Chandos a claim on Capital Steel’s bankrupt estate.
Deloitte applied to the Court for directions as to whether the Insolvency Clause was valid.
The application judge found that the Insolvency Clause was valid and enforceable. On appeal, the Court found it was not. Chandos appealed to the SCC.
In affirming the anti-deprivation rule, the SCC dismissed Chandos’ appeal.
The SCC stated that the anti-deprivation rule renders a contractual clause void if it meets two conditions:
- it is triggered by an event of insolvency or bankruptcy; and
- it has the effect of removing value from the insolvent estate.
This is referred to as the effects-based test since it works based on the effect of the contested clause and not on the intentions of the contracting parties. Chandos, however, argued that the anti-deprivation rule should use a purpose-based test that would not void a clause that was made as part of a bona fide commercial transaction, and which did not have the predominant purpose of depriving one of the parties of property on a bankruptcy or insolvency.
The SCC rejected the purpose-based test since the effects-based test would provide more certainty to parties at the time of contracting. If courts adopted the purpose-based test, then parties could plausibly pretend to have bona fide intentions regarding any transaction, which would justify inserting clauses to create a preference over other creditors and sidestep the bankruptcy process. This would make the anti-deprivation rule ineffectual.
Applying the effects-based test, the SCC found that the Insolvency Clause was invalid. It was triggered by the event of Capital Steel’s bankruptcy and charged a 10% fee that would be paid out of Capital Steel’s bankrupt estate. This would have the effect of depriving Capital Steel’s other creditors of property they would otherwise be entitled to.
Chandos also appealed on the basis that the lower Court of Appeal failed to consider the effect of setoff. The SCC dismissed this ground of argument. Canadian bankruptcy law does factor in setoff between a creditor and bankrupt debtor’s mutual debts. The law of setoff and the anti-deprivation rule are not incompatible however. The anti-deprivation rule simply voids debts that are created by the insolvent or bankrupt party’s insolvency or bankruptcy, while the law of setoff applies to debts owed by the bankrupt that were not triggered by the bankruptcy. Therefore, the law of setoff did not somehow save the debt created by the Insolvency Clause.
Due to the SCC’s decision in Chandos, parties to construction contracts should be wary that they cannot rely on their agreements to charge fees or other penalties in case of the counterparty’s bankruptcy or insolvency in the event of the same bankruptcy or insolvency. Contractors will instead have to think of other ways to protect against their counterparty going out of business.
In Chandos, the SCC itself laid out some possible solutions in recognizing “nuances” with the anti-deprivation rule, particularly:
- the anti-deprivation rule may not void contract clauses that eliminate property from an estate but not value;
- the anti-deprivation rule does not void clauses that are triggered by events other than insolvency or bankruptcy; and
- the anti-deprivation rule does not void any arrangement where the parties protect themselves from the counterparty’s insolvency by taking security, acquiring insurance, or requiring a third-party guarantee.
Considering these possibilities, contractors should ensure that their contracts provide for adequate security, are insured against the counterparty’s non-performance, or are guaranteed by a third party. Contractors may want to additionally ensure that any clause that charges a fee is not conditioned on an event of insolvency or bankruptcy, but some alternative such as the counterparty’s default. In doing so, contractors should ensure that their clauses are not framed as penalty clauses (which are excessive and unenforceable) but are genuine pre-estimates of damages (which have a reasonable basis for assessing the amount owing). Whatever option is chosen, contractors should first contact counsel to ensure their contract is drafted appropriately in the circumstances.