In Chandos Construction Ltd v Deloitte Restructuring Inc[1] [Chandos], the majority of the Supreme Court of Canada (the “SCC”) reaffirmed the common law anti-deprivation rule in Canada. The anti-deprivation rule voids contractual terms which apply upon a party’s insolvency and bankruptcy where the clause removes value from an insolvent person’s estate that would otherwise have been available for the insolvent person’s creditors. Anyone entering into construction contracts should avoid contractual provisions which may trigger the anti-deprivation rule and understand that if they are already in a contract, they may not be enforceable. However, despite the anti-deprivation rule, there are contractual provisions that can be used to protect parties where their contracting counterpart becomes insolvent or bankrupt.
Factual Background
Chandos Construction Ltd. (“Chandos”) was a general contractor who entered into a subcontract with Capital Steel Inc. (“Capital Steel”). The subcontract provided that in the event of Capital Steel’s insolvency or bankruptcy, Capital Steel would forfeit 10% of the contract price to Chandos “as a fee for the inconvenience of completing the work using alternate means and/or for monitoring the work during the warranty period” (the “Insolvency Clause”).
Capital Steel filed an assignment in bankruptcy prior to completing the subcontract work. Chandos argued that it was entitled to rely upon the Insolvency Clause and set-off 10% of the subcontract price as a fee. The Trustee in Bankruptcy for Capital Steel applied to the Alberta Court of Queen’s Bench to determine whether the Insolvency Clause was valid.
Trial and Appellate Judgments
In Chandos, the Alberta Court of Queen’s Bench found the Insolvency Clause was valid because the Insolvency Clause was not an attempt to avoid the effect of bankruptcy laws.[2] The majority of the Alberta Court of Appeal reversed this decision, finding the Insolvency Clause to be invalid based on the common law anti-deprivation rule.[3]
The SCC agreed the Insolvency Clause violated the anti-deprivation rule and was void. The Court articulated a two-part test for invalidating a contractual provision based on the anti-deprivation rule as follows:
- the relevant clause must be triggered by an event of insolvency or bankruptcy; and
- the effect of the clause must be to remove value from the insolvent’s estate.
The SCC stated the test for the anti-deprivation rule was an effects-based test, meaning the ultimate effect of the clause should be examined in assessing the above criteria.
The SCC affirmed that set-off is generally allowed during the bankruptcy of a contracting party due to section 97(3) of the Bankruptcy and Insolvency Act.[4] Set-off reduces the value of assets that are transferred to the insolvent’s estate, but it only applies to enforceable debts or claims. Since the anti-deprivation rule voided the Insolvency Clause, Chandos was unable to apply set-off against Capital Steel for the 10% amount.
Key Takeaways
Chandos urges parties entering into construction contracts to avoid clauses that are triggered by insolvency or bankruptcy and that remove value from the insolvent party’s estate. These clauses are invalid and unenforceable. Some contractual terms which are prohibited by the anti-deprivation rule include clauses where a party forfeits some or all of the contract price due to their insolvency or bankruptcy, or clauses where fees, charges, or other amounts are payable solely upon insolvency or bankruptcy.
Other contractual terms can be employed to protect a party in the event of insolvency or bankruptcy by their contractual counterpart. For example, any clause triggered by events other than bankruptcy or insolvency are valid, including penalties that arise upon default of the contract.
Contracting parties can consider using clauses where property is removed from the insolvent party’s estate but no value is eliminated from the estate. For example, the anti-deprivation rule does not apply if a third party’s assets are forfeited upon bankruptcy or insolvency, since this term would not reduce the value of the insolvent party’s estate. Additionally, parties may be able to modify their security interests or enter into a credit default swap agreement (amending the nature or type of security) upon the insolvency or bankruptcy of their contractual counterpart without offending the anti-deprivation rule, provided these clauses do not increase the amount of security held over the insolvent party.[5]
Parties can also protect themselves in the event of an insolvency or bankruptcy by their contractual counterparts by taking security, acquiring insurance, or requiring third-party guarantees when the contract is executed.[6] Before entering into a security agreement, parties should verify whether any creditors already have priority charges against the assets which comprise the security. In the case of guarantees, suitable guarantors may include a parent company, directors, or officers of the contracting party. A guarantee causes the guarantor to become personally liable for the debts or contractual breaches of the subcontractor.
Suppliers and subcontractors can require a labour and materials payment bond at the time of entering into a contract.[7] This bond guarantees that suppliers and subcontractors are paid for the work and materials that they supply, up to a specified amount. Additionally, parties may require a performance bond, which provides payment up to a specified amount if the contractor is unable to complete the project work or is in default of the construction contract. For the most project security (but usually at an additional cost to the price of the work), a contractor would have both a labour and materials payment bond and a performance bond in place for at least 50% of the value of the contract.
Overall, when entering into construction contracts, contracting parties should consider contacting legal counsel to ensure their contracts are drafted with enforceable terms that do not offend the anti-deprivation rule. When drafting construction contracts, parties should also consider if they are appropriately protected should their counterparty become bankrupt or insolvent.
The authors would like to thank Rachel Haack, formerly of Miller Thomson and currently a lawyer with the Government of Saskatchewan, for her contribution.
[1] 2020 SCC 25.
[2] Alta Q.B., Edmonton, 242169632, 17 March 2017.
[3] 2019 ABCA 32.
[4] RSC, 1985, c B-3. Set-off allows a creditor (who happens to also be a debtor) to reduce the amount they owe to the bankrupt by the amount they (as debtor) are owed by the bankrupt.
[5] Belmont Park Investments Pty Ltd v BNY Corporate Trustee Services Ltd, [2011] UKSC 38.
[6] Supra note 1 at para 40.
[7] See s. 81 of The Builders’ Lien Act, S.S. 1984-85-86, c. B-7.1 and s. 69 of The Construction Lien Act, R.S.O. 1990, c. C.30;
