The Anti-Deprivation Rule
Construction and Contracting Parties Cannot Rely on Liquidated Damages Clauses that are Triggered by Bankruptcy or Insolvency.
On October 2, 2020, the Supreme Court of Canada rendered its decision upholding the anti-deprivation rule in the context of a dispute between two construction parties. Construction companies and commercial parties must be mindful that liquidated damages clauses and other payment clauses will be unenforceable if they are triggered by events of bankruptcy or insolvency.
Chandos Construction Ltd. (“Chandos”), a general construction contractor, entered into a subcontract with Capital Steel Inc. (“Capital Steel”). A provision of their subcontract provided that Capital Steel would pay Chandos 10% of the subcontract price as a fee for the inconvenience of completing and monitoring the work in the event of Capital Steel’s bankruptcy.
Part way through completing its work, Capital Steel filed an assignment in bankruptcy. In reliance on the bankruptcy triggered provision, Chandos sought to set off the costs it had incurred to complete Capital Steel’s work and to set off 10% of the subcontract price.
Capital Steel’s trustee in bankruptcy applied to the Court for advice and directions as to whether the provision was valid. The application Judge found the provision to be a valid liquidated damages clause. The Court of Appeal of Alberta reversed the decision, holding that the provision was invalid and unenforceable because of the anti-deprivation rule. The Supreme Court of Canada upheld the Court of Appeal’s decision and dismissed the appeal.
The anti-deprivation rule invalidates provisions that remove value and are triggered upon bankruptcy or insolvency:
The Supreme Court of Canada upheld the common law anti-deprivation rule, which renders void contractual provisions that upon insolvency or bankruptcy remove value that would otherwise have been available to an insolvent person’s creditors. The rule is an effects-based, two-part test: first, the relevant clause must be triggered by an event of insolvency or bankruptcy; and second, the effect of the clause must be to remove value from the insolvent’s estate. The purpose of the rule is to help maximize global recovery for all creditors and prevent frustration of the Bankruptcy and Insolvency Act, R.S.C., 1985, c. B-3.
As an effects-based test, the relevant consideration is whether the effect of the provision was to deprive the estate of assets upon bankruptcy, not whether the intention of the contracting parties was commercially reasonable. In other words, the anti-deprivation rule is not a purpose-based test, which would require courts to determine the intention of contracting parties long after the fact and which would detract from the efficient administration of corporate bankruptcies.
The Supreme Court of Canada further commented that the law of set-off does not apply to these debts owed by the insolvent person that were triggered by bankruptcy or insolvency because the law of set-off applies only to enforceable debts; these debts are rendered unenforceable by the anti-deprivation rule.
In Chandos Construction Ltd. v. Deloitte Restructuring Inc., 2020 SCC 25, the provision in the contract between Chandos and Capital Steel violated the anti-deprivation rule and was therefore invalid and unenforceable.
The dissent in Chandos Construction Ltd. v. Deloitte Restructuring Inc., 2020 SCC 25 remarked that the anti-deprivation rule should not apply to transactions or contractual provisions that serve a bona fide commercial purpose. As such, the provision in the contract between Chandos and Capital Steel is enforceable and does not offend the anti-deprivation rule because it furthers a bona fide commercial purpose.