Canada: Supreme Court To Consider Enforceability Of Consequences Imposed Upon Insolvency

The Supreme Court of Canada recently granted leave to appeal from the Alberta Court of Appeal's decision in Capital Steel Inc v Chandos Construction Ltd, 2019 ABCA 32. The case addresses the enforceability of clauses that impose monetary consequences for breach of contract, particularly where those consequences are levied because of a contracting party's insolvency. A majority of the Court of Appeal concluded that clauses imposing such consequences cannot be enforced where the effect would prejudice creditors.

Background

Chandos Construction Ltd. was the general contractor for a condominium development in St. Albert. Chandos hired Capital Steel Inc. as a subcontractor for the project. The parties agreed that Capital Steel would forfeit 10 percent of the total contract price, approximately $140,000, in the event that it committed any act of insolvency (the "Insolvency Clause"). Capital Steel ultimately did become insolvent and voluntarily assigned itself into bankruptcy, triggering the Insolvency Clause. When Capital Steel became bankrupt, Chandos owed Capital Steel approximately $150,000 in unpaid amounts under the agreement. Chandos purported to reduce the amount owing to Capital Steel by $140,000, based on the Insolvency Clause, which would have reduced the assets available to Capital Steel's creditors.

The Alberta Court of Appeal considered whether the Insolvency Clause was an enforceable term of the agreement between the parties.

Ipso Facto Clauses and the Anti-Deprivation Rule

An ipso facto clause is a contractual provision that levies a consequence against a contracting party as a result of their insolvency. In restructuring proceedings, legislative provisions in the Bankruptcy and Insolvency Act, 1985, c B-3 [BIA] and the Companies' Creditors Arrangement Act, 1985, c C-36 [CCAA] expressly prohibit the enforcement of ipso facto clauses (BIA, ss 65.1, 66.34; CCAA, s 34). A similar limitation applies in the context of consumer bankruptcies (BIA, s 84.2). However, there is no legislative provision limiting the effectiveness of ipso facto clauses in commercial bankruptcies.

Apart from the legislative prohibitions, there is a common law "anti-deprivation rule" that may also invalidate certain ipso facto clauses. The anti-deprivation rule applies to ipso facto clauses that prejudice creditors by removing assets from an insolvent debtor's estate. The rule stems from the concept that parties cannot opt-out of the bankruptcy laws that govern the distribution of a debtor's estate. Recently, the rule underwent a significant revision in the United Kingdom. In Belmont Park Investments Pty Ltd v BNY Corporate Trustee Services Ltd, [2011] UKSC 38 [Belmont], the UK Supreme Court held that ipso facto clauses are unenforceable only if their primary purpose is to remove assets from an insolvent person's estate. Bona fide commercial arrangements are therefore exempt from the UK's anti-deprivation rule, even where such arrangements would effectively prejudice creditors.

The Majority's Decision

Despite its limited treatment in prior Canadian cases, the majority of the Court of Appeal held that the anti-deprivation rule does exist in Canadian law. The majority stated that the rule is intended to protect creditors and ensure an orderly distribution of the debtor's estate. Further, the rule continues to operate in the context of corporate bankruptcies, despite the adoption of express legislative provisions dealing with ipso facto clauses in other contexts. In the majority's view, the legislative provisions reflect an expansion of the common law, rather than a complete statement on the enforceability of ipso facto clauses. The majority also declined to adopt the purpose-based approach set out by the UK Supreme Court in Belmont, referring to academic commentary suggesting that such an approach would remove all effectiveness of the rule.

Applying the anti-deprivation rule to the contract between Chandos and Capital Steel, the majority concluded that the Insolvency Clause was an ipso facto clause that had the effect of prejudicing Capital Steel's creditors, and it was therefore unenforceable.

Dissent Favours Freedom of Contract

In a lengthy dissent, Justice Wakeling took a strong stance in support of freedom of contract. With respect to the anti-deprivation rule, he held that such a rule does not form part of Canadian law. He was guided by the lack of cases directly dealing with the rule, what he viewed as an implicit abandonment of the principle by the Supreme Court of Canada, and the fact that ipso facto clauses are expressly prohibited by legislation in specific but limited contexts. Justice Wakeling stated that even if the anti-deprivation rule does exist, it should be assessed using the purpose-based approach set out by the UK Supreme Court in Belmont. In his view, the common law should enforce ipso facto clauses that serve a reasonable commercial purpose.

Given his conclusion on the anti-deprivation rule, Justice Wakeling also considered the common law rule against penalties. He rejected any notion that a consequence for breach of contract needs to be reasonable in the circumstances or correlated with the damages flowing from the breach. Justice Wakeling stated that the true measure is a standard of oppression. He therefore concluded that clauses imposing a consequence for breach of contract in the commercial context should be enforced unless they are so "grossly one-sided" that enforcement would bring the administration of justice into disrepute.

Applying his conclusions, Justice Wakeling would have held that the Insolvency Clause was enforceable against Capital Steel's creditors.

Supreme Court of Canada Set to Weigh-In

The Supreme Court granted Chandos leave to appeal the majority's decision on July 11, 2019. While the hearing date has not yet been set, this will be an important case to watch. Should the Supreme Court choose to follow the UK and adopt a purpose-based approach to the anti-deprivation rule, or abandon the rule completely, it would represent a significant development in Canadian insolvency law. The Supreme Court may also take the opportunity to follow Justice Wakeling's lead and provide further clarity on the common law rule against penalties. To adopt the words of Justice Wakeling, this case will be one of "national importance," at least for those in the world of commercial contracts.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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