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Legal Notes: Contracted compensation clauses run afoul of the law during bankruptcy

John Bleasby
Legal Notes: Contracted compensation clauses run afoul of the law during bankruptcy

A Supreme Court of Canada ruling concerning a subcontractor who filed for bankruptcy during the course of their contract raises the issue of what compensation is due to the general contractor.

General contractor Chandos Construction had entered into an agreement with subcontractor Capital Steel. Included was a clause stipulating a 10 per cent fee payable by Capital to Chandos for monitoring Capital’s work during the warranty period. When Capital subsequently filed for bankruptcy prior to contract completion, Chandos demanded that the 10 per cent fee be set aside from any amounts it owed to Capital for work completed. The dispute ultimately landed at the Supreme Court after rulings by lower courts.

Marie-Pier Barabé of Miller Thomson LLP comments that because of their binding nature, contracts are generally considered to be “the law of the parties.” In fact, she adds, “this type of clause providing for compensation for the general contractor in the event of the bankruptcy of a subcontractor is widely used in construction contracts.”

However, this particular case brought attention to what is known as the anti-deprivation rule as applied during insolvency.

“The Supreme Court of Canada confirmed the application of the common law anti-deprivation rule in the context of a Bankruptcy and Insolvency Act (BIA) proceeding,” write Mary Paterson and Catherine Gleason-Mercier of Osler Hoskin & Harcourt. “The anti-deprivation rule applies to clauses that are triggered by insolvency and that have the effect of removing value from the insolvent company’s estate. Under the rule, such clauses are void and unenforceable.”

Had Chandos been successful in having the 10 per cent fee set aside from any amounts that it owed to Capital, they would have in fact owed nothing to Capital, rather than owing Capital the nearly $150,000 listed by Deloitte, the bankruptcy trustee.

As explained by Scott Rollwagen of Lenczner Slaght, the anti-deprivation rule, “is a general principle that prevents private parties to a bilateral arrangement from frustrating the scheme of distribution in insolvency by providing clauses in contracts for payments or other benefits triggered by bankruptcy.”

Rollwagen writes the Supreme Court majority determined that the arrangements made between Chandos and Capital, “were a ‘direct and blatant’ violation of the rule, effectively depriving Capital Steel’s other creditors of amounts owing to it. It also stressed that the test is effects-based, not purpose-based. What should be considered is whether the effect of the contractual provision is to deprive the estate of assets upon bankruptcy, not whether the intention of the contracting parties was commercially reasonable.”

Writing on behalf of the majority, Supreme Court Judge Malcolm Rowe explained such a purpose-based approach, rather than one based on effect, would, “frustrate Parliament’s statutory scheme that all of a bankrupt’s property is to be collected in the trustee, as set out in section 71 of the BIA.”

“Participants in the construction industry will likely view the outcome as negative and difficult to understand,” write David de Groot and Yang Guo of Burnet, Duckworth & Palmer LLP.

“However, despite the outcome being disappointing to construction industry participants, the reasoning allowing other mechanisms to protect these long-tail obligations is important. In this regard, parties retaining suppliers or contractors on a construction project can still consider mechanisms such as letters of credit, surety bonds, or guarantees.”

Paterson and Gleason-Mercier point out alternate strategies suggested by Judge Rowe: eliminate property from the estate, but do not eliminate value; apply where the effect is triggered by an event other than insolvency or bankruptcy; or take security, require insurance or require a third-party guarantee.

Rollwagen outlines that an important principle is established by this ruling.

“The court’s strong affirmation of the anti-deprivation rule avoids what could have become an arms race of contractual provisions in which parties may feel compelled to bargain for outcomes on insolvency out of the fear that others may be seeking to do the same thing.”

 

John Bleasby is a Coldwater, Ont.-based freelance writer. Send comments and Legal Notes column ideas to editor@dailycommercialnews.com.

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