Canadian Underwriter

How this Supreme Court ruling impacts contractor insolvency risk

November 3, 2020   by Greg Meckbach

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A recent Supreme Court of Canada ruling means construction clients need to be careful about contract wording that refers to insolvency or bankruptcy.

With the Oct. 2 ruling, the Supreme Court of Canada has taken away a tool that a contractor could use to manage the risk of a subcontractor becoming insolvent, Darren Bieganek, Edmonton-based leader of the insolvency & restructuring practice group at Duncan Craig LLP, said in an interview with Canadian Underwriter. Bieganek represented Chandos Construction in a dispute with Deloitte before the Supreme Court of Canada.

Construction clients need to be careful if the “sole triggering event” of a contractual clause (in this instance, a financial claw-back clause) is the insolvency or bankruptcy of a subcontractor, Bieganek told Canadian Underwriter.

“If there are other reasons that give rise to the trigger [in the contract] and insolvency happens to occur, if the parties can point to the fact that it is these other reasons that are triggering [the clause] and the contract is drafted accordingly, then the potential to get around this issue is there,” he said.

Chandos Construction was the general contractor on a $55-million condominium project in St. Albert, Alta. One of Chandos’s subcontractors was Capital Steel. Chandos agreed to pay Capital Steel $1.37 million to supply and install the structural and miscellaneous steel components.

Capital Steel filed for bankruptcy in 2016 and only completed part of the work that Chandos had subcontracted to it.

One risk in the construction industry is that contractors can experience problems leading to insolvency, rendering them incapable of fulfilling commitments, L’Unique General Insurance notes on its website. L’Unique is referring to surety bonds in general and not about the situation involving Chandos Construction and Capital Steel.

Deloitte is Capital Steel’s trustee in bankruptcy.

As a result of the Supreme Court of Canada ruling in Chandos Construction Ltd. v. Deloitte Restructuring Inc., released Oct. 2, 2020, one clause in Capital Steel’s contract with Chandos is now enforceable.

The now-voided clause reads:

“In the event the Subcontractor commits any act of insolvency, bankruptcy, winding up or other distribution of assets, or permits a receiver of the Subcontractor’s business to be appointed, or ceases to carry on business or closes down its operations … the Subcontractor shall forfeit 10% of the within Subcontract Agreement price to the Contractor as a fee for the inconvenience of completing the work using alternate means and/or for monitoring the work during the warranty period.”

The contractual clawback from Capital Steel raised the question of whether the amount could properly be withdrawn from a bankrupt’s estate, which is vested with the trustee [in this case, Deloitte].

When Capital Steel went bankrupt in 2016, Chandos owed Capital Steel nearly $150,000 on its contract for the St. Albert condo construction project. At the time, Chandos calculated it would have to pay $22,800 to complete the work that Capital Steel was not able to complete, so Chandos contended that it should be able to deduct that $22,800 from the amount still owed to Capital Steel.

Chandos also argued before the court that because Capital Steel went bankrupt, the amount Chandos owes capital steel is reduced by $137,330, which is 10% of the original contract price. So if you add $137,330 to the $22,800 that it cost Capital Steel to complete the work, that adds up to more than $160,000 that Chandos said it can deduct from the amount it has to pay Capital Steel. Since Chandos paid all but $150,000 of the original price in the contract, Chandos argued Capital Steel actually owes Chandos $10,000.

As the trustee in bankruptcy, Deloitte said Chandos should not be able to claw back 10% of the original price, even though that’s what the contract said.

In a decision released in 2017, Justice Kenneth G. Nielsen of the Alberta Court of Queen’s Bench ruled against Deloitte, finding that the clause in the Capital Steel’s contract with Chandos –  in which the subcontractor Capital Steel forfeits 10% of the total price if it goes bankrupt – is enforceable.

In a divided ruling, that decision was reversed in 2019 by the Alberta Court of Appeal. In essence, two of the three Alberta appeal court judges found that in Canada, parties to a contract cannot arrange their affairs through contract in a way that conflicts with the operation of federal bankruptcy law.

Canadian common law has what is known as an “anti-deprivation rule,” which has not been eliminated by either the courts or by Parliament through the federal Bankruptcy and Insolvency Act, Justice Patricia Rowbotham wrote in 2019 for herself and Justice Barbara Veldhuis of the Alberta Court of Appeal.

“The anti-deprivation rule prevents parties from agreeing to remove property from a bankrupt’s estate that would otherwise have vested in the trustee,” Justice Malcolm Rowe wrote for the majority of the Supreme Court of Canada, in its Oct. 2, 2020 ruling against Chandos.

So as it stands, Chandos cannot claw back $137,330 from what it owes Capital Steel because the bankruptcy clause in the contract is voided.

This does not prevent Chandos, which is still compiling the costs of alleged warranty deficiencies in Capital Steel’s work, from arguing it can subtract those costs from what Chandos still owes Capital Steel.

“We just can’t rely on the ‘liquidated damages’ piece,” said Bieganek. “They still have the opportunity to assert [their rights under warranty] and ensure what they are paying is in fact what is owing to Capital Steel.”

There was no surety bond in this particular case, said Bieganek.

“To the extent that the surety steps in to engage a [different] contractor to complete the contract, I am not sure that this decision will have any impact. In fact, as this contract was structured, it afforded a surety bond company the ability to step in and engage a completion contractor. And if it did that, then the provision would not have been triggered.”

Surety bonds offer financial protection in the event of contractor default as well as requiring the bonding company to assume the administrative burden of making the arrangements to complete the work and settle the overdue accounts of subcontractors and suppliers, L’Unique General Insurance notes on its website. That web page provides information on surety bonds and is not about the Chandos case or any other particular dispute.

Dissenting from the Supreme Court of Canada’s Oct. 2 ruling in Chandos was Justice Suzanne Côté, who would have restored the original Alberta Court of Queen’s Bench ruling in favour of Chandos. Justice Côté argued that the terms of the contract, clawing back 10% of the price if the subcontractor goes bankrupt, has a “bona fide” commercial purpose and does not offend the anti‑deprivation rule.

“A corporate bankruptcy ipso facto term is enforceable if its most important feature is the advancement of a reasonable and defensible commercial purpose, and its enforcement provides a benefit for the non-bankrupt party that is not significantly greater than is necessary to promote the non-bankrupt party’s legitimate commercial interests,” Justice Thomas Wakeling of the Alberta Court of Appeal wrote in his dissenting reasons in 2019. Justice Wakeling would have upheld the original Court of Queen’s Bench ruling in favour of Chandos.

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