Nov 1, 2019

Recent Decision Challenges Enforceability of Liquidated Damages Clause

Capital Steel Inc v Chandos Construction Ltd, 2019 ABCA 32 (CanLII)

Bankruptcy is one of the most costly forms of contractor default that can occur on a project. Occurring without notice, a bankruptcy will usually result in multiple liens by unpaid subcontractors and material suppliers and significant project delay.

As with any other form of default, parties may address by contract the consequences of bankruptcy or other similar forms of financial instability. Most standard construction contracts give an owner or general contractor the rights to immediately terminate a bankrupt contractor, complete the work, recover the cost to complete from the bankrupt, and withhold any monies due to the bankrupt until completion.

Another less common form of contractual protection which parties may agree to is a liquidated damages provision that is triggered only in the event of bankruptcy. The enforceability of such a provision was considered in Deloitte Restructuring v. Chandos Construction, 2019 ABCA 32.

The provision at issue was contained in a contract between Chandos Construction, the general contractor for a condominium project, and Capital Steel, a subcontractor responsible for steel-related work. The subcontract had a price of $1.37 million and included a liquidated damages provision which provided that in the event that Capital Steel made an assignment into bankruptcy, Capital Steel would forfeit 10 percent 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”.

Capital Steel completed the majority of its subcontract work and Chandos made payments totaling approximately $1.22 million. However, prior to completion, Capital Steel filed for bankruptcy.

In response to Capital Steel’s bankruptcy, Chandos exercised the liquidated damages provision against Capital Steel, claiming that Capital Steel was obliged to forfeit 10% of the contract price to Chandos. As a result of the 10 percent forfeiture and the offset of the relatively minimal cost to Chandos to complete the subcontract work, Chandos became a net creditor to Capital Steel with a $10,500 claim provable in the bankruptcy proceedings.

Deloitte Restructuring was appointed as the trustee in bankruptcy for Capital Steel’s estate. Deloitte applied to the Court of Queen’s Bench for directions as to whether Chandos was entitled to rely on the liquidated damages provision. Deloitte contended that the provision conflicted with bankruptcy law and the common law anti-deprivation rule as it had the effect of depriving Capital Steel’s other creditors of value otherwise available to them while effectively directing value to Chandos, an unsecured creditor in Capital Steel’s bankruptcy.

In the Court of Queen’s Bench proceedings, Chandos maintained that it was entitled to enforce the provision on the basis that it was an enforceable liquidated damages clause. The chambers judge agreed, finding that the provision was a genuine pre-estimate of damages, which imposed liquidated damages and not a penalty. He also held that the provision represented a bona fide commercial transaction that did not have as its predominant purpose the deprivation of Capital Steel’s property. In short, Chandos could enforce the clause against Deloitte.

On appeal, a majority of the Court of Appeal disagreed with the court below and allowed the appeal. The Court held that the provision offended the common law anti-deprivation rule, which the majority found to have originated in English law and to have been adopted into Canadian law. The Court explained that the anti-deprivation rule prevents parties from agreeing to remove property from a bankrupt’s estate in the event of insolvency that would have otherwise vested in the trustee.

The Court of Appeal held that Canadian law established that the application of the anti-deprivation rule requires a court to adopt an effects-based approach when assessing the enforceability of a particular contractual provision. As such the Court rejected Chandos’ argument advocating a purpose-based assessment which would examine the purpose of the provision rather than its effect. Chandos had contended that the liquidated damages provision was part of a good faith commercial transaction which did not have as its predominant purpose the deprivation of the property of one of the parties on bankruptcy.

The Court held that the anti-deprivation rule applies to provisions that operate in the event of insolvency and, in effect, remove value from a bankrupt’s estate to the prejudice of the bankrupt’s creditors.

Applying the anti-deprivation rule, the Court held that the liquidated damages provision in issue was invalid as it effectively redirected money owed to Capital Steel to Chandos, thereby prejudicing Capital Steel’s other creditors. The Court noted, however, that this determination did not affect Chandos’ other rights triggered by Capitial Steel’s bankruptcy to complete the work, recover the cost to complete, and to withhold monies until completion.

The dissenting judge in the Court of Appeal disagreed that the provision could not be enforced. He reasoned that there was no common law anti-deprivation rule as the provisions of the federal Bankruptcy and Insolvency Act occupied the field. He further reasoned that the principles of party autonomy and freedom of contract should be given paramount primacy. He reasoned that the provision in issue should be enforced unless it manifests a blatant attempt to hijack the bankrupt’s property and defeat the legitimate interests of the bankrupt’s creditors, which he did not find to be the case.

The final result of this case remains to be determined. In July 2019, the Supreme Court of Canada granted leave to appeal.