Take away: A penalty clause in a contract that provides for a reduction in the value of an asset in the event of bankruptcy may not be enforceable against the trustee in bankruptcy. It is also reducible if it is abusive.
The Quebec Court of Appeal confirms that the anti-deprivation rule applies in Quebec.
In 2020, in Chandos Construction Ltd v. Restructuration Deloitte inc.[1] (hereinafter “Chandos“), the country’s highest court crystallized the application of the anti-deprivation rule in the Canadian provinces, “which renders void contractual stipulations that have the effect of reducing the value of the asset to the detriment of the creditors.”[2]
More recently, in Syndic de 9283-9034 Québec inc. (hereinafter “Syndic de 9283“)[3], the Quebec Court of Appeal confirmed that this common law principle also applies in Quebec.
In this case, Distnet and 9283 entered into a receivables financing (factoring) agreement in 2019, whereby 9283 assigned its receivables to Distnet in return for immediately available funds. The agreement included a penalty clause of up to $50,000 in the event of 9283’s bankruptcy. In August 2021, 9283 filed a notice of intention to make a proposal to its creditors and went bankrupt in December 2021. Distnet owed 9283 for the assigned receivables, but withheld $50,000 under the penalty clause of the agreement. 9283’s trustee then instituted proceedings to recover this sum for the benefit of the creditors of the estate.
The trial judge ruled on the withholding and concluded that it was triggered by 9283’s bankruptcy and had the effect of reducing 9283’s assets by depriving its creditors of $50,000. Applying the common law anti-deprivation rule, the judge declared the penalty clause null and void, and ordered Distnet to remit the sum of $50,000 to 9283’s trustee.
On appeal, Distnet argued, among other things, that the anti-deprivation rule did not apply in Quebec. Justices Dutil, Gagné and Cotnam of the Court of Appeal dismissed the appeal and affirmed the conclusions of the trial judgment.
First, the Court of Appeal recalled that the objective of the anti-deprivation rule is in line with the objectives of the Bankruptcy and Insolvency Act (“BIA”), and more specifically section 71 BIA:
“[24] An important aspect of the BIA is to ensure fair treatment of creditors. However, the anti-deprivation rule gives effect to an implicit prohibition in the BIA that “prevents parties from agreeing to remove from the estate of a bankrupt certain property that would otherwise have vested in the trustee.”[4]
Thus, clauses that would prevent a bankrupt debtor’s assets from being vested in the trustee are void, as such stipulations thwart the BIA’s implicit prohibitions. To determine whether this rule has been breached, the Court of Appeal uses the two criteria established by the Supreme Court of Canada in Chandos, which are as follows:
“[26] […] 1) the application of the clause must be triggered by insolvency or bankruptcy; and 2) the clause must have the effect of reducing the value of the assets of the insolvent person. […] “[5]
Moreover, the Court of Appeal ruled that the anti-deprivation rule applied, so there was no need to refer to article 1623 of the Civil Code of Québec (“C.C.Q.”). This article provides that a court may reduce a penalty stipulated in a contract if the penalty is abusive in the circumstances. In a 2023 decision in 9085-3664 Québec inc. v. Succession de Boutin[6], the Court of Appeal applied article 1623 C.C.Q. in a case involving an emphyteutic lease to reduce the $25/day penalty and 18% interest stipulated in the lease, since the result was to impose the equivalent of 380% interest on the defaulting tenant. The Court thus reduced the penalty by deducting the $25 per day penalty, while maintaining the 18% interest on the rent due.
In light of the Quebec Court of Appeal’s Syndic de 9283 and Succession de Boutin decisions, it is important to take particular care when drafting penalty clauses in contracts, as they may not always have the effect intended at the time of drafting. Their application may be called into question and subject to review by the courts.
[1] Chandos Construction Ltd v. Restructuration Deloitte inc., 2020 SCC 25
[2] Syndic de 9283-9034 Québec inc. [Syndic de 9283], 2023 QCCA 938, par. 22.
[3] Ibid.
[4] Syndic de 9283, par. 24.
[5] Ibid., par. 26.
[6] 9085-3664 Québec inc. v. Succession de Boutin, 2023 QCCA 697
