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The Second Opinion: Beware Contractual Provisions triggered (even indirectly) by a Party’s Insolvency

A Commentary on Recent Legal Developments by the Opinions Group of McCarthy Tétrault LLP

Posted in The Second Opinion
Anthony Alexander

Following a recent ruling of the Ontario Court of Appeal, parties may need to proceed cautiously in enforcing contractual rights and remedies in circumstances where there is a risk of the counterparty subsequently becoming insolvent.

The common law has long recognized that a contractual provision which is explicitly and directly triggered by a party’s insolvency (and which thereby causes subsequent prejudice to the rights of the insolvent party’s creditors) may be unenforceable as a matter of public policy.

Those are not the facts of the recent decision in  Aircell Communications Inc. v. Bell Mobility Cellular Inc., 2013 ONCA 95, however.   In a ruling that may take many by surprise, the Court of Appeal ”extended” the traditional common law doctrine in order to deprive a contracting party of its agreed-upon rights.

The contract in question was a dealer agreement between a dealer and a distributor.  The contract permitted the distributor to terminate the agreement in circumstances where the dealer had failed to remedy a default in payment within 30 days.  Upon such a termination, any outstanding commissions owed by the distributor to the dealer were to become unenforceable.

The dealer had failed to make payments to the distributor, and the distributor accordingly gave the dealer the requisite 30 days to make good its obligation or face termination of the agreement.

Unbeknownst to the distributor, however, the dealer had already filed a notice of intention to make a proposal under the Bankruptcy and Insolvency Act.   As a result, before the 30 days had elapsed, and therefore before the contract could be terminated, the dealer was deemed a bankrupt.

The question for the courts was whether the distributor was permitted to terminate the contract in accordance with its terms — based on the dealer’s breach of contract (through non-payment), and not based on the dealer’s insolvency — with the concomitant right to be relieved of its obligation to pay outstanding commissions to the dealer (or, more accurately, to the dealer’s trustee in bankruptcy).

The Court of Appeal ultimately decided that, because the termination of the contract was caused by the dealer’s failure to meet its payment obligation, and because this failure was indirectly caused by the dealer’s insolvency, the termination itself should be deemed to have been caused by the insolvency.  For this reason, the traditional common law rule applied:

[12]      While the clause at issue in this case is triggered upon termination of the agreement for any number of reasons, and not only upon insolvency or bankruptcy, it was in fact triggered as a consequence of [the dealer's] insolvency.  The clause provides a windfall to one of [the dealer's] creditors:  [the distributor].  In the context of an insolvency, the clause is inequitable.  We agree with the trial judge that the principle in CIBC v. Bramalea [(1995), 33 O.R. (3d) 692 (Gen. Div.)] should be extended to declare the clause unenforceable as against [the dealer's] trustee in bankruptcy as contrary to the overriding public policy that requires equitable and fair distribution among a bankrupt’s creditors.

The Court’s willingness to thus “extend” the common law doctrine to the facts of the case caused the distributor to be denied its explicit contractual rights.  As a result, parties to commercial contracts which contain otherwise-inoffensive provisions may face a regrettable new area of uncertainty should an untimely insolvency intervene.

The McCarthy Tétrault Opinions Group consists of members of the firm’s litigation department whose practices focus on written advocacy and the provision of strategic advice and opinions in the context of complex business disputes and transactions.  The members of the Opinions Group are Anthony Alexander, Martin Boodman, Brandon Kain, Hovsep Afarian and Kirsten Thompson.