NORTH OF THE BORDER UPDATE
This article has been contributed to the blog by Mary Paterson and Patrick Riesterer. Mary Paterson is a senior associate in the litigation group of Osler, Hoskin & Harcourt LLP and Patrick Riesterer is an associate in the insolvency and restructuring group of Osler, Hoskin & Harcourt LLP.
In Aircell Communications Inc. v Bell Mobilicity Cellular Inc., 2013 ONCA 95 (“Aircell”), the Ontario Court of Appeal applied the “fraud upon the bankruptcy law” principle when deciding a dispute between a telecommunications company (“BDI”) and an independent dealer that sold BDI’s products and services on commission. The principle is an important common law rule intended to prevent parties from contracting out of insolvency legislation and depriving the estate of assets that otherwise could be distributed to unsecured creditors (“pari passu” distribution). The term ‘fraud’ is not used to refer to dishonesty, but rather to the effect of on the estate if the principle were not applied. The fraud upon the bankruptcy principle often goes by other names.
The dealer owed BDI $64,000 for inventory. BDI owed the dealer $188,981 for unpaid commissions. The Independent Dealer Agreement (the “Agreement”) between BDI and the dealer gave BDI certain rights to terminate the Agreement, including a right to terminate the Agreement if the dealer commenced proceedings under the Bankruptcy and Insolvency Act (“BIA”). The Agreement provided that BDI’s obligation to pay commission “shall cease immediately” upon termination of the Agreement (the “Cease Pay Clause”).
BDI gave notice of its intention to terminate the Agreement due to the dealer’s failure to pay for inventory. Simultaneously, the dealer commenced insolvency proceedings under the BIA. Shortly thereafter, the dealer was deemed bankrupt and a trustee in bankruptcy was appointed with respect to the estate of the dealer (the “Trustee”).
The Trustee sought payment from BDI of the $188,981 in unpaid commissions. BDI relied on the Cease Pay Clause and refused to pay the funds. The Trustee commenced an action for an order requiring BDI to pay. The Trustee was successful at trial. BDI appealed.
The Ontario Court of Appeal’s Reasons
In upholding the trial judge’s decision, the Ontario Court of Appeal applied the fraud upon the bankruptcy law principle, examined the impact of the Cease Pay Clause on the estate and its creditors, and held that the Cease Pay Clause was void and unenforceable against the Trustee. BDI was ordered to pay the net amount owing to the dealer after deducting the dealer’s debt for inventory from BDI’s debt for unpaid commission.
The Ontario Court of Appeal cited C.I.B.C. v. Bramalea Inc., 1995 CanLII 7420 (“Bramalea”), as authority for its application of the fraud upon the bankruptcy law principle. In Bramalea, the court decided a dispute with respect to a clause in a partnership agreement that provided that any partner who became subject to insolvency proceedings was required to sell its partnership interests to the solvent partner for the lesser of book value and fair market value. In Bramalea, the court weighed the importance of freedom of contract against the public policy objective of pari passu distribution contemplated by the BIA. The court held that clause in the partnership agreement was void as against the trustee in bankruptcy and the receiver as contrary to public policy because it would deprive the other creditors of the estate of value.
In Bramalea, the court was focused on the fact that the clause in the partnership agreement was triggered by insolvency. In Aircell, the court noted that any termination of the Agreement triggered the Cease Pay Clause and that the Agreement could be terminated for reasons other than insolvency. The court in Aircell nevertheless applied the fraud upon the bankruptcy law principle, finding that the effect of the Cease Pay Clause in an insolvency proceeding was the same as if the Cease Pay Clause specifically referenced insolvency. The Cease Pay Clause was therefore contrary to public policy as inappropriately affecting the distribution of value to unsecured creditors, contrary to the statutory insolvency distribution scheme.
Cases where the Principle was not applied
The fraud upon the bankruptcy law principle is not absolute. There have been cases where the principle has not been applied despite there being a clause in a contract that called for a different distribution on insolvency than the pari passu distribution that would otherwise be provided for in the relevant insolvency statute.
One interesting example is the unanimous decision of five judges of the Supreme Court of Canada in Coopérants, Mutual Life Insurance Society (Liquidator of) v. Dubois,  1 S.C.R. 900 (“Coopérants”). In Coopérants, the Supreme Court upheld a clause in an agreement that required a co-owner to sell its interest in an immovable property to the other co-owner if the first co-owner was in default. The purchase price was set at 75% of the co-owner’s interest in the immovable, appraised on the value of the immovable as a whole and without regard to the fact that it was held in undivided co-ownership. According to the agreement, a co-owner defaulted if it applied to the court for the appointment of a liquidator.
In deciding to enforce the clause, the court emphasised the importance of freedom of contract. Although there are statutory restrictions intended to prevent one co-owner from denying the other’s ability to partition the property, the court held that the parties had legally contracted out of the statute. The co-owners were sophisticated companies knowledgeable in matters of real estate. The parties freely agreed to limit their rights to partition the property. The purpose of the agreement was to protect the co-owners from the imposition of a judicial sale or of a new partner.
Central to the court’s decision in Coopérants was the fact that the immovable property was a unique, non-fungible asset, the judicial sale of which would harm the other co-owner out of all proportion to the benefit of the other creditors. The sale to the solvent co-owner would provide the insolvent co-owner with an amount very close to the fair market value of the immovable. The court stressed the difference between a case involving liquid assets, which should be sold and distributed pari passu, and unique, non-liquid assets. In the latter case, the court held that the principle of pari passu distribution “must be tempered with equity.”
Coopérants is distinguishable from Bramalea and Aircell. In Coopérants, the insolvent entity would receive value close to the fair market value of the property and serious harm to the other co-owner would be avoided. In Bramalea, there was a difference between the fair market value of the partnership interest and the price to be paid by the solvent partner and no evidence of hardship to the solvent partner. In Aircell, the application of the Cease Pay Clause would result in a windfall to BDI.
The fraud upon the bankruptcy law principle is a measured tool that permits the courts to weigh the importance of freedom of contract and the commercial interests of the parties to the contract against the fair and equitable treatment of all creditors provided for in insolvency legislation. It is important that insolvency practitioners are aware of the principle to ensure that any agreements that purport to modify the ownership of assets or the distribution of value in an insolvency are analyzed to ensure that the insolvent estate receives appropriate value for its asset and that the creditors of the estate are treated equitably. We anticipate that the courts will continue to apply the principle in a restrained manner, having regard to all the circumstances of a given case.