The past year has seen somewhat of a general let-up in activity in the insolvency bar, although a significant number of major restructurings were undertaken or completed as the year progressed. In the steel industry, Stelco filed for protection in January 2004, and Ivaco's and Slater Steel's Companies' Creditors Arrangement Act ("CCAA") proceedings proceeded toward conclusion. Air Canada 's restructuring was completed in September, 2004. Forest products company Doman Industries saw its long-standing and unsuccessful restructuring efforts finally take form behind a bondholder-led rights offering and debt-to-equity conversion. It emerged from protection as Western Forest Products in July, 2004.
It appears that we are seeing a growing trend toward longer and more drawn-out restructurings in Canada, at least in terms of major filings. Whether that is a problem may be in the eye of the beholder. It may also be a function of a number of recent restructurings involving attempts to achieve substantial operational changes in the debtor's business, rather than simple restructuring balance sheets.
The past year has also seen the continuation of the process of legislative reform, with ongoing review of possible changes to bankruptcy and restructuring law and the seeking of industry and professional input. Activity in this regard was hampered somewhat by the intervening federal election and certain other legislative issues and priorities. It is expected that this process will gain steam in the last quarter of 2004 and early in 2005.
The Continued Expansion of Initial CCAA Orders
The past 12 months have seen the continuation of a trend in major CCAA proceedings that has been somewhat disturbing for creditors, particularly unsecured creditors. A number of the debtors that sought protection during this period have been able to obtain initial orders from the court (similar to first-day orders in the United States ) that have gone far beyond previously established legal norms. Some examples follow.
DIP Financing
Ivaco, a public company group in the steel products business, had the majority of its business (including its profitable business) in two subsidiary limited partnerships. Each was separately financed and was in fact created and held out as a separate entity in order to obtain financing on terms which otherwise would not have been available to the group. When the CCAA filing took place, DIP financing was required primarily by the public company parent. Relatively little initial DIP financing was required by the two limited partnership subsidiaries.
Nevertheless, the initial CCAA order (made without notice to the bondholder creditors of the limited partnership) provided for super-priority DIP financing at the limited partnership level in amounts far in excess of the actual requirements of the limited partnerships. In fact, the limited partnerships were required to on-lend much of that DIP financing to their public company parent on a subordinated basis, as opposed to the super-priority basis upon which all other aspects of the DIP financing were ordered. One of the limited partnerships was already an unsecured trade creditor of the parent for over $60 million.
The end result was that the two limited partnership entities, which both had the strongest businesses in the group, and their own independent creditors were ordered to encumber themselves to borrow funds they did not need in order to lend those funds to the parent (not for the benefit of the main creditors of the two limited partnerships) on a subordinated basis. All of this was done on the strength of affidavit evidence from the public company parent debtor and a "desktop" valuation analysis from the proposed monitor, for which it itself was not prepared to accept any responsibility.
Director Protection
The trend in Canadian restructurings over the past few years has been for initial and subsequent orders under the CCAA to provide a great deal of protection to existing directors and officers of the debtor. That certainly appeared to continue in full force over the past 15 months. It is extremely rare to see a CCAA filing these days that is not accompanied by an initial order with very significant protections for directors, including indemnifications that can go beyond those otherwise permitted by corporate law, including very large secured indemnification charges, special secured charges for directors' counsel and, in many cases, the setting up of additional trusts (i.e., in addition to regular directors' and officers' liability insurance) utilizing the sometimes precious cash-flow resources of the debtor as a further protection for the directors and officers. Such protections were utilized to the fullest in the Ivaco, Stelco, Doman and Air Canada cases. Indeed, in Ivaco, the initial order even allowed the cross-collateralization of directors' charges on assets of other entities within the group with respect to which the directors in question were not directors, although that was altered to some extent in the comeback motion after vociferous creditor objection.
Such protections, regardless of whether they are appropriate, have led to a number of problematic results. For example, the creation of such charges can result in the need to establish a supplemental claims process to determine claims against directors and officers, such that distributions to creditors can be held up for months. It has also often been the case that, because of the secured charge protection given to directors in the initial orders—which are very difficult to appeal on a practical level and in respect of which there is generally a low success rate in so-called comeback motions—otherwise legitimate claims against such directors for prefiling conduct are in effect precluded, at least from unsecured creditors. After all, even if such claims are successful, the ability of the directors to obtain priority indemnification from the debtor's assets as a result of the initial order means that the successful complainant creditor will simply be paid on its lawsuit from money it would have received from the estate as a creditor.
Subordination Agreements
During Air Canada's CCAA proceedings, the Ontario Superior Court held1 that subordination agreements or similar arrangements between creditors may be enforced in the context of a CCAA restructuring plan and in particular that "selective subordination" of one subclass of unsecured creditors to another is permissible and does not result in a subordination of the subclass to all unsecured creditors generally. In Air Canada, certain holders of Air Canada 's senior debt had entered into a specific agreement with holders of Air Canada 's subordinated perpetual debt ("SP Debt") (which, according to its terms, was subordinate to the senior debt with respect to right to receive payment of principal and interest, both within and outside of insolvency proceedings). Pursuant to the agreement, the holders of the SP Debt were to be included in the general class of unsecured creditors for the purpose of voting on Air Canada's CCAA plan and the distribution to which the holders of the SP Debt would have been entitled but for the subordination of the SP Debt to the senior debt would be split between the holders of the SP Debt (26%) and the Senior Debt (74%). Air Canada sought court approval to incorporate this agreement into its restructuring plan.
A group of trade creditors brought a cross-motion for a declaration that any entitlement of the holders of the SP Debt must be distributed to all unsecured creditors pro rata in relation to their proven claims, rather than being distributed to the holders of the senior debt and the SP Debt in accordance with their settlement. The trade creditors argued that, the limited subordination contained in the SP Debt indenture notwithstanding, it was a "fundamental principle of Canadian insolvency law that, excepting only specifically enumerated preferred creditors, all unsecured creditors are entitled to pro rata distribution." The trade creditors maintained that since the unsecured SP Debt had been subordinated to the senior debt (which ranked as unsecured debt), the doctrine of subordination required that the SP Debt be subordinated to all unsecured debt (including trade debt) and that the entitlement of all unsecured creditors to a pro rata distribution could not be affected by a private agreement between select creditors.
The court dismissed the trade creditors' motion and held that subordination arrangements between creditors can be honoured by a company in its CCAA plan and that the subordination of one subset of unsecured creditors to another does not make that subset of unsecured creditors subordinated to all unsecured creditors generally. The judge rejected the trade creditors' argument that distributions in CCAA proceedings must adhere strictly to the priorities set out in the Bankruptcy and Insolvency Act ("BIA"). He confirmed that a CCAA plan is regarded as a contract between a company and its creditors and that companies have considerable latitude in formulating their CCAA plans and coming to compromises with creditors, as long as the plan is ultimately determined by a court to be fair and reasonable.
The Definition of "Insolvency"
One of the requirements that a company must meet in order to avail itself of the protections offered by the CCAA is that it must be bankrupt or insolvent.2 The CCAA itself contains no definition of "insolvent" or "insolvency." Accordingly, in practice, courts have looked to the definition of "insolvent person" in section 2(1) of the BIA to determine whether a company met the threshold of insolvency for the purposes of the CCAA. The definition in section 2(1) of the BIA reads as follows:
"'[I]nsolvent person' means a person who is not bankrupt and who resides, carries on business or has property in Canada, and whose liability to creditors provable as claims under this Act amount to one thousand dollars, and:
- who is for any reason unable to meet his obligations as they generally become due;
- who has ceased paying his current obligations in the ordinary course of business as they generally become due; and
- the aggregate of whose property is not, at a fair valuation, sufficient, or, if disposed of at a fairly conducted sale under legal process, would not be sufficient to enable payment of all his obligations, due and accruing due."
It is rare under the CCAA for any issue to be taken with whether or not the debtor is insolvent. Accordingly, the significance of the issue notwithstanding, there has been scant judicial consideration of the test to be applied to determine whether a debtor is insolvent and is therefore eligible for CCAA protection. In 2004, however, the issue was considered in detail in the Stelco Inc. ("Stelco") proceedings. A motion was brought in the Stelco proceedings by certain locals of the United Steel Workers of America (collectively, the "Union") in March, 2004, seeking to set aside the initial order pursuant to which Stelco was granted CCAA protection.3 The Union argued that Stelco was not insolvent at the time of its CCAA application and that it should not therefore have been granted protection under the CCAA. Stelco cited its large "legacy" obligations to retirees (including a substantial deficiency in its various pension plans) as evidence of a "looming liquidity crisis" that would have seen it run out of funds in the coming months.
Farley J. heard the motion and held that Stelco was indeed insolvent and entitled to seek protection from its creditors under the CCAA. In doing so, Farley J. arguably expanded the traditional definition of "insolvency" employed by the courts. He held that even if a company is not technically insolvent under the strict BIA tests at the time that it applies for CCAA protection, it may nonetheless be considered insolvent for the purposes of the CCAA if it is facing a looming liquidity crisis. Farley J. maintained that the purpose of the CCAA (allowing a company sufficient time to restructure so as to avoid liquidation) as compared to the BIA (liquidation of a debtor's assets) may require greater flexibility in determining whether the company is insolvent:
"It seems to me that the CCAA test of insolvency advocated by Stelco and which I have determined is a proper interpretation is that the BIA definition of [section 2(1)] (a), (b) or (c) of insolvent person is acceptable with the caveat that as to (a), a financially troubled corporation is insolvent if it is reasonably expected to run out of liquidity within a reasonable proximity of time as compared with the time reasonably required to implement a restructuring."
The court added that the proper test to be used in respect of a restructuring under the BIA (such as, for example, for the filing of a notice of intention to make a proposal under Part III, Division 1 of the BIA) would be to determine
"whether there is a reasonably foreseeable (at the time of filing) expectation that there is a looming liquidity condition or crisis which will result in the applicant running out of ‘cash’ to pay its debts as they generally become due in the future without the benefit of the stay and ancillary protection and procedure by court authorization pursuant to the order."
It will be interesting to see just how far courts will allow the pendulum to swing in permitting companies that are not presently insolvent according to the BIA but that are facing a "potential" liquidity problem in the future (for example, due to a projected deterioration in market conditions or long-term debt becoming due and payable at some time in the future) to avail themselves of CCAA protection in future cases.
It will also be interesting to see whether the reasoning employed by the court in this case will be applied equally in terms of assessing the conduct of debtors (including in the context of the oppression remedy) facing such a looming liquidity crisis when they choose not to act responsibly (or at all).
Liability of Assignors and Guarantors of Leases
A decision released by the Supreme Court of Canada in January, 2004 overruled the long-standing (and, as many would have argued, counterintuitive) principle from the 1965 Cummer-Yonge Investments Ltd. v. Fagot decision that a guarantor of a lessee's obligations ceases to be liable on that guarantee upon disclaimer of the lease by the lessee in bankruptcy (or its trustee), on the basis that the obligations of the guarantor dissolve with the obligations of the lessee when the lease is disclaimed. In Crystalline Investments Ltd. v. Domgroup Ltd.,4 the Supreme Court held that a tenant who validly assigned a lease remained liable to a landlord under the lease, notwithstanding that the assignee had become insolvent and had disclaimed the lease under the BIA.
The Supreme Court held that section 65.2 of the BIA, which allows a debtor that has filed a notice of intention to make a proposal to its creditors to disclaim a commercial lease upon 30 days' notice to the landlord, must be narrowly construed as benefiting only the insolvent person (in this case, the assignee) and should not be interpreted to terminate all obligations relating to the lease vis-à-vis third parties (i.e., an assignor). Accordingly, an original tenant who has assigned a lease potentially remains (subject to the terms of the lease and any agreement between the assignor and the landlord to the contrary) liable to the landlord.
In its decision, the Supreme Court also held that the Cummer-Yonge decision has created uncertainty in leasing and bankruptcy in creating an artificial distinction between guarantors, whose obligations disappear when a lease is disclaimed by a trustee in bankruptcy or debtor pursuant to the BIA, and assignors, who have primary obligations that survive such a disclaimer. The Court expressly overruled Cummer-Yonge and held that, upon disclaimer, assignors and guarantors are to be treated the same with respect to liability under a lease, in that the disclaimer of the lease by an insolvent tenant or assignee will not relieve a guarantor or an assignor from its contractual obligations.
Termination of Executory Contracts in CCAA Proceedings
It is common in proceedings under this CCAA for a debtor to wish to repudiate contracts that it determines are disadvantageous to it or not necessary for it in its business. The consequences arising from such termination (such as monetary damages) are treated as claims against the estate for purposes of voting on, and receiving distributions under, the debtor's plan of arrangement. By and large, the case law under the CCAA supports the proposition that, absent a demonstration that the debtor's decision to seek to terminate an executory contract is motivated by bad faith or anything other than a desire to improve a debtor's own financial condition, the debtor will be allowed to terminate executory contracts that do not involve the conveyance of proprietary rights and will provide for the consequences of such termination in the plan of arrangement.
However, the decision of Tysoe J. of the British Columbia Supreme Court in the CCAA proceedings of forestry products company Doman Industries Ltd.5, could, if followed by other courts, constrain the ability of debtors to terminate the executory contracts in a CCAA proceeding. After considering previous cases on the issue, including Re Blue Range Resource Corp., Re Skeena Cellulose Inc. and Re Dylex Ltd., Tysoe J. concluded that while it is not necessary for the debtor company to demonstrate that the termination of a contract was essential to the making of a viable CCAA plan, a company cannot simply terminate all of its contracts at will by providing for termination of those contracts in its CCAA plan of arrangement. The Court held that the ability of a company to terminate contracts in CCAA proceedings is subject to the overriding discretion of the court to prevent the termination where the court determines that such terminations are not "fair and reasonable" in the circumstances.
The decision of Tysoe J. appears to be at odds with the decision of Lo Vecchio J. in Re Blue Range Resource Corp., which had held that a company is entitled to unilaterally terminate non-proprietary executory contracts in CCAA proceedings provided that it provides for the consequences thereof in its CCAA plan. While the court in the Doman case acknowledged that Doman would likely be able to reduce its costs to some extent if it were permitted to terminate its contracts with two particular counterparties (the two renewable contracts that Doman sought to terminate as a condition precedent to the implementation of its CCAA plan), Tysoe J. concluded that the termination of the contracts would not be "fair and reasonable in all of the circumstances" since the company had not demonstrated that the potential savings to be realized by it would outweigh the prejudice that would be suffered by the two counterparties if the contracts were terminated.
In Doman, both counterparties had contracts to provide logging and related services to Doman which Doman was, pursuant to the terms of its forest licences with the Province of British Columbia, required to renew on an annual basis. Such contracts are commonly referred to as "evergreen contracts." In Skeena Cellulose, the British Columbia Court of Appeal confirmed that, the requirement under provincial law that such contracts were to be renewed annually notwithstanding, they could be terminated by a debtor in CCAA proceedings. If the potentially more restrictive test set forth in Doman is followed by other courts, it may materially restrict the extent to which companies will be able to achieve an operational restructuring, in addition to a financial restructuring, utilizing the CCAA, especially if it means that every counterparty to a sizable contract will be likely to force a debtor into long and expensive legal proceedings involving such issues on a regular basis.
Collective Agreements and Successor Employer Issues
The decision of the Ontario Court of Appeal in GMAC Commercial Credit Corp. Canada v. TCT Logistics Inc.6 is a significant development in the area of labour relations in the context of insolvency proceedings. Because the decision was made in the context of bankruptcy (i.e., liquidation) proceedings, it remains to be seen what impact, if any, the decision will have in CCAA proceedings.
In TCT Logistics Inc., the court held that a collective agreement is not a contract that terminates upon bankruptcy (i.e., liquidation bankruptcy) for all purposes. The court drew a distinction between the TCT Logistics case and the decision of the Supreme Court of Canada in Re Rizzo and Rizzo Shoes Ltd., which held that employment of all employees is terminated on bankruptcy. While the Ontario Court of Appeal in TCT Logistics agreed that employment contracts contained within a collective agreement would terminate upon bankruptcy, this did not mean that a collective agreement terminated for all purposes upon bankruptcy. The court held that the status of a collective agreement is governed by the Labour Relations Act (Ontario) and could only be terminated in the specific circumstances set out under that Act such as abandonment (section 63[17], fraud (section 64[1]) or failure to bargain (section 65[2]).
Of perhaps greater importance, the court in TCT Logistics also considered the ability of a court to protect receivers and trustees from successor employer obligations and the degree to which the stay of proceedings arising upon bankruptcy could be used to prevent unions from bringing successor employer proceedings before the Ontario Labour Relations Board ("OLRB"). The court held that the OLRB (and not the bankruptcy court) has the exclusive jurisdiction to determine whether or not a receiver or trustee is a successor employer for the purposes of the Labour Relations Act but that the bankruptcy court does have the jurisdiction, in a proper case, to deny leave to bring successor employer proceedings against a trustee or receiver before the OLRB.
Accordingly, it appears that the broad provisions which have typically been included in receivership orders declaring that receivers are not, and are not to be deemed, successor employers for the purposes of the Labour Relations Act may be of questionable value in actually protecting receivers from liability for successor employer obligations. The Ontario Court of Appeal has ruled that a court does not have the jurisdiction to make such a determination. In its decision, the Ontario Court of Appeal specifically stated that "the practice of receivers attending on the bankruptcy judge ex parte, with a draft order that gives the receiver extensive powers, while at the same time cloaking it with immunity from responsibilities to parties who are not before the court, can no longer be sanctioned." The court acknowledged that receivers and trustees may be unwilling to act without such blanket immunity from courts but suggested that the issue could be dealt with by the receiver meeting with the unions to try and negotiate an accommodation with respect to the basis upon which the receiver can operate the business on an interim basis without incurring undue liability.
The court also left open the question of the ability of courts to use section 215 of the BIA (which requires leave of the court before any action can be brought against an interim receiver or bankruptcy trustee) to deny leave to unions to bring an application before the OLRB to have a trustee or receiver declared a successor employer. Obviously, if such leave were denied, the issue would be of less significance to receivers.
In any event, this decision appears to increase uncertainty for receivers and trustees and those who indemnify them and may require a receiver or a trustee to seek to negotiate with unions early in the process in order to ensure that it has adequate protection against the relevant liabilities in the circumstances.
Prepared with the assistance of Raj Sahni, Associate, Bennett Jones LLP
1 (April 5, 2004) 03-CL-4932 (Ont. S.C.J.) [unreported].
2 Companies' Creditors Arrangement Act, R.S.C. 1985, c. C-36, as amended, s. 2(a).
3 [2004] O.J. No. 1257 (QL).
4 [2004] 1 S.C.R. 60.
5 Re Doman Industries Ltd. (2004) 45 B.L.R. (3rd) 78.
6 [2004] O.J. No. 1353 (QL).