Equitable subordination in Canada - Waiting for the right facts

17 minute read
18 June 2014

What does the U.S. doctrine of equitable subordination have to do with Canada? Superficially, the answer may be: not much. But for many financing and insolvency professionals here in Canada, there remains a palpable sense that the U.S. doctrine will eventually, if not inevitably, find its way fully across the U.S. border into Canada. So, perhaps the more appropriate response really ought to be: not much, at least not yet! It is because of this anticipation that it is worthwhile, from time to time, to summarize the central aspects of the U.S. doctrine and to determine its current level of acceptance here in Canada.

The U.S. Doctrine in Brief

Under the U.S. Bankruptcy Code, U.S. courts may apply equitable principles to remedy creditor misbehaviour, including by subordinating certain creditor claims - both secured and unsecured - to the claims of lower-ranking creditors. But, because the remedy disregards the otherwise freely negotiated arrangements of transacting parties, the remedy is considered an extraordinary one, which is to be utilized only sparingly.1 Three conditions must be satisfied before a subordination will be imposed by the court: (i) the creditor whose claim is to be subordinated must have engaged in some form of inequitable conduct (ii) the misconduct must have resulted in injury to the bankrupt's other creditors or conferred an unfair advantage upon the misbehaving creditor, and (iii) the subordination must otherwise be consistent with the provisions of U.S. bankruptcy legislation.2 As a result, the doctrine is usually applied in cases involving some element of fraud, unjust enrichment, breach of fiduciary duty or other inequitable conduct, where there is otherwise some connection between the creditor's misconduct and the injury or disadvantage suffered by the aggrieved creditors.3

The U.S. doctrine is most often applied to sanction the activities of "insiders," for example, the activities of parent corporations or other persons related to the bankrupt who have attempted (improperly) to gain a leg-up on other creditors. Due to the non-arm's-length nature of the relationship, insider conduct will always be subject to closer scrutiny by the courts.4 For "non-insider" cases, on the other hand, where no fiduciary duty is owed to the bankrupt and the impugned creditor otherwise deals at arm's length with the bankrupt, the doctrine is applied much more restrictively, and generally requires misconduct that is "gross and egregious."5 Specifically, the doctrine is usually applied when the arm's-length creditor has "dominated" or "controlled" the bankrupt in some way so as to gain an unfair advantage over other creditors. In the absence of domination, the doctrine may also be applied where the arm's-length creditor has actually defrauded another creditor. Not surprisingly, much of the impugned conduct in both insider and non-insider cases occurs on the eve of the debtor's insolvency.

A good example of non-insider subordination is the case of In re American Lumber Co.,6 a case in which the secured creditor (in this case, a bank) was found to have assumed dominant control over an insolvent debtor. There, the bank essentially took over and then ran the debtor's business, dictating which employees were retained, choosing what debts were paid, falsely informing unsecured creditors that the debtor was still solvent, and deliberately misleading unsecured creditors to enter into new supply arrangements with the debtor. In the result, the bank's secured claims were subordinated to the claims of the bankrupt's unsecured creditors.

The U.S. doctrine continues to evolve today under a massive body of case law. For example, in the recent case of In Re Yellowstone Mountain Club, LLC, the doctrine was applied (in a non-insider context) where an arranging bank for a senior syndicated loan knew, or ought to have known, that its loan - which was conceived, in part, to implement a significant "dividend recap" scheme - had little likelihood of being repaid.7 In the result, the senior secured claims of the bank syndicate were subordinated to the claims of the unsecured creditors, even though there was no evidence of control or domination by the arranging bank and no specific finding of fraud. Rather, the court concluded that the arranging bank (a) had conducted insufficient due diligence (b) had disregarded the fact that the loan left the bankrupt too thinly capitalized (c) had relied on inappropriate valuation methods, and (d) had arranged the loan principally to earn significant fees, while intending to hold very little of the loan post-syndication. Uniquely, and unlike most subordination cases, the impugned conduct here did not occur on the eve of the debtor's insolvency, but instead at the time of loan inception and syndication.

State of the U.S. Doctrine in Canada

In Canada, the U.S. doctrine has not yet been fully accepted as part of the Canadian legal landscape, although it is fair to say that the trend in the case law has progressed from initial statements of unrelenting resistance to cautious expressions of possible recognition. Indeed, recently, there have even been a few cases of outright application. Favourable judicial comment suggests that the U.S. doctrine may be incorporated as part of the bankruptcy court's inherent equitable jurisdiction.8 And while it is certainly true that the Bankruptcy and Insolvency Act (Canada) already contains various means of subordinating and invalidating certain creditor claims,9 and that various provincial statutes likewise seek to promote equitable outcomes, there is still a view that the U.S. doctrine may offer an additional tool to Canadian bankruptcy courts, to better assure equitable outcomes, particularly in the toughest of cases.10

To date, Canada's highest court has brushed paths only briefly and obliquely with the U.S. doctrine. For example, in CDIC v. Canadian Commercial Bank,11 the Supreme Court of Canada refrained from deciding whether or not the U.S. doctrine should become part of the Canadian legal fabric. Just as importantly, however, it did not shut the door on the doctrine either. Rather, on the facts, the Court simply held that there was no evidence of creditor misconduct, nor evidence of injury to other creditors, in either case sufficient to merit a detailed consideration of the U.S. doctrine. Most recently, the Supreme Court of Canada reaffirmed this "wait-for-the-right-facts" approach in Re Indalex Ltd.12 Once again, the Court left open the issue of the U.S. doctrine's acceptance in Canada, finding no evidence of creditor wrongdoing sufficient to merit an in-depth consideration of the doctrine.

As a result, numerous Canadian litigants have continued their attempts to have Canada's lower courts accept and implement the U.S. doctrine. In many of the decided cases, the applicable court found no evidence of improper or inequitable conduct, or of injury to other creditors, thereby allowing the court to side-step detailed consideration of the U.S. doctrine.13 Other courts of first instance have been far less charitable, suggesting that Canada's bankruptcy legislation provides a "complete code" as to the distribution of a bankrupt's estate.14 These cases have suggested that the U.S. doctrine has absolutely no place in Canadian law, and that to introduce it as part of the bankruptcy court's equitable jurisdiction would almost certainly lead to "chaos," resulting in numerous challenges to security arrangements based solely on the conduct of the secured creditor.

Still, other courts have suggested that equitable principles akin to equitable subordination may be available in cases not otherwise involving a statutory scheme of priorities such as that contained in Canada's bankruptcy legislation.15 And at least one court has fashioned a subordination remedy based on concepts of unconscionability, without mentioning the U.S. doctrine.16

The situation is equally uncertain at the appellate level across the country, with the British Columbia Court of Appeal having come closest to acknowledging the court's inherent jurisdiction to adopt the U.S. doctrine.17 Meanwhile, the Ontario Court of Appeal has largely adopted the same 'wait-for-the-right-facts' approach taken by the Supreme Court of Canada.18

Only a handful of lower court decisions have expressly applied the U.S. doctrine.19 For example, in Lloyd's Non-Marine Underwriters v. J.J. Lacey Insurance Ltd.,20 the Newfoundland and Labrador Supreme Court subordinated the unsecured claims of an affiliate of a bankrupt company to the unsecured claims of other creditors on the basis that the affiliate had been intimately involved in a fraudulent scheme perpetrated by the bankrupt company. In this classic case of insider misconduct, the Court dealt extensively with the U.S. doctrine, and purported to apply it directly to the facts before it. In particular, the Court ruled that the application of the U.S. doctrine was not inconsistent with the overall scheme of distribution contemplated by Canada's bankruptcy legislation and that chaos was not likely to result from the adoption of the U.S. doctrine here in Canada.

The Future of the Doctrine in Canada

There may be many reasons for believing that the U.S. doctrine will one day fully cross the border into Canada. One reason may be the ever-increasing convergence of the U.S. and Canadian marketplaces. In particular, with the elimination of withholding taxes on most interest flows between the two countries, and the resultant convergence of the distinct financial marketplaces that once existed on either side of the border, it should not be surprising that remedies which were at one time available only to aggrieved creditors in the U.S. might now receive greater attention in Canada, especially as more and more U.S. participants (and their advisers) expand their activities here in this country.

Furthermore, and as suggested above, there is a perception among some Canadian jurists that the U.S. doctrine, if applied cautiously here, might provide Canadian bankruptcy courts with an additional tool to further promote equity, especially in those difficult cases where existing bankruptcy laws might not otherwise produce a just result. After all, the primary objective of the U.S. doctrine is to correct inequitable conduct not otherwise voided by the express provisions of existing U.S. bankruptcy laws.

Undoubtedly, legitimate concerns remain that the wholesale incorporation of the U.S. doctrine into the Canadian legal landscape will result in legal uncertainty, specifically in terms of the administration of bankrupt estates. Furthermore, acceptance may increase the overall cost of financing for participants in the Canadian marketplace. The pros and cons of adopting the U.S. doctrine have to be weighed carefully. For now, it seems that the Supreme Court of Canada may have it just about right. That is, to allow Canada's lower courts the opportunity to properly sift through the various cases of interest, all the while waiting for the right facts to come along.

1 In Re Autostyle Plastics, Inc., 269 F. 3d 726 (US CA Sixth Cir. 2001). See generally "Making Sense Out of Bankruptcy Courts' Recharacterization of Claims: Why Not Use S. 510(c) Equitable Subordination," Nozemack, M., (1999) 56 Wash. & Lee L. Rev. 689; and "The Doctrine of Equitable Subordination as Applied to Nonmanagement Creditors" (1985) Business Lawyer, v. 40, 417.

2 In the Matter of Mobil Steel Company, 563 F. 2d 692 (US CA Fifth Cir. 1977).

3 See, for example, Pepper v. Litton, 308 U.S. 295 (USSC 1939); In re Nassau Associates, 169 B.R. 832 (Bankr. S.D.N.Y. 1994); In the Matter of Clark Pipe and Supply Co. Inc., 893 F. 2d 693 (US CA Fifth Cir. 1990); and Autostyle, supra note 1.

4 See Pepper, supra note 3.

5 In Re First Alliance Mortgage Co., 298 B.R. 652 (C.D. Calif. 2003).

6 Bergquist v. First National Bank (In re American Lumber Co.), 5 B.R. 470 (D. Minn. 1980); See also In re Process-Manz Press, Inc., 236 F. Supp. 233.

7 In Re Yellowstone Mountain Club, LLC, 436 B.R. 598 (Bankr. D. Mont. 2010). The senior lenders apparently settled with unsecured creditors prior to an appeal of the case, so there was no appellate review of the lower court decision. Doubts have been expressed as to whether the lower court decision would have survived an appeal, and more generally, whether the decision would be followed by other courts. See for example "Yellowstone: New Standards for Lender Liability in Today's Economic Climate," Brighton J.J. & Parrish, F.E., ABI Journal vol. XXVIII, no. 7 (Sept. 2009), and "Rekindling the War on Secured Creditors: Unsecured Creditors Score Important Early Victories," Ricotta, P.J., 2011 WL 586141.

8 Laronge Realty Ltd. v. Golconda Investments Ltd., (1986), 63 CBR (NS) 74; 7 BCLR (2d) 90 (B.C. CA).

9 See, for example, sections 95, 96 and 136-147 of the Act.

10See discussion of legal attitudes in "Transplanting Equitable Subordination: The New Free-wheeling Equitable Discretion in Canadian Insolvency Law?" Telfer, T.G.W., (2001) 38 CBLJ 36.

11 CDIC v. Canadian Commercial Bank [1992] 3 SCR 558.

12 Re Indalex Ltd., 2013 SCC 6.

13 See, for example, 674921 B.C. Ltd. v. Advanced Wing Technologies Corp. 2005 BCSC 1113 (reversed on other grounds, 2006 BCCA 49 (B.C. CA)); Olympia & York Developments Ltd. v. Royal Trust Co., 1993 CarswellOnt 187 (OCJ) (reversed on other grounds, (1993) 14 OR (3d) 1 (Ont.CA)); Nyugen, Re [2013 B.C.W.L.D. 922 (BCSC); I. Waxman & Sons Ltd., Re (2009) 62 CBR (5th) 292 (Ont.S.C.J.); Re Pine Valley Mining Corp., 35 C.B.R. (5th) 279 (BCSC); Unisource Canada Inc. v. Hongkong Bank of Canada, (1998) 43 B.L.R. (2d) 226 (Ont. Ct. (Gen. Div.)); Lorbeth Development Corp. v. 795243 Ontario Ltd., 1998 CarswellOnt 3388 (O.C.J. (G.D.)); National Bank of Canada v. Merit Energy Ltd., (2001) 28 C.B.R. (4th) 228 (Alta. Q.B.); New Solutions Financial Corp. v. 952339 Ontario Ltd., (2007) 29 C.B.R. (5th) 222 (Ont. S.C.J.); Romspen Investment Corp. v. Edgeworth Properties, 2012 CarswellOnt 10902 (Ont. S.C.J.); Re General Chemical Canada Ltd., 2006 CarswellOnt 4675 (Ont.S.C.J.); Re Christian Brothers of Ireland in Canada, (2004) 49 C.B.R. (4th) 12 (Ont. S.C.J.); and Stone Mountain Resources Holdings Ltd. v. Stone Mountain Resources Ltd., 2012 CarswellAlta 2436 (Alta. Q.B.).

14AEVO Co. v. D & A Macleod., (1991) 7 CBR (3d) 33, 4 OR (3d) 368 (Ont. S.C.); Matticks v. B. & M Construction Inc. (Trustee of), (1992), 11 O.R. (3d) 156; Re/Max Metro-City Realty Ltd. v. Baker (Trustee of), (1993), 16 C.B.R. (3d) 308 (Ont. Bktcy.); Canadian Imperial Bank of Commerce v Sayani, (1996) 1996 CarswellBC 2709 (BCSC).

15 Bulut v. Brampton (2000) 48 OR (3d) 108 (Ont. CA), where the Ontario Court of Appeal applied equitable principles to subordinate a prior secured claim to a subsequent court charge.

16 Sittuk Investments Limited v. A. Farber & Partners Inc., (2002), 61 O.R. (3d) 546 (Ont. S.C.J.).

17 See Laronge Realty Ltd., supra note 8.

18 See Olympia & York Developments Ltd., (1993) 14 OR (3d) 1 (Ont.CA); C.C. Petroleum Ltd. v. Allen, (2003) 46 C.B.R. (4th) 221 (Ont. CA); Re I. Waxman & Sons Ltd., (2010) 67 CBR (5th) 1 (Ont.CA);.

19 See, for example, S-Marque v. Homburg Industries Ltd., [1998 N.S.J. No. 550 (N.S. S.C.) and C.C. Petroleum Ltd. v. Allen, (2002) CarswellOnt 2375 (Ont S.C.J.), although, in each case, on appeal, the lower court's application of equitable subordination principles was not considered.

20 Lloyd's Non-Marine Underwriters v. J.J. Lacey Insurance Ltd., 2009 NLTD 148, 2009 CarswellNfld 244 (N&L.S.C.).

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