Continentalism, The Empire Of The St. Lawrence And The Development Of Canadian Insolvency Law

Friday, October 1, 2004 - 00:00

Introduction

In Canadian national political history and in Canadian politics the themes of
and tensions between the development and maintenance of separate national
Canadian institutions and ways and the geographic and natural north/south ties
between Canada and the United States are ubiquitous. These themes are also
evident in some recent developments in Canadian insolvency law. We think this is
illustrated by, among other things, the approach of Canadian courts to questions
of recognition and comity in cross-border insolvency proceedings, the recent use
of so-called "stalking horse" bidding processes in Canadian proceedings and a
recent decision about the test for entry into reorganization proceedings in
Canada. We briefly review some recent developments in these areas by way of
illustration.

Of course, the theme we suggest is not the only explanation for these recent
developments. They must also be seen in their own context. Canadian insolvency
law took a significant turn starting in the late 1980s and early 1990s. First,
Canadian insolvency practitioners "rediscovered" the Companies' Creditors
Arrangement Act
(the "CCAA"), virtually forgotten Depression-era legislation
put in place to permit arrangements between debtors and debentureholders. Many
people have called the CCAA "Chapter 11 without rules" (though it now might be
better to describe the CCAA as "Chapter 11 without too many written rules").
Also, in 1992 and again in 1997, the CCAA and the other principal Canadian
insolvency statute, the Bankruptcy and Insolvency Act ("BIA") were
amended. The amendments to the BIA embodied a fundamental change in favour of
reorganization as against the pre-amendment expectation of liquidation as the
usual insolvency option.

Comity

With the ever increasing integration of the North American economy, the need
for the co-ordination of insolvency proceedings relating to international,
primarily North American, commercial enterprises is more and more evident.
Justice Farley of the Ontario Superior Court of Justice1
commented on this reality stating: "In an increasingly commercially integrated
world countries cannot lie in splendid isolation and refuse to recognize foreign
judgments and orders."2 Canadian courts apply comity as a rule
of practice. However, they are reluctant to rubber stamp U.S. decisions.
Instead, a form of "custodial comity" is cautiously applied when Canadian
interests are at stake.

Prior to 1997, the CCAA lacked any codification of comity; the courts looked
to common law principles. Section 18.6 of the CCAA, enacted in 1997, provides a
codified framework for comity in international insolvency proceedings.

Section 18.6 of the CCAA was first considered in Re Babcock & Wilson
Canada Ltd
.3 (" Babcock "). This case involved mass
asbestos tort claims against Babcock & Wilson Canada, a Canadian company
with a U.S. parent. Chapter 11 proceedings resulted in a stay against U.S.
plaintiffs in all asbestos litigation. Due to potential plaintiff claims against
the Canadian subsidiary, the U.S. order requested "the aid and assistance of the
Canadian courts in carrying out the U.S. Bankruptcy Court's orders."

In Babcock , Justice Farley set out the governing principles with
respect to Section 18.6. Justice Farley found that comity should apply given
that: (a) the substantive and procedural aspects of the U.S. Bankruptcy Code
(the "U.S. Code") and the CCAA are very similar; (b) a real and substantive
connection existed as the parent company was in the U.S. and the U.S. Code had a
mechanism for dealing with mass tort claims; (c) the CCAA is a flexible statute;
and (d) the proceeding and debtor company were within the plain meaning of the
statute. Following Babcock, major corporate players, such as Philip
Services Corp. and Lowen Group, have chosen to file concurrently under the CCAA
and Chapter 11. In other cases, proceedings have been commenced primarily in the
U.S. with ancillary proceedings in Canada seeking recognition and giving effect
to the primary proceedings.4 The Canadian courts continue to
approach comity by considering the principles set out in Babcock. While
not being territorialist, Canadian courts have asserted their sovereignty and
have been careful not to allow American courts to encroach on their
jurisdiction.

While the majority of insolvency case law exemplifies that comity is applied
in a frictionless manner, select cases illustrate the Canadian court's
opposition to merely acting as a rubber stamp. This was exemplified in
Recoton Canada Ltd., again a matter in front of Justice Farley. A request
was made to approve a sale of assets that had taken place pursuant to a U.S.
stalking horse procedure. Justice Farley stated:

It would be prudent and respectful for the integrity of the Canadian
insolvency regime and court process in the overall interests of justice for
approval of the Canadian courts to be sought explicitly in advance ...
rather than implicitly in arrears.

Although these words are bold, U.S. insolvency counsel should not be hesitant
in seeking comity from Canadian courts. Close economic ties, similarities in
legislation and respect between judiciaries have resulted in many positive
cross-border cases which have granted requests for comity.

Stalking Horse Bids - Process Reigns

The process is in essence a court driven auction in which an initial bidder,
the "stalking horse" establishes a benchmark bid. While common in the U.S.,
stalking horse processes are a new animal in Canada.

In Canada, the stalking horse process follows the general principles
established in Royal Bank of Canada v. Soundair
Corp
.5 ("Soundair"). This case established the test
to be applied by a court on an application for approval of an agreement of
purchase and sale by a court appointed receiver. Soundair established
that the court should consider the following:

1.Whether the receiver has made a sufficient effort to get the best price and
has not acted improvidently;

2. The interests of all parties;

3. The efficacy and integrity of the process by which offers are obtained;
and

4. Whether there has been unfairness in the working out of the process.

Canadian courts have generally accepted the stalking horse process as long as
the process does not diverge from the Soundair principles. While the
issues for Canadian stalking horse proceedings are similar to those in the U.S.,
some differences do exist. For example, while Canadian courts have accepted that
lead bidders are entitled to expense reimbursement, break-up fees have been
controversial north of the border. The Canadian courts are cautious in awarding
payments that are unrelated to the expenditures related to purchase
negotiations. In PSINet, the Ontario court did not object to the
break-fee but Justice Farley commented that while appropriate, the fee must be
"reasonable." Should the break-fee be too high or perceived to be unreasonable,
it will undoubtedly be scrutinized by the court based on the principles
established in Soundair. The break-fee was also considered and approved
in Archibald Candy (Canada) Corporation (" Archibald "). It
appears that Canadian courts are of the view that break-fees higher than 3% are
suspect. In Archibald, courts on both sides of the Canada-U.S. border
worked in concert, supervising and approving the stalking horse sale process;
the Canadian and U.S. courts were connected by real-time video conference
hearings.

In Canada, deference to Soundair's principles creates a context in
which the process of the sale is as important as the sale itself. The process
will be scrutinized. However, the flexibility of the CCAA gives parties involved
in the process latitude in fostering a deal. Currently in Canada, the process is
mainly used for situations where the debtors's assets and creditors are on both
sides of the border. We think it is fair to say that, at least at this stage,
most Canadian courts will permit this kind of sales process to proceed provided
that they are satisfied that the Soundair principles are respected.

Access to the CCAA

We understand that a debtor need not be insolvent to take advantage of
Chapter 11 under the U.S. Code. In Canada the tests for access to the CCAA or
the BIA require insolvency or the commission of an act of bankruptcy. At first
blush access to the reorganization regimes seems to be more limited in Canada
than in the U.S. In light of a recent decision in the restructuring of Stelco
Inc., a steel maker, the rules for access to the CCAA and Chapter 11 may not be
as different as they might first appear.

In Re Stelco,6 Justice Farley decided that access to
the CCAA should not be impeded by a narrow approach to the requirement that a
debtor company be "insolvent." This decision means that Canadian corporations in
financial trouble will have easier access to the CCAA. In other decisions,
Justice Farley made it clear that the CCAA should not be the "last gasp" of air
for companies going under. By widening the scope of "insolvent," companies can
have a greater opportunity to seek protection before their situation is fatal;
somewhat akin to Chapter 11 filings.

The CCAA protects debtor companies who are insolvent, deemed to be insolvent,
or have committed an act of bankruptcy. In Stelco, the precise nature of
the very threshold for protection under the CCAA was considered in light of that
statute's legislative purpose. Canadian courts have clearly enunciated that as
framework legislation, the CCAA is a remedial piece of legislation which is to
be applied liberally. In Stelco, Justice Farley found that the
"insolvency test" in the CCAA should not be as onerous as to block a company's
access, while leaving it to only obtain assistance when it is too late - that
final "gasp of a dying company; it should be implemented; if it is to be
implemented prior to the death throe."7 Justice Farley concluded that "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."8 This certainly does
open the door.

In Stelco, Justice Farley disagreed with the conclusions of Justice
Ground, of the Ontario Superior Court of Justice, in which a creditor sought to
place a debtor under the CCAA. Justice Ground held that to include every debt
payable at some future date in "accruing debt" for the purposes of insolvency
tests would render numerous corporations with long term debt insolvent for the
purposes of the BIA and CCAA. If this case would have been decided pursuant to
Justice Farley's new test, insolvency would have been established, as Justice
Farley has held that every obligation of a corporation, in a hypothetical or
notional sense, must be treated as "accruing debt." This significant variation
in the interpretation of "due and accruing due" may result in the court looking
more favourably on a creditor-initiated application.

Although the gate for access to the CCAA has been significantly opened by the
Stelco decision, Justice Farley clearly stipulated that the court shall
continue to utilize its "judicial discretion" in deciding whether or not to
accede to an application by a creditor or debtor for relief. That is, satisfying
the insolvency test is a necessary condition of obtaining court protection but
may not be a sufficient condition. It remains to be seen how future cases will
be decided and how the expanded definition is balanced with the court's inherent
jurisdiction and use of judicial discretion.9

1 In Canada jurisdiction in insolvency and bankruptcy is
national; it is a federal head of power. But the law is administered by the
Superior Courts in each Province with appeals, ultimately, to the Supreme Court
of Canada. Accordingly, subject to decisions by the Supreme Court of Canada, it
is possible that insolvency law may vary by Province depending on the judicial
decisions made in each Province. Justice Farley is one of the leading insolvency
judges in Canada and his decisions have persuasive effect nationally.

2 Re Matlock, (2001) 26 C.B.R. (4th) 45.

3 (2000), 18 C.B.R. (4th) 157 Ont. S.C.J.

4 This mirrors Section 304 of the U.S. Bankruptcy Code
which recognized proceedings commenced in Canada.
5
(1991), 4 O.R. (3d) 1 (C.A.).
6 (2004) O.J. No.
1257.
7 Ibid.
8 Ibid.

9 In Stelco, Justice Farley attempted to
distinguish the test of insolvency under the CCAA from that of the BIA. It
remains to be seen whether this distinction will last.

Michael J. MacNaughton is a
Partner of Borden Ladner Gervais LLP in Toronto and a member of the firm's
insolvency and restructuring group. He can be reached at (416) 367-6646.
Tanya M. Kozak is an Associate of the firm in Toronto and
a member of the insolvency and restructuring group. She can be reached at
(416) 367-6145.

Please email the authors at mmacnaughton@blgcanada.com and tkozak@blgcanada.com with questions about this
article.