“Another Day”: Equitable Subordination in CCAA Proceedings

The Michael MacNaughton Student Writing Award for Insolvency Law was created to encourage law students to prepare a written submission on a recent case or a topical issue of interest to insolvency practitioners.

The late Michael MacNaughton was one of the leading insolvency lawyers in Canada and was well known for his consistent contributions to the body of literature in the area of insolvency and restructuring.

The OBA Insolvency Law Section is pleased to present the 2017 winning submission, authored by James Hardy. 

In 1992, Justice Iacobucci left the question of whether the equitable subordination doctrine should exist in Canadian law “open for another day.”[1] With the Supreme Court of Canada’s (“SCC”) decision to grant leave to appeal on that issue from the Ontario Court of Appeal’s decision in U.S. Steel Canada Inc., Re[2], that day will soon arrive. This essay will argue that the SCC should follow the Ontario Court of Appeal in finding that equitable subordination is not available in proceedings under the Companies’ Creditors Arrangement Act (“CCAA”).[3]

The Doctrine of Equitable Subordination

Equitable subordination is a doctrine in United States bankruptcy law which allows the court to subordinate the claim of a creditor based on the creditor’s conduct. While the doctrine now enjoys statutory recognition,[4] it was initially developed by the U.S. courts relying on the court’s equitable jurisdiction.[5] The principles of the doctrine were set out as a three-part test in Mobile Steel Co., Re:

            (i) The claimant must have engaged in some type of inequitable conduct.

(ii) The misconduct must have resulted in injury to the creditors or conferred an unfair advantage on the claimant.

(iii) Equitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy Act. [6]

Equitable Subordination in Canada and the Decision in U.S. Steel

Equitable subordination has had a varied history in Canada. While the SCC has considered the doctrine twice, each time it declined to decide whether it should exist in Canada.[7] Some subsequent cases have been skeptical of the doctrine’s existence[8], while others have found it to exist and used it to subordinate the claim of a creditor.[9][10]

The most recent consideration of equitable subordination occurred in U.S. Steel. The case concerned U.S. Steel Canada (“USSC”), who is under CCAA protection. USSC’s former employees claimed that the parent company, United States Steel Corporation (“USS”), deliberately caused USSC to underperform and thereby caused USSC to become insolvent. The former employees argued that as a result USS should have their secured claims subordinated to the claims of the unsecured creditors.

The Ontario Court of Appeal was unanimous in finding that equitable subordination was not available in CCAA proceedings. Speaking for the Court, Chief Justice Strathy found that the doctrine did not help the CCAA fulfil its purpose.

The Unsuitability of Equitable Subordination in the CCAA Context

In U.S. Steel, the Court decided that the CCAA did not grant the Court authority to order equitable subordination, as “nowhere in the words of the CCAA is there authority, express or implied, to apply the doctrine of equitable subordination. Nor does it fall within the scheme of the statute, which focuses on the implementation of a plan of arrangement.”[11] This meant that the Court’s broad discretion under section 11 CCAA[12] could not be exercised. Chief Justice Strathy found that section 11 only granted the Court the jurisdiction to grant orders “in furtherance of the purposes of this act.”[13]

This is an appealing argument. The title of the CCAA makes clear that the act is “to facilitate compromises and arrangements between companies and their creditors”. Equitable subordination is a doctrine that seeks to settle disputes between creditors, not between creditors and a company, and so falls outside of the goals of the CCAA.

There are further reasons to be skeptical of equitable subordination in the CCAA context. It is a remedy that, even in the U.S. context, lacks clarity. By the first limb of the test, equitable subordination requires there to be “inequitable conduct”. While certain behaviours such as fraud clearly suffice, the U.S. courts have struggled to define the lower limit of inequitable conduct: it has been called “the elusive boundary that cannot be clearly defined.”[14] Importing such a standard into Canadian law is liable to cause ambiguities. This would make it harder for commercial actors to reliably predict their likely recovery in CCAA proceedings, and would lead to delays and costly litigation as parties fight over their entitlements. Lastly, it makes credit more expensive: risk averse parties who could formerly rely on their secured interest become less willing to lend when there is a possibility their interest could be subordinated due to conduct that is found, on the margins, to be inequitable.[15]

This is particularly the case for an imported standard. Equitable subordination was developed in the U.S. in a manner that is not sensitive to the Canadian legal context, and transplanting such a doctrine could cause problems. This difficulty was recognized in Re I. Waxman & Sons Ltd.,[16] where Justice Pepall noted “[t]here is of course a danger associated with taking a doctrine divorced from its legal home and applying it to Canada’s statutory bankruptcy regime unencumbered with the deep knowledge of the origin, development and legal system from which it originated.” Similarly, Alan Watson has noted that generally “legal rules which are unsatisfactory at home appear even less satisfactory when they are transplanted.”[17]

One situation where the differences between the U.S. and Canadian legal systems may cause difficulties is that of fiduciary duties. In Pepper v Litton[18], a breach of fiduciary duty led to the granting of equitable subordination. Jeremy Opolsky argues that “the scope of breaches of corporate fiduciary duty in Canada is more limited.”[19] Such differences make proper analysis of the standard of “inequitable conduct” more challenging in the Canadian context, raising the possibility that conduct falling short of a breach of fiduciary duty could be deemed as inequitable conduct.

Furthermore, the unfamiliarity of Canadian courts with American jurisprudence is likely to cause errors in interpretation. For example, in Blue Range Resource Corp., Re,[20] the Court accused other Canadian cases of “accept[ing] the erroneous proposition that inequitable misconduct is required in all cases under the American doctrine”,[21] whereas in the U.S. in In re Lifschultz Fast Freight[22], the Court stated to the contrary that “equitable subordination is predicated upon creditor misconduct”. Canadian commentary has suggested Blue Range “runs counter to recent United States Supreme Court jurisprudence which prohibits the categorical subordination of claims.”[23] Such uncertainty about the correct position of the law is likely to cause extra expense and delays when pursuing legal action.

The Necessity of Equitable Subordination in the CCAA Context

It is also questionable whether the equitable subordination doctrine is necessary in Canada. There are several other paths to challenge the priority of competing creditors. For example, common law principles (including equitable principles) may be used where there is the absence of a statutory regime governing the priority of different claims.[24] Alternatively, courts have been willing to consider whether a debt could be properly recharacterized as equity, which would result in the claim ranking behind the unsecured creditors.[25]

If a discretion-based approach is desirable, a potential avenue rooted in Canadian law already exists in the form of the oppression remedy. Section 241 of the Canada Business Corporations Act gives the court a broad discretion to “rectify the matters complained of”, including, under s 241(3)(d), “an order directing an issue or exchange of securities.” [26]

This potential order was considered in the context of CCAA proceedings in Lightstream Resources Ltd., Re.[27] In similar language to U.S. Steel, the Court found that the remedy at s 241(3)(d)[28] was “contrary to the scheme and object of the CCAA.” However, the analysis of the inappropriateness of the remedy requested was focused on the prejudice it would cause to other creditors, as opposed to any incompatibility with the goals of the CCAA.

More promising is the recent case of Ernst & Young Inc. v. Essar Global Fund Ltd. et al.[29] While the Court did not reorganize the priority of claims in the case, they were willing to take the radical step of altering the disputed transactions. This had the effect of improving the position of the Represented Creditors, as their reasonable expectation that unwarranted value would not be given to a third party was protected, thereby enhancing their potential recovery.

While the oppression remedy has not yet evolved to a point where courts are comfortable using it to subordinate the claims of one creditor to another, the wide discretion it offers combined with the radical approach the courts are adopting with respect to the remedies they order suggest that this may be an avenue to give the equitable subordination doctrine its own Canadian flavour.

Conclusion

Due to the unsuitability of equitable subordination in CCAA proceedings, and the uncertainty associated with introducing such a new doctrine, we should hope that the SCC follows the Ontario Court of Appeal’s decision in U.S. Steel. If there is an appetite for this sort of equitable remedy, developing equitable subordination through the oppression remedy rather than introducing it independently may provide the courts with more reliable guidance.

However, one of the most significant sources of uncertainty is the uncertainty over the current state of the law. If nothing else, the upcoming U.S. Steel case before the SCC should be welcomed for providing clarity about the position of the doctrine of equitable subordination in Canadian law.