The demise of a major timber player with over a six billion dollar market capitalization continues to leave its mark on the Canadian financial and legal industries. In a decision released on November 23rd, the Ontario Court of Appeal upheld a lower court decision that indemnity claims of underwriters and auditors against a debtor company in a Companies' Creditors Arrangement Act ("CCAA") restructuring constitute equity claims, thereby subordinating these claims to the claims of unsecured creditors.
What does this mean for underwriters and auditors whose clients file for CCAA protection?
Sino-Forest Corp. listed on the Alberta Stock Exchange through a reverse takeover of a dormant shell company in 1994 and then graduated to the TSX in 1995. Since then, Sino-Forest has raised over $3-billion in the debt and equity capital markets. Canadian underwriters provided underwriting services in connection with three equity offerings in 2007 and 2009, and four note offerings from 2008 to 2010. Sino-Forest agreed to indemnify the underwriters against a number of matters relating to these offerings. The auditors of Sino-Forest, through their engagement letters, also had the benefit of indemnities from the company related to their audit reports.
At its peak, Sino-Forest had a market value of over $6-billion. But on June 2, 2011, Carson Block's Muddy Waters report sent the forestry company into a tailspin, with an immediate and staggering 71 percent plunge in the company's share price in the week that the report was released. Commencing in March, under CCAA protection from creditors, the company attempted an asset sale process, which proved to be unsuccessful. That then led Sino-Forest to initiate the restructuring process in August of this year.
Prior to the initiation of the CCAA proceedings, class actions were commenced against Sino-Forest for misrepresenting its assets and financial situation in its public disclosure and against the underwriters and auditors for failing to detect these misrepresentations. With the commencement of the CCAA process and the appointment of a monitor for the company, Sino-Forest applied for an order that the claims against Sino-Forest arising from the ownership, purchase or sale of an equity interest in the company, including the shareholder claims, and any indemnification claims against Sino-Forest relating to or arising from the shareholder claims, were "equity claims", as defined by the CCAA.
THE CCAA AND THE COURT'S VIEW
The CCAA provides that no payment can be made in respect of equity claims until all other claims are paid in full. This provision, included in the CCAA by amendments in 2009, codified the subordination of equity claims to the claims of creditors to the assets of the company.
What constitutes an equity claim? According to the CCAA, a claim for an "equity interest"1 including claims for a dividend or similar payment, a return of capital, and a redemption or retraction obligation are all equity claims, as is a claim for "monetary loss resulting from the ownership, purchase or sale of an equity interest or from the rescission, or, in Quebec, the annulment, of a purchase or sale of an equity interest". However, the CCAA goes on to say that a "contribution or indemnity in respect of a claim" referred to above is also an equity claim.
One of the main arguments of the underwriters and auditors in this case was that their relationship with the debtor company was contractual and that their claims are not claims that are "in respect of an equity interest" because they, unlike shareholders, did not have an equity interest in Sino-Forest.
However, the court confirmed that claims of shareholders for a loss in the value of their equity interest constitute equity claims. The court went on to find, primarily based on statutory interpretation, that where a shareholder has a claim against an underwriter or auditor for loss in the value of their equity interest, any claim for contribution or indemnity by the underwriter or auditor against the debtor company also constitutes an "equity claim" and is subordinated to the claims of unsecured creditors.
Although the lower court and the Court of Appeal may have placed different weight on the U.S. approach to this issue, the end result appears to be consistent with the treatment of indemnity claims of underwriters in the United States in the context of the insolvency of a company.
Finally, although the court did not definitively decide the issue, it did note that if the claims of shareholders in the class actions were unsuccessful, the indemnity claims of the underwriters and the auditors for their defence costs may not be characterized as equity claims.
A WAY OUT OF THE WILDERNESS?
This decision undoubtedly raises some concerns for advisors such as underwriters and auditors acting for companies raising capital, particularly if the company subsequently faces financial difficulty and seeks relief under the CCAA. While the financial and legal industries continue to analyse the implications of this decision a few observations are worth noting.
First, since the case deals with indemnity claims of underwriters and auditors related to an underlying equity claim, it raises the question of whether an indemnity claim of an underwriter or an auditor against a company in connection with an offering of debt securities would rank equally with all other unsecured claims of the company. If so, the risk profile for advisors acting in equity offerings may be greater than when acting in debt offerings.
Second, in the case of underwriters involved in a prospectus offering, a due diligence defence is available under securities law to claims by purchasers of securities that the prospectus contained a misrepresentation. Given that they may not be able to rely on any indemnity given by an equity issuer, underwriters may need to consider whether IPO level diligence is required for any type of offering of equity securities, even in instances where the underwriters' involvement with the company arose years after the company became a public company. In addition, underwriters will have to consider the time involved for such diligence and ultimately issuers may have to bear the cost of such diligence whether or not an offering proceeds.
Third, in the course of its analysis, the court reiterated a prior decision where a claim for indemnity by directors and officers against debtor companies were held to be equity claims. The indemnity claims in that case arose from arbitration proceedings brought against the directors and officers individually by a disgruntled investor in the debtor companies. This is a useful reminder to directors and officers that although an indemnity from a company is helpful, considering that an indemnity claim may rank behind unsecured creditors, having D&O insurance in place may be more helpful.
Although it is possible that attempts are made to structure indemnity claims of advisors so that they are not equity claims, based on the reasoning of the court it is not clear whether such attempts will be successful. Until then however, the indemnity claims of underwriters and auditors in the context of equity offerings may well be stuck in the wilderness with general equity claims.
1 Essentially defined as a share in a company or a unit in an income trust, and options or warrants or other rights to acquire such interests, other than rights derived from convertible debt.About BLG
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