As a result of Sino-Forest Corporation's insolvency, the shareholders of the Company will lose their investment. Certain shareholders have started class actions in Canada and the United States (not yet certified) to recover damages from the underwriters of Sino Forest's shares and its auditors, based on alleged misrepresentations in the prospectus and financial statements. The underwriters and the auditors would have claims for contribution and indemnity against Sino-Forest based on their engagement letters. The Ontario Court of Appeal1 recently affirmed an earlier decision of Justice Morawetz concluding the prospective claims against Sino-Forest were "equity claims" which could not be satisfied before the creditors are repaid in full. As a result, these indemnity claims will likely be worthless.
Prior to 2009 amendments to the Companies' Creditors Arrangement Act ("CCAA"), the subordination of equity claims in an insolvency was not codified in the CCAA. The CCAA now expressly prohibits the court sanctioning a plan unless it provides for the payment in full of all non-equity claims before any equity claim is paid. In Re Sino-Forest Corporation, the issue before the Ontario Court of Appeal was the proper interpretation of the definition of "equity claim" in the CCAA. Specifically, the Court considered whether claims by auditors or underwriters against a debtor corporation for contribution and indemnity fall within that definition.
Sino-Forest is a Canadian public holding company listed on the Toronto Stock Exchange. Between 2005 and 2009, Sino-Forest raised funds through equity and debt offerings to the public. In connection with these offerings, Sino-Forest entered into agreements with several large institutional underwriters and auditors to indemnify these parties for any damages or legal costs arising out of their participation in the offerings. In 2011 and 2012, Sino-Forest's shareholders started proposed class action proceedings in Canada and the United States alleging that Sino-Forest misrepresented its financial situation and the auditors and underwriters failed to detect these misrepresentations. The claims against Sino-Forest were stayed in the initial order granted by Morawetz J. in the Company's CCAA proceedings. The auditors and underwriters filed individual proofs of claim against Sino-Forest, seeking contribution and indemnity for amounts they may be ordered to pay in the shareholder class actions; these were contingent claims.
Sino-Forest and certain of its directors, officers and note holders subsequently brought a motion seeking a court order that the auditor and underwriter indemnification claims be classified as "equity claims" pursuant to the CCAA. The auditors and underwriters opposed it on the basis that their claims arose out of contractual relationships with Sino-Forest and could succeed independent of the underlying shareholder claims.2 Accordingly, the underwriters argued they were creditors and not equity claimants.
Justice Morawetz of the trial division ruled the claims were equity claims. He considered the plain language of the CCAA and the effect of the 2009 amendments concluding that both underlying shareholder claims and related indemnity claims were equity claims. Specifically, Morawetz J. found that the 2009 amendments to the CCAA not only codified the common law subordination of equity claims but broadened their scope. Because the plain language in the definition of "equity claim" focuses on the nature of the claim and not the identity of the claimant, it was clear the indemnity claims fell within the definition.
On November 23, 2012, the Ontario Court of Appeal unanimously upheld the lower Court's ruling. The Court agreed with Morawetz J. that the definition of equity claim focuses on the nature of the claim and not the identity of the claimant. The Court emphasized the expansive language used in the definition of "equity claim" to determine the auditors' and underwriters' claims for contribution and indemnity fell within that definition. Because the indemnity claims of the auditors and underwriters would only arise if the shareholder claims were successful, the Court concluded that the indemnity claims fell within the broad definition of "equity claim".
Finally, and perhaps most importantly, the Court emphasized Parliament's intent in enacting the amendments to the CCAA was to prevent equity claims from diminishing the assets of a debtor available for distribution to its creditors. To allow auditors and underwriters to assert claims of contribution and indemnity against the debtor would have precisely this effect. As a result, the Court dismissed the appeal.3
As a practical matter, the ultimate financial outcome in this case may not have been materially different had the Court reached the opposite conclusion. If the auditors and underwriters successfully convinced the Court that their claims were not equity claims, their indemnification would be limited to what they could recover as unsecured creditors. Given the large pool of creditors and the nature of Sino-Forest's "assets", it is not expected that there will be a large recovery for each dollar of claim; however, something is always better than nothing. From a legal perspective, the Court of Appeal's ruling represents a decisive clarification as to the status of auditors and underwriters seeking contribution in respect of underlying shareholder claims brought against them. The underwriters have indicated that they intend to seek leave to appeal to the Supreme Court of Canada.
1 Re Sino-Forest Corporation, 2012 ONCA
2 The underwriters also argued that the issue was premature in that the Court was being asked to determine the proper interpretation of the definition of "equity claim" without the benefit of an actual claim or proper evidentiary record. Justice Morawetz disagreed, finding that the issue was independent from a determination as to the validity and quantification of any claim. As a result, it was appropriate to determine the issue on the motion. This decision was upheld on appeal.
3 Notably, Morawetz J. did not characterize the auditors' and underwriters' claims for defence costs as equity claims on the basis that these costs were not necessarily "in respect of" an equity claim. This determination was not appealed.
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