Canada: Imminent Insolvency – Shifting Fiduciary Duties of Directors

We know that directors owe a duty to their corporation’s shareholders. An emerging question is whether, in circumstances where a corporation is heading toward insolvency, the directors owe fiduciary duties to the corporation’s creditors?

We are looking forward to an answer to this question from the Supreme Court of Canada, which heard argument in May 2004 on an appeal from the Québec Court of Appeal in Peoples Department Stores Inc. (Trustee) v. Wise. The Trial Court answered the question in the affirmative. The Québec Court of Appeal overturned that decision. It now rests with the Supreme Court of Canada to provide us with some direction on the issue.

The facts in Peoples involved a corporate relationship whereby Wise Stores Inc. was a public company under the Canada Business Corporations Act (CBCA). The Wise brothers (3 brothers) were majority directors and 75% shareholders. Wise Stores Inc. owned 100% of the shares of Peoples Department Stores and the three Wise brothers were the sole directors of Peoples. As at January 1994, the fiscal year end, Wise Stores was at or near insolvency whereas Peoples was solvent. Leading up to this point, the history of each entity was that they each purchased their own inventory. As of February 1, 1994, a new policy was adopted whereby Peoples would buy inventory for both itself and Wise Stores and would sell to Wise the inventory needed by Wise. The trade debt of Peoples escalated and 10 months later it too was insolvent along with Wise. Peoples’ creditors ended up with the huge unpaid intercompany receivable "asset" due from the insolvent parent company.

In the reasons for judgment at trial, the trial judge found that the new purchasing policy was a drastic departure from past practice with disastrous financial consequences for Peoples. The new policy resulted in hard assets going from Peoples in return for uncollectable receivables from Wise. The Judge found that the Wise brothers as directors recklessly preferred the interests of Wise over Peoples. The Judge acknowledges that there was no evidence of any direct financial gain by the directors personally and no dishonesty or fraud by Wise brothers. The failure to consult professional advisors when instituting policy and the failure to monitor the consequences of the policy on Peoples, in the Judge’s view, violated the duties under Section 122(1) of the CBCA to exercise care, diligence and skill and under Section 100 of the Bankruptcy and Insolvency Act, this inventory sale was a reviewable transaction as there was a "conspicuous" difference in value between what Peoples gave (the inventory) and what it got in return (an uncollectable receivable).

The Judge finally declared that where the best interests of the subsidiary are in direct conflict with those of the parent, the former must prevail in regard to the actions of the directors of the subsidiary. The trial Judge states that it is not unreasonable, in exchange for the benefit of limited liability, to impose a duty on directors not to sacrifice creditors’ interests when the going gets rough.

In reversing the judgment at trial, the Québec Court of Appeal declared that directors’ compliance with statutory duties is a purely subjective test. Here it was found that the directors had acted honestly and not in any fraud upon the corporation. As directors of both the parent and the subsidiary, the directors were entitled to sacrifice the interests of the subsidiary for the "greater good" of the parent. The directors were entitled to invoke the Business Judgment rule, that is, the court should not second-guess business judgment of directors made honestly in the belief that the entire corporate business would benefit and impose liability for honest error in business judgment. The Court of Appeal determined that creditors are not stakeholders in the sense of having a stake in the management of the business. If there is to be a change in this understanding, it should be legislated and not constituted by way of the judgment of the court.

In considering the main question before the Supreme Court of Canada, there are substantial points on both the side of the creditors and that of the directors. In favour of the creditors:

ONE. Once a corporation is insolvent, the directors’ continuing fiduciary duty to the corporation is not to prejudice the interest of creditors whose rights to corporate assets displace shareholders with no equity and therefore no economic claim to the business.

TWO. As a matter of legal policy, it makes sense to impose liability as a means to have directors focus on the rights of creditors at that point where a corporation approaches insolvency. Liability may reduce the tendency to take excessive risks to stay afloat.

THREE. Directors, with access to inside information and control over management, are in a better position than creditors to protect corporate assets.

The argument on behalf of directors is:

ONE. Creditors are able to look after themselves and they do so by obtaining:

(a) security on hard assets;

(b) inter-corporate and personal guarantees (usually from owner/directors in closely held corporations); and

(c) financial disclosure.

TWO. Creditors’ interests amongst themselves are frequently in conflict in the race to get paid. How will directors, as a practical matter, be able to satisfy trust-like duties owed to divergent creditor interests?

THREE. Directors accept appointment from shareholders on the basis that they owe duties to the corporation, not to financial institutions and suppliers who re-characterize themselves as "stakeholders". If the rules are to change, it should be for parliament to change them, not the courts.

FOUR. Directors already face liability for certain unpaid taxes, various labour claims, and environmental problems. The addition of potential liability to pay creditors will simply empty the board rooms of talented people and make insurance difficult to obtain.

FIVE. Existing law, for example, the oppression remedies in business corporation statutes and the bankruptcy and insolvency provisions relating to liability for reviewable transactions and liability for approving share dividends and redemptions is a sufficient safeguard to protect the interests of third parties without opening the gates to further assault by creditors under the guise of a newly created fiduciary duty.

SIX. In conclusion, as was expressed in the 1987 English House of Lords decision in Winkworth v. Baron, cited with approval in 1999 by the Ontario Court of Justice in Canbook v. Borins, "the conscience of the company, as well as its management, is confined to its directors". It is consistent with established principle and precedent to find that directors owe no direct fiduciary duties to creditors but, rather, continue to owe fiduciary duties solely to the corporation. The interests of the corporation are usually congruent with those of its shareholders, but on or near insolvency, the corporation’s best interests are to preserve and protect what it has. The company’s conscience to do so is with its directors.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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