Canada: Restructuring And Insolvency Report - December 2014

Last Updated: December 29 2014
Article by John Birch, Natalie E. Levine and Monique Sassi

In This Issue

  1. Constructive Trust 1 vs. Secured Creditor 0
  2. Void Ab Initio: The Dangers of Insufficient Disclosure
  3. What We've Been Up To

Constructive Trust 1 vs. Secured Creditor 0

By John Birch

Many secured creditors see their position in absolute terms. They rely on their general security and aggressively assert their priority over unsecured creditors, such as trade creditors. However, a recent decision of the Ontario Court of Appeal(306440 Ontario Ltd. v. 782127 Ontario Ltd. (Alrange Container Services), 2014 ONCA 548) demonstrates that creative arguments by trade creditors may allow them to take priority over even secured creditors in certain circumstances, by using trust principles to remove assets from the estate.

In this case, a lender held general security over a borrower for advances made on an operating loan. The borrower carried on business storing, repairing and selling shipping containers for its customers, including a major international container lessor. Pursuant to a depot agreement (the "Depot Agreement") with this customer, the borrower stored and repaired the customer's containers. From time to time, the borrower also refurbished and sold the customer's containers to third parties. The customer then invoiced the borrower for the containers that had been sold. Nothing in the Depot Agreement gave the customer any security over the sale proceeds collected by the borrower or required such proceeds to be held in trust.

By early 2013, the borrower was insolvent and the lender applied for and obtained an order pursuant to section 243 of the Bankruptcy and Insolvency Act (Canada) and section 101 of the Courts of Justice Act (Ontario) appointing a receiver over all of the property, assets and undertaking of the borrower (the "Receiver"). Cassels Brock acted as counsel to the Receiver but took no position regarding priority.

By that point, all of the customer's containers had been sold, although not all sale proceeds had been received. After the Receiver liquidated the remaining assets of the borrower, the customer claimed a priority to a portion of the total proceeds. The customer claimed that the borrower had breached the Depot Agreement by selling many containers without the consent of the customer. Although such claim would normally have been advanced as an unsecured claim for damages for conversion of the containers or for breach of the Depot Agreement, the customer instead asserted a constructive trust over the proceeds in the Receiver's hands.

The customer's claim for priority over the lender based on constructive trust was unsuccessful at first instance. The Ontario Superior Court of Justice concluded that any proceeds from container sales had been comingled with other monies in the borrower's bank account and, in any event, the bank balance had fallen to zero prior to the appointment of the Receiver. The Court also concluded that it would be unjust to impose a constructive trust in light of the pre-existing general security held by the lender.

The customer appealed the decision to the Ontario Court of Appeal and the appeal was partially allowed. The Court of Appeal provided a clear explanation of constructive trusts and their potential use in insolvency situations. A constructive trust is a proprietary remedy. As such, it carries certain significant benefits, such as the removal of property from the estate of the insolvent party, effectively trumping the usual priority scheme under insolvency legislation. However, the Court noted that the nature of constructive trust as a proprietary remedy requires that there be "a close link between the property over which the constructive trust is sought and the improper benefit bestowed" on the other party. The Court found that the requirement of having such close connection should be even more stringent in commercial cases like this.

In respect of those proceeds of container sales that had been received and spent prior to the appointment of the Receiver, the Court concluded that a constructive trust remedy was not appropriate because there was no longer any clear and direct connection between those dissipated proceeds and the funds then in the hands of the Receiver. However, the Court did grant a constructive trust over the part of the proceeds that the Receiver collected after its appointment. The Court concluded that, even though the corresponding containers had been sold before the appointment of the Receiver, the proceeds were directly linked to those sales and thus the required close connection existed. The Court also concluded that, because the borrower had sold those containers without the requisite prior approval of the customer and in breach of the Depot Agreement, there was no "juristic reason" for the borrower to receive and retain those proceeds. The borrower had been unjustly enriched at the expense of the customer. As such, the Court of Appeal imposed a constructive trust over those proceeds, including the portion of the proceeds that represented the borrower's profit on the sale.

This case is therefore both good news and bad news for secured creditors. The Court made it clear that there is a high hurdle to overcome to establish a constructive trust, especially in commercial cases. However, the Court appears to have opened the door for trade and unsecured creditors to seek a constructive trust over proceeds realized from the sale of those creditors' goods as long as they can establish the required connection. General security may not be as infallible as lenders have previously thought.

Void Ab Initio: The Dangers of Insufficient Disclosure

By Natalie E. Levine, Monique Sassi

While it is common practice in Canada to seek certain emergency orders on an ex parte basis (i.e. where only one party (and not the adversary) appears before a judge), applicants for such orders are held to a high standard of candour with the court. Recently, the Ontario Superior Court of Justice (Commercial List) took the unusual step of finding that the initial order (the "Initial Order") granting protection under the Companies' Creditors Arrangement Act (Canada) (the "CCAA") was void ab initio as against all of the applicants thereto (CanaSea Petrogas Group Holdings Limited (Re), 2014 ONSC 6116). This was because subsequently produced evidence did not support the Court's initial conclusions regarding the applicants' eligibility for CCAA protection. In reaching this decision, the Court was very critical of the applicants for not fulfilling their high obligations of candour and disclosure on the ex parte hearing.

In September 19, 2014, CanaSea Petrogas Holdings Limited ("CPGH"), a Canadian holding company, and its subsidiaries (the "Applicants") sought CCAA protection on an ex parte basis. The other Applicants included two Singaporean companies, one of which, CanaSea Oil and Gas Group Pte. Ltd. ("COGG"), was the issuer of certain notes representing 49% of the debt obligations of the Applicants, and two Saskatchewan companies, one of which, CanaSea Oil and Gas Limited ("COGL"), held the major assets of the group being petroleum and natural gas licenses.

At the ex parte hearing, the Applicants relied on what they purported to be unaudited financial statements and advised the Court that the Applicants were eligible for CCAA protection as they each (i) had liabilities in excess of $5 million, (ii) were unable to meet their obligations as they came due; and (iii) had finances "inextricably intertwined" through intercompany advances. The Applicants also advised the Court that, although the Singaporean company (COGG) was the issuer of the notes, its Saskatchewan subsidiaries were "on the hook" for the notes due to the intercompany obligations thereby bringing the Applicants within the insolvency and $5 million debt thresholds required by the CCAA. On the basis of these representations, the Court granted the Initial Order.

Subsequently, COGG's noteholders sought a declaration that the Initial Order did not apply to COGG alleging that their loan documents designated Singapore as the venue for dispute resolution and that COGG did not qualify for CCAA protection because it did not have assets or business in Canada. However, the evidence produced by the noteholders lead the Court to also question the eligibility of the other Applicants. More specifically, while the Applicants purported to have included in the evidence unaudited financial statements that proved their insolvency and liabilities in excess of $5 million; instead they included only profit and loss statements or general ledgers. These documents alone could not demonstrate insolvency or these requirements. In addition, there was no evidence of intercompany loans that supported their representation that the Applicants' finances were inextricably intertwined.

The Court held that its previous conclusions were, in fact, wrong and that there was no evidence of the Saskatchewan subsidiary's (COGL's) insolvency independent of COGG. While the Canadian holding company and the two Singaporean companies were insolvent and had liabilities in excess of $5 million, the holding company did not do business in Canada, and the Singaporean companies, which were the real debtors in the proceeding, had very little connection to Canada. The Court held that, had it previously been aware of these facts, it would not have exercised its discretion to grant the Initial Order and ordered the Initial Order void ab initio as against all of the Applicants. The Court also found that the Applicants had not fulfilled their statutory obligation under section 10(2)(c) of the CCAA to disclose all financial statements prepared during the year before their CCAA application and held that it was "not satisfied that the [A]pplicants had filled their high obligations of candor and disclosure on an ex parte application."

The Applicants sought leave to appeal from the Ontario Court of Appeal on the basis that they were denied procedural fairness. They argued that the lower court terminated the Initial Order for their failure to make full and frank disclosure and, had they known this was the issue, they would have been able to satisfy the lower court that the disclosure made was adequate.

A single judge of the Court of Appeal denied leave to appeal (CanaSea PetroGas Group Holdings Limited, 2014 ONCA 824). The Court disagreed with the Applicants' characterization of the lower court's decision as an issue of disclosure. Instead, it reiterated the deference given to CCAA judges and deferred to the lower court's findings. The Court also held that the Applicants were unable to provide any authority to support their assertion of a common law doctrine of "common enterprise insolvency" and, therefore, simply because the two Singaporean companies were part of a larger group headed by a Canadian holding company, they could not claim the benefit of CCAA protection in respect of debt incurred in Singapore that is governed by Singapore law.

This case demonstrates that applications for insolvency proceedings on an ex parte basis will require a high level of disclosure and candour with the court. Companies and individuals who are considering seeking court protection from their creditors on an ex parte basis must be careful to err on the side of caution and ensure that all relevant financial and other information is disclosed to the court and interpreted fairly. In addition, this case demonstrates that a solvent company may not be eligible for CCAA protection where only its affiliated companies are insolvent.

What We've Been Up To

We are acting as counsel for Grant Forest Products Inc. and its affiliates in connection with their CCAA proceedings. The Office of the Superintendent of Financial Services has now perfected its appeal of an order of the Honourable Mr. Justice Campbell made last fall which, among other things, held that the CCAA stay should be lifted to permit an unsecured creditor to bankrupt Grant Forest Products Inc. affording no priority to outstanding wind-up deficits for two defined benefit pension plans whose wind-up had commenced during the CCAA proceedings. The appeal will be heard on January 13, 2015.

We are acting as counsel for Edgeworth Properties Inc. and certain of its subsidiaries in connection with their parallel CCAA and receivership proceedings. One of Edgeworth's secured creditors has perfected its appeal of an order of the Honourable Madam Justice Thorburn dated July 18, 2014, which varied the receivership order to correct an unintended effect of debt accruing interest at 12% per annum being repaid prior to debt accruing interest at 24% per annum to the prejudice of Edgeworth's subordinate creditors, and to achieve a commercially reasonable result. The appeal will be heard on January 21, 2015.

Alison Manzer was elected as Chair of the Project Finance and Development Committee of the American Bar Association (ABA) in September 2014.

Eleonore Morris was a panelist on "Careers in Law" as part of a Skills Development Series hosted by a conglomerate of Women's Shelters in Calgary, Alberta on September 15, 2014.

John Birch was elected as Vice-Chair of the Insolvency Committee of the Inter-Pacific Bar Association at the Mid-Year Council Meeting held in Brazil from September 24-30, 2014. John will serve a two year term as Vice-Chair from 2015 to 2017. The Inter-Pacific Bar Association is an international association of business and commercial lawyers from more than 65 national jurisdictions around the world.

Eleonore Morris was a member of the organizing committee for the Turnaround Management Association's Annual Conference held in Toronto, Ontario on September 29-30, 2014. Cassels Brock was a bronze sponsor for this event.

Joseph Bellissimo and Jane Dietrich were panelists on "TMA NextGen: Pitch Perfect: A Mock Pitch Event" at the Turnaround Management Association's Annual Conference held in Toronto, Ontario on September 29-30, 2014.

Alison Manzer and Eleonore Morris published a revised chapter on "Secured Debt Arrangements" in Manzer's International Finance in October 2014.

Alison Manzer was appointed to the Advisory Board of Practical Law Canada in October 2014.

Eleonore Morris taught the creditors' segment of the Internationally Trained Lawyers Program offered by the University of Toronto in Toronto, Ontario on November 9, 2014.

Eleonore Morris spoke on "Planning Networking Events" at the Turnaround Management Association's Global NextGen Leadership Conference in New York on December 15, 2014.

Seema Aggarwal was appointed as the Director of Community Service of the Ontario Network of the International Women's Insolvency & Restructuring Confederation (IWIRC) in December 2014. Seema will serve a one year term commencing on January 1, 2015.

Eleonore Morris was elected as Chair of the Turnaround Management Association's Toronto NextGen Chapter on December 3, 2014. Eleonore will serve a one year term commencing on January 1, 2015. As Chair, Eleonore will also sit on the Board of Directors of the TMA's Toronto Chapter.

David Ward will be a panelist on the topic of "Enforcement of Judgments in Foreign Proceedings" at the 12th Annual Review of Insolvency Law (ARIL) in Toronto, Ontario on February 6, 2015.

Alison Manzer and Carla Potter will be publishing a new edition of the book entitled "Asset Based Lending in Canada." The new edition is expected to be published in 2015.

The Cassels Brock Financial Services Group will be publishing a guide to project finance in Canada. The new book is expected to be published in Autumn 2015.

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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