This paper was the winning entry for the 2021 Michael MacNaughton Student Writing Award for Insolvency Law.
The addition of a statutory good faith requirement in Canadian insolvency proceedings has opened more doors than it has closed. In late 2019, section 18.6 of the Companies’ Creditors Arrangements Act[1] (“CCAA”) and section 4.2 of the Bankruptcy and Insolvency Act[2] (“BIA”) were introduced, requiring all interested parties to a proceeding to act in good faith (“2019 Amendments”). The 2019 Amendments do not define “good faith” or provide specific remedies for a breach of it. Rather, the amendments provide the court with unfettered discretion to make any order it considers appropriate when a stakeholder breaches its good faith obligation.[3]
The breadth of these powers could breathe new life into the often-rejected but frequently entertained doctrine of equitable subordination. The 2019 Amendments may provide fertile grounds for a court to subordinate the priority of a creditor for misconduct, as it provides the court with jurisdiction to fashion remedies as a matter of equity to enforce good faith. Accordingly, this paper suggests that door is now opened for equitable subordination to be adopted in Canada.
Equitable Subordination: What is it?
Canadian courts have long grappled with the doctrine of equitable subordination. The doctrine is codified in the US Bankruptcy Code,[4] and provides that the claim of a creditor may be subordinated in priority where they have engaged in misconduct. Its purpose is to undo wrongdoing by a creditor that harms the interests of other creditors.[5]
The test for the application of the doctrine generally requires: (1) the creditor to have engaged in inequitable conduct; (2) the conduct to have resulted in injury to the creditors of the debtor, or to have conferred an unfair advantage to the creditor; and (3) for the subordination not to be inconsistent with insolvency legislation.[6]
Whether the doctrine is desirable as a matter of policy is beyond the scope of this paper. However, it suffices to say that the consequences of the application of equitable subordination would be drastic, as it could be used to alter or void valid legal arrangements, introducing contractual uncertainty.[7]
Canadian Treatment of Equitable Subordination
Equitable subordination has received uneven treatment in Canada and has never been fully adopted.[8] The Supreme Court of Canada has twice left the question of whether equitable subordination is available in Canada “open for another day”.[9]
Courts have called the application of the doctrine one of “simple fairness”, requiring an inquiry into “what is right and just in all the circumstances”.[10] Some courts have gone so far to determine that the remedy is available in Canada, encouraging courts to embrace “expanding the law” when there is oppressive unfairness.[11] Further, the Ontario Court of Appeal has observed that the BIA appears to give bankruptcy courts explicit jurisdiction as a court of equity to apply the doctrine, and that it remains an issue for another day.[12] The most recent decision that the author is aware of addressing the doctrine holds that it is indeed available in Canada.[13]
However, jurisprudential support for the doctrine has not been consistent. Several decisions have rejected the application of the doctrine, citing its inconsistent application in Canada,[14] the fact that it remains “an open question”,[15] the doctrine’s inconsistency with the legislative purpose and scheme of the CCAA,[16] and because of its potential to create “chaos” and lead to challenges to security agreements.[17]
The Meaning of Good Faith Following the 2019 Amendments
The 2019 Amendments do not define “good faith”. As a consequence, courts have looked to the common law duty of good faith to guide their interpretation of the 2019 Amendments:
(1) the statutory duty requires that an interested party not bring or conduct proceedings for an oblique motive or improper purpose;
(2) it requires parties not to lie to or mislead the other; and
(3) whether dishonesty has occurred in a given case is fact-specific and may, depending on the circumstances, include lies, half-truths, omissions and even silence.[18]
When it comes to remedies, one court has stated that section 4.2 of the BIA provides broad discretion, which includes a power to put “stakeholders in the same position as if the duty of good faith had been discharged”.[19] Equitable subordination may lend itself to this “power”.
Another decision notes that there is not necessarily a breach of the statutory duty if a party knows that their conduct is extremely harsh, so as to cause the other party significant financial hardship.[20] This appears to align with equitable subordination, which similarly requires there to be inequitable conduct as opposed to just harsh treatment.
One recent case cited academic authority to inform the statutory duty of good faith. In the Court’s view “bad faith conduct” may be: (1) where a party fails to act candidly, honestly, forthrightly, and reasonably in their dealings, (2) where parties act arbitrarily or capriciously, or (3) where parties lie or knowingly mislead each other.[21] This type of misconduct is at the core of equitable subordination.
An example of the application of the 2019 Amendments can be found in Bank of Montreal v 592931 Ontario Inc.[22] When a creditor was required to deliver an executed agreement as a condition of closing, and chose willingly to engage in conduct that was prejudicial to the ability of a purchaser to obtain financing, this demonstrated a lack of good faith under section 4.2 of the BIA.[23] The conduct consisted of leaving the agreement unsigned and undelivered, despite having knowledge that the purchaser’s financing depended on it, as the creditor was preoccupied with entertaining the prospect of a richer deal from a competing bidder. The Court’s finding was driven by the fact that the creditor insisted on maintaining this prejudicial conduct when it could have easily been corrected, and as the creditor was “distracted by visions” concerning its self-interest.[24] A fact scenario such as this which considers competing priorities is ideal to meet the requirements of equitable subordination.[25]
The 2019 Amendments and Equitable Subordination – The Door is Opened
It has been 30 years since the Supreme Court of Canada left the question of equitable subordination open for another day. Since that time, courts have slowly began to entertain the doctrine. The 2019 Amendments introduce general good faith requirements that are still taking shape, along with apparently unfettered powers to remedy a breach. It remains to be seen whether equitable subordination will fill the lack of jurisprudential or legislative guidance.
No decision has yet considered the application of equitable subordination following the 2019 Amendments. The doctrine would be a powerful tool for courts to address misconduct by creditors. The time is arguably ripe for the equitable subordination to be applied, as the jurisprudence has gradually built a foundation that could align with the statutory duty of good faith:
- the purpose of the doctrine is to undo wrongdoing;
- the application of equitable subordination is one of simple fairness and what is just in the circumstances;
- the doctrine is targeted at misconduct;
- there is authority advocating for courts to embrace the doctrine where there is oppressive unfairness;
- Ontario’s highest court has stated that a bankruptcy court retains the jurisdiction to potentially apply the doctrine as a matter of equity; and
- deference is given to the Supreme Court of Canada’s words that the availability of the doctrine is a question for another day.
“Another day” is now. Definitive adoption of equitable subordination would constitute a useful aid to the 2019 Amendments. A codified requirement that parties not act with an improper purpose, coupled with an undefined and unrestricted scope for remedying a breach of good faith, is why the time is ripe for equitable subordination to have its day in Canadian courts. To the extent it can put stakeholders in the same position as if the duty of good faith had been discharged, equitable subordination provides an ideal remedy to enforce a new obligation.
All in all, the door is open, and it takes one court to walk through it. Creditors must be made aware that their conduct will now be scrutinized in novel ways, and that with the right set of facts, an ambitious court may subordinate the priority of their claim.
[3] Section 18.6(2) of the CCAA; Section 4.2(2) of the BIA.
[8] A recent decision acknowledges this: Doyle Salewski Inc. v. Scott, 2019 ONSC 5108 at para 559.
[9] CDIC, supra note 6 at para 97; See Indalex Ltd., Re, 2013 SCC 6 at para 77.
[11] Lloyd’s Non-Marine Underwriters v J.J. Lacey Insurance Ltd., 2009 NLTD 148 at para 54; See also Christian Brothers of Ireland in Canada, Re, [2004] OJ No 359 (SCJ Commercial List) at para 104 as an additional example of a court stating that it has the jurisdiction to apply equitable subordination.
[16] In US Steel, supra note 12, the Ontario Court of Appeal, although leaving the door open under the BIA, rejected the application of the doctrine under the CCAA at paras 82-87, 101-103.
[17] AEVO, supra note 7 at para 32.
[23] Ibid at paras 34-35, 48, 50.
[24] Ibid at paras 34-35, 48.
[25] Priorities of stakeholders were irrelevant in this case.
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