On September 17, 2009 our firm published a summary of recent amendments (the "Amendments") to Canada’s Bankruptcy and Insolvency Act ("BIA") and Companies’ Creditors Arrangement Act ("CCAA"). This summary provided a detailed review of the significant legislative changes that were brought into force on September 18, 2009. This will article will focus on certain of the Amendments to which equipment financiers should pay particular attention as they may impact how equipment financiers transact business.
- Disclaimer of Contracts
The Amendments provide the restructuring debtor with the right to disclaim contracts with the approval of the Monitor/Trustee or the Court. Specifically exempted are, inter alia, (i) financing agreements where the debtor is the borrower and (ii) leases of real property or of an immovable if the company is the lessor.
Clearly, any financing document by way of either note and security agreement cannot be disclaimed under the new provisions. The treatment of personal property leases, however, may be more interesting. A lease may be determined to be either a "financing" lease or a "true" lease. The Amendments do not define what a "financing agreement" is nor do they define or make comment as to whether a lease is a financing agreement.
The common law has drawn a distinction between the two by treating a finance lease akin to a loan and a true lease akin to a use of equipment for a fee, but the Courts have developed different approaches to determining whether a lease is a true lease or a financing lease depending on the context of the analysis – i.e., tax treatment, PPSA, or insolvency.
Prior to the Amendments, in the insolvency context, determining whether a lease is a true lease or a financing lease has been primarily important in order to determine whether the lessor is entitled to the payment of post-filing rent from the lessee-debtor. Section 11.3(a) of the CCAA and section 65.1(4)(a) of the BIA provide that a lessor can require payment for the post-filing use of leased property. The Courts have interpreted those provisions, however, to only apply where the lease in question is a true lease not a financing lease. Moreover, the tests developed by the Courts for making the distinction are more strict and debtor-friendly than in the context of the PPSA and, as such, many leases that would have been treated as true leases under the PPSA are financing leases under the insolvency regime. The logic of the Courts has been that the sections should be interpreted narrowly in order to facilitate the debtor-lessee’s restructuring efforts.
As a result of the Amendments, both the lessor and debtor will have new strategic decisions surrounding the determining of the nature of the lease. If a lessor seeks to have the lease determined to be a true lease in order to obtain payment during the restructuring period, it will then be taking the risk that the lease may be disclaimed (which given the economics, the lessor may prefer). If the debtor does not want to pay lease payments during the restructure period, then it will have to claim that the lessor is a secured creditor which will preclude the debtor from disclaiming the lease and may impact the dynamics of its restructuring and proposed plan. While the Amendments do not provide a lessor with the right to require a debtor to either disclaim or pay directly1, the lessor could effectively force the issue by making an application to compel payment under section 11.3 of the CCAA or section 65.1(4)(a) of the BIA, depending on which restructuring proceeding has been engaged.
In such a case where the lease is a true lease, the application would effectively force the debtor to decide whether it will pay or disclaim the lease2. What will be most interesting will be to see whether the Amendments create a shift in the approach taken by the Courts in determining whether a lease is a true lease or a financing lease. As noted above, the Courts tended to favour the debtors by making it more difficult to conclude that a lease is a true lease for purposes of the CCAA or BIA. However, now that a determination that a lease is a financing lease – which presumably then qualifies it as a "financing agreement" for the purposes of the disclaimer provisions – may negatively impact the debtor’s restructuring, the Courts may tend towards re-balancing the approach to be applied. However, that presumes that the Court applies the same standard in the context of post-filing payment as the new disclaimer provisions.
The impact of this provision has also raised some concern for securitizations. A common structure for automobile securitizations is the use of a "concurrent lease" structure whereby the lessor leases certain "lease rights" (which includes payments due under leases) to a securitization vehicle ("SPV") that in turn makes a prepayment of rent due under the concurrent lease and receives the lease payments over time. In essence, the SPV is fully performing all of its obligations under the concurrent lease. If this concurrent lease can be disclaimed, then the SPV would have paid for the lease rights up front but not be entitled to the benefit of them. While it is a risk, it is likely a very remote one as it would be unlikely for a Court to use its discretion to the extreme detriment of one of the parties. Notwithstanding the remoteness of the risk, credit rating agencies have been reluctant to provide ratings using this structure and alternative arrangements have started to be implemented.
- Assignment of Contracts
Under the Amendments, a restructuring debtor is authorized to apply to obtain a Court Order assigning its rights and obligations under a contract to a third party, subject to certain limitations, including a requirement that monetary defaults under the agreement be remedied. Specifically exempted from these provisions are post-filing agreements, eligible financial contracts, collective agreements and agreements that are not assignable by reason of their nature (such as personal service contracts).
Generally speaking, it is likely that most lessors would be pleased to have the contract assigned to another party if the new party met the appropriate financial criteria and if the monetary defaults have all be remedied. Under the new provisions, one of the factors that the Court is to consider in assessing the proposed assignment is "whether the person to whom the rights and obligations are to be assigned would be able to perform the obligations." It is noteworthy, however, that the ability to pay is not an absolute prerequisite, but is simply a factor to be considered. It will therefore be interesting to see how much weight the Courts give to that consideration when it is a contentious issue.
- Interim Financing
The Amendments provide for the ability of restructuring debtors to obtain interim financing (DIP financing) on application to the Court on notice to the secured parties likely to be affected by the security. In doing so, the Court will grant a security or charge over "all or part" of the company’s property and the Court "may" order that the security or charge rank in priority over the claims of any secured creditor. The security or charge cannot however secure an obligation that existed before the Order is made.
What is not clear is whether this interim financing will result in priority over existing equipment financing. Based on the common law it is likely that a "true" lease will not be trumped by the DIP financier. But it is unclear whether a financing lease or conditional sales contract would be trumped, and cases prior to the Amendments where the Court has granted DIP financing under its inherent jurisdiction have not created any firm guidelines as to how financed equipment will be treated.
While the Court clearly has the authority to charge "all" property, arguments could easily be made that the DIP financier should only receive a specific charge over current assets (accounts receivable, WIP and inventory). Often the cash that is injected into the entity from a DIP loan will be utilized to create new current assets equal to or close to equal to the value of the advance. As such, the existing current asset secured parties are in no worse position. The fixed assets lender on the other hand is not obtaining any direct benefit as its assets are being utilized to create accounts receivable and inventory but no payment is being received. To provide a DIP financier with a charge over these assets may therefore be a double penalty. On the one hand, the asset is depreciating and on the other hand, the secured creditor’s collateral is subject to another prior charge. It is also interesting to note that when the Wage Earner Protection Program amendments were put into effect in July 2008, fixed assets were specifically exempted from the priority charge created for unpaid wages and pension plan amounts. This may be helpful to equipment financiers as a potential legislation recognition that equipment financiers should be treated as a different class than a secured creditor over current assets.
The new provisions also do not address how the DIP financing charge is to be prorated over the various secured creditors. To date, when this issue has arisen, the parties have tended to reach some form of an agreement outside of Court and as such, there is very little case law on this particular area. However, with the Amendments it is quite possible that this area will not be settled as quickly out of court.
- Transfers at Under Value and Preferences
The Amendments specifically eliminate the concepts of "settlements" and "reviewable transactions" and replace them with a new regime of "transfers at under value." In essence, under the new provisions, provided transactions were not undertaken for an amount that was "conspicuously less than the fair market value," the transaction will not be reviewed. This may be helpful for finance companies in undertaking a sale leaseback transaction. Prior to the Amendments, there was always a concern (albeit remote in most circumstances) that the sale leaseback transaction may be reviewable by a Court if the vendor/lessee sold the assets to the leasing company for its fair market value. Many US lessors have avoided undertaking Canadian transactions for this reason. With the advent of the Amendments, the risk will be further reduced as leasing companies tend to ensure that its collateral value is close to its loan value.
However, the new provision may create increased risk where the leasing company greatly over collateralizes its position. In such a case the value transferred to the leasing company may be a transfer for under value. Under the old regime this tended not to matter as the sale lease back was really in the nature of a secured transaction and, if there was value left after an event of default occurred, such value would form part of the debtor’s estate. While this may occur under the Amendments, the trustee will have a method to attack a transaction that would otherwise not have been reviewed.