This article has been contributed by Julien Morissetteassociate in the Insolvency & Restructuring and Litigation groups of Osler, Hoskin & Harcourt LLP.

Canada has seen many corporate group insolvencies, some of which have involved hundreds of related entities – each with their own assets, liabilities and creditors. Reconciliation of intercompany transactions is often a drawn out and costly exercise, even more so in cases where intentional diversion, misappropriation or fraud is alleged. Nonetheless, each entity will be wound up individually… or will they? In a recent judgment, an Ontario court issued an order regrouping the assets, liabilities and creditors of several for-profit companies and a charitable foundation. This is a rare glimpse into a powerful remedy known as substantive consolidation.

The Backstory and the Bankruptcies

The Millenium Educational & Research Charitable Foundation (the Foundation) was created (under another name) by real estate developer Thomas C. Assaly in 1989. In the 2000’s, his health declined and his son Thomas G. Assaly gained control of the Foundation and of the ongoing real estate ventures.

The Foundation’s initial assets had a value estimated at $5 million and Thomas C. Assaly later gifted an additional $2.8 million. In 2013, the Foundation and four real estate development companies controlled by Thomas G. Assaly (the Companies) filed for bankruptcy. Allegations surfaced that, after 2006, significant corporate funds had been diverted from the Companies to the Foundation and later used for personal purposes, including the upkeep of a large house in Florida. Individual investors having suffered losses initiated proceedings against the Foundation, the Companies, Thomas G. Assaly and other related persons.

In the bankruptcy proceedings, the estate of Thomas C. Assaly (the Estate) filed a claim for about $3.8 million. The Estate’s trustee is Robert Assaly, brother of Thomas G. The Estate asserted priority over other creditors on the basis that the original gift was to be revoked, given the failure by the Foundation to advance its stated objectives, itself caused by the alleged misappropriation of funds. The trustee to the bankruptcy rejected the claim in its entirety and the Estate filed an appeal.

The Judgment

In a judgment rendered in mid-October 2014 (Bacic v. Millennium Educational & Research Charitable Foundation2014 ONSC 5875), the Ontario Superior Court of Justice rejected the appeal on a variety of grounds, including that there was no condition to the gifts to the Foundation and that, as a potential beneficiary of the Estate, Thomas G. Assaly would stand to benefit from the diversion and comingling of assets of which he was allegedly the directing mind.

More interestingly for the commercial insolvency community, Justice Kane also granted an order for substantive consolidation of the Foundation’s and Companies’ estates. Author Helen Sevenoaks has defined substantive consolidation as follows:

[T]he treatment of the assets and liabilities of two or more enterprise group members as if they were part of a single insolvency estate. The practical effect of an order for substantive consolidation is that creditor claims are satisfied from a common pool of assets, inter-company transactions are extinguished and a levelling of creditor recoveries occurs by decreasing the recoveries of some creditors and increasing the recoveries of others. (The remedy of substantive consolidation under the Companies’ Creditors Arrangement Act: A closer examination of domestic and cross-border issues, 2010 at p. 7)

Unlike procedural consolidation, which is common but limited to joint proceedings, this remedy has rarely been sought in Canada, and even more rarely been applied. It has been discussed in approximately 10 reported cases in the past 25 years. The courts’ power to grant it has no explicit statutory basis; courts have generally relied on their inherent jurisdiction. In this case, the Court applied the criteria developed in prior cases, some of which were originally borrowed from U.S. case law:

The test as to substantive consolidation requires the balancing of interest of the affected parties and an assessment whether creditors will suffer greater prejudice in the absence of consolidation and the debtors or any objecting creditors will suffer from its imposition. Regard must be had to the:

  1. difficulty in segregating assets;
  2. presence of consolidated Financial Statements;
  3. profitability of consolidation at a single location;
  4. commingling of assets and business functions;
  5. unity of interests in ownership;
  6. existence of intercorporate loan guarantees; and
  7. transfer of assets without observance of corporate formalities

in order to assess the overall effect of consolidation. (par. 113)

Justice Kane concluded that the test for substantive consolidation was met given that the Companies operated “as departments of one commercial enterprise” (par. 52), the Foundation’s financial statements actually included some of the Companies’ assets and a full tracing exercise would be very costly but yield an uncertain result. He ordered that the Foundation’s assets be folded in the same estate as the Companies’.

Substantive Consolidation Going Forward

Substantive consolidation is a highly particular remedy. It disregards the existence of distinct corporate persons for reasons of necessity and fairness. It can be a shining beacon for some creditors and an absolute nightmare for others. While the test adopted by Justice Kane in this case suggests a balancing exercise, courts have treaded lightly. They have been clear that mere expediency is not sufficient to grant substantive consolidation (Ashely v. Marlow Group Private Portfolio Management Inc.2006 CanLII 31307 (ON SC) at par. 75). There is no apparent appetite to use it outside of cases of fraud, large-scale fund diversion or operations with blatant disregard for distinct legal personalities.

Insolvency practitioners should watch for future judgments applying substantive consolidation. Any expansion of this doctrine would have significant legal and business implications and many of its ramifications, such as its effect on cross-border corporate groups or on secured claims, remain virtually unexplored by the courts.

Julien Morissette