Indemnification clauses are often considered a critical component of risk mitigation strategies in legal relationships. However, as is well understood, the value of an indemnification clause, in the event it becomes applicable, is dependent on the underlying financial viability of the entity granting the indemnity.

A critical consideration in any claim for indemnity in an insolvency proceeding is whether the claim is determined to be based in debt or equity. Both prior and subsequent to the September 2009 amendment to the definition of "equity claim" in the Companies' Creditors Arrangement Act (CCAA),1 the courts have been reducing the ability of parties to recover pursuant to an indemnity where it is, directly or indirectly, related to an "equity interest". Indemnification claims by purchasers of flow-through shares in relation to the loss of tax benefits, the claims of directors and officers in relation to shareholder litigation claims and, most recently, underwriters' and auditors' claims for indemnity in the context of shareholder lawsuits have been considered equity claims.

In light of the difficulties associated with the enforcement of a contractual indemnity in the context of an insolvency proceeding, due diligence and insurance procedures should remain primary risk management strategies.


In Canadian insolvency law, it has long been settled that a claim to the equity of a corporation is subordinate to a creditor's claim in debt. Consequently, a shareholder has an economic interest in an insolvent corporation only after the creditors are repaid in full. Under the CCAA, the term "equity claim" is used to describe this subordinated claim.

Since September 2009, the CCAA has defined "equity claim" broadly to include claims for dividends or similar payments, return of capital, redemption or retraction payments, a claim for monetary loss resulting from the purchase or sale of an equity interest and a claim for a contribution or indemnity made in respect of any of the foregoing.2 In the case of a corporation, "equity interests" are generally defined as shares in the corporation, or a warrant or option or another right to acquire a share of the corporation, other than one derived from convertible debt.3

While equity claims are clearly subordinate to those of creditors under the CCAA, prior to the 2009 amendments to the CCAA several court decisions considered cases where the claim was not directly attributable to any equity holder but rather arose pursuant to a contractual right associated with a claim involving the legal or contractual rights of equity holders.

Prior to the introduction of the current statutory definition of "equity claim", the Court in National Bank of Canada v Merit Energy Ltd.4 held that where subscribers under a flow-through share issue were attempting to exercise their rights to indemnification under a subscription agreement (for loss of the flow-through benefits and related tax penalties), those claims were in substance equity claims. By contrast, the indemnity claims of the officers, directors and underwriters were found to be creditors' (i.e., not "equity") claims. This decision was affirmed by the Alberta Court of Appeal, but the result has now been superseded by the amendments to the CCAA and overruled in the Sino-Forest decision (below).

In EarthFirst Canada Inc. (Re),5 purchasers in a flow-through share offering sued on the corporation's covenant to indemnify them for any taxes payable under the Income Tax Act (Canada) as a consequence of EarthFirst breaching its obligation to renounce certain qualifying expenditures. The Court determined that any shareholder claims arising in respect of an indemnity provided by an issuer in a flow-through share offering would be treated as equity claims under the CCAA claims process.

In Nelson Financial Group Ltd.,6 the Court confirmed that the claims of preferred shareholders for declared but unpaid dividends and unperformed requests for redemption were equitable interests rather than claims in debt, after an extensive analysis of the terms of the preferred shares to confirm that they were equity interests (as defined in the CCAA).

In Return on Innovation Capital Ltd. v Gandi Innovations Ltd.,7 the Court analyzed, among other things, the claims for indemnity advanced by persons who were directors/officers. The Court relied heavily on Nelson (above) and determined, notwithstanding the fact that the claims for indemnity were based on litigation alleging breaches of contract, torts and equitable rights, that the underlying purpose of the litigation was the recovery of an investment, thus the claim for indemnity was an equitable claim. This case was referred to in the recent Sino-Forest case (below).

Court Analysis of the CCAA 2009 Amendments

Recently, in conjunction with CCAA proceedings involving Sino-Forest Corporation, the Ontario Superior Court of Justice was asked to consider whether a right to indemnification granted to the auditors and underwriters in relation to lawsuits by equity holders arising in respect to public offerings of equity (not debt) and other public disclosure documents was a claim in debt pursuant to contractual rights or a claim in equity.

In Sino-Forest Corporation (Re),8 the Court conducted an in-depth analysis of the current provisions of the CCAA and the prior case law. Focusing on the nature of the underwriters' and auditors' claims, the Court held that the indemnity was tied to the shareholders' claims for monetary loss resulting from the purchase or sale of shares of Sino-Forest. Therefore, the underwriters and auditors could have no greater claim and could be in no better position than the shareholders of Sino-Forest in the CCAA proceedings. The Court focused on the nature of the claim and not the identity of the claimant. It should also be noted that the Court differentiated between the indemnity for the shareholder claims and the costs incurred to defend in the event the claim by the shareholders was unsuccessful. It is possible that defense costs would give rise to a claim that is not an equity claim if the shareholders' claims failed.

On November 23, 2012, the Ontario Court of Appeal dismissed an appeal by the underwriters and auditors.9 Applying the expansive language of the CCAA, the Court of Appeal upheld the decision of the Superior Court.


The decision in Sino-Forest is a good reminder that once a corporation seeks protection under the CCAA, many stakeholders may not be able to effectively enforce contractual indemnities received from the corporation if their claim represents an equity claim. Unfortunately, due to the definition of "equity claim" in the CCAA, an indemnity might be meaningless just when it is needed most. It should be noted that the limitation on recovery under an indemnity is limited to an action against the corporation in respect of its equity and would not necessarily limit a recovery against another party.

From a legal perspective, this new ruling confirms the broad application of the revised CCAA regime with respect to equity related indemnity claims. Until further consideration by the courts, underwriters, auditors, other third parties, directors and officers should carefully consider the risk of liability and the level of due diligence necessary to provide real, lasting protection against shareholder claims.

Readers are reminded that, under securities legislation in force in the various Canadian provinces, each underwriter, every director and every person who signs the certificate in a prospectus, offering memorandum or take-over bid circular (usually the Chief Executive Officer and the Chief Financial Officer) and certain other persons have civil liability with respect to the applicable disclosure document.10 Those documents often incorporate other documents by reference; liability extends to the disclosure in those other documents. There are statutory exceptions from liability that apply in cases where a person relied on an expert or conducted an investigation sufficient to provide reasonable grounds to believe there was no misrepresentation or did not believe that there was a misrepresentation.11 Experts whose report, statement or opinion contains a misrepresentation are also protected, unless the person did not conduct an investigation sufficient to provide reasonable grounds for the belief that there was no misrepresentation or believed that there was a misrepresentation.12

The provincial securities acts in Canada also impose liability with respect to disclosure in public documents, public oral statements and failure to make timely disclosure—the so called secondary market civil liability regime. For example, misrepresentations in core public documents results in a right of action for damages against, among others, each director and each officer who authorized, permitted or acquiesced to the release of the document.13 A person is not liable with respect to misrepresentations in core public documents under the secondary market liability regime if that person proves that, before the release of the document, he/she conducted or caused to be conducted in a reasonable investigation and, at the time of the disclosure, he/she had no reasonable grounds to believe that the document contained a misrepresentation.

Securities legislation14 sets out factors that a court will consider in determining whether an investigation was reasonable, including (among other items) the nature of the issuer, the knowledge and experience and function of the person, the office held if that the person was an officer, the existence and the nature of any system designed to ensure the issuer meets its disclosure obligations and the reasonableness of reliance by the person on the disclosure compliance system and the responsible issuer's officers, employees and others whose duties, in the ordinary course, would give them knowledge of the relevant facts.

The due diligence process in the context of public markets transactions has become somewhat mechanical. The use of due diligence checklists, which have evolved over the years in response to issues identified in connection with prior transactions, is both appropriate and necessary, as they help to ensure a minimum level of due diligence. However, it is important that a well thought out due diligence plan be developed at the early stages of a transaction and that experienced personnel take the time to identify areas of potential material risk and customize the due diligence plan in light of that analysis and the specific transaction. The due diligence defense afforded by securities legislation in force in Canada is predicated upon the conduct of meaningful due diligence investigations. Simply recycling the due diligence plan from a prior transaction (and delegating conduct of due diligence solely to junior personnel) is not optimal from a risk mitigation perspective. The due diligence process should be comprehensive and responses and the related disclosure should be assessed considering both the specific circumstances of the entity and the market as a whole. The due diligence defense has been held to be unavailable in circumstances where the due diligence process was formulaic and inadequate to identify reasonably foreseeable risks.

We believe that individuals and organizations involved in public markets transactions should view the due diligence process as a critical risk mitigation strategy. The equity holders may have contractual and equitable rights in the event of a misrepresentation (or failure to disclose) in addition to the statutory rights granted pursuant to provincial securities laws.

We recommend that underwriters, agents, other third parties, directors and officers consult with legal counsel and carefully consider their risk exposure and mitigation strategies beyond the protection of a contractual indemnity. This should include a review and understanding of the issuer's internal control procedures related to information disclosure and, in the case of directors and officers, a review of insurance policies to consider whether the coverage is sufficient.