In April 2010, we reported on the decision of the Ontario Superior Court of Justice (the “Superior Court”) in In the Matter of the Proposal of C.I.F. Furniture Limited (“CIF”) which dealt with the question of circular priorities. This decision was recently upheld by the Ontario Court of Appeal (“Court of Appeal”). The Court of Appeal’s decision will offer some comfort to lenders where intercreditor agreements exist between some but not all of the secured lenders of a borrower.

Where multiple creditors have a security interest in a debtor’s assets, they may leave the order of priority of their interests to the timing of the registrations and priority dictated by applicable personal or real property legislation. Many, however, choose to vary or confirm their relative priorities contractually by way of an intercreditor agreement, a priority agreement or a subordination agreement. Of course, when the debtor’s assets are sold and there are inadequate proceeds to be distributed among competing creditors, the question of priorities becomes of critical importance in the recovery analysis. An issue arises when creditor A is entitled to priority over creditor B, creditor B is entitled to priority over creditor C and creditor C, by virtue of a contractual subordination, is entitled to priority over creditor A, and there is no agreement amongst all the parties setting out their relative priorities. The result is an issue of circular priority that may not be contractually addressed and is not dealt with by personal or real property legislation. The resolution of this dispute is often left to the courts.

In CIF, there were three competing secured creditors; creditor A, creditor B who entered into an intercreditor agreement with creditor A giving creditor A priority over creditor B, and creditor C who provided funding to CIF subsequent to creditors A and B, and who entered into an intercreditor agreement with creditor A (in which C was given priority over A) but not with creditor B. The sale of CIF’s assets did not generate enough money to satisfy its secured creditors and the case turned on whether a theory of complete subordination or partial subordination should be used to resolve this dispute between creditors A and B. Under the complete subordination theory creditor B would have priority, because A would be found to have subordinated the entirety of its claim to B by subordinating to C. Under the partial subordination theory creditor A would have priority over B, to the extent of an agreed upon quantum.

The Superior Court determined that the partial subordination theory applied so that the effect of the subordination agreement between creditor A and creditor C operated as follows: 

  1.  the amount of creditor A’s claim was required to be set aside from the proceeds of sale and, from this fund, creditor C’s claim was satisfied and any surplus remaining after creditor C’s claim was satisfied was paid over to creditor A;
  2. creditor B’s claim was next satisfied from the remaining proceeds of sale; and
  3. any further proceeds of sale would then be distributed to creditor C if its claim was not already satisfied in full, then to creditor A if its claim was not satisfied in full. Creditor B therefore enjoys the priority position that it bargained for: the proceeds of sale less creditor A’s prior ranking claim. The Superior Court, as affirmed by the Court of Appeal, found this to be an equitable result as creditor B was neither burdened nor benefited by the subordination agreement between creditor A and creditor C to which it was not a party.

The Court of Appeal added the following:

  • It would be unreasonable to find that creditor A intended complete subordination.
  • As the Superior Court pointed out, complete subordination would confer a windfall on creditor B whereas partial subordination would leave creditor B in second position which is exactly what it bargained for.
  • There was no document whereby creditor A agreed to subordinate its interest to creditor B’s interest.