As most are aware by now, the Ontario Court of Appeal (the “OCA”) recently caused alarm by finding that claims of pension plan beneficiaries ranked higher than the super-priority debtor-in-possession financing charge (the “DIP Charge”) created by the amended initial order (the “CCAA Order”) in the Companies’ Creditors Arrangement Act (the “CCAA”) proceedings of the Indalex group of Canadian companies (collectively, “Indalex”). The OCA ordered that the remaining proceeds of a going concern sale (the “Sale”) be paid to cover shortfalls in two pension plans, instead of being paid to Indalex’s US parent group (“Indalex US”) which had been subrogated to the DIP Charge after covering a would-be short-fall to the original DIP lenders pursuant to its cross-guarantee. The OCA thereby reversed the earlier rulings of Justice Campbell of the Ontario Superior Court Commercial List (the “CCAA Court”), who had found that none of the funds in question were subject to a deemed trust under the Ontario Pension Benefits Act (the “PBA”) which might prime the DIP Charge.

One of the pension plans, that of the salaried employees (the “Salaried Plan”), was already in the process of being wound-up pursuant to the PBA prior to the start of the CCAA proceedings. The second pension plan, that benefitting retired executives (the “Executive Plan,” and, together with the Salaried Plan, the “Plans”), did not begin its windup process until sometime after the relevant CCAA Court decisions and the closing of the Sale. Both Plans were underfunded and the purchaser assumed no responsibility of liability for the Plans.

The OCA based its decision on two main lines of argument. The first, applied only to the Salaried Plan, was based on the existence of a provincial statutory deemed trust. The second, applied to both Plans, was based on the equitable remedy of the constructive trust.

In its first line of analysis, the OCA held that, in the case of the Salaried Plan, the amount of the shortfall had accrued as of the commencement of the wind-up, and thus was subject to a deemed trust (backed by a charge on Indalex’s assets) under the PBA, even though it would not, in the ordinary course, have been payable in full for a number of years.1 Under Subsection 30(7) of the Ontario Personal Property Security Act (the “PPSA”), a security interest in accounts or inventory and proceeds therefrom (other than a purchase money security interest) is subordinate to the claims of a beneficiary of a deemed trust under the PBA.2 The OCA held that the CCAA Order could not have wiped out the PBA deemed-trust claim, or reversed its PPSA-imposed priority, unless the CCAA Order had included an explicit ruling that the purpose of the CCAA was paramount in this case to the PBA and the PPSA. The OCA noted that the CCAA Court had not been alerted to any pension shortfall issues and, rather, had been told that Indalex intended to satisfy any statutory deemed trust obligations. The OCA held that, in the absence of an explicit paramountcy ruling, the general DIP Charge super-priority language of the CCAA Order was not sufficient to give the DIP Charge priority over the PBA deemed trust claim of the Salaried Plan beneficiaries.

One difficulty with the OCA’s deemed trust priority argument is that the DIP Charge, being a lien created by order of a court, was likely not subject to the PPSA.3 In the decision of the Supreme Court (the “SCC”) in Bank of Montreal v. i Trade Finance Inc. (released six weeks after Indalex) the SCC held that, where rights resulted from a court order (rather than from a transaction that in substance creates a security interest), the PPSA did not apply.4 Another OCA decision, Bulut v. Brampton (City), is cited by commentators as authority for the same proposition (though it appears that, rather than being ruled on, the point was simply conceded by counsel in that case).5 If the DIP charge was not subject to the PPSA, it could not be subordinated to the PBA deemed trust by Subsection 30(7) of the PPSA. Moreover, the mere creation of the DIP charge (ignoring, for purposes of argument, the priority conferred on it) is not inconsistent with the existence of the PBA deemed trust. The statutory conflict that concerned the OCA therefore had to have been between the priority granted to the DIP Charge by CCAA Order, and the priority held to have been given to the PBA deemed trust by operation of Subsection 30(7) of the PPSA. If that conflict does not exist, then the OCA’s demand that the CCAA Court had to have given an explicit paramountcy ruling to defeat the PBA deemed trust also loses its relevance.

Looking forward, another reason why Subsection 30(7) of the PPSA may not apply in future cases is that the provision appears to conflict with the new pension provisions of Subsection 6(6) of the CCAA, which came into effect after the date of the CCAA Order, and thus did not bind the Indalex proceedings. CCAA Subsection 6(6) prohibits a court from sanctioning a CCAA plan unless the plan ensures payment of certain amounts to pension plans. In its language, Subsection 6(6) largely mirrors the language of Section 60 of the BIA which imposes similar requirements when a court is approving a BIA proposal, and follows closely the language in Sections 81.5 and 81.6 of the BIA, which create super-priority charges for certain pension claims in bankruptcy and receivership. In all cases, the payment of unfunded pension deficits upon wind-up are excluded from the requirements. If, as the OCA in Indalex held, the PBA creates a deemed trust and lien for such amounts, the PBA is, arguable, now in conflict with the CCAA and the CCAA will automatically be paramount in a proceeding to which it applies, without any need for a court declaration to that effect.

In Bulut, a court order had created a charge competing with existing personal property security without making any declaration as to that charge’s priority (thus differing from the DIP Charge in Indalex which was both created, and had priority conferred upon it, by the CCAA Court). According to the OCA in Bulut, when priorities cannot be determined by the PPSA or the BIA, the common-law rule recognizing the priority of the earlier charge applies unless (i) the rule is overridden by a statute that allows a new lien to arise despite existing security interests, or (ii) if misconduct of the party with first-in-time priority calls for an equitable re-ordering of the priorities. In Indalex, the common-law priority rule only comes into play if we accept, for the previously outlined reasons, that the PPSA Section 30(7) priority rule does not apply. But, if we accept the non-application of the PPSA, then we also must accept (again for the previously outlined reasons) that the CCAA Order that created and conferred priority on the DIP Charge was not in any way defective for lack of an explicit paramountcy ruling. The starting point for analysis of the priorities between the DIP Charge and the Salaried Plan’s PBA deemed trust must therefore be the priorities as they are set out in the Initial Order, with the DIP Charge having priority despite the timing of its creation. The analysis therefore becomes whether there are equitable reasons for altering the priorities of the CCAA Order. The OCA clearly thought there were as it stated that, even if it was wrong in its deemed trust analysis, it would still reach the same result on equitable grounds.

The OCA’s second, equitable line of analysis relied on the SCC’s ruling in Soulos v. Korkontzilas that the equitable remedy of the constructive trust could be applied in cases where an equitable duty had been breached (when such remedy was usually reserved for cases of unjust enrichment where monetary damages are insufficient).6 The OCA found that, as administrator of the Plans, Indalex had a fiduciary duty both under the PBA and at common law. Since Indalex continued on as administrator during the CCAA proceedings, it was required to safeguard the interests of the Plans’ beneficiaries at the same time as it made corporate decisions in furtherance of general stakeholder interests. The OCA found that Indalex knew the Plans were underfunded and that pensions would be reduced unless additional funds were paid into the Plans, but took no steps to correct the underfunding. Instead, Indalex took a number of actions to prevent further Plan funding: it applied for CCAA protection, and then for the DIP-Charge, both without notice to the Plans’ beneficiaries; it entered the Sale transaction and moved for distribution of the proceeds without providing for any payment to the Plans; and it also sought to make a voluntary assignment in bankruptcy to defeat any deemed trust claims by the Plan beneficiaries. The OCA found therefore that Indalex had breached its fiduciary duty as administrator of the Plans.

The four-part test developed in Soulos for the imposition of a constructive trust requires, among other things, that the assets (on which the plaintiff wishes the trust imposed) have resulted from the same activities whereby the defendant breached its duties. The OCA reasoned that this requirement was satisfied because the assets in question, the Sale proceeds, resulted from Indalex’s conduct of the CCAA proceedings, the same proceedings in which Indalex breached its duties as administrator. If we drill down however, it is almost tautological that the Sale proceeds arose from the Sale and the marketing, auctioning and negotiation by Indalex and the CCAA monitor (the “Monitor”) that led to the Sale. The marketing process, the bidding procedure and the Sale were each approved by the CCAA Court by separate orders made on different dates, by two different judges. The activities involved, as described in the Monitor’s various reports, were also approved (at least to the extent of the Monitor’s involvement therein7). The bidding procedure was approved without objection from the beneficiaries of the Salaried Plan, who were already represented by counsel at that point. The Sale itself was declared by the CCAA Court to be “commercially reasonable and in the best interest of [Indalex] and its stakeholders,” and despite the Court hearing opposition from the Executive Plan beneficiaries. Based on these findings of fact by the CCAA Court, it is hard to see how the OCA could be correct that these activities that created the Sale proceeds involved a breach of Indalex’s duties.

Refocusing at a more general level, it is worth noting that, for much of the time in question, the Executive Plan beneficiaries were represented by counsel, who would have been the most effective advocate for their interests (rather than the conflicted Indalex). During the period between the approval of the marketing process and the approval of the bidding procedure, the CCAA Court increased the amount of the DIP Charge and counsel to the beneficiaries of the Salaried Plan appeared at the hearing of that motion without opposing it. On the same date that the bidding procedure was approved (without objection from the Executive Plan beneficiaries), the CCAA Court dismissed a motion by the Executive Plan beneficiaries to have all post-filing payments to the Executive Plan reinstated. The CCAA Court was quite strong in its dismissal:

“The SERP Group has not established that they are entitled to any priority with respect to their SERP benefits and there is, in my view, no basis in principle to treat the SERP Group differently than any other unsecured creditors of the Indalex Applicants. The reinstatement of the SERP payments would, in my view, represent an improper re-ordering of the existing priority regime.”8

Given such clear guidance by the CCAA Court against conferring any preference on the Executive Plan beneficiaries, and given that the interests of those beneficiaries were by that time being actively advocated for by counsel, it is hard to understand how the OCA expected Indalex to have behaved (in respect of the Executive Plan beneficiaries) any differently than it did when it subsequently sought approval of the Sale and of distribution of the proceeds therefrom.

Although the OCA said it did not need to consider the equitable subordination argument raised by the Executive Plan beneficiaries (because it had not been raised before the CCAA Court), the result of the OCA’s constructive trust reasoning certainly looks like equitable subordination. Equitable subordination is a remedy developed by the courts in the United States and eventually enshrined in the US Bankruptcy Code, but with limited and questionable application in Canadian insolvency law. The test for the application of equitable subordination most often referenced in Canadian case law is the three requirements set out by the U.S. Court of Appeal for the Fifth Circuit in Matter of Mobile Steel Co.: (a) the otherwise priority claimant must have engaged in some type of inequitable conduct; (b) the misconduct must have resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the priority claimant; and (c) equitable subordination of the priority claim must not be inconsistent with the provisions of the bankruptcy statute.9

The only time the SCC has addressed the issue of equitable subordination was in its 1992 decision in Canada Deposit Insurance Corp. v. Canadian Commercial Bank, where it cited the Mobile Steel statement of the doctrine, but ruled the test was not satisfied in the case before it (because there was no inequitable conduct, or injury or unfair advantage to satisfy the first two prongs of the test) and declined to speculate on whether such a doctrine even existed in Canadian insolvency law.10 The OCA similarly declined to decide the issue in its 1993 decision in Olympia & York Developments Ltd. v. Royal Trust Co., as it already reached, by other reasons, the result in aim of which the doctrine was being advanced.11 In C.C. Petroleum Ltd. v. Allen, the OCA reversed, in part, a lower court decision which had subordinated the general security interest of the spouses of principals of the debtor to the unsecured claim of a trade creditor.12 Citing the uncertainty over the doctrine, the OCA ordered that the equitable subordination reasoning in the lower court’s decision be deleted as unnecessary and not clearly within the lower court’s power.

In Bulut, however, the OCA upheld a lower court order that had applied what “resembled” the doctrine of equitable subordination. Faced with a priority dispute between secured creditors and a mortgagee who had obtained a court-ordered lien on personal property, where neither the PPSA nor the BIA provided a solution to the dispute, the OCA found that the lower court’s ordering of the claims was acceptable, in part because it did not overturn any statutory priority regime. The OCA thus held that the lower court’s use of common law and equitable principles was nothing novel, and not an application of equitable subordination in the sense previously contemplated by the SCC and OCA in Canada Deposit Insurance Corp. and Olympia & York, where application of the doctrine would have re-ordered statutory priority regimes in contravention of the third part of the Mobile Steel test.

To my knowledge, all other cases where the doctrine of equitable subordination has been applied in Canada (and there are but a handful) have, like Bulut, satisfied the requirement that no statutory priority regime be altered.13 All of these cases involve the subordination (for inequitable conduct) of unsecured shareholder loans below the claims of other unsecured creditors. The OCA’s decision in Indalex is, to my knowledge, the only standing decision in Canadian jurisprudence where the priority of a secured creditor over an unsecured creditor has been reversed on equitable grounds.14 According to my prior reasoning, both the Salaried Plan and the Executive Plan had lower priority prior to the OCA’s equitable flip.

Even on the OCA’s own analysis, the Executive Plan, which did not benefit from a PBA deemed trust, was unsecured prior to imposition of the constructive trust. The OCA’s equitable subordination of the DIP Charge was, therefore, a faulty application of a very questionable equitable doctrine. Even if the OCA’s constructive trust reasoning was sound, it was very much dependent on the unusual facts of Indalex, and therefore of limited future application and of concern mainly to guarantors (or their estates). The Soulos test for imposition of a constructive trust in response to breach of a duty also requires that no arm’s-length creditor be unjustly prejudiced by the imposition of a constructive trust. It is, therefore, key that the OCA decided that Indalex (being the fiduciary) and Indalex US (being the negatively affected creditor) were to be treated as identical because of their shared management at all relevant times.15 It is difficult to imagine a fact scenario where an arm’s length secured creditor could be treated in the same way. Similarly, the regular test for imposition of a constructive trust in response to unjust enrichment requires that there have been no juristic (i.e. legal) reason for the enrichment in question, but the contracts or law that give rise to a secured creditor’s rights usually supply exactly such a juristic reason for a secured creditor’s enrichment.

Another aspect of Indalex that should not have extension to an arm’s-length secured creditor is the OCA’s obiter comment that it would be inappropriate for Indalex to seek to strategically assign itself in bankruptcy to defeat any priority the Plans might have. There exists good authority that an arm’s length secured creditor is free to seek a strategic debtor bankruptcy in a receivership or a CCAA proceeding in order to overturn priorities.16

Leave to appeal Indalex to the SCC has been sought and I expect that, for some of the above reasons, leave will be granted.