A recent decision of the Ontario Court of Appeal illustrates that secured creditors should address their priority position relative to all other creditors of their borrower in order to achieve a complete subordination of competing security. Failure to do so in this case resulted in circular priorities that the Court was left to resolve. In light of the Court of Appeal’s decision, secured creditors should ensure they are a party to all subordination agreements with the debtor in order to achieve their expected result.
The Facts and Agreements
This case (C.I.F. Furniture Limited (Re)) involved a priorities dispute between two secured creditors of an insolvent corporation, C.I.F. Furniture Limited (the “Debtor”), arising out of conflicting subordination agreements. Under Ontario law, subordination agreements are generally valid. However, in this case the dispute arose because the two subordination agreements did not include all of relevant secured parties.
The shares of the Debtor were held by Kari Holdings (“Kari”). In 2004, the principals of Kari sold their shares in the Debtor to a purchaser for approximately $7 million. In connection therewith, Kari provided $1 million in vendor take-back financing secured by a general security agreement. The VenGrowth group of investment funds (“VenGrowth”) also provided $4.35 million in financing, secured by a senior subordinated debenture. In addition, VenGrowth advanced significant additional capital to the Debtor on a junior and/or subordinated basis to Kari, with certain of such advances being made in 2004 to finance the share purchase. At the time of the transaction, the Bank of Nova Scotia (“BNS”) as the operating lender to the Debtor, Kari and VenGrowth entered into an inter-creditor agreement setting out the following priorities between the parties:
- first, BNS to the extent of its loans to the Debtor;
- second, VenGrowth to the extent of its $4.35 million senior subordinated debenture;
- third, Kari to the extent of its $1 million secured note; and
- fourth, VenGrowth to the extent of the additional loans it had advanced on the purchase of Kari’s shares.
BNS was subsequently paid out in 2006. A priorities issue arose later when Comerica Bank agreed to provide a revolving credit facility to the Debtor in 2008. At such time, Comerica Bank and the Debtor signed a commitment letter which expressly provided that Kari’s $1 million note was to rank ahead of Comerica and required VenGrowth to provide Comerica with a $1 million guarantee, which guarantee would terminate on repayment of the Kari note. Comerica Bank and the Debtor also entered into a credit agreement for the provision of up to $2.5 million to the Debtor, secured by a general security agreement. The credit agreement recognized the Kari note as a first priority lien and Comerica’s security interest as a second priority lien. In connection with the financing, Comerica and VenGrowth entered into an inter-creditor agreement pursuant to which VenGrowth agreed to subordinate its security to Comerica’s security.
As a result of the foregoing inter-creditor agreements, a circularity in priorities was created:
- VenGrowth ranked ahead of Kari under the 2004 inter-creditor agreement;
- Kari ranked ahead of Comerica under the 2008 inter-creditor agreement; and
- Comerica ranked ahead of VenGrowth under the 2008 inter-creditor agreement.
The Decision – Partial or Complete Subordination?
The Court of Appeal considered whether the theory of complete subordination or partial subordination should apply to the priorities dispute. The Court held that complete subordination would confer a windfall on Kari, who would have jumped in the priorities queue from second position to first position. In contrast, partial subordination would produce an equitable result because Kari would not be burdened nor benefited by the 2008 inter-creditor agreement. In addition, the Court of Appeal held that complete subordination would only be justified if supported by “clear and unequivocal language”. In this case, there was no clear evidence in any of the documentation, including the 2008 inter-creditor agreement, that VenGrowth intended to subordinate its entire priority position. As VenGrowth was not a party to the 2008 commitment letter or credit agreement, Comerica and the Debtor could not by themselves subordinate the priority interest of the VenGrowth senior debenture to the Kari note.
Accordingly, the Court concluded that the theory of partial subordination should apply to the priorities dispute, resulting in the following priorities:
- first, Comerica to a maximum of $4.35 million, and then VenGrowth to a maximum of $4.35 million less Comerica’s claim;
- second, Kari;
- third, Comerica for any claim in excess of $4.35 million; and
- fourth, VenGrowth for all of its remaining claims.