The Ontario Court of Appeal decision in Re Indalex released on April 7 is certainly the talk of the town in secured financing circles. Unless overturned, it will almost certainly have a significant negative impact on the availability of asset backed loans for entities with defined benefit pension plans given that it conferred priority over secured creditors (including the creditor subordinated to the rights of the super-priority DIP lender) for unfunded employer liabilities to the company’s defined benefit pension plans. As many appreciate, this liability is potentially a huge whack of dough for some companies. But does it have the same negative effect on credit support provided for derivatives transactions and other securities financing transactions, such as securities loans, repo and margin loans? I’m going to refer only to derivatives in this note, but similar comments apply to the collateral for securities financing arrangements. If you’re holding your breath, you can relax a bit because there are reasons why the decision is not likely to have the same impact on the typical collateral arrangement for derivatives transactions as it will have in the commercial finance context. It is problematic though with respect to cash collateral.

The Decision

If you haven’t yet read 20 law firm newsletters on this case, here’s a short description focusing on the aspects potentially relevant to derivatives markets and leaving out some of the details and my more colourful thoughts about the court’s analysis. You have to buy me lunch if you want those!

Insolvent Indalex Canada commenced a proceeding under the Companies’ Creditors Arrangement Act (CCAA). Essentially it was a sale of the business as a going concern (what’s called a liquidating CCAA) and the dispute was over part of the sale proceeds. A debtor-in-possession financing was put in place, which was guaranteed by a related company, Indalex U.S. The sale proceeds were not sufficient to repay the DIP lenders so Indalex US paid out on the guarantee and became subrogated to the rights of the DIP Lenders. By the terms of the court order the DIP loan had priority over “all other security interests, trusts, liens, charges and encumbrances, statutory or otherwise”. 

There were two pension plans involved, one for the company executives and one for the salaried employees. The case revolved around whether a portion of the sale proceeds equal to the unfunded pension liability belonged to the pension funds, based on a statutory deemed trust under the Ontario Pension Benefits Act (PBA) or an equitable constructive trust, or to Indalex US (or more accurately its senior secured creditor), based on the priority conferred on the DIP loan by the court order. The Court of Appeal held that the salaried pension fund had priority based on the statutory deemed trust under the PBA and the priority conferred on the deemed trust by the PPSA and for both funds based on an equitable constructive trust over the employer’s assets (in this case the proceeds of sale of the business). 

One important point to note at the outset is that the statutory deemed trust under the PBA for accrued but not yet due employer pension plan contributions only arises on a wind-up of the pension plan by either the employer or on order of the Superintendent of Financial Services. Employers have a statutory obligation to make certain payments into a pension plan. There are three deemed trust provisions; one for amounts collected from employees that were to be contributed, one for unpaid current service costs and one for amounts accrued to the date of the wind up but not yet due under the plan or regulations.    The latter applies only on a wind-up of the plan and the case related to this third type of deemed trust. An employer must pay (over a five year period) amounts in addition to the current service costs if there are insufficient assets to cover the value of the pension benefits (deficiency liability). The question was whether the amounts that would have been payable by the employer over the period extending beyond the wind-up date for the deficiency liability were “accrued” obligations or not. The executive plan was not in the process of being wound-up at the date of the sale so no deemed trust under the PBA arose. The salaried plan was, however, in the process of being wound up before commencement of the CCAA proceeding. The commercial list judge had held that the deemed trust did not apply to the deficiency liability. 

The deemed trust provision the case was dealing with is found in section 57(4) of the PBA. Where a pension plan is wound up, it deems the employer to hold in trust an amount “of money” equal to “employer contributions accrued to the date of the wind-up but not yet due under the plan or regulations”. Under the PPSA, the PBA deemed trusts have priority over a security interest in accounts or inventory. Because of the reference to “accrued” liabilities, the appeal court held that it included all the liabilities, including the unfunded deficiency liability that would otherwise be paid over the period following the wind-up. Until this case, it was thought that the deemed trust applied to current contribution liabilities that were accrued due but were not yet payable at the wind-up date, but not the deficiency liability, at least in the context of an insolvency proceeding such as the CCAA or bankruptcy. The deficiency liability was considered to be an unsecured claim (as the commercial list judge had held). The court agreed that a DIP financing charge could be given priority over this deemed trust, but held that the Indalex order didn’t do so because the court was not alerted specifically to the issue and there was some suggestion on the affidavit material that the deemed trust would not be affected.

For various reasons I won’t get into the court also found that the employer, as administrator of the plans, had breached its fiduciary duty to the plans in not managing the CCAA so as to take into account the interests of the plan beneficiaries and that an appropriate remedy was a constructive trust over its assets to fund the deficiency. Consequently, even though the executive plan was not being wound-up and, therefore, did not benefit from the deemed trust, effectively the employees received the equitable equivalent (or even better since the deemed trust has priority only with respect to accounts and inventory and the constructive trust was applied to the proceeds of the sale without regard to the source of the proceeds - although the court didn’t limit the statutory trust to those types of proceeds either). 

This case focused on priority over a DIP financing charge. However, it also has implications for other secured creditors as all secured creditors with a security interest in accounts and inventory (and proceeds) are subordinated to the deemed trust by virtue of section 30(7) of the PPSA. In a bankruptcy proceeding, however, the deemed trust would be ineffective as a constitutional matter based on its interference with the scheme of distribution in the BIA (and a host of deemed trust case law). The CCAA itself says that a court cannot sanction a restructuring plan unless it provides for payment of the employer’s current liabilities to the plan. The legislation very deliberately does not include that requirement for unfunded deficiency liabilities, but as this case demonstrates the court may require it in any event.    

If the Court of Appeal decision is not overturned, then, other than in a BIA proceeding, all employer liabilities to company pension plans, including unfunded deficiencies in a defined benefit plan, could take priority over secured creditors with a security interest in accounts and inventory and if justified on the facts a constructive trust analysis could provide a priority for the pension liabilities over the assets of the debtor generally.      

Collateral for Derivatives

In a typical credit support arrangement for derivatives, the collateral is securities or cash. Securities are delivered through the book entry system to the secured party (or transferee in the case of a title transfer arrangement) and in Securities Transfer Act terms, the secured party becomes the entitlement holder. Cash is also transferred directly to the account of the secured party. To the extent it matters to the analysis, the charge which the secured party has is in the nature of a fixed charge. 

An important point to note is that, whether based on the statutory deemed trust or some constructive trust remedy, the priority should not extend to securities, securities entitlements or securities accounts. The statutory priority for the deemed trust conferred by the PPSA applies only over “accounts” and “inventory” and their proceeds. And, even if there was a case where the facts supported some sort of equitable trust arising from a breach of fiduciary duty, it seems unlikely it would or could apply to property that is no longer in the possession or control of the employer. Nor should equitable remedies such as constructive trusts deprive third parties of their interests in property. In Indalex the court was influenced in the context of the constructive trust analysis by the fact that Indalex was the administrator of the plans, but was being controlled by Indalex U.S., which later become the holder of the DIP charge (although query how this was relevant given that it became holder of the DIP charge after the wind-up order). The Securities Transfer Act also protects a purchaser for value (which would include a secured party under a Credit Support Annex) from adverse claims of which it has no notice and as an entitlement holder, secured parties should not be subject to these provincial law claims that arise after the transfers. 

There is also a statutory lien under the PBA (not discussed in the case) for the same amounts, but again it should not have priority over a fixed charge type security interest, which the typical security interest in securities is. 

Cash collateral may be an “account”, however, and the deemed trust could defeat a security interest in cash if the set-off under the creditor support arrangement is not effective (because of a Caisse Drummond  type analysis). An argument could be made that “accounts” as used in the relevant section of the PPSA means accounts receivable and not the broader concept of any monetary obligation owing to the debtor such as would cover the cash collateral account. Also, there are some ameliorating factors that may defeat the deemed trust in the particular circumstances, but one can’t necessarily rely on them in all cases.

First, the CCAA provides that no order made in the proceeding can have the effect of subordinating financial collateral for an eligible financial contract. Hopefully, that provision would prevent a court from relying on any express or inherent CCAA jurisdiction to confer priority on the deemed trust in an initial order or preventing realization on the collateral.

Second, if the collateral is held outside of Canada by a non-Canadian entity (which is often the case), the deemed trust claimants would have to assert the claim in a foreign jurisdiction. That may be a tough case to make in a foreign court, especially in jurisdictions like the U.S. which apply the law of the depositary intermediary to priority issues. 

Third, the statutory deemed trust under s.57(4) of the PBA only arises on wind-up. That wind-up very often occurs after an insolvency proceeding has already commenced. By that time, a derivatives counterparty, not being subject to the normal insolvency stays, will have realized on its cash (or securities collateral) and the deemed trust or constructive trust cannot therefore attach to that property for that reason alone.   If, however, there was a pension plan wind-up prior to an insolvency proceeding with respect to the employer (as was the case in Indalex), the deemed trust could have priority over cash collateral.   

Those of you paying close attention, might be asking – doesn’t the deemed trust still apply to current service costs and special payments that were owing at wind-up? Yes, it does, but as a practical matter, these amounts tend to be in a less significant amount and consequently they get paid from the assets readily available to the insolvency representative. There is no requirement to share the pain of the deemed trust among secured creditors so the most readily accessible assets tend to fund the liability. The deemed trust beneficiaries may be looking further afield, however, when it comes to the deficiency liability and a nice healthy pool of cash collateral may make a pretty target. 

Some Recommendations

I continue to believe that parties should use the ISDA Transfer Annex CSA or amend the NY Form of CSA to provide for title transfer of cash. While there is no assurance it will defeat the problematic Caisse Drummond analysis, there is certainly a good basis for that position. If the set-off is effective, the only property the deemed trust could attach to is the excess collateral value.

If you are taking cash collateral, it would be prudent to determine whether a counterparty has a defined benefit pension plan, to monitor its funding status and to include a termination event triggered by any step taken to wind-up the plan. 

Canadians already face enough challenges in explaining the priority issues with respect to cash collateral to their creditors without the added impediment of priming deemed trusts. Let’s hope the Supreme Court of Canada hears the appeal and reverses the decision.