Equitable subordination – will it find a home in Canada?

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When a debtor is insolvent, recovery by a creditor will generally depend on the creditor’s ranking. Secured creditors will have priority over preferred creditors who in turn have priority over unsecured creditors. If a claim can be characterized as an equity claim, it could be further subordinated. Notwithstanding these general rules, the Supreme Court of Canada could soon give courts wider discretion to adjust priorities even further in certain situations.

Earlier this year, our country’s highest court granted leave to certain creditors to appeal the decision of the Ontario Court of Appeal in Re U.S. Steel Canada Inc. in which that court refused to apply the United States remedy of equitable subordination in proceedings under the Companies’ Creditors Arrangement Act (CCAA).

Occasionally applied in insolvency proceedings, this remedy, sometimes called the doctrine of equitable subordination, will allow the court in appropriate cases to subordinate a creditor’s claim, usually a secured creditor, to the claims of other creditors, where it is established that the subordinated creditor has engaged in inequitable conduct that prejudices the interests of other creditors.

Under this remedy, a creditor’s claim may be subordinated if:

  • The creditor has engaged in inequitable conduct;
  • The misconduct has caused injury to other creditors or conferred an unfair advantage on such creditor; and
  • Subordination is not inconsistent with the bankruptcy statute.

In such cases, the subordinated creditor’s claim must stand behind the claims of unsecured creditors. If such a ruling is made against a significant secured or unsecured creditor, the recovery by unsecured creditors could increase substantially.

This would seem to be the case in the US Steel Canada case. The Canadian company owed nearly $2 billion in unsecured and an additional amount in secured intercompany debt to its US parent company. Unionized former employees of the Canadian subsidiary argued before the Ontario Court of Appeal that equitable subordination should be applied to the intercompany debt. In other words, unsecured creditors should be paid out before the US parent was allowed to recover on its nearly $2.2 billion claim. However, the Court of Appeal concluded that:

… nowhere in the words of the CCAA is there authority, express or implied, to apply the doctrine of equitable subordination. Nor does it fall within the scheme of the statute, which focuses on the implementation of a plan of arrangement or compromise. The CCAA does not legislate a scheme of priorities or distribution, because these are to be worked out in each plan of compromise or arrangement.

The Court of Appeal said there may be some potential for equitable subordination under the Bankruptcy and Insolvency Act (BIA) as:

… it would appear that the BIA gives the bankruptcy court explicit jurisdiction as a court of equity to ground such a remedy and a legislative purpose that is more relevant to the potential reordering of priorities.

Where the BIA is concerned, courts across Canada have ruled on both side of the question of equitable subordination; however, the Supreme Court of Canada has found it unnecessary to comment specifically on the remedy in any case to date. In the US Steel Canada case the Court will need to address the specific question of application of the doctrine of equitable subordination in CCAA proceedings; and in doing so, may well comment on the application of the doctrine in relation to other insolvency proceedings.

Creditors should watch for the Supreme Court of Canada ruling in US Steel Canada.

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