Summaries of Expert Papers on Cross-Border Insolvencies

Introduction

In 1997, amendments to section 216 of the Bankruptcy and Insolvency Act (BIA) and section 22 of the Companies' Creditors Arrangement Act (CCAA) included a provision that both Acts would be referred to a Committee of Parliament for review five years after the amendments came into force. In May 2003, the Standing Senate Committee on Banking, Trade and Commerce (the Senate Committee) began its review of the BIA and CCAA.

One of the key issues under review deals with cross-border insolvencies. In order to prepare for the review by the Senate Committee, Industry Canada commissioned E. Bruce Leonard, Jacob Ziegel and Kevin Davis to compare the Canadian and American systems and analyse the reasons behind, and the implications of, cross-border insolvencies in order to gain a better understanding of the issue. A comparison between both systems is also key to ensuring that the Canadian system is responsive to Canadian economic interests given the increasingly integrated North American economy.

Mr. Leonard is the partner-in-charge of the Business Reorganization Group at Cassels Brock & Blackwell LLP in Toronto. He is the Past Chair of the International Bar Association’s Committee on Insolvency and Creditors’ Rights. He is a Founding Member, and served as the Chair and a Director of the Insolvency Institute of Canada. Mr. Leonard is the Chair, a Director and a Founding Member of the International Insolvency Institute. Mr. Leonard has also contributed to numerous publications and has been involved in some of the most significant reorganization proceedings in Canada. He is a graduate of the University of Manitoba and Osgoode Hall Law School and was admitted to the Bar in 1970.

Professor Jacob Ziegel is Professor of Law Emeritus at the University of Toronto’s Faculty of Law. He went to the University of London where he obtained his doctorates in Law and Philosophy followed by membership in Lincoln’s Inn. He co-founded the Canadian Business Law Journal in 1975 and has organized the Annual Workshop on Commercial and Consumer Law for the past 28 years. Professor Ziegel has written ten books and more than sixty articles as well as writing commentaries and editing collections published in Canada and abroad.

Kevin Davis is an Associate Professor at the University of Toronto’s Faculty of Law. He holds a degree in economics from McGill University and law degrees from the University of Toronto and Columbia University. Kevin Davis served as a law clerk for the late Supreme Court of Canada Justice John Sopinka. Mr. Davis also wrote numerous articles and reports, all of which are focussed on commercial law.

Summary of the Report by E. Bruce Leonard entitled: “Structural Features that Promote Reorganizational Filings Outside Canada”

Mr. Leonard’s study was prompted by the fact that a number of prominent Canadian companies have sought bankruptcy or creditor protection in the United States and subsequently reincorporated themselves as U.S. entities or branches of existing U.S. companies. The objective of Mr. Leonard’s study was twofold: determine the primary reasons for this phenomenon and assess whether any changes can be made to the Canadian regime to address any of its perceived inefficiencies. This situation is of utmost importance as virtually all major Canadian reorganizations now involve a U.S. component due, in large part, to the integration of the two countries’ economies.

Mr. Leonard identifies five major factors that may influence Canadian companies to file in the United States. The primary factor is probably the status of securities-related claims which rank as equity-level claims in U.S. proceedings (which are below the claims of ordinary creditors), while in Canada, they rank as creditor-level claims. The second factor is the greater leeway that exists for negotiation in the United States. Thirdly, the American system can be described as being more predictable in the way it deals with reorganizations than the Canadian system which is more flexible. Fourth is the fact that the American system has a high degree of expertise due to the specialized insolvency judiciary. The last factor is that U.S. based creditors do not necessarily understand, and are not willing to attempt to work with, the Canadian system. Mr. Leonard states that these perceived shortcomings in the Canadian system can be dealt with through non-substantive changes to Canada’s bankruptcy and insolvency laws.

In addition to these five major factors, Mr. Leonard also identifies other policy contrasts between the Canadian and the U.S. systems of reorganizations which he feels may also influence Canadian companies to file in the U.S.

For example, Mr. Leonard opines that the reorganization process in the U.S. is more transparent because creditors have greater opportunities to participate in the restructuring process and have a say in the direction that the process is going by being part of a Creditors’ Committee. This is contrasted with the position in Canada: while the BIA mandates a Board of Inspectors in liquidation, in cases of reorganizations, inspectors become part of the reorganization only if the debtor makes it part of its proposal. Moreover, the CCAA has no provision for the appointment of a Creditors’ Committee and, as such, the transparency responsibility devolves to the Monitor, who has only rudimentary responsibilities to report to the creditors. According to Mr. Leonard, the situation in Canada is not adequate to represent the interests of ordinary Canadian creditors in situations where Canadian courts are asked to make orders deferring to a U.S. reorganization. Hence, Mr. Leonard proposes that a provision for Creditors’ Committees be made in the CCAA and the powers of inspectors in the BIA be expanded. Mr. Leonard also suggests that insolvency officeholders should be independent of other interests and other relationships which might influence their decision in carrying out their responsibilities.

Another problem discussed by Mr. Leonard is that the Canadian structure for reorganizations has a tendency to promote foreign ownership of Canadian businesses because successful financial restructurings are relatively few. This can be explained by the fact that the Canadian restructuring system puts an emphasis on speed and efficiency rather than on the advantages of a reorganization, which means that a sale of assets is easier and faster than the negotiation and implementation of a restructuring plan. As such, creditors will almost always look for credit worthy buyers outside Canada where the markets and the financing for purchases are extraordinarily broad compared to what is available in Canada.

Mr. Leonard suggests that the “Concurrent Proceedings” model for international cases that already exists in the BIA and CCAA could be modified to be more effective and to ensure that the interests of Canadian creditors are safe from prejudice or dilution. The author suggests that amendments to the BIA and CCAA could create a regime that would level the playing field between the two reorganizing systems, thus making the Canadian system as attractive for reorganizations and restructurings as the existing U.S. system. Furthermore, Canada should act in concert with its major trading partners and adopt the UNCITRAL Model Law on Cross-Border Insolvency. However, he cautions that there still exists the prospect that Canadian companies will continue to file in the U.S., either voluntarily as a means of protecting their own interests, or involuntarily at the suggestion or persuasion of major creditors.

According to Mr. Leonard, stays of proceedings in the U.S. have also proved to be an influential factor in making Canadian companies file under Chapter 11 of the U.S. Bankruptcy Code (the Code). A stay of proceedings in reorganizations (which is intended to provide a period of stability for a reorganizing company to plan and negotiate a compromise of its liabilities with its creditors) is an important consideration since a shorter period of stability results in a lessened likelihood of creditor motivation to negotiate a compromise of claims. This is why Chapter 11 is seen as advantageous: under Chapter 11, a reorganizing business is given a minimum period of 120 days and can usually get much longer periods of protection. However, under both the BIA and CCAA, the initial period of protection is only 30 days. Chapter 11 has other advantages as well: the protection offered is automatic, worldwide in scope, and binds all creditors that are subject to the jurisdiction of the Code (which applies to major Canadian-based creditors if they have operations or a physical presence in the U.S.). As such, Mr. Leonard recommends that the initial period for stays of proceedings for reorganizations be lengthened in the BIA and the CCAA.

Mr. Leonard also identifies another stability-related distinction between the two systems. In the BIA, a reorganizing company can be placed into bankruptcy even before its creditors vote on its proposals. In the CCAA, a negative vote by creditors can also prompt the court to appoint a receiver to sell the assets of the company. However, in the U.S., if the court and creditors are not satisfied with the course of a reorganization, the court can remove the statutory protection given to the reorganizing business by dismissing the reorganization proceedings (which is usually a sufficient incentive to prompt the business to make the necessary effort to come up with acceptable arrangements with their creditors and stakeholders). Hence, the author recommends that reorganizing businesses should not be placed automatically into bankruptcy for failing to observe technical statutory requirements nor after an adverse vote by one or more classes of its creditors, without an application to the court. The court should also be able to remove the debtor’s protection from creditors.

Another major difference between the two systems explained by Mr. Leonard is that in the U.S., the reorganizing company is given the responsibilities of a trustee within the meaning of the Code upon a Chapter 11 filing, which means that the reorganization applies to all claims against the “old company”. As such, secured creditors are included in the reorganization. This has another advantage for reorganizing companies because security granted by the company prior to its filing (pre-petition security) does not apply to collateral created after the filing. In Canada, pre-existing security continues to apply to the debtor after its filing and continues to apply to assets produced after the debtor’s filing and during the course of the reorganization. In the U.S., the separation of assets between “pre-petition” and “post-petition” is of assistance to reorganizing businesses in that it facilitates debtor-in-possession financing. However, in Canada, post-filing assets are “owned” by the secured creditors of the business unless such creditors are over-secured.

An additional difference between the Canadian and American systems is that in the U.S., practice does not require that a debtor be insolvent in order to seek protection from its creditors. However, in Canada, under both Acts, a business has to be legally insolvent before it can seek to reorganize under protection from its creditors. Therefore, it is prevented from starting a restructuring with its creditors until much later than is the case for a company in the U.S.

Mr. Leonard recommends that a reorganizing business should be able to begin a financial restructuring or reorganization based on impending or anticipated insolvency or an inability to meet its obligations generally as they become due (subject to the ability of the court to dismiss proceedings that have been taken improperly).

Mr. Leonard also recommends that a provision be made to prevent the administration of Canadian assets from being carried out by courts in other countries in the same fashion as the 1997 amendments to the BIA and CCAA precluded courts from having the ability to direct assets transferred out of Canada.

In conclusion, Mr. Leonard states that Canada should not refrain from adopting better ways of doing things simply because the U.S. system produced solutions prior to Canada; rather, he states that, if Canada does not have the resources or the inclination to study, review, and assess its own system, it should endeavour to pick the best available concepts from other countries (a number of which have already been adapted and accepted by the Canadian courts).

Summary of the Study by Jacob S. Ziegel entitled: “A Comparison of Canadian and United States Commercial Bankruptcy Law”

Professor Ziegel’s study to compare the commercial bankruptcy systems in Canada and the U.S. was based on numerous factors including the intermeshing of corporate, trading and financial ties between the two countries (especially since both are members of NAFTA). When comparing the two regimes, Professor Ziegel summarizes some of the principal differences between the two systems and suggests which aspects of the U.S. system could be considered useful for adoption in Canada.

By examining the legislation in both systems, Professor Ziegel was able to identify some of the pervasive differences between the two insolvency regimes:

• The Code is several times larger than the BIA, with many of its sections long and complex, but nonetheless logically organized. However, the BIA rules have lost their logical structure because of several amendments to the Act. Moreover, Canada has a bifurcated system of rules for insolvency reorganizations contained in two statutes: the BIA and CCAA.


• The U.S. has a specialized and federalized bankruptcy court system, while in Canada it relies on the provincial superior court system assisted by provincially appointed bankruptcy Registrars.


• In both countries, trustees serve essentially the same functions in straight bankruptcies; however, Canada has no panel system of trustees in consumer bankruptcies and in situations where creditors are not interested in appointing their own trustee. Unlike U.S. trustees, Canadian trustees play important monitoring roles in BIA and CCAA reorganizations even though the debtor remains in possession.


• In constitutional matters, the U.S. Supreme Court has endorsed a more liberal reading of the American government’s legislative powers in bankruptcy than the Supreme Court of Canada has attributed to the federal government under subsection 91(21) of the Canadian Constitution Act.


• Involuntary Chapter 7 commercial bankruptcy proceedings are discouraged in the Code and are relatively few; proportionately, there are a lot more involuntary commercial bankruptcies in Canada.


• The Code has much broader automatic stay provisions which apply to “all entities” including secured creditors (unless it is expressly exempted in the Code). There are also powerful sanctions for violations of the automatic stay of proceedings in the American system. Under the BIA, the stay of proceedings is restricted to unsecured creditors unless the courts order otherwise. In any event, a stay of proceedings does not apply to property lawfully in the secured creditor’s possession at the time of bankruptcy. Unlike the American system, the BIA only provides for weak sanctions against the violation of stays.


• In the Code, the estate has a separate legal personality and the title to the debtor’s property does not vest in the trustee, while the opposite is true in the Canadian system.


• In the American system, a trustee has considerably broader rights of access to property not in the debtor’s possession at the time of bankruptcy than has a Canadian trustee. Moreover, if the court approves, the trustee may be authorized to sell the property free of any security interest (with the security interest attaching to the proceeds of sale).


• The American system has detailed rules for debtor-in-possession financing that apply to both Chapters 7 and 11 proceedings, while the BIA and the CCAA have no such rules. However, in Canada, a section 11 or subsequent order will frequently authorize such financing.


• The voidable transfer rules contained in sections 547 and 548 of the Code (whose application does not turn on the debtor’s subjective intention) are very powerful. As for the Canadian system, the rules are comprised of a mix of federal rules in sections 91-100 of the BIA and provincial fraudulent preference and conveyance rules.


• With respect to priorities in the distribution of the estate, the Code has very detailed rules governing the priority of administrative expenses while the BIA has very few.


• The Code has only one reorganizational vehicle for non-railroad businesses in Chapter 11. With minor exceptions, Chapter 11 covers all business reorganizations regardless of the debtor’s size. However, Canada has a bifurcated system of reorganizations.


• Chapter 11 of the Code is structured to address all key issues likely to arise in the course of a reorganization. In Canada, the BIA covers some of the issues in considerable detail, but does not address a lot of other issues. The CCAA has even larger gaps than the BIA which are normally bridged by tailor-made judicial orders.

After identifying some of the differences between the two systems, Professor Ziegel looks at what Canada could borrow from the American system. It is important to note that Professor Ziegel is not recommending a literal transplant of the applicable Code provisions, but only an adoption of the underlying concepts adapted to Canadian circumstances. Professor Ziegel also states that the federal government will have to consider the political saleability of the suggestions and the intensity of possible creditor opposition.

Professor Ziegel suggests incorporating the CCAA into the BIA as a result of the skeletal character of the CCAA and due to the fact that a bifurcated reorganizational system seriously weakens the credibility of the BIA itself. He suggests one set of BIA rules for commercial reorganizations with appropriate exceptions for small and medium sized enterprises. However, if it is decided that small and medium sized businesses should be treated separately in the BIA, Professor Ziegel states that Part III.1 of the BIA should be given a thorough overhaul to reflect the substantial evidence now available concerning its operation.

Professor Ziegel also suggests removing the insolvency requirements for voluntary proceedings in the BIA (and in the CCAA if it is retained). This would put Canadian and U.S. reorganizations on a more level playing field and remove some of the incentives for Canadian companies to initiate Chapter 11 proceedings in the U.S. It would also encourage Canadian companies to reorganize earlier and it would assist them in coping better with future class actions.

Professor Ziegel suggests that the BIA’s restructuring rules should be amended to enable debtor companies in Canada to handle class actions efficiently, effectively, and fairly. The revised rules should enable the courts to give instructions with respect to the conduct of existing class actions in any part of Canada and, with respect to the creation of a trust fund, satisfy existing and future claims of members of the class.

Section 69.3 of the BIA should be broadened to preclude secured creditors from repossessing property in the trustee’s possession for a period of 30 days following the bankruptcy order. This will enable the trustee to determine whether the collateral is important for the orderly liquidation of the estate or the sale of the business as a going concern which, in turn, would assist the trustee in maximizing returns from the estate. If necessary, the trustees would have to give adequate assurance of protection to secured creditors (as provided in section 362 of the Code), and the secured creditors would be free to seek relief from the stay before the expiry of the 30 day period. Conversely, the trustee would be free to seek an extension of the 30 day period. Professor Ziegel opines that, if empirical evidence shows that a section 362 type stay maximizes returns for the estate without imposing unreasonable costs or burdens on third parties, then section 69 of the BIA, relating to stay of proceedings, should be expanded to include non-creditors (but with exceptions similar to those appearing in the American legislation).

Professor Ziegel states that a modified and streamlined version of section 365 of the Code should be adopted in the BIA for straight and reorganizational bankruptcies so as to allow an insolvency representative to adopt, reject, or assign existing contracts (i.e., other than contracts that are non-assignable under general contract principles).

Professor Ziegel suggests that an in-depth enquiry should be conducted to determine the U.S. experience with no-fault voidable transfer provisions in sections 547 and 548 of the Code and with respect to substituting the existing provisions in sections 91, 95 and 100 of the BIA with similar provisions. Professor Ziegel recommends that the Uniform Law Conference of Canada be encouraged to draft model voidable preference and voidable transactions legislation for adoption by the provinces and use outside of bankruptcy.

Professor Ziegel suggests that the BIA should remain neutral with respect to the status of the doctrine of equitable subordination and should neither support nor oppose its use in insolvency proceedings. Professor Ziegel also recommends that Canada adopt the UNCITRAL Model Law and preferably adopt a version that is in harmony with the Chapter 15 provisions proposed in Congressional bills. Professor Ziegel also suggests that provisions in Part XIII of the BIA and section 18.6 of the CCAA be clarified, and if Canada adopts the Model Law, Part XIII as revised, be incorporated in the Model Law provisions.

Finally, Professor Ziegel recommends that the federal government continue to foster research dealing with Canada’s bankruptcy legislation, as well as, make a commitment to review the federal legislation at least every ten years.

Summary of the Report prepared by Kevin Davis entitled: “An Economic Analysis between Canadian and American Commercial Insolvency Laws”

In this report, Professor Davis discusses the economic significance of the differences between the Canadian and U.S. commercial insolvency systems and the effects of the possible harmonization of the two systems where viable.

As a result of the degree of integration that exists between the Canadian and American economies, there may be considerable benefits associated with the harmonization of the two insolvency systems (such as: increasing the transparency of each country’s laws, facilitating the conduct of insolvency proceedings that involve firms operating in both jurisdictions, and reducing the total cost of updating laws over time, if a commitment to ongoing harmonization is contemplated).

Professor Davis analyses the potential consequences of the possible modifications to the Canadian insolvency regime in terms of the institutional infrastructures and the form and content of the two regimes, while taking into account the distinctive social, economic, and legal context in which the Canadian regime operates.

In discussing the differences in the institutional infrastructure of the two regimes, Professor Davis focusses on the presence of specialized bankruptcy courts in the American system and concludes that increased judicial specialization in Canada may lead to inefficient allocation of resources and raise concerns about compromising the judicial appointment process.

As for the differences between the American and Canadian insolvency systems vis-à-vis form, Professor Davis discusses the relatively rule-like nature of U.S. law versus the more standards-based Canadian system. However, he finds that, in at least two areas (reorganizations and pre-bankruptcy transactions), the Canadian regime contains more distinct rules than the American system. Professor Davis concludes that the relatively low volume of bankruptcy litigation that exists in Canada, and the correspondingly limited stock of experience upon which to draw when formulating rules, provide a reasonably strong economic justification for Canadian lawmakers’ high degree of reliance upon standards rather than rules, as found in the American system. Notwithstanding this reliance upon standards, Professor Davis suggests that Canadian law should become increasingly rule-like over time. As for the multiplicity of rules that exists in the Canadian system (as a result of having two regimes to deal with commercial insolvency), the distinctive size distribution of Canadian firms weighs in favour of maintaining the bifurcated reorganization regime. However, Professor Davis also suggests that there is no obvious economic justification for the multiplicity of rules concerning pre-bankruptcy transactions.

As for the differences in content between the Canadian and U.S. insolvency systems, Professor Davis states that there are affirmative reasons not to adopt the American approach in the following areas: equitable subordination, rejection of contracts, and adequate protection of secured creditors in the context of interim financing (under the CCAA). For example, Professor Davis states that for equitable subordination, the disadvantages seem to outweigh the advantages, with the principal disadvantages being the prospect of confusing the Canadian actors who are unfamiliar with the U.S. law. On the topic of rejection of contracts, the fact that the problem of inefficient rejection can be solved by giving claims arising from breach or rejection of a contract super-priority or either by relying on the parties’ ability to renegotiate in the event of insolvency, weighs against the adoption of the American approach. As for the adequate protection of secured creditors in the context of interim financing under the CCAA, Professor Davis opines that because of the differences in the size distribution of Canadian and U.S. firms, the costs of adopting an adequate protection rule are likely to be relatively high in Canada (at least in cases involving relatively large firms).

Professor Davis’ analysis also suggests that there is no strong economic justification to either reject or accept the American approach with respect to the following: initiation of involuntary proceedings; the scope of stay of proceedings in straight bankruptcies; preferences; super-priority for government claims; assumption of contracts; non-assignment clauses, and cramdown of junior classes of debt.

However, Professor Davis states that there are good reasons for adopting the U.S. approach when dealing with the subordination of claims arising from a purchase of a security and ipso facto clauses. The Code provides that claims arising from the purchase or sale of common stock should have the same priority as common stock (i.e., claims arising from a securities transaction should be subordinated to unsecured creditors). The American approach to this issue is consistent with the notion that creditors’ priorities should be determined by the relative ability to bear credit risk. This outlook is justified because the parties involved in purchasing or selling securities are in a better position to detect and prevent securities fraud than a firm’s other creditors, but should be in a worse position than a firm’s shareholders.

As for the ipso facto clauses, Professor Davis suggests that the American approach should be adopted: i.e., Canadian law should refuse to enforce non-assignment and ipso facto clauses, instead of permitting the override of non-assignment and ipso facto clauses only in the context of real estate leases (in some provinces) and reorganizations respectively as is presently the case in Canada.

Conclusion

All three papers identify a variety of differences between the Canadian and American bankruptcy and insolvency systems which arguably contribute to the decision by Canadian companies to reorganize under Chapter 11 of the Code rather than under the BIA and CCAA.

Mr. Leonard states that the status of security-related claims, the greater leeway for negotiations in the U.S., the predictability of the American system, the high degree of expertise that exists in the American system, and the fact that U.S. based creditors are not willing to work with the Canadian system, all play a role in the Canadian exodus towards reorganizing in the United States. One possible solution suggested by Mr. Leonard is to change Canadian legislation so as to harmonize with the laws of the United States. Mr. Leonard also suggests that Canada study and review its system; however, regardless of whether Canada does so, Mr. Leonard advises that Canada should not discount adopting ideas from the U.S. system or from other countries in order to improve its own system.

Professor Ziegel identifies the pervasive differences between the two insolvency systems before examining what Canada can borrow from the American system. Professor Ziegel suggests numerous facets of the American regime which could successfully be incorporated into the Canadian legislation. However, Professor Ziegel recommends an adaptation of the Code provisions to Canadian circumstances and not a literal transplant of U. S. legislation.

Professor Davis bases his research on that of Professor Ziegel, but he engages in an analysis of the differences between the two systems within the context of commercial insolvencies. He also does an economic analysis of the possible effects of a harmonization of the two systems. While doing his economic analysis, Professor Davis takes into account the distinctive social, economic and legal contexts in which the Canadian regime operates. Professor Davis concludes that Canada should adopt the American system to deal with the subordination of claims arising from a purchase of a security and with ipso facto clauses. However, with respect to other commercial insolvency issues, Professor Davis did not find any real justification for adopting the American approach nor did he suggest a course of action.

While these papers have been prepared for Industry Canada, the content and any views expressed, or recommendations made, are those of the authors only and do not necessarily reflect the views or policies of Industry Canada.

These publications are available upon request in multiple formats.
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