by Michael B. Rotsztain DEBTOR-IN-POSSESSION FINANCING IN CANADA: CURRENT LAW AND A PREFERRED APPROACH

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1 DEBTOR-IN-POSSESSION FINANCING IN CANADA: CURRENT LAW AND A PREFERRED APPROACH by Michael B. Rotsztain Copyright Michael B. Rotsztain All Rights Reserved

2 INTRODUCTION A critical issue for a restructuring debtor is how it will finance its business while it is operating under the court ordered or statutory stay of proceedings. The optimal solution is having sufficient positive cash flow from operations so that borrowings are not necessary. This happy circumstance arises from time to time since, as a result of the stay of proceedings, pre-filing debt does not generally have to be serviced and cash receipts are usually available for use as working capital. More typically, borrowings are required during the restructuring period. In most situations, there is at least one senior lender which holds comprehensive security against the debtor s assets. Any person considering making a debtor-in-possession ( DIP ) loan to the debtor will have to determine, on the best available evidence, whether there is sufficient remaining equity in the debtor s assets after taking into account existing secured loans, to support the DIP financing. If there is insufficient equity to do so, a DIP lender will likely not be prepared to advance funds without a court order granting the DIP financing super priority over existing lenders (with the exception of holders of statutory liens and purchasemoney security interests who typically are not subordinated to DIP loans). Neither the Companies' Creditors Arrangement Act ( CCAA ) nor the Bankruptcy and Insolvency Act ( BIA ), the two principal Canadian restructuring statutes, contains provisions dealing with DIP. As discussed below, however, in CCAA proceedings Canadian judges have responded creatively to this legislative inadequacy and permitted DIP financing in a number of cases, including on a super priority basis. An important question for stakeholders in the restructuring and insolvency process is whether it would be preferable (a) to maintain the status quo and leave the matter to judicial discretion, or (b) to amend either or both the CCAA and BIA by the addition of specific rules governing DIP financing. If the latter were adopted as the preferred approach, consideration would have to be given to the scope and content of the specific rules. Canadian law makers will have to face this issue no later than 2002 since the 1997 amendments to the CCAA and BIA included provisions (section 22 of the CCAA and section 216 of the BIA) referring the legislation to a committee of Parliament for review within five years. That committee must in turn submit a report to Parliament within one year of commencing its review. Those who favour a rule-based regime often cite the U.S. Bankruptcy Code, which contains provisions applicable to DIP financing, as the model for Canadian legislation to follow. This paper therefore includes a brief description of the relevant Code provisions. The author s views on the preferred Canadian approach are set out below. That approach involves the introduction of statutory guidelines on DIP financing which do not materially impair the current flexibility of the CCAA process, a critical element of the effectiveness of that process. Implicit in this approach is the belief that adopting specific rules in Canada such as those which exist under the Code might not necessarily create a better result in every restructuring. EXISTING CANADIAN JUDGE-MADE LAW Before considering what approach ought to be adopted in Canada, it is necessary to examine the existing state of Canadian judge-made law on DIP financing. All such law has been created in CCAA proceedings: the conventional view is that the rule-driven restructuring process available under the BIA leaves no room for the exercise of the court s inherent jurisdiction which has been the basis for DIP financing orders made under the CCAA.

3 - 2 - Despite the absence of specific statutory authorization, it is now well established law in Canada that the court has the inherent jurisdiction within the very general framework of the CCAA to approve DIP financing in appropriate circumstances, including financing on a super-priority basis. Consistent with the common law approach, these circumstances are not rigidly defined. Rather, the court exercises its discretion on a case-by-case basis on whether to approve DIP financing. This judge-made law has evolved even though there has been much debate over the merits of judicial reliance on inherent jurisdiction to effect substantive as opposed to mere procedural results. The following guidelines have emerged from the Canadian cases: 1. A company with a viable basis for restructuring will be permitted to borrow funds for working capital and grant security for such borrowings ranking ahead of the claims of unsecured creditors: Westar Mining Ltd.( Re) 1 ; The T. Eaton Co. (Re) Super-priority DIP financing will be approved where all or substantially all the existing secured creditors acquiesce or consent: Willann Investments Limited v. Bank of America Canada Super-priority for DIP financing will be granted where existing secured creditors will not be adversely affected thereby because the financing results in the creation of new collateral assisting in repaying the DIP financing, specifically new receivables: Dylex Limited (Re) Super-priority DIP financing will be approved where the funds are used to pay essential expenditures which have priority in any event over existing secured lenders, who will therefore suffer little overall prejudice as a result, particularly where the new financing is not very significant...relevant to the overall numbers involved : SkyDome Corp. (Re) In initial CCAA orders, which are usually granted on very short notice, extraordinary relief such as super-priority financing should be restricted to what is necessary to meet urgent short-term needs. Requests for additional DIP financing should be made on adequate notice to the affected parties so that they are provided with a reasonable opportunity to consider the impact of such financing and make their submissions to the court: Royal Oak Mines Inc. (Re) The court s inherent jurisdiction to grant super-priority financing does not extend so as to permit it to grant DIP financing super-priority over security (in this case, builders liens (1992), 14 C.B.R. (3d) 88, [1992] 6 W.W.R. 331 (B.C.S.C.). (1997), 46 C.B.R. (3d) 293 (Ont Ct. (Gen. Div.)). [1991] O.J. 721 (QL) (Ont. Ct. (Gen. Div.)). (Unreported endorsement, January 23, 1995, Ontario Court (General Division), Court File No. B-4/95, January 23, 1995, Houlden J.A.) (Unreported endorsement, November 27, 1998, Ontario Court (General Division), Court File No. 98-CL-3179, Blair J.) (1999), 6 C.B.R. (4th) 314 (Ont. Ct. (Gen. Div.)).

4 - 3 - under British Columbia legislation) which by statute is afforded priority over all other interests: Royal Oak Mines Inc. (Re) Deciding whether to grant super-priority DIP financing is an exercise of balancing the interests of the debtor and its stakeholders. The court should not permit super-priority DIP financing unless there is cogent evidence that the benefit of DIP financing clearly outweighs the potential prejudice to the lenders whose security is being subordinated : United Used Auto & Truck Parts Ltd. (Re) ( United ) 8, applied in Sharp-Rite Technologies Ltd. (Re) 9. (In the latter case, despite its application of the United decision, the court granted super-priority financing against the debtor s current assets, where the first-ranking secured creditor raised no objection, but other secured creditors did.) 8. The interests of existing secured creditors can be prejudiced by the granting of super-priority financing only if the court is satisfied this is justified in the circumstances of the case. The court will not be satisfied that there is such justification where the secured creditors have a high level of distrust and wide ranging lack of confidence in the debtor s managers and directors, and the appointment of an interim receiver under the BIA is found to be the more appropriate course of action. An order authorizing super-priority DIP financing is only rarely made unless the security for such financing can be provided by hitherto unsecured assets : General Electric Capital Canada Inc. v. Euro United Corp. 10 Although secured lenders have expressed very legitimate concerns over their potential loss of priority (and thus fundamental property rights) as a result of the actions of an over-active judiciary, which could have a dampening effect on the availability and/or cost of loans for working capital, Canadian courts have overall shown both remarkable creativity and restraint in their approach to DIP financing. The principles, both substantive and procedural, which have emerged from the existing case law, outlined above, demonstrate that in the best traditions of the common law, the courts are endeavouring to strike a proper balance between the interests of restructuring debtors and their junior stakeholders and the interests of senior secured lenders. This is well illustrated in the following passage (dealing with SkyDome s request to use funds in a capital reserve fund established under a trust indenture) from Blair J. s unreported endorsement in SkyDome Corp. (Re) 11 : I am satisfied that the Court has the authority either under s. 8 of the CCAA or under its broad discretionary powers in such proceedings, to make such an order. This is not a situation where someone is being compelled to advance further credit. What is happening is that the creditor s security is being weakened to the extent of its reduction in value. It is not the first time in restructuring proceedings where secured creditors - in the exercise of balancing the prejudices between the parties which is inherent in these situations - have been asked to make such a sacrifice. Cases such as Re Westar Mining Ltd. (1992) 14 C.B.R. 88 (B.C.S.C.) are examples of the flexibility which the courts (1999), 7 C.B.R. (4th) 293 (Ont. Ct. (Gen. Div.)). [1999] B.C.J. No (QL) (B.C.S.C.). [2000] B.C.J. No. 135 (QL) (B.C.S.C.). (Unreported endorsement, December 24, 1999, Ontario Superior Court of Justice, Court File No. 99-CL-3592, Blair J.). Supra, footnote 5.

5 - 4 - bring to situations such as this. See also Re Lehndorff General Partner (1992) 17 C.B.R. (3d) 24 (Ont. Gen. Div); Olympia & York Developments Limited v. Royal Trustco (1993) 17 C.B.R. (3d) 1 (Ont. Gen. Div.). The underlying flexibility of the CCAA process should not be replaced by an overly rigid rulebased system without due consideration of the consequences, since such a system will not necessarily result in every case in the best outcome for the debtor, affected stakeholders and the community-at-large. U.S. BANKRUPTCY CODE RULES The principal provisions of the Code dealing with DIP financing are found in section 364. Procedurally, the Code requires that there must be notice and a hearing before the court approves post-filing financing other than unsecured financing in the ordinary course of business for actual and necessary costs of preserving the estate. The court also has the authority to make an order authorizing this type of financing, which ranks as an administrative expense with priority over the claims of unsecured creditors. If the trustee or debtor-in-possession is unable to obtain such unsecured financing ranking as an administrative expense, the court may authorize the obtaining of financing with one of the following rankings: (a) priority over certain administrative expenses; (b) secured by a lien on property not otherwise encumbered; or (c) secured by a junior lien on encumbered property. The court may authorize DIP financing secured by a senior or equal lien on encumbered property only if: (i) the trustee or debtor-in-possession is unable to obtain such credit otherwise; and (ii) there is adequate protection of the interest of the lienholder on the property against which the senior or equal lien is proposed to be granted. The trustee or debtor-in-possession has the burden of proof on the issue of adequate protection. Section 361 of the Code provides that, in the case of secured DIP financing, adequate protection may be provided by: a) a cash payment or periodic cash payments to the existing secured party to the extent that the granting of the senior or equal lien by the court results in a decrease in value of the secured party s interest in the property; b) an additional or replacement lien to the existing secured party to the extent that the granting of the senior or equal lien by the court results in a decrease in value of the secured party s interest in the property; or c) such other relief (other than ranking as an administrative expense) as will result in the realization by the existing secured party of the indubitable equivalent of such secured party s interest in the property. Although one may be tempted to conclude that the existence of specific rules in the Code authorizing super-priority DIP financing results in the granting of such financing on a routine basis, albeit only when there has been compliance with the rules, the experience of at least one U.S. expert suggests otherwise. In his affidavit filed on behalf of an existing secured creditor opposing super-priority

6 - 5 - financing in Royal Oak Mines 12, but ruled inadmissible by the court as inappropriate evidence, Professor Kenneth Klee of the UCLA Law School summarizes his experience as follows with respect to the frequency of the approval of super-priority DIP financing in the U.S. Bankruptcy Court and how that court deals with the interest of an existing under secured party: 16. In my experience, Bankruptcy Courts in the United States rarely grant relief under section 364(d) of the Bankruptcy Code over the objection of existing secured parties whose liens are to be subordinated; the vast majority of DIP financing in corporate reorganization cases is authorized under section 364(c) of the Bankruptcy Code alone, or under both sections 364(c) and 364(d) in cases where existing lenders supply secured new money loans and prime or consensually subordinate their prebankruptcy lien positions to such new financing. In these latter cases, other secured creditors generally not participating in the DIP financing are not otherwise disturbed and retain their senior lien positions vis-à-vis the new money loans. 17. Thus, in my experience, unless existing secured parties consent to the subordination of their liens, DIP lenders generally are granted security interests on otherwise unencumbered property, junior liens on encumbered property of the debtor s estate and/or superpriority unsecured administrative claims under section 364 (c) (1) of the Bankruptcy Code. Section 364 (d) priming relief is considered extraordinary and is granted rarely. 32. Based on my experience and education in the field of United States bankruptcy law, particularly with regard to business reorganizations under chapter 11 of the Bankruptcy Code, it is my experience that a United States Bankruptcy Court applying principles of United States bankruptcy law would not allow the interest of an undersecured party (i.e., a party with a security interest in property that may not have sufficient value to insure the full satisfaction of such party s claim), or a party likely to be rendered undersecured by the proposed transaction, to be subordinated to that of a DIP lender without such undersecured party s consent unless: (a) such party had been provided with reasonable notice and an opportunity to be heard in opposition to the request for relief, including the opportunity to contest the debtor s evidence of valuation and present evidence on other matters relevant to the impact of the proposed subordination; (b) the debtor had demonstrated by competent evidence that (i) it was unable, despite appropriate efforts, to obtain credit on an unsecured or non-priming secured basis, (ii) the credit transaction was necessary to preserve the debtor s assets, (iii) the terms of the transaction were fair, reasonable and adequate under the circumstances, and (iv) the debtor has at least a reasonable prospect of successful reorganization; and, of critical importance, (c) if all the debtor s property were encumbered, the debtor had demonstrated by competent evidence that there would be adequate protection of the marginal secured party in the form of (i) periodic cash payments, from an assured source, designed to counteract the diminution of the value of its interest in the relevant collateral or (ii) a demonstrated increase in the value of the collateral, as a direct result of the new capital, equal to or in excess of the value of such new capital. In my experience, such relief is rarely granted over the objection of an existing lienholder with an interest in the collateral. 12 Supra, footnote 7.

7 - 6 - Based upon Professor Klee s observations, priming relief is considered an extraordinary remedy in the U.S. and there are safeguards built into the system to protect existing undersecured parties. Presumably, he is therefore of the view that the U.S. experience has been favourable from the perspective of secured lenders. The wisdom of the Code s focusing on adequate protection for priority DIP financing is subject to question. Absent from the statutory test are such relevant criteria as the interests of the debtor and other stakeholders, the purpose of the financing and the value and benefit which will result from the borrowings. A less restrictive test, capable of adjustment to the facts and circumstances of a particular case, is more desirable. THE PREFERRED CANADIAN APPROACH After considerable debate on the relative merits of the flexible, skeletal CCAA versus the ruledriven BIA, Parliament enacted significant amendments to both statutes in 1997 which achieved a partial harmonization of the two statutes. Many of the hallmark features of the CCAA, however, were left untouched and it has retained a good deal of its inherent flexibility which makes it such a powerful restructuring tool. I believe that the same approach should be adopted on the issue of priority DIP financing; i.e., there should be some statutory guidance, both procedural and substantive, with respect to the circumstances in which super-priority DIP financing can be granted, but the rules should not be so extensive or rigid that the advantages of a flexible system with room for the exercise of judicial discretion in appropriate circumstances are lost. If it is agreed that some statutory rules are required, the first issue is whether these rules should be imported into both the CCAA and the BIA, or whether the status quo of not allowing super-priority DIP financing under the BIA should be maintained. There seems to be no cogent reason why the DIP financing rules should not be the same under both statutes. It is therefore recommended that the process of harmonization commenced in 1997 continue with respect to this issue. The more difficult question is the nature and scope of the statutory guidelines, bearing in mind the considerations noted in the previous paragraph. On the procedural side, the same approach should be adopted as that taken by the court in Royal Oak Mines 13. In initial applications made on little or no notice, super-priority financing should be restricted to what is necessary to meet urgent short-term needs, provided that, consistent with section 11(6)(a) of the existing CCAA, the applicant satisfies the court that circumstances exist that make such an order appropriate. Requests for additional DIP financing should be made on adequate notice to the affected creditors so that they have a reasonable opportunity to consider the request, prepare responding material and appear and make submissions at the hearing. On substantive issues, the criteria for obtaining additional DIP financing should be consistent with the CCAA test for obtaining an extension to the initial 30-day stay of proceedings. In many situations, the considerations relevant to whether DIP financing should be allowed are inextricably related to the merits of extending the stay. Particularly in the critical first 60 to 90 days of the stay period, as information is gathered and the court and stakeholders have an opportunity to formulate their 13 Supra, footnote 6.

8 - 7 - views on the debtor s prospects of survival, it is important to maintain a flexible process which encourages rather than discourages successful restructurings. It is therefore recommended that the statutory guidelines enumerate specific, but not overly rigid or restrictive, criteria authorizing (but not requiring) the court to approve super-priority DIP financing in certain defined situations. The court s discretion should be subject to an overriding restriction, identical to that in section 11(6) of the CCAA dealing with orders extending the initial stay; namely, that the court shall not make an order approving additional super-priority DIP financing unless: a) the applicant satisfies the court that circumstances exist that make such an order appropriate; and b) the applicant also satisfies the court that the applicant has acted, and is acting, in good faith and with due diligence. c) The following is a recommended list of the specific situations in which the court should be authorized, in its discretion, to grant additional super-priority DIP financing over and above any initial amount authorized to meet urgent short-term needs: d) where the applicant satisfies the court that the borrowed funds are to be used for expenditures necessary to preserve or protect the debtor s property for the benefit of all interested parties, including existing secured creditors. This is consistent with the law applicable to borrowings by court-appointed receivers: Robert F. Kowal Investments v. Deeder Electric 14 ; e) where the applicant satisfies the court that the borrowed funds are to be utilized to maintain the value of the assets or business (e.g. to permit the continuation of operations and the maintenance of going concern value) for the benefit of all interested parties; f) where the applicant satisfies the court that the borrowed funds are to be used to pay amounts which enjoy legal priority over the interests of existing secured creditors and that not paying the amounts would result in material prejudice to the debtor s property or business. This is consistent with the approach taken by the court in SkyDome Corp. (Re), or g) where the applicant satisfies the court that the borrowed funds are necessary to operate the business for a limited period of time in order to give all interested stakeholders, including government entities, the opportunity to prepare a restructuring plan which would avoid, or at least moderate, the social and economic consequences of a receivership or liquidation. This involves considering the public interest in maintaining the enterprise, as was done in SkyDome Corp. (Re), and Royal Oak Mines Inc. (Re). It is submitted that these specific rules strike the appropriate balance between the virtually openended flexibility existing under the current CCAA and the rigidity of the rules under the Code. If the applicant were able to justify such borrowings on any of the grounds listed above, adequate protection of the interests of existing secured creditors would not have to be proved. The justification for this is that grounds (a), (b) and (c) are so compelling that, in the interests of preserving enterprises, the superpriority borrowings should be approved even though some prejudice might be suffered by existing 14 (1975), 9 O.R. (2d) 84, 21 C.B.R. (N.S.) 201 (C.A.).

9 - 8 - secured creditors. The latter will still have full opportunity to oppose the borrowings and the court will still have the discretion to refuse to approve the borrowings, even if one or more grounds are proved. There is no reason to believe that Canadian courts will not continue to balance the competing interests of the parties inherent in the restructuring process. It is to be expected that in appropriate cases, courts will decline to expose existing secured creditors to significant potential prejudice. Overall, the proposed approach would preserve some of the flexibility of the current common law approach but build in reasonable protection for existing secured creditors, thereby achieving a fair balance for all stakeholders. While my hope is that the courts interpreting the proposed amendments will treat more favourably requests for super-priority financing consistent with the need to preserve assets and maintain viable businesses, I am not advocating incorporating overly specific concepts into the Canadian legislation, particularly those focused on existing secured lender protection. The more general guidelines proposed above leave some room for the adoption by the courts of a number of different criteria where appropriate, but do not represent a radical departure from current CCAA law and practice and from Canadian common law tradition. It is submitted that such an evolutionary approach best serves the affected constituencies and the community as a whole.

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