BUSINESS TRUST FINANCING AND RESTRUCTURING: KEY BANKING AND INSOLVENCY ISSUES J. A. LEVIN * FASKEN MARTINEAU DuMOULIN LLP TORONTO, ONTARIO * Portions of this paper are based upon material previously prepared by the author together with Donald Milner and Jon Holmstrom of Fasken Martineau DuMoulin LLP
BUSINESS TRUST FINANCING AND RESTRUCTURING: KEY BANKING AND INSOLVENCY ISSUES J. A. Levin * Fasken Martineau DuMoulin LLP What are Business Trusts? Business trusts are unincorporated alternatives to corporations in the form of trusts. Thus, the typical company shareholder relationship inherent in a corporate environment is replaced by a trustee beneficiary relationship. While trustees may be corporations (including trust companies), commonly in the publicly markets, trustees of business trusts will be individuals who, for practical purposes, will function in much the same way as directors of a company function. Popularity of Business Trusts The popularity of business trusts as investment vehicles in Canada is undoubted. During the last two years, more than 100 business trusts were established in Canada, the units of which are publicly traded. They accounted for 57% of the value of new listings on The Toronto Stock Exchange in 2002 and currently account for approximately 7% of the market value of the S&P/TSX Composite Index, the main benchmark for stocks on The Toronto Stock Exchange. At least four Canadian business trusts are listed on the New York Stock Exchange Canadian Coal Trust, Enerplus Resources Fund, The Pengrowth Energy Trust and the PrimeWest Energy Trust. * Portions of this paper are based upon material previously prepared by the author together with Donald Milner and Jon Holmstrom of Fasken Martineau DuMoulin LLP
- 2 - Initially, business trusts were confined largely to the oil and gas sector or the real estate sector. However, in recent years, business trusts have been established in diverse industries such as horticulture, food processing, cheque printing, telecommunications, ice manufacturing, customs brokerage and seafood processing. The attraction of business trusts to investors principally is their high yields, particularly in an era when yields on debt instruments have significantly fallen. For example, a recent estimate of the cash on cash yield for various business trusts listed on The Toronto Stock Exchange produces a total weighted average yield in excess of 9% per annum with typical yields between 8% and 14%. As well, business trusts have frequently produced significant capital growth. An income trust index compiled by BMO Nesbitt Burns Inc. gained 6.4% in the twelve months ended March 31, 2003 compared with a 17.1% decline in the S&P/TSX Composite during the same period. Another feature of business trusts is that they may offer investors a tax deferral in that, for income tax purposes, a significant portion of the distributions (usually monthly) often will not be taxable on a current basis as ordinary income for most investors but, rather, will serve to reduce the adjusted cost base of the units held by investors. What Kind of Businesses are Best Suited for Ownership by Business Trust Many of the assets and businesses currently owned by business trusts previously were owned by companies. When owned by companies, such assets and businesses did not typically result in dividends payable to shareholders that were even remotely comparable to the yields being offered by business trusts. One reason why business trusts are able to offer an enhanced yield relative to corporate ownership is that business trusts are pass through vehicles which do not attract income tax on
- 3 - their distributions, as compared with corporations which are separate persons in law and must bear their own income taxes. However, corporate income taxes only account for a portion of the differential in yield. It is almost certainly the case for many business trusts that this differential is, in large part, due to the absence of accumulation of retained earnings and due to the lack of reinvestment in plant, equipment and expansion. It would seem that the most suitable candidates for conversion from a corporate environment into a business trust are well established businesses with stable cash flow that is not required for significant capital reinvestment. Thus, the ideal business trust will typically own a mature business with steady earnings, e.g. a utility that has a steady income from an energy supply. Similarity of Business Trust Units to Corporate Securities A Standard & Poors analyst, Maria Raviasz, has compared the role played by Canada s business trusts with the high yield (or junk bond) market in the United States. Both instruments provide financing for small and mid-size issuers. Both types of securities have pricing that is sensitive to interest rate fluctuations. Notwithstanding that business trust units might be viewed as having similarities to high yield debt, units of business trusts embody the risks of equity securities. They carry voting rights to elect trustees (in lieu of directors) and appoint auditors. As well, they carry voting rights in relation to major reorganizations or merger transactions. However, it is likely the case that they carry a higher risk than typical equity securities due to the absence of any cash reserve buffer in the form of retained earnings. The absence of retained earnings flows from the tax treatment of business trusts and the pass through nature of the vehicles, whereby earnings are taxed in the hands of a unitholder rather than at the business trust level as a separate taxpayer.
- 4 - Non Applicability of Canadian Insolvency Statutes to Business Trusts One only has to look at recent activity in Canadian capital markets to appreciate the importance of business trusts as vehicles for raising capital. In a somewhat different context, one also sees trusts playing an important role in the business world as the primary vehicle for the establishment of mutual funds and the primary vehicle for securitization financings. As well, major pension funds are themselves trusts. While the use of trusts for mutual funds, securitizations and pensions is not new and while the use of a trust structure for real estate and the oil and gas sector is also not new, the application of the trust structure to other types of businesses is relatively novel. What is extraordinary, given the importance that trusts play in the Canadian business community is the paucity of legislation in relation to trusts in a business context. One need only look at the question of how a financially distressed business trust will achieve a financial restructuring to understand the dearth of Canadian legislation. The principal statutes that have traditionally been used for purposes for financial restructuring are the Bankruptcy and Insolvency Act (the BIA ), the Companies Creditors Arrangement Act (the CCAA ) or (rarely) the Winding-Up and Restructuring Act (the WURA ). As a trust is not a legal entity, it is not surprising that a trust is not a person as defined in the BIA and so it cannot be a debtor or an insolvent person within the meaning of the BIA. Only a debtor can be the subject of a petition for a receiving order (an adjudication of bankruptcy) under Part II of the BIA. Only an insolvent person can make a voluntary assignment under Part II of the BIA or make a proposal to creditors under Part III of the BIA.
- 5 - Similarly, a trust is not a company or a body corporate and thus cannot be a debtor company within the meaning of the CCAA. Nor is a trust a trading company within the meaning of the WURA or any of the other types of incorporated entities or societies to which the WURA applies. Provided that a trustee is a person and therefore capable of being a debtor (for an involuntary case) or an insolvent person (for a voluntary case), within the meaning of the BIA, the trustee of a trust can become bankrupt in his or her personal capacity. Upon bankruptcy, the property of the bankrupt vests in the trustee in bankruptcy, subject to stated exceptions. The relevant exception here is property held by the bankrupt held in trust for another person. In fact, this exception appears to be no more than a codification of the position that would apply in any event. The title of a trustee to the trust property is treated as merely nominal, so that the trust s property is not thought to form part of the property or assets of the person who is the trustee and therefore is not divisible amongst the trustee s personal creditors. Since such property is excluded, a bankruptcy trustee has no authority to gather in trust property from others or to liquidate or distribute trust property for the benefit of personal creditors of the bankrupt (see Ramgotra (Trustee of) v North American Life Assurance Company (1996), 37 C.B.R. (3d) 141 (S.C.C.)). In Newbank Group Inc. Estate v Handelman (1991), C.B.R. (3d) 240 (Ont. C.J.) [Gen. Div.], in Bankruptcy)), the court held that while the Trustee Act (Ontario) enables the trustees of a trust to replace a bankrupt trustee by written appointment, it does not automatically remove the trustees status as such upon his bankruptcy. Moreover, the court held that the power of replacement is not intended to be exercisable by a trustee who is himself the bankrupt. The court then exercised
- 6 - its power under a separate section of the provincial statute to remove the bankrupt from his position as trustee and appoint in his place the firm that was acting as his bankruptcy trustee. This decision would seem to make it clear that a bankruptcy trustee does not automatically inherit the bankrupt person s status as a trustee. A bankruptcy trustee may receive possession or control in fact of trust property. However, any person claiming a higher right of possession or control (such as a substitute trustee of the trust) can follow the requisite BIA procedure for asserting a proprietary claim in the event that the trustee in bankruptcy does not simply cede possession or control because he questions the existence of a trust, the identification of the trust property or the status of the claimant. The bankrupt s entitlement to be indemnified out of the trust property for obligations incurred as a trustee is, in some sense at least, part of the personal property of the bankrupt. However, this is only meaningful where a creditor of the trust has been paid from the trustee s personal assets which would then trigger a right to be reimbursed. If the creditor is unpaid, it will be entitled to proceed by subrogation against the property of the trust. Indeed, if the creditor has accepted that it will not have recourse to the trustee personally, it will not really be a creditor of the bankrupt. In the case of proposal proceedings by a person who is a trustee, the insolvent cannot properly use trust property to pay personal debts. Where the insolvent is answerable to cause trust company to be applied in payment of a creditor of the trust, it should not be able to seek to compromise that creditor s ability to proceed by subrogation against the trust property, as that right is not a provable claim for the purposes of being compromised. The position would be the same if an incorporated trustee sought to reorganize via a CCAA plan.
- 7 - In light of the foregoing, while there seems to be within the business community a tendency to treat business trusts on a corporatized basis, the analogy does not work well in the context of insolvency. Does Variation of Trust Legislation Assist in the Restructuring of a Trust? A question that might be posed is the extent to which provincial variation of trusts legislation (such as the Variation of Trusts Act (Ontario)) and trustee legislation (such as the Trustee Act Ontario)), together with the inherent jurisdiction of the court, operate to permit the court to amend the declaration of trust governing a business trust in the context of a financial restructuring of that business trust. Such legislation is typically designed to deal with trusts in a non-business environment, such as trusts arising on someone s death, and to deal with the rights of beneficiaries. Since it is self-evident that creditors are not beneficiaries, such provincial legislation appears to be of limited relevance in the context of the financial restructuring of a business trust and is likely not available to be utilized as a substitute for the CCAA. What is the Significance of a Business Trust Owning a Corporation in the Context of a Financial Restructuring? Most business trusts are structured so that they own corporations, subsidiary trusts or limited partnerships. They typically lend money to those entities and often guarantee their liabilities. Corporations owned by a business trust (including incorporated general partners of such limited partnerships) could seek relief under insolvency statutes in the same manner as any other corporation. However, the relief available under those statutes, including stay orders that prevent creditors from enforcing rights for a period of time pending consideration of a financial restructuring, does not automatically apply to the parent business trust, to subsidiary trusts or to assets directly owned by the respective trusts.
- 8 - It would be open to counsel to ask a court to grant a discretionary stay order under the court s general powers applicable to the business trust, any subsidiary trust and their respective directly owned assets. Such an order would have to be sought on the basis that, if the court failed to grant the order, the restructuring of corporations owned by the business trust would be frustrated. However, there is no direct precedent that can be pointed to where similar relief has been granted and there is no certainty that a court will be co-operative or, if co-operative, that it will give nearly as extensive relief as is typical under the CCAA. As well, it is doubtful that such relief could extend to a permanent compromise of creditor claims against a business trust where the relevant creditor disagrees, notwithstanding the agreement of the bast preponderance of equal ranking creditors of the business trust. Are Insolvency Related Remedies Available to Retrieve Excessive Payments Made by Trusts? Corporations pay out dividends or, by way of redemptions, retractions or share buy-backs, return capital to shareholders. Trusts replace such payments with distributions of income earned on trust assets or distributions of capital. These distributions flow from the fundamental relationship between the trustees of the trust and unitholders as being in the nature of a fiduciary/beneficiary relationship, not one of debtor/creditor. As a result, some of means available to recover payments by an insolvent person may not be applicable when the debtor is a trust (i.e. the trustees). Generally speaking, a payment of money is not readily susceptible to attack as a fraudulent conveyance (provincial law), a settlement (the BIA) or a reviewable transaction (the BIA) regardless of the nature of the debtor. However, a trust distribution is not impeachable as an unjust preference (under the BIA or provincial law), because the beneficiary does not receive
- 9 - that distribution in the capacity of a creditor. It is also self-evident that a trust distribution is not vulnerable to attack under the provisions (in the BIA and corporate statutes) directed at improper dividends or returns of share capital. The oppression remedy (under corporate statutes), which can be resorted to by disaffected creditors, is of doubtful availability in the context of a trust. Perhaps, it might be applied to distributions by an incorporated trustee. However, this remedy concerns the conduct of the business affairs of a corporation. It might well be contended that the actions of an incorporated trustee do not meet this test because they relate, rather, to the business or affairs of the trust. It appears that restitutionary remedies (e.g. an action based on unjust enrichment) may be available to seek the return of distributions to the beneficiaries of a business trust where such distributions ought not to have been made because they rendered the creditors incapable of being paid in full out of the income and capital (assets) of the trust. In the first instance, the liability for a wrongful distribution rests on the trustees, who in turn may pursue the beneficiaries for restitution. However, if the trustees are unable to pay or if the creditors have waived their right to sue the trustees personally, the courts may allow the creditors to proceed directly against the beneficiaries. In such a case, much might turn on the terms of the trust. As one example, a creditor would want to ensure that its underwriting of the credit took sufficient account of the risk inherent in financing a trust governed by a deed that defined free income in some way which could preclude later complaint that a distribution was inappropriate. Lender Considerations Where lenders are dealing with business trusts or entities owned or controlled by them, it is vital that the lenders understand the structure. Since a typical structure will involve the business trust
- 10 - lending substantial amounts of money to these entities, the lender will likely require assignments and subordinations in relation to such loans. A lender will wish to be conscious of the potential for leakage in a business trust structure. Such leakage may arise in circumstances where payments are required to be made to an externalized manager or where royalty payments are required. In terms of recourse, a lender will have to address whether it wishes recourse only to specific assets and operating entities owned or controlled by the business trust or whether it wishes recourse to the trust itself. Such recourse may be desirable in circumstances where the lender wishes, through subrogation, to pursue distributions to unitholders, as discussed above. In terms of distributions to unitholders, it will be vital for lenders to consider what restrictions, if any, are to be imposed on cash distributions. Lenders will have to recognize that the imposition of such restrictions will make it difficult, if not impossible, for the business trust to issue additional units and pay down debt. A matter of particular concern to most lenders will be whether a business trust has sufficient capital to support its activities, particularly in an economic downturn. What this concern gives rise to is a need for a prudent lender to have early warning signals of trouble (e.g. in the form of stringent financial tests and ratios) and an exit strategy when lending to a business trust, i.e. a strategy whereby it can exit from its loan well before the business trust suffers any financial difficulty. Of course, it is also possible that the business trust was created at the instigation of the lender as part of an exit strategy for a pre-existing problem loan.
- 11 - Lenders must consider their positions in relation to business trusts in light of the foregoing. On the one hand, a lender may take comfort that, if it has a claim against a business trust and there is no means under the BIA, CCAA or WURA to restrict or limit the lender s ability to enforce its rights against the trustees or against the assets of the trust, the lender may not be delayed unduly in an enforcement proceeding. On the other hand, if the lender is of the view that there is greater long term value for it and greater recovery of its loss if the undertaking of the business trust can be sustained (e.g. with debt to equity conversion), the lender will be discomforted by the inherent uncertainty of the situation. Lenders to a business trust or its operating entities will likely wish to ensure they are secured lenders, not just because of the obvious benefits of security, but because (i) such lenders will have a much higher level of certainty of achieving significant influence in any financial restructuring of the trust, (ii) with security from the trust in the form of a pledge/assignment of its various interests in corporations or partnerships (whether those interests are comprised of receivables from operating entities or equity securities of those entities), the trust may have minimal influence in any BIA, CCAA or WURA filing while the lender will have significant influence and (iii) if, in a default scenario, the trust may not be able to obtain a stay order, even if such an order is obtained by its operating entities; in that event enforcement against the trust could nevertheless proceed. June 13, 2003