DIRECTORS & OFFICERS LIABILITY EXPOSURE IN AN INSOLVENCY ENVIRONMENT AUBREY E. KAUFFMAN CAROLE J. HUNTER Fasken Martineau DuMoulin LLP Barristers & Solicitors Suite 4200, TD Bank Tower Toronto Dominion Centre Toronto, ON M5K 1N6 Tel: 416 868 3538 Fax: 416 364 7813 THE CANADIAN INSTITUTE S 11 TH ANNUAL CONFERENCE ON PROTECTING DIRECTORS & OFFICERS FROM LIABILITY (October 15 & 16, 2007)
Directors & Officers Liability Exposure in an Insolvency Environment Aubrey E. Kauffman and Carole J. Hunter 1 A. INTRODUCTION The concept that directors and officers can be found liable for failing to exercise their powers and discharge their duties in an appropriate manner has existed for over a hundred years. However, the number of areas in which directors and officers can be exposed to liability has expanded greatly. Directors and officers liabilities are now clearly laid out in several corporate, environmental, employment and taxation statutes. The most common area of statutory liability for directors and officers is in respect of deductions and remittances due under taxation and employment statutes. The common law liabilities are, however, also increasing with more emphasis now being placed on liabilities of directors and officers of insolvent corporations. As a result of these expanding potential liabilities, in order to keep the directors and officers on board in an restructuring proceeding, in addition to directors and officers insurance ( D&O Insurance ), the directors are given a court-approved indemnification in respect of certain claims that may arise during the course of the restructuring proceedings. Directors and officers will also be granted a charge on the corporation s property as security for the court-approved indemnity. In this paper we will deal with: (i) (ii) (iii) an overview of directors and officers liabilities; a review of issues concerning D&O insurance; and protections for directors and officers in restructuring proceedings. 1 Members of the Fasken Martineau DuMoulin LLP Insolvency and Restructuring Group.
3 B. OVERVIEW OF DIRECTORS AND OFFICERS LIABILITIES (i) Liabilities under Common Law At common law, directors and officers have always faced potential liabilities for a breach of their duty of care and their fiduciary duty to the corporation. These common law liabilities have now been codified in corporate law statutes and are discussed in more detail below. Directors and officers may be subject to personal liability for tortious conduct in certain circumstances. The Ontario Court of Appeal has held in NBD Bank, Canada v. Dofasco Inc. 2 that, absent fraud, deceit, dishonesty or want of authority, it is rare for the corporate veil to be pierced such that a director or officer is held personally liable for actions ostensibly carried out in the corporate name unless (a) the actions were entirely or partly in their own interests, rather than the interests of the corporation, or (b) their actions are independently tortious or exhibit a separate identity or interest from that of the company, even if they were in the corporation s best interest. It is not enough that the actions of the directing minds are found wanting, there must be some activity on their part that takes them out of the role of directing minds of the corporation. In the NBD case an officer made representations to a bank in connection with an advance under an existing unsecured credit facility. When the bank raised concerns about the corporation s creditworthiness, the officer assured the bank that the corporation was creditworthy. The corporation filed for protection under the Companies Creditors Arrangement 2 NBD Bank, Canada v. Dofasco Inc. (1999), 46 O.R. (3d) 514 (C.A.) at 532 (leave to appeal to the SEC dismissed April 6, 2000)
4 Act 3 two weeks later. The court found that there was no basis for protecting a corporate officer from personal liability for negligent misrepresentation simply because the officer was acting in the best interests of the corporation. (ii) (a) Liabilities Under Corporate Statutes Duty of care The common law duty of care is codified in the corporate law statutes as the duty of the directors and officers to exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances. 4 The statutory formulation of the duty of care places a more objective and somewhat higher standard upon directors and officers than the pre-existing common law formulation. 5 Generally speaking, the statutory duty of care imposes an obligation upon directors and officers to be diligent in supervising and managing the affairs of the corporation. The ability to pursue directors or officers for breach of their duty of care requires more than simply wrongful conduct against a specific creditor or stakeholder, it requires the directors and officers be shown to have, in some manner, mismanaged the corporation to the detriment of the claimant. The courts have provided relatively little guidance concerning the precise nature of the duty of care, diligence and skill required of a director. Both the OBCA and the CBCA stipulate that directors and officers cannot contract out of or be relieved from any liability for breaching the obligation to act with care, diligence and skill. 6 3 4 5 6 R.S.C. 1985, c. C-36, as amended ( CCAA ). OBCA, section 134(1)(b); CBCA, section 122(1)(b). In Re City Equitable Fire Insurance Co. Ltd., [1925] Ch. 407, Romer J. stated that a director need only exhibit that degree of care and skill that might be expected of a person with the knowledge and experience of the director in question. OBCA, section 134(3); CBCA, section 122(3).
5 The CBCA provides that a director will not be liable for a breach of the statutory duty where he or she has relied in good faith on financial statements of the corporation represented by an officer of the corporation or in a report of an auditor to fairly reflect the financial condition of the corporation or a report of a person whose profession lends credibility to a statement made by the professional person. 7 The provision under the OBCA is similar except that it requires the financial statements to be presented in accordance with the generally accepted accounting principles and states that the report must be made by a lawyer, accountant, engineer, appraiser or other person. 8 The limitation of liability for the breach of the statutory duty is limited to directors; there is no similar protection for officers. In addition to the statutory defences, the courts have developed what is known as the business judgment rule which provides that there is no ground for director liability where the court determines that the process employed in reaching a decision was either rational or employed in a good faith effort to advance corporate interests. 9 This principle of deference to the decision-making process presupposes that directors are scrupulous in their deliberations and demonstrate diligence in arriving at decisions. In this regard, while courts are ill-suited and should be reluctant to second-guess the application of business expertise to the considerations that are often involved in corporate decision-making, they are capable, on the facts of any case, of determining whether an appropriate degree of prudence and diligence was brought to bear in reaching what is claimed to be a reasonable business decision. 10 7 8 9 10 CBCA, section 123(5)(a) & (b). OBCA, section 135(4)(a) & (b). UPM-Kymmene Corp. v. UPM-Kymmene Miramichi et al. (2002), 214 D.L.R. (4 th ) 496 (Ont. S.C.J.). Peoples Department Stores Inc. (Trustee of) v. Wise (2004), 244 D.L.R. (4 th ) 564 (S.C.C.).
6 (b) Fiduciary duty The statutory formulation of the fiduciary duty of officers and directors requires them to act honestly, in good faith and with a view to the best interests of the corporation. 11 This duty is a recognition and codification of the common law fiduciary duties owed by directors and officers to the corporation. In accordance with their fiduciary duty, directors and officers must respect the trust and confidence that has been placed in them to manage the assets of the corporation in pursuit of the realization of the goals of the corporation. They must avoid conflicts of interest with the corporation, avoid abusing their position to gain personal benefit and maintain the confidentiality of information they acquire by virtue of their position. A party seeking to prove a breach of fiduciary duty must show the directors or officers: (a) have scope for the exercise of some power or discretion; (b) can unilaterally exercise this power or discretion so as to affect the party s legal or practical interest; and (c) the party is peculiarly vulnerable to or at the mercy of the director or officer holding the discretion or power. 12 (c) Oppression remedy Directors and officers may also have potential liability to creditors under the oppression remedy provisions of the OBCA or CBCA. To be successful in pursuing a claim under the oppression remedy, a claimant must establish that the powers of the directors of the corporation or any of its affiliates are or have been exercised in a manner that is oppressive, unfairly prejudicial to the interests of, or unfairly disregards the interests of certain parties. 13 The remedies set out in the statutes are very broad and are aimed at rectifying the damage caused by 11 12 13 OBCA, section 134(1)(a); CBCA, section 122(1)(a). LAC Minerals v. International Corona Resources Ltd. (1989), 61 D.L.R. (4 th ) 14 (S.C.C.). OBCA, section 245; CBCA, section 241
7 the act or omission of the directors. The oppression remedy was originally designed to overcome the problems faced by minority shareholders in pursuing claims but the universe of those parties that can utilize the oppression remedy has been expanded to include creditors of the corporation. The courts have, however, made it clear that they will not allow debt actions by creditors to routinely be converted to oppression actions. 14 Most commonly, courts have found directors liable under the oppression remedy when dealing with small closely-held corporations, where the director has been the sole directing mind of the corporation and where the conduct complained of has personally benefited the director. 15 The courts have also held that while some degree of bad faith or lack of probity in the conduct of the director may occur, it is not essential for the finding of oppression. 16 (iii) Liabilities under Employment, Taxation and Pension Statutes In addition to the more general duties and liabilities that directors and officers are subject to under the OBCA and CBCA, there are also specific statutory duties and liabilities prescribed in the context of a wide variety of statutes. It is beyond the scope of this paper to discuss the myriad of statutes that create exposure for directors. (a) Employment issues Section 131(1) of the OBCA provides that directors of a corporation are jointly and severally liable to employees for all debts not exceeding six months wages that become payable to employees for services performed while they are directors. In addition, directors are liable for up to 12 months vacation pay due to the employees under the Employment Standards 14 15 Royal Trust Corp. of Canada v. Hordo (1993), 10 B.L.R. (2d) 86 (Ont. Gen. Div.). Sidaplex-Plastic Suppliers Inc. v. Elta Group Inc. (1998), 40 O.R. (3d) 563 (C.A.).
8 Act, 2000 17 or a collective agreement while they are directors. In accordance with the ESA, the directors are not liable for termination pay or severance pay. 18 Section 119(1) of the CBCA contains a virtually identical provision except it does not make reference to vacation pay. However, in light of the provisions of the ESA, directors of CBCA corporations will still be liable for vacation pay. The ESA imposes liability on directors for up to six months unpaid wages, up to 12 months vacation pay, holiday pay and overtime wages. 19 Directors are also liable to pay interest on the outstanding wages for which a director is liable. 20 Directors are also jointly and severally liability (together with the corporation) where an employer fails to deduct and remit the amounts required for the employees pensions plus any interest and penalties relating to the unremitted amount under the Canada Pension Plan. 21 The Employment Insurance Act 22 also provides that directors are jointly and severally liable, together with the corporation, for the failure of the corporation to deduct and remit required premiums. 23 Under both the CPP and the EIA, where a corporation is guilty of an offence, every officer or director or agent who directed, authorized, assented to, acquiesced in or participated in the offence is liable to the punishment provided for the offence whether or not the corporation has been prosecuted or convicted. 24 16 17 18 19 20 21 22 23 24 Brant Investments Ltd. v. KeepRite Inc. (1991), 3 O.R. (3d) 289 (C.A.). S.O. 2000, c.41 (the ESA ). ESA, section 81(3). ESA, section 81(3)-(7). ESA, section 81(8). R.S.C. 1985, c. C-8 (the CPP ), section 21.1(1). S.C. 1996, c.23 (the EIA ). EIA, section 83(1). CPP, section 103(2); EIA, section 107.
9 (b) Taxation issues The Income Tax Act 25 and the Excise Tax Act 26 both provide that directors are jointly and severally liable, together with the corporation for the failure to withhold and remit employee income tax deductions and goods and services tax. 27 A director will not be liable to pay the unremitted amount (together with interest and penalties) where he or she exercised the degree of care, diligence and skill to prevent the failure that a reasonably prudent person would have exercised in similar circumstances. 28 (d) Pension issues Another potential area of liability for directors is under the Pension Benefits Act 29 and the Pension Benefits Standards Act, 1985 30. These statutes require the administrator of the pension plan (which is normally the corporation itself) to exercise the care, diligence and skill that a person of ordinary prudence would exercise in dealing with the property of another person. 31 However, if the administrator possesses, or by reason of his profession or business ought to possess, a particular level of knowledge or skill relevant to the administration of a pension plan the administrator is required to employ that particular level of knowledge or skill. The potential liability for directors and officers arises from the general offence provisions of these acts which prohibit, among other things, the contravention of any provision of the statutes. The PBA, for instance states that directors and officers will be guilty of an offence if, they (a) 25 26 27 28 29 30 31 R.S.C. 1985, c. 1 (5th Supp.) (the ITA ). R.S.C. 1985, c. E-15 (the ETA ). ITA, section 227.1(1); ETA, section 323(1). ITA, section 227.1(3); ETA, section 323(3). R.S.O. 1990, c.p.8 (the PBA ). R.S.C. 1985, c.32 (the PBSA ). PBA, section 22(1); PBSA, section 8(4).
10 cause, authorize, permit, acquiesce or participate in the commission of the offence by the corporation or (b) fail to take all reasonable care in the circumstances to prevent the corporation from committing the offence. The PBA provides that directors and officers would be liable for a fine on the first conviction of not more than $100,000 and on each subsequent conviction of not more than $200,000. The punishment is quasi-criminal in nature under the PBSA with directors and officers facing fines of up to $100,000 or imprisonment for terms not exceeding twelve months. In addition the court may assess the amount not submitted or not paid and order payment of such amount. 32 C. D&O INSURANCE (i) Nature of D&O Insurance As set out in section 124(6) of the CBCA and 136(4) of the OBCA, a corporation may purchase and maintain insurance for the benefit of its directors and officers against any liability incurred by such individual (a) in the individual s capacity as a director or officer of the corporation, or (b) in the individual s capacity as a director or officer, or similar capacity, of another entity, if the individual acts or acted in that capacity at the corporation s request. The insurance policies purchased by corporations typically include what is referred to a Side A Coverage, Side B Coverage and (increasingly) Side C Coverage. Side A Coverage represents a promise by the insurer to pay the director in respect of a specific loss. Side B Coverage represents a promise by the insurer to reimburse the company in respect of amounts that the company has paid on its statutory, by-law or contractual indemnities of directors. Side C Coverage is a promise by the insurer to indemnify the company itself in respect 32 PBA section 110
11 of securities claim liability. Although there is no standard list of the risks insured under Side A and Side B Coverage, typical examples of risks insured would be tort claims and various statutory claims (i.e. unpaid wages, taxation remittances, etc.). Directors should be careful to assess the nature of the risks they may be exposed to in a particular business and ensure that those risks are covered. Side A Coverage generally only comes into play when the corporation is financially impaired which means, for example, that the corporation is insolvent or otherwise unable to pay under the indemnity provided to the directors. Unlike Side B Coverage, there is no deductible for claims covered by Side A Coverage. A D&O insurance policy is typically written for a one-year period and is typically a claims-made policy, which means that the policy responds to claims made during the term of the policy. In addition, the insurance policy may have a run-off or extended reporting period, which allows a director to report a subsequently discovered claim and have the insurance policy (which has otherwise expired), respond to that claim. Directors should carefully review the insurance policy and consider the adequacy of the coverage in the context of an insolvency proceeding. In some circumstances, it may be necessary to purchase additional/new insurance that provided appropriate coverage in insolvency situations. If the directors decide to purchase additional/new insurance at or about the time the corporation files for protection from its creditors, the directors must remember that like all other insurance policies, there is a strict obligation of good faith on the potential insured to disclose risks (including the financial status of the corporation). This will hold true even though, as discussed later, there is probably less risk of the directors accessing the insurance policy for postfiling claims under the CCAA as the claims that typically attract liability for the directors will be required to be paid by the corporation pursuant to the terms of the initial order.
12 (ii) Insured v. Insured Exclusion The insurance policy for directors and officers will normally include an insured v. insured exclusion which is intended to prevent collusion among parties with similar interests. In Federal Insurance Co. v. Continental Casualty Co. 33, the United States District Court for the Western District of Pennsylvania held that the insured v. insured exclusion in a D&O policy did not apply to an action brought against former directors and officers or a company by the company s trustee in bankruptcy. This decision seems to be based on the fact that the debtor-inpossession (i.e. the post-bankruptcy petition debtor) was not the same legal entity as the prebankruptcy petition debtor and there was no evidence that the debtor-in-possession had transferred the claims to a litigation trust 34 to avoid the insured v. insured exclusion. This is not a universally accepted position. Some American courts have held that the pre-bankruptcy petition debtor and the debtor-in-possession are always the same entity. Others have concluded that the pre-bankruptcy petition debtor and the debtor-in-possession should be treated as the same entity in certain contexts. In a bankruptcy scenario in Canada, it is submitted that the court would come to the same conclusion as in the Federal Insurance case. As noted by Justice Farley in Re Air Canada Inc. 35 when dealing with the applicability of legal set-off to pre-filing and post-filing claims in a CCAA proceeding, [i]n a bankruptcy, the trustee is inserted into the proceedings. Post-bankruptcy dealings of a creditor with the trustee in bankruptcy do not involve the same party, namely the debtor before the condition of bankruptcy. When a bankruptcy occurs, there is a new estate created: there is the estate of the debtor under the direction and control of the debtor 33 34 No. 5-CV-305, 2006 U.S. Dist. LEXIS 85323 (W.D. Pa. Nov. 22, 2006). The debtor in possession had assigned claims to the litigation trust pursuant to its bankruptcy plan.
13 before the bankruptcy which is a different estate than the one post-bankruptcy where there is an estate of the bankrupt under the direction and control of the trustee in bankruptcy. Thus, creditors who incur post-bankruptcy obligations to trustees in bankruptcy cannot claim legal setoff to avoid paying such obligations by setting-off such obligations against their proven (prebankruptcy) claims against the bankrupt. The same parties are not involved so there cannot be mutual cross-obligations. The holding in the Federal Insurance case is beneficial to the directors in a bankruptcy scenario since they will still have insurance coverage in the event that trustee in bankruptcy, at the request of the creditors, commences proceedings against them. (iii) Ownership of Insurance Proceeds In two recent and related cases in the United States, the courts ruled that proceeds of a D&O insurance policy are not the property of the debtor s estate. 36 The policy in issue contained a priority provision that provided that payments under Coverage A (coverage for the directors and officers) had priority over payments under Coverage B (coverage for the debtor for amounts paid to indemnify the directors and officers) and Coverage C (coverage for the debtor for specific claims). Both of the cases were focussed on the ability of the trustee in bankruptcy to challenge a settlement agreed to by the directors and officers and the debtor s shareholders in respect of violations of various securities laws that would exhaust the limits of the insurance policy through payments under Coverage A. The basis for the trustee in bankruptcy s challenge was that the proceeds of the insurance policy were the property of the bankrupt estate. 35 36 (2003), 45 C.B.R. (4 th ) 13 (Ont. S.C.J.). Miller v. McDonald (In re World Health Alternatives, Inc.), 2007 WL 1670357 (Bankr. D. Del. June 8, 2007) and In re World Health Alternatives, Inc., Sec. Lit., 2007 WL 1670180 (W.D. Pa. June 8, 2007).
14 The courts both determined that where the insurance policy provides coverage directly to officers and directors (as is the case with Coverage A), the proceeds are not the property of the estate. Although there was some disagreement on this issue when the policy provides for some coverage to the debtor (as was the case in Coverage C), the courts ruled that policy proceeds are not property of the estate where the debtor [the company] is covered for indemnification but indemnification either has not occurred, is hypothetical or speculative. Since there were no pending claims against the debtor (the company), the courts held that the policy proceeds were not property of the estate. In addition, it was noted that the priority payment provision would also grant the directors and officers a priority claim to the policy proceeds. It is submitted that the conclusion reached in these decisions would be equally applicable in Canada since it appears that D&O policies in Canada are structured in the same manner as they are in the United States with the Side A or Coverage A insurance covering the directors individually and the Side B or Coverage B insurance covering the companies for payments made by the companies to the directors. This should be a source of comfort to directors in the context of insolvency proceedings since they will not have to be worried that the trustee in bankruptcy appointed in respect of the corporation could seize the proceeds of an insurance policy established for the benefit of the directors or frustrate a settlement. D. PROTECTION FOR DIRECTORS & OFFICERS IN RESTRUCTURING PROCEEDINGS (i) Need for Protection Throughout the restructuring process, it will be essential to continue to have directors and, in particular, independent directors, in place to guide the corporation and assist in
15 making key business decisions. Independent directors are often not paid a great deal of money, view restructuring proceedings as being risky and often times would prefer to resign than deal with the stress and risk of the restructuring proceedings. In order to encourage directors to remain, corporations offer to provide directors with more protection than simply their D&O insurance. In the context of CCAA proceedings, the corporation will generally provide an indemnity to directors and officers in respect of claims from the date of the filing that relate to the failure of the corporation to make certain payments (e.g. employee entitlements for wages, vacation pay, termination or severance pay, etc.) or that result from the director s or officer s position or involvement as a director or officer of the corporation. The directors and officers will also be granted a charge on the present and future property and assets of the corporation as security for the indemnity provided by the corporation. The quantum and ranking of the directors and officers charge vis-à-vis other court-ordered charges, such as the administrative charge and the debtor-in-possession ( DIP ) charge will be negotiated by the various stakeholders prior to the commencement of the proceedings. (ii) Stay of Proceedings as Against Directors Section 11.5 of the CCAA permits the initial order (or subsequent orders) to contain a provision that no person may commence or continue any action against a director of a debtor company on any claim against the director that arose before the commencement of the CCAA proceedings and where directors are under any law liable in their capacity as directors for the payment of such obligations pending the filing of a plan. This stay does not apply in respect of an action against a director on a guarantee given by the director relating to the company s
16 obligations or an action seeking injunctive relief against the director in relation to the obligations of the company. (iii) Court-Ordered D&O Indemnity and Charge As of September 12, 2006, the Commercial List Users Committee for the Ontario Superior Court of Justice approved a model form for the initial CCAA order (the Model Order ) to be used (subject to modifications as may be appropriate in the context of the specific filing) by parties commencing CCAA proceedings in Ontario. The Model Order includes the following provisions in respect of the directors and officers indemnification and charge: 15. THIS COURT ORDERS that the Applicant shall indemnify its directors and officers from all claims, costs, charges and expenses relating to the failure of the Applicants, after the date hereof, to make payments of the nature referred to in subparagraphs 5(a), 7(a), 7(b) and 7(c) of this Order which they sustain or incur by reason of or in relation to their respective capacities as directors and/or officers of the Applicants except to the extent that, with respect to any officer or director, such officer or director has actively participated in the breach of any related fiduciary duties or has been grossly negligent or guilty of wilful misconduct. 16. THIS COURT ORDERS that the directors and officers of the Applicant shall be entitled to the benefit of and are hereby granted a charge (the Directors Charge ) on the Property, which shall not exceed an aggregate amount of $, as security for the indemnity provided in paragraph 15 of this Order. The Directors Charge shall have the priority set out in paragraphs 32 and 34 herein.
17 In accordance with paragraph 15 of the Model Order, the directors and officers indemnity (and hence the Directors Charge) would be restricted to certain specified claims that relate to the failure of the corporation to make payment of the following claims: (b) all outstanding and future wages, salaries, employee and pension benefits, vacation pay, bonuses and expenses payable on or after the date of the Order, in each case incurred in the ordinary course of business and consistent with existing compensation policies and arrangements; (c) any statutory deemed trust amounts in favour of the Crown in the right of Canada or of any Province thereof or any other taxation authority which are required to be deducted from employees wages, including, without limitation, amounts in respect of employment insurance, Canada Pension Plan, Quebec Pension Plan and income taxes; (d) all goods and services or other applicable sales taxes required to be remitted by the corporation in connection with the sale of goods and services by the corporation, but only where such sales taxes are accrued or collected after the date of the Order, or where such sales taxes were accrued or collected prior to the date of the Order but not required to be remitted until on or after the date of the Order; or (e) any amount payable to the Crown in the right of Canada or any Province thereof or any political subdivision thereof or any other taxation authority in respect of municipal realty, municipal business or other taxes, assessments or levies or any nature or kind which are entitled at law to be paid in priority to claims of secured
18 claims and which are attributable to or in respect of the carrying on of the business of the corporation. Although the list of claims for which the directors and officers are indemnified is limited in the Model Order, the directors and officers can negotiate with other interested parties, namely the senior secured creditors and DIP lender, for additional protection including, for example, indemnity in respect of any claims against the directors and officers that may arise from their dealings or position as directors and officers prior to the commencement of the CCAA proceedings and, in particular, for pre-filing wages and vacation pay. The quantum of the Directors Charge is most often calculated by determining the directors potential exposure for claims in respect of the final pay period prior to the filing. The court must approve the indemnification and charge and has the discretion to limit both the quantum and types of claims covered. In Re Air Canada Inc. 37, the initial order contained a Directors Charge for pre-filing and post-filing claims in the amount of $170 million. At a later motion, the temporal scope of the Directors Charge was left unchanged (with wilful misconduct and gross negligence being excluded from coverage). However, as an incentive to encourage directors to dedicate themselves to coming up with a successful restructuring plan, any affected director or officers was required to contribute to Air Canada 5.0% of any of amount of the $170 million charge utilized for the protection or indemnification of that person. This left a significant potential exposure on the directors. The Directors Charge will rank in priority to all of the unsecured and, usually, pre-filing secured creditors, however, its ranking vis-a-vis other court-ordered charges namely, the administrative charge and the DIP charge will be the subject of negotiations between the
19 parties. In the majority of cases, the administrative charge will rank in priority to all of the courtordered charges so the real issue is the ranking of the DIP charge and the Directors Charge. There is a clear tension between these parties as the lenders do not want to have their security position eroded for the purpose of paying claims of the directors and directors. As a compromise, the Directors Charge will sometimes be split so that a certain portion of the charge will rank in priority to the DIP charge and the rest will rank behind it. It is interesting to note that the granting of the Directors Charge may result, indirectly, in the re-ordering of certain priorities. For example in the context of a CCAA proceeding, vacation pay is simply an unsecured claim. However, if a claim is made against a director for vacation pay, the indemnity and charge may respond - effectively changing the priority of the vacation pay change. (iii) Directors and Officers Claims Process If a Director s Charge is granted there must be a mechanism to flush out and adjudicate claims as against directors and officers in an expeditious manner. Otherwise, there could never be a distribution to creditors of amounts secured by the Director s Charge. Where the Director s Charge is for a significant amount, it is common for the court to make an order putting in place a claims process with respect to directors and officers. In this process, claims as against directors and officers must be submitted within a specified time failing which they are barred. Disputed claims are adjudicated in a summary manner by a claims officer appointed by the court. Generally, the D&O insurer will participate in this process. In the Ivaco restructuring there has been a significant delay in releasing some proceeds to creditors as a result of the number of claims as against directors and officers that are being dealt with. 37 (2003), 42 C.B.R. (4 th ) 166 (Ont. S.C.J.).
20 (iv) Release of Directors and Officers in Plans of Arrangement Section 5.1 of the CCAA provides that a plan of arrangement made in respect of a debtor company may include provisions for the compromise of claims against directors of the company that arose before the commencement of CCAA proceedings and that relate to the obligations of the company where the directors are by law liable in their capacity as directors. Claims against directors that relate to contractual rights of creditors (eg claims on guarantees) or that are based on allegations of misrepresentation, wrongful or oppressive conduct by the directors may not be compromised. In re Canadian Airlines Corp. 38 the court expanded this protection to officers and employees. In the case of re Muscletech Research & Development Inc. 39 Justice Ground made a far ranging order approving a plan of arrangement which released the claims of tort claimants as against the debtor company and a wide range of other persons, including officers and directors. These tort claimants intended to claim directly against the officers and directors (and other persons) but Justice Ground held that the releases were part of the overall settlement that formed the basis of the plan of arrangement and the court had the jurisdiction to grant such releases. (v) Continued Provision of Insurance The Model Order also contains a general provision relating to the continuation of services, which includes insurance (though not specifically directors and officers insurance), during the period for which the stay of proceedings is in effect. The Model Order provides as follows: 38 39 (2000) 20 C.B.R. (4 th ) 1 (affirmed by the Court of Appeal) (2007) 30 C.B.R (5 th ) 59
21 12. THIS COURT ORDERS that during the Stay Period, all Persons having oral or written agreements with the Applicant for the supply of goods and/or services, including insurance to the Business or the Applicant, are hereby restrained until further Order of this Court from discontinuing, altering, interfering with or terminating the supply of such goods or services as may be required by the Applicant provided in each case that the normal prices or charges for all such goods and services received after the date of this Order are paid by the Applicant in accordance with normal payment practices of the Applicant or such other practices as may be agreed upon by the supplier or service provider and each of the Applicant and the Monitor, or as may be ordered by this Court. In some court orders, the Applicants expand this provision to include a fail to renew clause which requires service providers to renew contracts that are due to expire during the course of the CCAA proceedings 40. Although there may be some question as to whether the court should or can force an insurer to renew a directors and officers insurance policy (and on what terms) in the context of an insolvency proceeding, the reality is that the corporation will normally require such insurance to keep its directors and officers in place to assist in effectively navigate through the restructuring process. Though not specifically dealing with the provision of directors and officers insurance, the issue of whether a insurer had to continue to provide insurance was discussed in 40 See, for example, the Initial Orders in Re Archibald Candy Corp. et al. dated February 2, 2004, Re Air Canada Inc. et al. dated April 1, 2003, Re GT Group Telecom Inc. et al. dated June 26, 2002, Re The Loewen Group Inc. et al. dated June 1, 1999, Re Country Style Food Services Inc. et al. dated December 13, 2001 and Re General Chemical Canada Ltd. dated January 19, 2005.
22 Re Village Green Lifestyle Community Corp. 41, which was a receivership proceeding instituted under the Bankruptcy and Insolvency Act and the Courts of Justice Act (Ontario). Village Green owned and operated a large retirement community in Palmerston, Ontario. The insurer was seeking leave of the court to terminate its contract of insurance because it did not underwrite insurance for a risk in receivership. The insurance policy had been renewed for a one-year period on July 1, 2006 (at a premium of $16,490) prior to the commencement of the receivership proceedings on September 5, 2006. The Receiver had contacted other insurance providers to determine if alternative insurance coverage could be obtained but received only one quote for a one-year policy at a premium of $80,000. The Receiver could not continue to operate the retirement community without adequate insurance coverage and could not afford the alternative insurance at the price quoted. The Court denied leave for the insurer to terminate the insurance contract for three principle reasons: (i) there was no viable alternative available to the Receiver since the cost of the alternative policy was prohibitive and could not be funded by the receivership; (ii) there had not been any material change in the risk insured since the date that the insurer renewed the policy on July 1, 2006 and, if anything, the risk had diminished since the Receiver s appointment; and (iii) the insurer would not be materially prejudiced by the Court s decision to not lift the stay of proceedings and allow for the termination of the insurance policy. The court in Village Green, supra makes a valid point regarding the risk with respect to the insurer following the commencement of insolvency proceedings. In respect of proceedings under the CCAA, the insurer should take comfort in knowing that the Monitor is overseeing the business and payments that are made by the corporation. As set out in the Model Order, certain payments are required to be made by the corporation which would, if not paid, 41 (2007), 27 C.B.R. (5 th ) 199 (Ont. S.C.J.).
23 typically give rise to directors and officers liabilities (e.g. statutory remittances required to be deducted from employees wages). In the ordinary course, if a corporation is struggling with liquidity issues (outside of a formal insolvency proceedings), these types of payments are often not made or substantially delayed giving rise to potential claims against directors and officers and, in turn, potential claims against the insurance policies. (vi) Rights of Subrogation and the Insurance Carve-Out The Model Order contains a provision that restricts the right of insurers to claim that they are subrogated to or entitled to claim the benefit of the Directors Charge. Specifically, the Model Order provides: 17. THIS COURT ORDERS that, notwithstanding any language in any applicable insurance policy to the contrary, (a) no insurer shall be entitled to be subrogated to or claim the benefit of the Directors Charge, and (b) the Applicant s directors and officers shall only be entitled to the benefit of the Directors Charge to the extent that they do not have coverage under any directors and officers insurance policy, or to the extent that such coverage is insufficient to pay amounts indemnified with paragraph 15 of this Order. Generally, insurers have a right of subrogation where the insurer makes a payment to a party for a claim of the insured. In Re General Publishing Co. Limited et al 42, the insurer brought a motion claiming entitlement to subrogation into the Directors Charge established under the initial order. In the course of the decision, Justice Ground noted, 42 (2002), 39 C.B.R. (4 th ) 216 (Ont. S.C.J.).
24 [I]f the Initial Order was silent as to the directors insurance and subrogation, the insurance policy would be applicable if claims were made against the directors and, pursuant to the common law of subrogation and the provisions of the policy relating to subrogation, the insurer would have subrogation rights to the Directors Charge Fund and the benefit of the superpriority granted to claims against the Fund by virtue of the Initial Order. In denying the insurer s right to be subrogated into the Directors Charge Fund, Justice Ground relied on the following findings: (i) the purpose of the Directors Charge in the case of CCAA proceedings which have a legitimate prospect of restructuring is to keep the directors in place during the proceedings by providing them with additional protection for the additional exposure they may have as directors of an insolvent company; (ii) the insurer continues to be liable for claims made against the directors covered by the insurance policy and continues to have subrogation rights against the company to the extent claims are made against the directors personally and that situation is not changed by the institution of the CCAA proceedings; and (iii) if the claims made against the directors are claims that would have been covered by the insurance policy, they should not be claims which could be made against the Directors Charge Fund since the fund was only put in place to provide directors with additional protection, over and above that which was provided under the insurance policy. Justice Ground concluded that to provide the insurer with subrogation rights against the Directors Charge Fund would elevate the insurer s unsecured subrogated claim and the directors common law indemnity to a secured claim with a superpriority. Such a re-ordering of priorities was not necessary in order for the CCAA proceedings to continue and to provide the company with an opportunity to work out a restructuring or arrangement.
25 The Model Order also restricts the directors and officers entitlement to the Directors Charge to instances where they do not have insurance coverage or where the coverage is insufficient to pay the amounts for which the corporation provided the indemnity. This is a relatively new concept in the context of CCAA proceedings, which was not traditionally included in Initial Orders prior to 2004. The first Initial Order that appears to have included a carve-out for claims covered by directors and officers insurance was in Re Consumers Packaging Inc. et al. on May 23, 2001. The concept was also included in the initial orders in Re A.G. Simpson Automotive Inc. et al. on October 2, 2001, Re Fantom Technologies Inc. et al on October 25, 2001 and Re Country Style Food Services Inc. et al. on December 13, 2001. The concept appeared again in Re General Publishing Co. Limited et al on April 30, 2002, followed by Re AT&T Canada Inc. et al on October 15, 2002, Re Cotton Ginny Limited/Cotton Ginny Limitee on January 15, 2003 and Re Air Canada et al on April 1, 2003 and finally in Re Stelco Inc. et al on January 29, 2004. Since that time, the carve-out for directors and officers insurance had become standard practice and, as evidenced in the Model Order, has been widely adopted by insolvency practitioners. The effect of the insurance carve-out is to require directors and officers to look first to the insurance policy in respect of post-filing claims and use the indemnification and charge provided for in the initial order only if necessary. Where the directors and officers have no or limited pre-filing liabilities, the requirement to look to the insurance first is unlikely to have an impact of the personal exposure of the directors and officers. However, where there are significant pre-filing liabilities and significant potential post-filing liabilities, the directors and officers could find themselves personally exposed if the insurance policy is accessed for postfiling liabilities and the Director s Charge only deals with post filing liabilities. In such
26 circumstances, the directors and officers would undoubtedly argue that they were in a better position to deal with their potential liabilities and limit their personal exposure prior to the introduction and adoption of the insurance carve-out since they would rely on the insurance policy for pre-filing liabilities and rely on the directors indemnification and charge for postfiling liabilities. Although the terms of the Model Order relating to the insurance carve-out can be negotiated to be more favourable to the directors and officers, the senior secured creditors and DIP lenders are unlikely to agree to remove the insurance carve-out in circumstances where their recoveries would be materially impacted by a large claim (or claims) against the Directors Charge. (vii) Potential Amendments to the CCAA On November 25, 2005, Bill C-55, An Act to establish the Wage Earner Protection Act, to amend the Bankruptcy and Insolvency Act and the Companies Creditors Arrangement Act and to make consequential amendments to other Acts received Royal Assent. 43 The proposed section 11.52 of the CCAA would codify the creation of a priority charge for directors and officers liabilities. The directors and officers charge would include an indemnification for any obligations and liabilities that may be incurred after the commencement of CCAA proceedings but would not cover any obligation or liability incurred as a result of gross negligence or wilful misconduct. In addition, the court could grant a directors and officers charge only if adequate insurance can not be obtained at reasonable cost. Query 43 Bill C-55 has since been enacted as Chapter 47 of the Statutes of Canada, 2005 but has not been proclaimed into force. Chapter 47 is now the subject of Bill C-62, which proposes various, largely technical, amendments. With all party consent in the House of Commons, the Bill was referred directly to the Senate, where it received first reading on June 14, 2007. It is expected to receive second reading and be referred to the Senate Committee for hearings after the Senate returns on September 8, 2007.
27 what evidence will be necessary to satisfy this requirement and whether courts will be willing to grant a Director s Charge immediately on the commencement of a proceeding. Conclusion There are many land mines that a directors and officers can step on in the normal circumstances. Those land mines can be multiplied when a company is in financial distress. Careful consideration of director and officer s insurance coupled with proper provisions in an initial order under the CCAA can go a long way in protecting directors and officers from those land mines.