Equitable Subordination Reaches Canada Part I

Courts everywhere have
always used their powers to sanction improper conduct by creditors and to
restore parties to the positions they would have had if the improper conduct
had not taken place. In most common-law jurisdictions, the principles of equity
evolved to allow courts to remedy an unfair or "inequitable"
result. One aspect of the ability of the courts to grant equitable relief to
redress improper activity in situations of insolvency is the equitable
subordination remedy that courts can use to adjust priorities between
creditors. U.S. experience with equitable subordination has made it one of the
most refined remedies of its kind in the world.

</p><p>Canadian corporate legislation has for many years featured
the "oppression remedy" power, which is essentially an
extraordinarily broad jurisdiction given to the courts to remedy the effects
of corporate conduct that is "unfairly prejudicial." In Canada,
there have been isolated examples of courts applying remedies in insolvency
situations that have the "look and feel" of equitable
subordination, but recently an Ontario court took the bold step of explicitly
applying the doctrine of equitable subordination to subordinate the claims of a
secured creditor to the claims of an unsecured and unpaid supplier.

</p><p>The case, <i>C.C. Petroleum v. Allen,</i> (2002)
(Ont. S.C.) 35 CBR (4th) 22, involved a closely held company that had given
security interests to its insider shareholders. The company was never in good
financial condition, but it staggered along, aided by, as the court described
it, kiting checks among its various bank accounts. The kiting scheme allowed
the company to carry on its business longer than it should have, but when the
scheme ultimately collapsed, the shareholders applied for the appointment of a
receiver under their security and for the sale of the company's assets to
repay their loans.

</p><p>The court concluded that the actions of the shareholders/insiders amounted to fraud
and that even the appointment of the receiver was a part of the fraud. Because
the fraud had prevented the supplier from being paid (or, for that matter, even
knowing that there was a financial problem with the business), the court held
that it would be inequitable and unjust to permit the shareholders to retain
the benefit of their secured position. Consequently, the court used the
doctrine of equitable subordination to subordinate the secured claims of the
shareholders to the unsecured claim of the unpaid supplier. For good measure,
the court also awarded punitive damages against the shareholders.

</p><p>A similar result was reached in another more recent Ontario case, <i>Sittuk
Investments Limited v. Farber &amp; Partners Inc.,</i> (2002) 61 O.R. 3rd (546) (Ont. S.C.). Creditors of a bankrupt company
had relied on representations made to them by the principal of a sister
company. The sister company was also a creditor of the bankrupt company and was
controlled by the same officers and directors. The representations made to the
creditors (concerning the priority of their claim in a potential bankruptcy)
proved to be untrue and, in the court's view, the creditors had lost
badly as a result. The court ruled that the conduct of the sister company and
its officers and directors was unconscionable and that the appropriate remedy
was to subordinate its claims against the bankrupt company to the claims of the
creditors that it had led astray. The legal analysis that the court followed to
achieve this result did not specifically refer to the concept of equitable
subordination but, to use a tried and true legal analogy, anything that looks
like a duck, walks like a duck, swims like a duck and quacks is quite likely a
duck! Whether the remedy is called the "oppression remedy" or
"equitable subordination" is less important than the fact that
courts in Canada are finding ways in insolvency situations to redress improper
creditor behavior.