As readers of the Journal know all
too well, legislators in all countries deal with bankruptcy the way they
deal with a trip to the dentist. It is something you have to do, but it
is certainly not going to be enjoyable. So it is unusual, and perhaps
even frightening, to see bankruptcy legislation changed more than once a
decade. Twenty-five years seems to be a bit of a norm for major changes
in bankruptcy legislation, but Canada once went 43 years without
significant changes. This, however, is by no means a world record, since
several countries have exceeded 50 years, and there are reports of some
instances of insolvency reforms being almost 100 years apart.

During its last series of amendments, Canada tried to remedy the
problem by providing a requirement for a review with amending
legislation at the end of five years. That was in 1997. It is 2005, and
the proposed new amendments have just been introduced in Parliament.
This is good news in a way: It seems that five years takes longer these
days than it used to.

Canada proposes to embark on several new directions in its bankruptcy
legislation. Many constructive things may come from all of this, but
there are a number of situations in which the Canadian government
proposes to make things worse. It is a case of the "good," the "bad" and
the "ugly."

First the "ugly:" Any thought that Canada would get provisions like
§1113 of the Bankruptcy Code, allowing for the rejection of union
contracts when no agreement can be reached and the existing contract
imperils the reorganization, has been firmly squelched. Reorganizing
companies will not be able to reject or alter collective agreements no
matter what harm will result to other stakeholders of the business.
There was a thought that the existing CCAA might permit this sort of
thing, but the government has now indicated that it won't
happen—ever.

Continuing in the "ugly" vein, the amendments propose a
super-priority for arrears of wages, giving them priority over secured
creditors holding security on current assets (viz, banks).
Arrears of pension contributions would have priority over secured
creditors on all assets of the debtor (viz, everyone).
Wage arrears as a practical matter have not been a problem in Canadian
practice, but no matter; the situation is going to be fixed whether it
is a problem or not.

<blockquote><blockquote>
<hr>
<big><center>
Arrears of pension contributions would have priority over secured
creditors on all assets of the debtor.... Wage arrears as a practical
matter have not been a problem in Canadian practice, but...the situation
is going to be fixed whether it is a problem or not.

</center></big>
<hr>
</blockquote></blockquote>

As if that isn't bad enough, a new bureaucratic organization will be
created called the Wage Earner Protection Program (WEPP), although this
organization will be based in a different department from the one that
operates the bankruptcy system. (There is awfully deep thinking involved
in some of this stuff.) The WEPP will "promptly" pay employee arrears
and then will become subrogated to the employees' super-priority clams
over secured creditors. This, of course, creates a government-sponsored
agency with super-priority liens on the assets that the beleaguered
reorganizing debtor needs most to survive. Will the government agency
take a long-term reasonable view of the situation to assist the business
in its attempts to reorganize and carry on? You can believe in that or
the Easter Bunny—take your pick.

The economic fallout from the creation of major super-priority claims
over security held by existing lenders has not yet been assessed, nor
has any empirical research measured the extent of the harm to the credit
system that these changes will present. Though very few businesses
actually go bankrupt, every operating loan to every active business will
now be reduced by the amount necessary to margin for the super-priority
claims on the collateral involved. This could lead to significant
contractions of credit for small and medium-sized businesses, which,
after all, employ most of the workforce. This social engineering will
benefit the only relative handful of employees who suffer wage arrears
on the bankruptcy of their employer. It is worse than using a
sledgehammer to swat a fly.

The original idea for protecting unpaid wages in a bankruptcy
involved a fund that would be created through a very small weekly levy
on workers' wages, along the lines of Social Security or employment
insurance. A fund of this kind would have readily created enough
resources to handle many years of unpaid employee wage claims and
bankruptcies without creating the chaos on secured creditors that is
going to result from the WEPP. That idea, unfortunately, was a tad too
reasonable for the social engineers designing Canada's bankruptcy
system.

Now to the merely "bad." It is claimed in the amendments that Canada
has adopted the UNCITRAL Model Law on Cross-border Insolvency, which
provides an international set of procedures for recognition of foreign
insolvency proceedings and foreign insolvency representatives. To date,
nine countries have adopted the Model Law, including, most recently, the
United States as a new chapter 15 to the Bankruptcy Code.

It was called a "Model Law" because the international consensus was
that all countries would adopt the same basic form of the Model Law.
This would create a network of comparable domestic statutes around the
world that would function, in effect, as a kind of international
bankruptcy treaty. Canada, of course, was prominently involved in the
development of the Model Law and signed on (as did some 60 other
countries in the UNCITRAL Working Group that prepared the Model Law) to
the idea that it would be adopted in substantially the same form all
around the world. That was fine in theory, and the Canadian government
supported the theory at the time.

But Ottawa, for inexplicable reasons, has devised its own form of
Model Law, which doesn't resemble any other adaptation anywhere in the
world.

And now to the "good"; this won't take nearly as much space.
Provisions have been made to incorporate into legislation practices that
have become standard in Canadian reorganizations. Such things as DIP
financing, which was ostensibly anathema to Canadian creditors not so
long ago, are given legislative recognition.

You will look in vain for creditors' committees, which Canadian
legislators apparently continue to regard as expensive, time-consuming
creations of the devil. There is an interesting provision under which
the court can award reimbursement for professional costs reasonably
necessary to permit an interested party to "participate effectively" in
a case, although this may be more likely to assist larger creditors in
protecting their own interests rather than assisting committees to look
after the interests of creditors generally. The court has been given the
power to remove directors who are impairing the prospects of a
successful reorganization and to replace them with those who won't.
Curiously, the court can also replace a director who is "acting
inappropriately as a director," which sounds sort of imprecise.

At long last, claims of equity-holders (e.g., damages for
misrepresentation, etc.) will be relegated to equity-level status in
reorganizations rather than, as at present, being ordinary creditors
like all other creditors.

Procedures for asset sales have been introduced, but they are overly
complex. On asset sales out of the ordinary course of business, the
court is directed to give a specific consideration to six factors, only
one of which relates to the potential benefit to the creditors of the
estate. Specific measures have been put in place to attempt to
discourage the use of the insolvency process to convey assets from an
insolvent company to its solvent principals.

Avoidance provisions have been streamlined. Under current law, the
most important factor in an avoidance situation is the intention of the
debtor. If the intention of the debtor was to prefer a particular
creditor over other creditors, the creditor has received a preference
that can be attacked and recovered by the trustee for the benefit of the
estate. Under the proposed system, the test will be whether transfers by
the debtor have taken place at an appropriate value. If not, the trustee
can recover from the transferee the difference between the value
received in the transaction and the actual value of the subject matter
of the transaction. Avoidable preferences will now be called "transfers
at undervalue," or TUVs. This is a major improvement over Canada's
current intention-based test, which is complex in practice and does not
effectively deter avoidance transactions.

Some improvement, but not much, has been made in reclamation
remedies. The only reason that this is a positive development from the
point of view of unpaid suppliers was that a proposal had been made to
abolish reclamation rights entirely.

New provisions have been added to permit a court to grant a lien in
favor of professionals for the payment of their reasonable fees in
reorganizations. However, Canada will still lack an administrative
expense priority, and unpaid claims for post-petition goods and services
in a failed reorganization will continue to rank equally with unpaid
claims for pre-petition goods and services—i.e., right at
the bottom of the food chain. In Canadian reorganizations, suppliers are
well advised to still observe the precept "in cash we trust."

Because Canada's current government does not have a majority in the
House of Commons, it is hard to predict what amendments will eventually
make their way into law. There are a number of observers who would
prefer that none of the amendments be enacted. This is rather a harsh
view of the process, and most observers consider that most of the
amendments will be enacted, although there may be some changes to some
of the more controversial provisions during the process. The
International Scene will keep readers apprised of developments.

Journal Authors

Bruce E. Leonard

Journal Date

Friday, July 1, 2005 - 12:00

Bankruptcy Rule

2005

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