Debtor In-Possession Financing: The Dark Lending Hole

Article by I. Berl Nadler and Karine De Champlain

INTRODUCTION

The two principal Canadian restructuring statutes are the Bankruptcy and Insolvency Act1 (the "BIA") and the Companies' Creditors Arrangement Act2 (the "CCAA"). The CCAA, which will be the focus of this article, was originally enacted by Parliament in 1932- 33 in the midst of the Great Depression, with the intention of providing an alternative to the liquidation of companies in financial difficulty and providing a structured environment for the negotiation of compromises between a company and its creditors.

The CCAA fell into significant disuse between the years of the Great Depression and the 1980s when it was revived for use in a modern setting. One of the challenges presented in the adaptation of the CCAA for modern purposes was the absence of any express provisions therein for the financing of restructuring expenses. Accordingly, applicants who filed under the CCAA found it necessary to set aside significant "war chests" or to spend considerable amounts of time at the outset of the proceedings to obtain court approval for the use of otherwise generally unencumbered assets in order to finance ongoing operations during the stay period.

These restructuring expenses generally include, but are not limited to, (a) the costs of operating the business as a going concern during the course of the proceeding; (b) the fees and disbursements of the monitor appointed by the court to oversee the restructuring process, including the legal fees of the monitor's counsel; and (c) the fees and expenses of the company's own legal counsel and any restructuring professionals appointed or retained by the company to assist it in restructuring its operations and formulating a plan of compromise or arrangement.

Under ideal conditions, a CCAA applicant would have sufficient cash flow from operations to satisfy its funding requirements during the restructuring, rendering further borrowings unnecessary. More typically, however, the applicant will require access to a new source of funding to complete its restructuring successfully. A lender providing such debtor-in-possession (or "DIP") financing is unlikely to do so without some assurance that advances made to the debtor company in the interim period will be adequately secured.

In some cases, the debtor has unencumbered assets that can be charged as security for the funds advanced. One early example of this type of funding was sanctioned by the so-called "GAR" Order initially obtained by the Olympia & York group of companies ("O&Y") in the context of the CCAA proceedings involving O&Y. 3 In that case, a number of creditors who held security over specific assets had brought motions before the court seeking to segregate revenues in order to ensure that the rents from buildings owned by a specific debtor company would not be used to pay the expenses of another building owned by another debtor. Such a segregation was generally inconsistent with the centralized cash management system historically employed by O&Y. More importantly, however, without access to revenues from these assets there would have been no mechanism available to O&Y to finance its general, administrative and restructuring (or "GAR") expenses. The issue of who should fund the GAR costs occupied most of the time and energy of the participants in the restructuring during the months of May and June of 1992 and diverted time and resources from the pressing task of restructuring the enterprise.

In the result, a hybrid and unique type of funding was put in place, grounded on a two-pronged basis for financing: (a) the application of cash flow from secured assets, such as rental income from real property and dividends from securities, to cover the costs of managing the properties and to pay a management fee intended to cover overall GAR costs; and (b) the sale of unencumbered assets to generate further revenues to fund GAR costs.

This mechanism for financing GAR costs was far less efficient than the mechanism of DIP financing that was available south of the border in Chapter 11 proceedings. The absence of such a financing mechanism was an unnecessary impediment to the ability of Canadian debtors to effect a restructuring. As a result, in the decade that followed, Canadian courts borrowed the concept of and the term DIP Financing from Chapter 11 of the US Bankruptcy Code (the "Code") which, in s. 364 and related sections, sets out a detailed scheme for the provision of such financing. 4 They have not, however, adopted the US approach, 5 especially with respect to the "adequate protection" requirement contained in s. 364(d) and explained in s. 361 of the Code.

In contrast to the Code, the CCAA is relatively short, containing less than two dozen provisions, and does not explicitly address the availability of interim financing for the company. As stated by Justice Farley in Dylex Ltd., Re ("Dylex"), "the history of CCAA law has been an evolution of judicial interpretation". 6 Nowhere has the creativity and flexibility of the courts been more evident than in its development of the law relating to DIP financing under the CCAA.

THE JUDICIAL RECEIVERSHIP APPROACH

Until the early 1990s, the prevailing view was that the principles developed under the law regarding judicial receivers would apply equally to cases decided under the CCAA. In judicial receivership cases, financing for the debtor company was usually built into the permitted expenses and disbursements of the receiver, and priority was determined in accordance with the principles enunciated by the Ontario Court of Appeal in Robert F. Kowal Investments Ltd. v. Deeder Electric Ltd. 7 ("Kowal"). In that case, a receiver had been appointed by the court in respect of the assets of a partnership on the application of some of the partners, without the consent of a mortgagee in whose favour partnership lands were encumbered. The dispute arose as to whether the receiver should be granted a charge over the assets of the partnership ranking in priority to the mortgage for amounts advanced in respect of payments made on the mortgage debt during the course of the receivership. The Court of Appeal refused to grant the receiver priority status. Essentially, the court held that the receiver's right to indemnity was restricted to the assets under his control, and confined to the equity of the debtor in those assets. As a general rule, there was no power in the receiver to subordinate the security of existing creditors in favour of his own expenses and disbursements. There were, however, three exceptions to the general rule:

if a receiver had been appointed at the request of or with the consent or approval of the holders of security, the receiver would be given priority over the security holders;

if a receiver had been appointed to preserve and realize assets for the benefit of all interested parties, including secured creditors, the receiver would be given priority over the secured creditors for charges and expenses properly incurred by him; and

if the receiver had expended money for the necessary preservation or improvement of the property, he might be given priority for such an expenditure over secured creditors.

One of the first cases to consider the issue of financing for the debtor under the CCAA was Fairview Industries Ltd., Re8 ("Fairview"), a decision of the Nova Scotia Supreme Court. In that case, an initial order had been granted under the CCAA on an ex parte basis on the application of Fairview Industries Limited and five related companies. The initial order issued by the supervising court in those CCAA proceedings included, among other things, provisions permitting the monitor and certain restructuring professionals retained by the companies to be paid in priority to all other creditors of the applicants. After receiving notice, several secured creditors moved to rescind or vary the order, including the provisions relating to the priority of professional and administrative costs.

It was submitted by Fairview that "...the amount of work involved in these applications, including the ongoing work of preparing a plan, is substantial and that without priority of payment the six companies could be left without professional assistance to pursue the stated ends of the C.C.A.A.". 9 While the court sympathized with the position of the companies, it nonetheless held that it did not have the authority to subordinate pre-existing secured claims: 10

Although this position may have some validity, an analysis of the legislation does not lead me to conclude that such an extension can be attached to the wording of the C.C.A.A. Although such advisors and professionals must be paid, payment in priority to all of the creditors could result in deterioration of the value of the security held by the creditors.

The court therefore concluded that "...the payment in priority to anyone other than the monitor was void ab initio". 11 With respect to the priority position of the monitor, the court went on to state: 12

As to the court-appointed monitor, it is with reluctance that I conclude that although the court has the power to appoint such a monitor, there is no jurisdiction in the C.C.A.A. to give the monitor priority of payment unless the parties agree.

Therefore, the circumstances under which a monitor would be granted priority for its costs were highly circumscribed in the early days of the CCAA revival.

THE CCAA AND INHERENT JURISDICTION

The approach of the courts shifted in 1992, with the decision of the British Columbia Supreme Court in Re Westar Mining Ltd. 13 ("Westar"). In that case, the initial order granted by the court required suppliers of goods and services to extend further credit to Westar beyond the date of the initial order. The court subsequently held that it did not have the jurisdiction to make that particular order and, as security for credit which had been extended to the debtor company in the interim period...