Equitable Subordination In Canada – Waiting For The Right Facts

What does the U.S. doctrine of equitable subordination have to do with Canada? Superficially, the answer may be: not much. But for many financing and insolvency professionals here in Canada, there remains a palpable sense that the U.S. doctrine will eventually, if not inevitably, find its way fully across the U.S. border into Canada. So, perhaps the more appropriate response really ought to be: not much, at least not yet! It is because of this anticipation that it is worthwhile, from time to time, to summarize the central aspects of the U.S. doctrine and to determine its current level of acceptance here in Canada.

The U.S. Doctrine in Brief

Under the U.S. Bankruptcy Code, U.S. courts may apply equitable principles to remedy creditor misbehaviour, including by subordinating certain creditor claims — both secured and unsecured — to the claims of lower-ranking creditors. But, because the remedy disregards the otherwise freely negotiated arrangements of transacting parties, the remedy is considered an extraordinary one, which is to be utilized only sparingly.1 Three conditions must be satisfied before a subordination will be imposed by the court: (i) the creditor whose claim is to be subordinated must have engaged in some form of inequitable conduct (ii) the misconduct must have resulted in injury to the bankrupt's other creditors or conferred an unfair advantage upon the misbehaving creditor, and (iii) the subordination must otherwise be consistent with the provisions of U.S. bankruptcy legislation.2 As a result, the doctrine is usually applied in cases involving some element of fraud, unjust enrichment, breach of fiduciary duty or other inequitable conduct, where there is otherwise some connection between the creditor's misconduct and the injury or disadvantage suffered by the aggrieved creditors.3

The U.S. doctrine is most often applied to sanction the activities of "insiders," for example, the activities of parent corporations or other persons related to the bankrupt who have attempted (improperly) to gain a leg-up on other creditors. Due to the non-arm's-length nature of the relationship, insider conduct will always be subject to closer scrutiny by the courts.4 For "non-insider" cases, on the other hand, where no fiduciary duty is owed to the bankrupt and the impugned creditor otherwise deals at arm's length with the bankrupt, the doctrine is applied much more restrictively, and generally requires misconduct that is "gross and egregious."5 Specifically, the doctrine is usually applied when the arm's-length creditor has "dominated" or "controlled" the bankrupt in some way so as to gain an unfair advantage over other creditors. In the absence of domination, the doctrine may also be applied where the arm's-length creditor has actually defrauded another creditor. Not surprisingly, much of the impugned conduct in both insider and non-insider cases occurs on the eve of the debtor's insolvency.

A good example of non-insider subordination is the case of In re American Lumber Co.,6 a case in which the secured creditor (in this case, a bank) was found to have assumed dominant control over an insolvent debtor. There, the bank essentially took over and then ran the debtor's business, dictating which employees were retained, choosing what debts were paid, falsely informing unsecured creditors that the debtor was still solvent, and deliberately misleading unsecured creditors to...