Derrick C Tay of Gowling Lafleur Henderson explores how the "bad faith" test has been used in Canada.
"Restructurings are all about fairness, balancing prejudices and trying to find the greatest good for the stakeholders as a whole."
Distressed debt investors (DDIs) have been very active participants in the Canadian insolvency market for some time now. Largely US-based, DDIs tend to push the envelope in terms of leveraging their positions, often at the expense of other creditors. “How far is too far?” is one of the most difficult questions that judges in Canada have to deal with. The insolvency regime in Canada is highly dependent on the sophistication of our judges in dealing with cutting edge practices in the market place. The law is always playing catch-up and much depends on the judges applying their broad discretion in policing the rough-and-tumble world of insolvency.
At law, someone who buys debt gets to exercise all the rights that flow from the full face-value amount of the debt. Having said that, Canadian judges have long been willing to “contrast between those affected persons who have put 100 cents on the dollar into the situation only to be caught in a credit crunch and those who have ‘speculated’ at pennies on the pound knowing that situation is risky”. That contrast is particularly relevant when it comes to analysing the behaviour of DDIs in any particular fact situation.
A lack of regard for the interests of other stakeholders in the proceedings, and a lack of interest in facilitating a debtor’s reorganisation, have been recognised by the courts in Quebec to be sufficient to find a lack of good faith. Those courts have held that the actions of DDIs seeking to maximise returns at the unfair expense of other stakeholders would not be condoned. Courts in Quebec have the benefit of a specific provision of the Quebec Civil Code that requires parties to act in good faith both at the time the obligation is created and at the time that it is performed and extinguished.
In the common law jurisdictions of Canada (everywhere other than Quebec), courts have to rely on their broad statutory discretion or on their “inherent jurisdiction” to advance the objectives of the insolvency legislation.
There are two principal insolvency statutes that are used in Canada for restructuring companies. The Companies’ Creditors Arrangement Act (CCAA) is the most widely used statute, especially for the larger and more complicated restructurings. The Bankruptcy and Insolvency Act (BIA), in addition to dealing with formal bankruptcies, also has provisions for restructuring a company, but tends to be the tool for smaller and more straightforward restructurings.
Unlike the CCAA, which is silent on the issue, the BIA has a specific provision that provides the court with a remedy where the court is of the opinion that “substantial injustice has been caused”. Courts have held that this threshold is crossed when “the BIA is used for an improper purpose”. However, in applying this test in the Laserworks case, the court recognised that a “creditor should not be denied the right to vote for wrongful motives alone; motives must be supported by a tortious act to support a finding of improper purpose”.
The British Columbia case Blackburn Developments imported this restricted test in applying it to a CCAA situation. That court recognised the creditor’s right to vote its claim in whatever way it perceives to be in its economic interest, as long as its actions are not unlawful and do not result in a substantial injustice. And by approving the reasoning in Laserworks, for there to be substantial injustice there would have to be tortious-like behaviour.
The attempt by the Blackburn case to draw clear lines around the concept of actionable bad faith is not really a useful one and a departure from the usual approach of Canadian courts to always allow themselves latitude in ensuring fairness in the insolvency process. More often than not, courts will know when the line has been crossed and should not be constrained by artificial rules. The Blackburn case also held that if Parliament wanted to control the activities of hedge funds, they should legislate such controls and it is not up to the courts to provide such controls.
Interestingly, it was the recent decision in another British Columbia case that pointed to a much more flexible, fact-based and pragmatic approach to this issue. The Telus case was not a CCAA restructuring but rather a plan of arrangement under a corporate statute. Notwithstanding that, the principles and analysis of that case, issued in the context of considering whether a corporate plan of arrangement was fair and reasonable, would apply equally in a CCAA context.
The Telus case involved the activities of a hedge fund called Mason Capital Management LLC (Mason) which tried to employ “empty voting” tactics to try and block the approval of the plan of arrangement (the arrangement) under the Business Corporations Act of British Columbia.
The arrangement was essentially to consolidate the existing two classes of shares of Telus into one class. The dual share structure was historical in origin. US-based Horizon was originally a substantial shareholder of Telus. The dual share structure was put in place to comply with Canadian foreign ownership restrictions in respect of telecommunication companies. Verizon disposed of the last of its holdings in Telus in 2004.
Given the challenges to corporate governance and to overall share liquidity caused by the dual share structure, Telus proposed this arrangement to simplify its share structure by consolidating the two classes into one, thereby creating value for the shareholders.
Mason had acquired 18.7 per cent of Telus’ common stock while at the same time shorting approximately the same amount of stock. As a result, Mason had legal ownership, and therefore voting rights, to approximately $2 billion worth of stock having only put a net $25 million at equity risk. Apart from Mason, the arrangement had the overwhelming support of both the common and the non-voting shares of Telus. Mason was blocking the arrangement to hold out for a premium payment on its holdings.
A basic tenet of fairness in Canadian proceedings is that the people with the economic interests are the ones whose wishes should be listened to, rather than the wishes of those who simply have the legal right to vote the position. It is no wonder that the judge in this case had great difficulty with Mason’s course of action and behaviour.
In her introduction, Justice Shelley Fitzpatrick noted that: “Mason opposes the proposal despite it being well acknowledged by both Telus and Mason that there are significant benefits to Telus and its shareholders in achieving this result.” In lengthy reasons, Justice Fitzpatrick disposed of Mason’s arguments with well-reasoned logic and law. Underlying it all was the court’s basic difficulty with the unfairness of “empty voting” tactics to the other stakeholders.
Rather than taking the formalistic approach of the court in Blackburn, or asking whether what Mason was trying to do was legal, Justice Fitzpatrick chose to take into account the larger view of what was happening in this case. The first and fundamental question she chose to consider was “whether, in the context of the fairness analysis, Mason’s unique circumstances and motivations are relevant factors to consider”.
Further on in her analysis, she refined the question as being, “In the exercise of its discretion under the Act in considering the arrangement, must the court be blind to Mason’s unique circumstances?” She then went on to examine the case law in this area (including Blackburn) and held that she could properly take all of this into a consideration of fairness.
She found that:
Fairness is an amorphous concept... What factors are relevant will vary from case to case... The Court...has gone some way towards crafting a framework for the analysis and has identified many factors that are to be considered within the articulated fairness test. The listed factors, however, are not exhaustive. Having in mind the unique circumstances of this case, particularly as they relate to Mason, in my view, it would be unhelpful and indeed detrimental to disregard the dynamics that clearly exist between, Mason, Telus and the other shareholders.
In finding the arrangement to be fair despite Mason’s opposition, Justice Fitzpatrick explained, “Mason’s opposition must be viewed through the lens of its unique strategy, which has nothing to do with the wellbeing of Telus and its shareholders. I do not make this comment in the sense of disregarding Mason’s vote, but in the sense of understanding its vote. Mason stands alone and its submissions are clearly directed at the benefits it alone will achieve at defeating the arrangement.”
The Telus case stands as a fine example of the approach that the Canadian courts should and usually do take when it comes to dealing with the issue of fairness and bad faith. They are ultimately the same issue. Restructurings are all about fairness, balancing prejudices and trying to find the greatest good for the stakeholders as a whole. What that greatest good is depends entirely on the particular facts and circumstances of the case. And those who want to rely solely on legal rights to achieve their personal objectives should remember the old adage that “just cuz it’s legal don’t make it right”.