When Reasonable Commercial Efforts are Not Enough: How far will Courts allow companies to disclaim their existing contracts and commercial leases, due to COVID-19?

By Damon Stoddard, LL.B., LL.M., Heal & Co. LLP

As a result of the coronavirus (COVID-19) pandemic, some businesses are relying on force majeure clauses in their contracts to try to excuse themselves from contractual performance.  If there is no force majeure clause in their agreements, companies may seek to rely on the legal doctrine of frustration and take the position that it is impossible to perform their contractual obligations as a result of the government-imposed shutdown. Hard times make for hard cases.

But what happens when the shutdown ends and the economy reopens? We may collectively plan for the best, but companies in difficult situations might have to make hard financial choices, where financial recovery plans are not working.

Construction projects will most likely resume, landlords who have been patient will expect tenants to pay their outstanding rent, and parties to longstanding supply agreements will expect their counterparty to begin performing again.  However, companies may find that the economic landscape has changed so much that they can no longer economically perform their contracts, or that they want to downsize and disclaim, some or all, of their commercial leases.

This article will briefly set out the federal insolvency statutes that companies may use to try to disclaim their contracts and leases, and to reorganize their businesses, when the Ontario Superior Court of Justice re-opens for hearings of non-urgent matters.

Communication, co-operation and negotiation remain the most valuable tools in the business toolkit to achieve a better outcome with your contractual counterparty, but if financial losses continue under the harsh economic realities of the COVID-19 economic slowdown, there is some limited room to use the legislative tools available to obtain some relief in last resort situations.

  1. Proposals under Part III of the Bankruptcy and Insolvency Act

Part III of the Bankruptcy and Insolvency Act allows a debtor to make a proposal to its creditors to try to restructure its affairs.  A proposal must be made to a debtor’s unsecured creditors, and it may be made to its secured creditors.[1] A proposal can be commenced by filing a notice of intention (NOI) to make a proposal.  A proposal typically includes a term for the debtor to repay a portion of its debt owing to its unsecured creditors.

Proposals are voted on by the debtor’s creditors at a creditors’ meeting. In order to be binding, a proposal must be approved by a majority of creditors (50% plus one) and that majority must represent 66% of voting claims.

In addition to creditor approval, the proposal must be approved by the court.  Section 59(2) of the BIA provides that if the terms of a proposal are not reasonable, nor calculated to benefit the general body of creditors, nor made in good faith, the court shall refuse to approve the proposal.[2]

With respect to a debtor’s existing contracts, section 65.11 of the BIA provides that a debtor may, on notice to the other parties to its agreements,[3] disclaim any agreement to which the debtor is a party, on the day its NOI was filed (subject to exceptions for collective agreements, a lease if the debtor is the landlord, and certain financial contracts).[4]

Within 15 days after notice is given, the counterparty to the agreement may apply to court for an order that the agreement is not to be disclaimed. The factors the court considers are (a) whether the trustee has approved the proposed disclaimer; (b) whether the disclaimer would enhance the prospects of a viable proposal being made; and (c) whether the disclaimer would likely cause significant financial hardship to a party to the agreement.[5]

In light of the economic effects of COVID-19, it will be interesting to see how far courts will allow debtors to disclaim their agreements, particularly since companies may seek to disclaim their less profitable agreements, only, while downsizing to focus on a niche part of their business.  How much financial hardship on the part of a counterparty is required for a court to order that a debtor’s contract should not be disclaimed?

  1. Disclaimer of commercial leases under the BIA

Section 65.2 of the BIA provides that a tenant under a commercial lease may file a proposal and seek to disclaim a lease on giving 30 days’ notice to its landlord.

The landlord may challenge the disclaimer by applying to court for a declaration that the tenant’s disclaimer does not apply in respect of the lease.  The onus is on the landlord, and the court will not make a declaration in favour of the landlord if “the court is satisfied that the insolvent person would not be able to make a viable proposal without the disclaimer of the lease, and all other leases that the lessee has disclaimed” under s. 65.2.

In the 2001 decision in Superstar Group of Companies,[6] the court refused to grant the landlord a declaration that the debtors’ disclaimer did not apply to certain leases, since the court found that debtor companies “did not have sufficient cash flow and … the closure of 22 stores and consolidation of the inventory into the remaining stores … was immediately required”.[7]

The economic effects of COVID-19 may result in companies with multiple leases and stores seeking to disclaim some, or most of their leases, in the hope of downsizing to focus on their most profitable flagship stores, only.

Subsection 136(1)(f) of the BIA does give a landlord a preferred claim in respect of three months of arrears of rent preceding the bankruptcy. But what about the landlord’s claim as an unsecured creditor for the unpaid balance of rent under the lease term?

In a 2020 decision entitled Curriculum Services Canada,[8] the Ontario Court of Appeal held that a commercial landlord did have an unsecured claim for the unpaid balance of its preferred claim for accelerated rent under the lease, but did not have an unsecured claim for the repayment of over $200,000 in tenant inducements, since the obligations under the lease between the tenant and landlord came to an end after the trustee disclaimed the lease.[9]

In the coming months, commercial tenants across Ontario may seek to use the BIA to disclaim most (or all) of their leases, and landlords may challenge those disclaimers to try to collect a portion of their preferred claim for three months’ rent arrears, and a portion of their unsecured claim for the unpaid balance under the lease.

  1. Plan of arrangement under the Companies’ Creditors Arrangement Act

The Companies’ Creditors Arrangement Act (CCAA)[10] is allows certain debtor companies that owe at least $5 million to their creditors,[11] to restructure their affairs by way of a plan of arrangement. Companies that do not reach this $5 million threshold can use the Division I Proposal under the BIA.

Section 32(1) of the CCAA permits a debtor to disclaim agreements to which the company is a party, on notice to its counterparties to the agreement, and the monitor.  Section 32(2) empowers a counterparty to apply to the court within 15 days after notice is given, to block the disclaimer.  Further, the debtor can apply to court if the monitor does not approve the disclaimer.

Similar to BIA section 65.11(5), CCAA section 32(4) provides the following list of factors the court is to consider in deciding whether to order that the agreement be disclaimed or resiliated:

  1. whether the monitor approved the proposed disclaimer:
  2. whether the disclaimer will enhance the prospects of a viable compromise or arrangement being made in respect of the company; and
  3. whether the disclaimer would likely cause significant financial hardship to the counter-party.

CCAA proceedings have been used to facilitate downsizing. For instance, in Skeena Cellulose Inc., Re[12] the debtor terminated two long-term logging contracts, and such terminations were upheld by the B.C. Court of Appeal.

In an employment-related decision entitled Timminco Ltd et al.,[13] a retired executive of Timminco brought a motion to compel Timminco to honour its obligations under their agreement to pay him termination and retirement benefits of $250,000 per year. Timminco brought a cross-motion for a declaration that it was entitled to disclaim the agreement under the CCAA. Justice Morawetz (as he then was), granted Timminco’s motion and held that the test for whether an agreement should be disclaimed is subjective, as follows:

[60] … the test of whether a disclaimer of an agreement will cause significant financial hardship to the counter party depends and is centered on an examination of the individual characteristics and circumstances of such counter party. Further, an objective test for “significant financial hardship” would make it difficult to debtor companies to disclaim large contracts regardless of the financial ability of the counter parties to absorb the resultant losses. It seems to me that such a result would be contrary to the purpose of principles of the CCAA.

In light of COVID-19, it is an open question as to how far Canadian courts will allow companies to downsize and disclaim their contractual obligations, particularly since the test for whether the disclaimer of a contract will cause financial hardship to the counterparty, is subjective.

  1. Assignment of agreements under the BIA and CCAA

Section 84.1 of the BIA allows the court to grant an order assigning the rights and obligations of the bankrupt under an agreement to a third-party purchaser, even without the consent of the counterparty to the agreement. There are exceptions for collective agreements and eligible financial contracts.[14]

There is an equivalent provision in the CCAA, section 11.3, which permits a debtor company to apply to court for an order assigning the rights and obligations of the company under an agreement “to any person who is specified by the court and agrees to the assignment”. Again, there are exceptions for collective agreements and eligible financial contracts.[15]

In deciding whether to make the order, the court is to consider, among other things:

  1. whether the monitor approved the proposed assignment of contractual rights;
  2. whether the person to whom the rights and obligations are to be assigned would be able to perform the obligations; and
  3. whether it would be appropriate to assign the rights and obligations to that person.

Many assignments have been ordered in CCAA proceedings.  In TBS Acquireco Inc., Re,[16] the court approved the assignment of certain leases and designated contracts, finding that this would result in the continuation of the business in the greatest number of stores and the continued employment of the greater number of people.

That said, courts have refused to order an assignment of a contract if the assignment prejudices the other party to the contract. In the 2009 CCAA proceeding entitled Nexient Learning Inc., Re,[17] Nexient and Global Knowledge Inc. brought a motion for an order assigning Nexient’s contract with ESI International, to Global Knowledge, on terms that would permanently stay ESI’s right to terminate the contract as a result of Nexient’s insolvency.

ESI and Global Knowledge were major competitors for management and corporate training services in Canada.  Justice Wilton-Siegel denied Nexient and Global Knowledge’s motion, and discussed the reasons why it would be unfair to authorize the assignment of less than all of a debtor’s contracts with a third party, as follows:

[63] … Courts are also reluctant to authorize as assignment that would prevent a counterparty from exercising set-off rights in contracts that are not to be assigned. In respect of financial contracts between the same parties, for example, it would be highly inequitable to permit a purchaser to take only “in the money” contracts leaving the counterparty with all of the “out of the money” contracts and only an unsecured claim against the debtor for its gross loss.  It would also be inappropriate in many circumstances to permit a selective assignment of a debtor’s contracts if the competitive position of the third party relative to the assignee would be materially and adversely affected, at least to the extent the third party is unable to protect itself against such result.

As a result of COVID-19, it will be interesting to see how readily Judges are willing to assign and potentially “re-write” the contractual rights and obligations of debtor companies and bankrupts, despite the legitimate opposition from counterparties.

Landlords, tenants, contractors and subcontractors (and their sureties) improving the built environment will have to contend with situations where the financial landscape has shifted significantly for their counterparties, and to contend with the financial fallout as the economy seeks to restart in the coming months, particularly where resort is had to the insolvency statutes.

Heal & Co. LLP is able to provide timely advice with respect to Canada’s bankruptcy and insolvency laws affecting companies, particularly in the Construction industry, and can help debtors as well as creditors protect their rights in this uncertain economic time.

[1] Section 50(1.2) of the BIA

[2] Kitchener Frame Ltd., Re, 2012 ONSC 234 (SCJ) at para 22.

[3] See Form 44.1 – Notice by Debtor to Disclaim or Resiliate an Agreement

[4] Section 65.11(10) of the BIA

[5] Section 65.11(5) of the BIA

[6] Superstar Group of Companies, 2001 BCSC 447

[7] Ibid at para. 21

[8] 2020 ONCA 267

[9] Ibid at paras. 6-7

[10] R.S.C. 1985, c. C-36 as amended

[11] Section 3(1) of the CCAA

[12] Skeena Cellulose Inc., Re, 2003 BCCA 344

[13] 2012 ONSC 4471 (SCJ – Commercial List)

[14] Section 84.1(3) provides that the court cannot assign rights and obligations that “are not assignable by reason of their nature or that arise under (a) an agreement entered into on or after that date of the bankruptcy; (b) an eligible financial contract; or (c) a collective agreement.

[15] See section 11.3(2) of the CCAA

[16] 2013 ONSC 4663 (SCJ – Commercial list)

[17] Nexient Learning Inc., Re, 2009 CarswellOnt 8071; [2009] O.J. No. 5507 (SCJ)

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