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Directors face important challenges in this post-Enron world of stricter regulation and growing shareholder activism. Now, more than ever, they need firm guidance to help them comply with their legal duties.

In recent years, the extent of directors' duties to creditors of financially troubled corporations has been uncertain. Outside Canada, some courts have imposed a fiduciary duty on directors to act in the best interests of creditors as the corporation approaches insolvency. This theory has now been firmly rejected in Canada. In its unanimous judgment in Peoples Department Stores Inc. (Trustee of) v. Wise, the Supreme Court of Canada held that under Canadian corporate statutes, directors owe fiduciary duties only to the corporation and not to its creditors.

Directors are not absolved of their other duties to creditors, however. The decision clearly confirms that directors owe duties directly to creditors under the statutory duty of care. In addition, creditors may have access to the oppression remedy to protect their interests from prejudicial conduct by directors.

Although the Peoples case involved only directors, the Court expressly extended its reasoning to corporate officers. Accordingly, the decision provides important guidance for both directors and officers.

BACKGROUND

In 1992, Wise Stores Inc. acquired all the shares of Peoples Department Stores. Peoples became a wholly-owned subsidiary of Wise, with three Wise brothers as its only directors. The purchase agreement provided that until the purchase price was paid in full (over eight years), Wise and Peoples could not amalgamate.

The joint operation of Wise and Peoples did not proceed smoothly. In early 1994, to address inventory management problems, the Wise brothers implemented a joint inventory procurement policy on the recommendation of the companies' vice-president of administration and finance. Wise made all purchases from overseas suppliers and Peoples made all purchases from North American suppliers. Each company transferred, and charged the other company for, all purchases made on the other's behalf. When both Wise and Peoples declared bankruptcy in January 1995, Wise owed Peoples $4.44 million from the procurement program.

Peoples' trustee in bankruptcy sued the Wise brothers, claiming they favoured the interests of Wise over Peoples to the detriment of Peoples' creditors in breach of their duties as directors under section 122(1) of the Canada Business Corporations Act ("CBCA"). The trustee also claimed that in the year preceding the bankruptcy, the Wise brothers had been privy to transactions in which Peoples' assets were transferred to Wise for conspicuously less than fair market value within the meaning of section 100 of the Bankruptcy and Insolvency Act ("BIA").

At trial, the Quebec Superior Court broke new ground in Canadian law by holding that directors' fiduciary duty under section 122(1)(a) of the CBCA extends to creditors when a company is approaching insolvency. The Superior Court held the Wise brothers personally liable for breach of their fiduciary duty and duty of care and awarded the trustee $4.44 million in damages. The Superior Court also based the defendants' liability on section 100 of the BIA. The Court of Appeal for Quebec reversed this decision and exonerated the Wise brothers from liability.

NO FIDUCIARY DUTY TO CREDITORS

The Supreme Court of Canada held that directors owe no fiduciary duty to creditors under the CBCA. While directors are entitled to have regard to the interests of various stakeholders, they owe their fiduciary duty only to the corporation. As a corporation approaches insolvency, directors are entitled to make good faith and honest efforts to redress the corporation's financial problems. If successful, their efforts will retain value for shareholders and improve the position of creditors. If unsuccessful, their efforts will not breach their statutory fiduciary duty to the corporation.

DUTY OF CARE TO CREDITORS

The Court emphasized that creditors have other remedies against directors. Creditors can assert claims based on directors' duty of care under section 122(1)(b) of the CBCA. In Quebec, Article 1457 of the Civil Code of Québec is available for holding directors liable to creditors in respect of extra-contractual obligations when directors breach the CBCA standard of care. The Court also discussed the duty of care to creditors at common law.

For the first time, the Supreme Court of Canada formally approved use of the "business judgment rule" in assessing whether directors have fulfilled the duty of care. While directors must meet an objective standard of care, they need not be perfect. Instead, they must make reasonable business decisions on a prudent and informed basis. To avoid the risk of second-guessing directors' decisions with hindsight bias, Canadian courts should defer to directors' reasonable business decisions.

The Court held that the Wise brothers did not breach their duty of care to creditors. The procurement policy was a reasonable business effort to address inventory management problems. General economic conditions, and not the procurement policy, caused Peoples' and Wise's bankruptcy.

The Court narrowly construed section 123(5)(b) of the CBCA, which exonerates directors from liability if they rely on the advice of professionals. It held that the vice-president of administration and finance did not qualify as a "professional". Despite his commerce degree and fifteen years of experience, he was not an accountant subject to the overview of a professional organization who carried independent insurance coverage for professional negligence.

OPPRESSION REMEDY

Although no oppression claim was before the Court in the Peoples case, the Court discussed the oppression remedy under section 241 of the CBCA at length, noting that the remedy gives "the broadest rights to creditors of any common law jurisdiction." The Court recognized that as a corporation's finances deteriorate, creditors' interests increase in relevancy. The remedy provides a possible mechanism for creditors to protect their interests from the prejudicial conduct of directors.

REVIEWABLE TRANSACTION

The Court denied the claim that the procurement policy resulted in a "reviewable transaction" under section 100 of the BIA. The Wise brothers, as the controlling minds behind the procurement policy, were "privies" to the transaction. However, the disparity of slightly more than 6% between fair market value and the consideration received did not constitute a "conspicuous" difference within the meaning of section 100 of the BIA.

THE IMPACT OF THE PEOPLES DECISION

The Peoples decision puts to rest the concern that corporate directors owe fiduciary duties to creditors as insolvency looms. But, for the first time, the Supreme Court of Canada has expressly recognized that in the context of directors' other statutory and common law duties, creditors' interests become more relevant when a corporation's financial condition deteriorates. In such circumstances, creditors potentially have significant recourse against corporate directors and officers under the duty of care and the oppression remedy. Because the Court did not have an oppression claim before it, it did not determine the extent to which the oppression remedy protects creditors' interests. This question will be answered in future cases where courts are faced squarely with such a claim.

The decision in Peoples also confirms that directors and officers are protected from personal liability when they make honest, good faith and prudent business decisions based on proper and adequate inquiry. Canadian courts will continue to apply the "business judgment rule" to defer to reasonable business decisions without requiring perfection. The decision underscores the importance of corporate boards obtaining the advice of persons with professional qualifications when appropriate.

The purpose of this document is to provide information as to developments in the law.  It does not contain a full analysis of the law nor does it constitute an opinion of Ogilvy Renault or any member of the Firm on the points of law discussed.

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