Publication

Insolvency and Restructuring Team

One of the greatest challenges faced by a company which is trying to restructure its affairs through formal court proceedings is the question of how it is going to finance itself during the process.

In the United States, the Bankruptcy Code provides for a specific kind of financing called debtor-in-possession financing ("DIP financing") whereby a new lender providing DIP financing obtains super priority over the assets of the debtor.

Canada has no such comparable statutory provisions in its insolvency statutes.  The necessity for such financing is nonetheless just as real north of the border.  Sometimes companies get by because their bankers, who generally have blanket security on all the debtor's assets, are willing to fund the restructuring process, relying on their existing security.  However, this solution is not available where the bankers do not have first ranking security over all the assets of the debtor.

Where such financing has to be sought from third parties who have no current exposure to the debtor, it becomes even more evident that no such party would be willing to provide financing unless it is given first ranking security over sufficient of the debtor's assets to guarantee repayment of its loans.
Most of the large restructurings in Canada are done under the aegis of the Companies' Creditors Arrangement Act (the "CCAA").  The CCAA is a statute that was born of the Great Depression in order to assist large companies in restructuring. In its structure, the CCAA reflects the simplicity of that era.  It sets out the principal objectives and a very rudimentary framework for restructurings.

The CCAA lay almost unused for close to half a century.  In the 1980s creative lawyers started using the CCAA, because it contained few rules and was thus a very flexible tool.

In applying the CCAA, a concept developed in the common law which became known as "inherent jurisdiction".  In essence, courts decided that they had the inherent jurisdiction to fill in the gaps left by the statute, as necessary, in order to give effect to the objectives of the statute.  What this allowed us to do in Canada was to use the CCAA to tailor solutions to the unique facts of each restructuring.

The CCAA was amended a couple of times in the 1990s to update certain of its concepts.  However, the basic flexibility and freedom it offers has remained largely unchanged.  Accordingly, when Canadian courts were faced with the need for DIP financing, they resorted to the concept of inherent jurisdiction to grant super priority to secure the DIP financing.  When the courts first started allowing DIP financing, no one was entirely sure whether they were exceeding their jurisdiction.

Where no affected party objected to the granting of such priority, the courts' power lay unchallenged.  However, in recent years, affected parties have started questioning the courts' ability to create such priority.  The most notable recent example involved the case of Algoma Steel Inc. ("Algoma") one of Canada's largest steel companies.

On April 23, 2001, Algoma sought and obtained protection under the CCAA.  The initial order contained a provision for a DIP financing facility ("DIP facility") up to a maximum amount of $50 million.  At the time of filing, Algoma's principal secured creditors consisted of operating lenders owed approximately $146 million and first mortgage noteholders owed approximately $551 million.  The first mortgage notes had been issued to the public through offerings in 1995 and 1996 pursuant to a trust indenture.  The purpose of the financing was to finance construction of a specialized steel processing facility.  The notes were secured by a first charge on substantially all of Algoma's fixed assets, but not on inventory and accounts receivable, which were charged as security for the operating lenders.

The DIP facility was to be provided by the same lending syndicate as had been providing the operating loans.  Those lenders, after significant investigation and analysis, had concluded that it was in the best interest of all stakeholders for Algoma to be restructured rather than liquidated.  They arrived at this conclusion even though they thought that their position would have been adequately protected in a liquidation.

The question then was whether to provide the DIP financing themselves or to allow Algoma to seek the financing from third parties.  Given the time frame within which such funding had to be obtained, it seemed highly improbable that Algoma could get outside financing.

Accordingly, with our assistance as legal counsel, the lenders decided to construct the DIP facility in a way which would not prejudice their security for the operating loans, while at the same time providing Algoma with the extra funding which it critically needed.

The initial court order issued under the CCAA provided that the DIP facility would rank behind the lenders' existing security on accounts receivable and inventory and ahead of the charge on the fixed assets securing the notes.

The rationale behind this structure was that since the operating lenders had little to gain from the restructuring and the notes had much to gain, the risk for the DIP facility should fall on the notes.

In an affidavit filed in support of the initial application, Algoma stated to the court that the terms of the DIP facility were not only reasonable but in fact more favourable then those Algoma might have obtained from a third party, assuming that a third party could in fact have been found.

The reality was that, without the DIP facility, Algoma would have to be liquidated; and there was really only one source from which that financing could come.

As for the notes, evidence at the initial hearing indicated that the notes had been trading at somewhere at or about 40 cents on the dollar and as low as 20 cents in the week of Algoma's filing.  Based on these estimated values, the Court could conclude that it was in the noteholders' interest to have Algoma's operations continue and that the prejudice that would ensue by not granting the DIP facility would be far greater than that caused by granting the DIP facility priority over the fixed assets.

At the initial hearing, no one appeared for the noteholders because they were not served.  As is typical of these situations, the noteholders had difficulty gathering themselves as a committee or unit, selecting appropriate advisors and instructing them on a timely basis.  At the time of the initial filing there was no identifiable noteholder or advisor who could have been served.  This situation seemed to persist through the early stages of the restructuring.  However, once representation was obtained, the noteholders took action.

In order to preserve their rights of appeal, the noteholders filed a motion seeking leave to appeal the initial order which included the provisions governing the DIP facility.  It is relevant that despite having approved a $50 million DIP loan, Algoma only sought to authorize $20 million of borrowing through the initial restructuring period.  The noteholders' leave motion was heard on May 19, 2001 in the Ontario Court of Appeal.  The basis of appeal was summarized by the appellate Court as follows:

1. Did the motions judge exceed his jurisdiction making the initial order by altering the existing priorities of and between the secured creditors through the granting of super priorities without the consent of the first mortgage noteholders?
2. Did the motions judge exceed his jurisdiction or otherwise err in law by granting the super priorities without any notice to the first mortgage noteholders or the trustee under the trust indenture?
3. Did the motions judge err in law by failing,
• to treat the first mortgage noteholders in an equitable and even-handed manner relative to the bank lenders; and
• to give due regard to the prejudice suffered by the first mortgage noteholders as a result of the initial order?

The Court of Appeal concluded that the motion for leave was premature, and dismissed it.  The Court made many references throughout the hearing to the wisdom of bringing the matter back before the supervising judge, who had extensive experience in these matters and whose judgment and care in assessing the balance of prejudice had been duly noted by the Court on many occasions.

The Court noted in its reasons that,

Proceedings under the CCAA are often urgent, complex and dynamic.  The Algoma proceedings fit that description.  Farley J. was faced with complex facts and a difficult decision potentially implicating the closure of one of the largest companies in Ontario. Moreover, he had to make his decision in a very timely fashion.  In these circumstances he recognized that his initial order might not be acceptable to all interested parties, including some of Algoma's creditors.  That is why he included a comeback clause in his order and specifically invited parties to resort to it in his endorsement.

The fact that the CCAA provides that an appeal of an initial order is only available with leave indicates that appeals in CCAA proceedings should be limited.  An appeal court should be cautious about intervening in the CCAA process, especially at an early stage.

...we do not say that leave to appeal should never be granted in the midst of CCAA proceedings.  However, it is premature to grant such leave at this juncture in the Algoma proceedings.  The noteholders availed themselves of this opportunity by initiating a motion to vary which was scheduled to be heard on the very day the initial order expired. In our view, this is precisely how dynamic CCAA proceedings should unfold.  Accordingly, it would be unwise to interrupt this normal and desirable process by granting leave to appeal at this juncture.  The issues that the noteholders want to raise can be considered by Farley J., importantly in the context of the entire proceedings with which he is familiar.

Despite the fact that the Court was ruling on whether leave to appeal should be granted in the circumstances, there are several principles which may be extracted from the Court of Appeal's decision:

1. DIP financing will be permitted where it is in fact necessary in the circumstances.
2. DIP financing may be authorized without notice to affected parties, even where the DIP facility may have a significant effect on a person who did not receive notice.
3. For practical purposes, and in order to preserve the integrity of the restructuring process, parties taking issue with the DIP facility are required to exhaust all opportunities for variance etc. under the terms of the initial order of the supervising judge before seeking leave.

When the matter was brought back before Farley J., Algoma negotiated a settlement with the noteholders whereby the DIP facility was capped, expenditures limited to conservatory measures, cash flows made subject to review by noteholders and lenders and provisions spelled out in the order for subrogation to the lenders' collateral if the DIP lenders obtained recovery from the fixed assets.  Incidentally, the latter was already intended in the initial order and was mandatory under the terms of the DIP facility.  However, the concept was fleshed out as part of the negotiation.  Moreover, the basis of the business settlement was nothing other than what was intended by Algoma initially.  The DIP facility had always been formulated on an analysis based on need and how much would be absolutely necessary to see Algoma through the restructuring.  Essentially, the noteholders negotiated their way to a position which Algoma was prepared to concede at the outset had they simply asked.

By undertaking this challenge to the DIP facility, the noteholders played a dangerous game in which, had they won, the DIP facility would have been withdrawn and Algoma would have been put into liquidation.  It was quite clear that the Court of Appeal understood this in dismissing the leave to appeal.

To DIP or not to DIP?  The answer clearly is that courts will continue to allow DIP financing.  However, since any super priority given to DIP financing may prejudice stakeholders, courts will go to great lengths to ensure that proceeds of DIP financing are used judiciously and conservatively.

Derrick Tay

Mario Forte

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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