Equitable Subordination in Canada: Clear as Mud, eh?

by Kaitlan Buchko

The concept of equitable subordination is well entrenched in American bankruptcy law. In Canada, it is not so clear.

The doctrine of equitable subordination has been described by the authors of the leading bankruptcy text, the Annotated Bankruptcy and Insolvency Act, Houlden, Morawetz & Sarra, as enabling a “bankruptcy court, as a court of equity, to subordinate the claims of one creditor to those of other creditors in circumstances when the creditor has engaged in some type of inequitable conduct that has secured for it an unfair advantage or that has resulted in injury to either creditors or the debtor” (G§160).

In a leading American decision on the doctrine, Mobile Steel Co., Re. ((1997) 563 F.2d 692 (U.S. C.A. 5th Cir.)), the Court set out the following three-part test for equitable subordination:

  1. the claimant must have engaged in some type of inequitable conduct;
  2. the misconduct must have resulted in injury to creditors of the bankrupt or conferred an unfair advantage on the claimant; and
  3. equitable subordination of the claim must not be inconsistent with the provisions of the bankruptcy statute.

The doctrine has been used in the United States not only to subordinate claims of creditors in the same class of priority, but also to subordinate the claims of secured creditors to those of unsecured creditors (In re American Lumber Co. 5 B.R. 470 (D. Minn. 1980)).

Although the doctrine is well established in the United States, the concept of equitable subordination has only been considered twice by the Supreme Court of Canada (“SCC”). Both times the question of its existence in Canadian law was left open to future consideration as the facts in each case did not meet the test for equitable subordination as set out in Mobile Steel Co., Re., such that the determination of its application was unnecessary (Canada Deposit Insurance Corp. v Canadian Commercial Bank, [1992] 3 SCR 588; Sun Indalex Finance, LLC v United Steelworkers, 2013 SCC 6). While the SCC failed in each circumstance to apply the doctrine on the facts, the Court did not denounce the doctrine’s potential application to Canadian law.

Despite the indeterminate application at the SCC level, lower courts have provided a somewhat more thorough exploration of the doctrine. Unfortunately, the lower courts have still at times been conflicted as to the applicability of the doctrine, leaving its scope and operation uncertain in Canadian jurisprudence.

The doctrine was outright rejected in one Ontario lower court decision, where Justice Chadwick noted his concern about the chaos that would ensue if Canadian courts adopted the principle of equitable subordination (AEVO Co. v D & A Macleod Co., 1991 OJ No 1354). The chaos described is yet to be seen, despite the fact that the doctrine has been applied in Canada both expressly as well as implicitly. Furthermore, in the event that instability and uncertainty were to arise, Canadian courts could look to the United States for guidance as to how American courts have dealt with the repercussions of altering priorities in insolvency, as the doctrine has been applied in the United States for decades.

Justice Chadwick further mused that if Parliament had intended the doctrine to apply in Canada, it would form part of our insolvency laws. However, it is often the case that the common law fills in gaps left by statute. Despite the fact that there is a statutory scheme of distribution in the Bankruptcy and Insolvency Act (“BIA”), the doctrine should be applied to intervene and subordinate a claim where equity calls for it. This is especially so given the equitable jurisdiction of Canadian courts. The Court of Appeal in U.S. Steel Canada Inc., Re (2016 ONCA 662) held that the doctrine of equitable subordination does not apply in Canadian insolvency situations under the Companies’ Creditors Arrangement Act (“CCAA”), as that piece of legislation does not have express language referring to equitable jurisdiction. However, the Court of Appeal specifically drew a distinction between the CCAA and the BIA, stating that equitable subordination may apply under the BIA, given that s. 183(1) of the BIA expressly gives the bankruptcy court “jurisdiction at law and in equity.”

Despite the rejection of the doctrine in AEVO Co. v D & A Macleod Co., equitable subordination was applied outright in Lloyd’s Non-Marine Underwriters v J.J. Lacey Insurance Limited (2009 NLTD 148) to subordinate a claim in a bankruptcy proceeding, demonstrating that Canadian courts are willing to apply the doctrine when the circumstances are appropriate. The Court stated that “[d]ifficulty in limiting the scope of the doctrine should not stop courts from expanding the law so that the law responds to those clear cases where right-thinking persons can clearly and easily discern oppressive unfairness as having occurred.”

There have also been cases in Canada where the doctrine of equitable subordination was applied in practice, but under a different guise. For example, the Court in Sittuk Investments Limited v A. Farber & Partners Inc. (2002 OJ No. 354) subordinated the claim of an unsecured creditor to other creditors on the basis of unconsionability. Although proclaimed to be made on the basis of unconsionability, the reasoning as described by the Court seems to fit under the ambit of equitable subordination: “the courts may grant relief from the consequences that would otherwise flow from a transaction where that transaction is unconscionable; ie. it has been obtained by taking advantage of the weaker bargaining position of the complainant party and has had an improvident result for that party.”

Justice Chartier of the Manitoba Court of Queen’s Bench in Royal Bank of Canada v Keller & Sons Farming Ltd. and Keller Holdings Ltd (2017) again considered the doctrine and application of equitable subordination. In that decision, the Court stated that “…assuming equitable subordination exists as a doctrine in Canadian law, a necessary requirement is the existence of inequitable conduct. There is no uncertainty regarding that pronouncement.” Ultimately, as no inequitable conduct was found, the Court concluded that the doctrine would not apply. However, in my respectful view, this is a somewhat narrow and out-of-date interpretation of the doctrine in light of the developments it has made over time. While the Mobile Steel test has consistently been applied as a leading case on equitable subordination, the Court in Blue Range Resource Corp., Re (2000 ABQB 4) stated that it is an “erroneous proposition that inequitable misconduct is required in all cases under the American doctrine.” American case law is moving away from a strict requirement of inequitable conduct. For example, the Court in Re Virtual Network Services Corporation (902 F 2d 1246 (7th Cir 1990)) subordinated a claim by stating that courts may “equitably subordinate claims to other claims on a case-by-case basis without requiring in every instance inequitable conduct on the part of the creditor." This line of authority demonstrates that the test is evolving, and perhaps Canadian courts would be wise to embrace the developments that American courts have made with the benefit of time.

Although the application of the doctrine has been uncertain at times in Canadian law, it seems that courts are becoming increasingly open to the possible application of the doctrine to subordinate the claims of creditors. Based on the past case law, it appears that courts will apply the doctrine of equitable subordination where no other statutory scheme for priorities exist, and are becoming less hesitant, in the appropriate circumstances, to apply the doctrine even to alter statutory priorities. Moreover, the public policy rational for allowing the doctrine to apply to Canadian insolvency comes up repeatedly in the case law, that being fairness. The application of the doctrine of equitable subordination to Canadian insolvency would give courts a means by which to monitor inequitable behaviour and provide for fairness on a case-by-case basis, notwithstanding the Bankruptcy and Insolvency Act’s statutory priority scheme.

For questions or legal advice on bankruptcy and insolvency matters, please contact a lawyer in our Bankruptcy and Insolvency practice area.