In recent years, there has been an upward trend in the use of the Canadian insolvency regime as a mechanism to “detach” an unprofitable Canadian subsidiary from a larger corporate enterprise. In circumstances where an economically viable parent is hemorrhaging losses as a result of its Canadian subsidiary operating unprofitably, it is not uncommon for the healthy parent to effect an orderly winddown through an insolvency filing.
On the other hand, in circumstances where the entire corporate enterprise is in financial distress, a Canadian insolvency filing may be less of a strategic option and more the result of financial necessity. In these circumstances, value maximization, rather than the preservation of goodwill, can be the driving force behind the insolvency proceedings. Accordingly, the manner in which a Canadian insolvency filing transpires is heavily influenced by the financial condition of the corporate parent.
Many distressed Canadian retailers are wholly owned subsidiaries of foreign-domiciled parent retailers that have established their brands abroad, typically in the United States, before expanding into the Canadian market. In these circumstances, if the parent remains economically viable, formulating a graceful exit that preserves brand value may be of paramount concern. This was the approach taken in the Target Canada Co. and Express Fashion Apparel Canada Inc. Companies’ Creditors Arrangement Act (CCAA) proceedings
In the Target Canada CCAA case, to incentivize creditors to support a CCAA plan, Target Corp. and certain related parties (Target U.S.) subordinated billions of dollars of intercompany debt to the claims of third-party creditors (many of whom were inventory suppliers to Target U.S. as well) and agreed to fund the severance obligations owing to Target Canada’s terminated employees through the novel method of establishing an employee trust fund.
Express Inc., Express Canada’s U.S. parent, was not experiencing any financial hardship and also agreed to subordinate intercompany debt, which helped to facilitate the payment of third-party trade creditors in full. In both the Target Canada and Express Canada cases, following a highly successful inventory liquidation, the CCAA plans filed by the distressed retailers, which provided for a distribution of realization proceeds, passed with unanimous support of voting creditors and was approved by the court.
When both a Canadian retailer and its U.S. parent are facing financial distress and must seek creditor protection, one of the fundamental questions that must be addressed is in what jurisdiction or jurisdictions should proceedings be commenced? This engages an analysis of, among other factors, the distressed retailer’s center of main interests.
One approach is for the distressed Canadian retailer to file for Chapter 11 protection along with its U.S. parent and then have the U.S. proceedings recognized in Canada under the recognition provisions of the CCAA, the equivalent to Chapter 15 of the U.S. Bankruptcy Code. This was the route taken in the recent Payless Holdings LLC et al. (Payless Shoes Canada) insolvency proceedings. Payless Shoes Canada’s center of main interests was found to be in the United States, where management resided and corporate decisions were made. In that case, Payless Shoes Canada, along with its U.S. parent, filed Chapter 11 proceedings, which were thereafter recognized in Canada.
Another, more common approach is to have a full-blown plenary case in both the United States and Canada for the parent and the subsidiary, respectively. This was the approach taken in Bombay Furniture Company of Canada Inc. (the first restructuring), InterTAN Canada Ltd. (Circuit City), and Linens ‘N Things Canada Corp. (although Linens ‘N Things Canada Corp. did not file for protection under the CCAA but, rather, became subject to receivership and bankruptcy proceedings in Canada, while its U.S. corporate parent liquidated while under Chapter 11 protection).
A third and more unique approach is for the Canadian distressed retailer to file under both Chapter 11 and the CCAA, thus being subject to two plenary proceedings in two different jurisdictions. This is the case in the recent Toys R Us Canada proceedings (the court material filed in the case indicated that Toys R Us Canada’s center of main interest was in Canada, as it had relatively autonomous management).
Notably, the CCAA requires that a CCAA debtor be insolvent on either a balance sheet or cash flow basis. Prior to its Chapter 11 filing, Toys R Us Canada was neither. The Chapter 11 filing, however, triggered an event of default under the joint credit facility with its parent, resulting in Toys R Us Canada losing access to its operating line at a critical time, when such credit availability was needed to fund its holiday inventory build. Thus, the Chapter 11 filing precipitated Toys R Us Canada’s insolvency, qualifying it for relief under the CCAA. The first day hearings in Canada and the U.S. took place on the same day, starting only a few hours apart.
In many circumstances the preponderance of prefiling corporate decision making rests with the U.S. parent. The rights and interests of a corporate parent and its insolvent subsidiary, however, may not always be aligned. For example, the entities may be in a debtor/creditor relationship, and the optimal outcome for the Canadian entity may differ from the result sought by the U.S. parent.
Canadian creditors and the Canadian court supervising the proceeding will require some assurance that decisions are being made in the best interest of the Canadian entity and its stakeholders as a whole and that Canadian interests are not being subordinated for the benefit of another creditor constituency.
In both the Target Canada and Express Canada CCAA proceedings a U.S.-based corporate officer was designated at the outset of the proceedings as an autonomous decision maker for the Canadian subsidiary. The move was made to provide further decision-making independence to the Canadian subsidiaries and further reassure stakeholders that there was an executive voice speaking on behalf of the insolvent Canadian subsidiary within the broader corporate family.
The American Apparel Canada Retail Inc. et al. insolvency proceeding provides a more complex example. Prior to entering into Chapter 11 proceedings in the U.S., American Apparel Canada’s U.S.-based affiliates (although not its immediate parent) advised that they would no longer provide all stock and inventory to the American Apparel Canada entities and would cease to provide all other critical support functions. Most of the administrative functions for the American Apparel Canada entities were performed out of Los Angeles by the U.S. affiliates. This left a corporate governance vacuum.
After filing a notice of intention (NOI) to make a proposal under the Bankruptcy and Insolvency Act (Canada) (BIA)—a summary proceeding which provided for an immediate stay of proceedings—American Apparel Canada sought and obtained the appointment of an interim receiver over itself pursuant to the provisions of the BIA. An interim receiver is a court-appointed officer, a licensed insolvency professional, and a fiduciary. It is very unusual for a debtor company to seek the appointment of an interim receiver over itself following the filing of an NOI, but nothing in the BIA forbids it. Pursuant to its appointment order, the interim receiver filled the corporate governance void and supervised the inventory liquidation.
It is very common for a Canadian retailer to share and be dependent upon the back office support of its parent. Indeed, often the Canadian retailer could not function autonomously without the provision of a whole host of management services provided by the corporate parent, which often include shared finance and legal departments and licensing arrangements (e.g., trademarks and information technology licenses). In the Target Canada and Express Canada CCAA proceedings, these shared services agreements were terminated prior to the CCAA filing and replaced with agreements specifically designed to facilitate the liquidations.
As there was some risk that Target Canada could forcibly assign the Target trademark in connection with CCAA proceedings, Target U.S. paid the insolvent Canadian estate to consensually terminate the licence agreement, essentially buying back its own trademark.
In the (first) Bombay Canada CCAA case, the corporate parent, Bombay Co. (Bombay US), failed to secure a going concern solution, but its more viable Canadian subsidiary was acquired by a Canada-based strategic buyer that replicated the back office support functions previously provided by Bombay U.S. While the matter was ultimately resolved consensually, there was uncertainty at one point as to whether Bombay U.S. would consent to the assignment of its trademark to the Canadian buyer.
Canadian retailers are often funded by their corporate parent, which can be by way of more traditional intercompany financing or through the supply of inventory on credit. The provision of shared services may also be recorded as a payable on the books and records of the Canadian subsidiary.
In its court material, Target Canada stated that Target U.S. had invested $7 billion into the failed Canadian venture, much of it recorded as intercompany debt. Prior to a comprehensive settlement being reached and effected by way of a CCAA plan, a number of arguments were proffered by aggrieved creditors asserting that much of the intercompany debt on the books should be recharacterized as equity on the theory that such characterization more accurately reflected the intention of the parties at the time the funds were advanced and services were provided.
An alternate theory was that the debt should be equitably subordinated—a U.S. doctrine that holds that, in certain circumstances because of the conduct of the lender, the court should exercise its equitable authority to subordinate the lender’s debt claims to the claims of third parties (in the U.S. Steel Canada Inc. CCAA proceedings, the Ontario Court of Appeal largely shut the door on the application of this doctrine in CCAA cases). As noted earlier, these allegations were all resolved consensually through a plan that was unanimously approved by creditors and the court and provided for the subordination of billions of dollars of intercompany debt.
A CCAA monitor—the court-appointed officer that supervises the case and acts as the “eyes and ears of the court”—has statutory authority to review and scrutinize prefiling transactions to determine if the company transferred any assets for “conspicuously” less than fair market value or preferred certain creditors over others through the repayment of debt. If certain criteria can be established, among other things, the impugned transactions can be voided by the court. When such transactions are made between related parties, the transactions may garner heightened attention. A corporate parent needs to be cognizant of the flow of funds between itself and its subsidiary and the movement of collateral between the two entities and carefully consider any issues that may arise following a CCAA filing.
On a variety of theories, a monitor also can review the efficacy of dividends paid to shareholders prior to the CCAA filing. In the Sears Canada CCAA proceedings, the monitor indicated that it is reviewing the payment of a $102 million dividend payment on December 31, 2012, and a $509 million dividend payment on December 6, 2013. At the time of this writing, the monitor had not reached any conclusion. Sears Canada, a publicly traded company, was largely spun off from its former U.S. parent, Sears Holdings Corp., in 2012. Sears Canada shut down its operations in January 2018 following a failed attempt to secure a going concern sale.
The Target Canada plan, like that of Express Canada, provided comprehensive releases in favor of the parent companies, officers and directors, and other related parties. To get the benefit of a third-party release (i.e., a release in favor of a party other than the debtor), it must be demonstrated that the release is reasonably connected to the plan. The court will also want to see that the beneficiaries of the release contributed to the plan in a meaningful way. Subordination of debt is a form of contribution.
Third-party releases can include releases from claims related to reviewable transactions and those relating to any alleged improper conduct by the controlling shareholder.
There are myriad approaches that a parent retailer may adopt when dealing with a distressed subsidiary. Each option must be reviewed and considered by a corporate parent prior to supporting the CCAA filing of its distressed subsidiary. Its own financial condition and its capacity to provide ongoing support are, of course, at the top of the list of considerations. The cases show that a diligent parent that carefully weighs the options available and executes a strategic plan in a thoughtful and balanced way is best positioned to avail itself of the benefits of Canada’s robust and flexible insolvency regime.