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04/07/2013
1
John Birch, Cassels Brock
David Ward, Cassels Brock
Joseph Bellissimo, Cassels Brock
Andrea Safer, Royal Bank of Canada
June 25, 2013
Contracts in
Insolvency
slide | 2
Agenda
● Introduction
● Overview of contract disclaimer under the BIA and CCAA
● Noteworthy cases on the disclaimer or assignment of contracts
● Preventative steps in dealing with counterparties (front-end due
diligence and ongoing monitoring)
● Insolvency considerations in contract drafting
● Treatment of real property leases
● Treatment of personal property leases
● Source code escrow provisions (and other preventative contract
clauses)
● Q&A
04/07/2013
2
slide | 3
Introduction: Restructuring in Canada — How Is It
Done?
● Two relevant statutes:
● Bankruptcy and Insolvency Act (BIA): liquidation and restructuring
● Companies’ Creditors Arrangement Act (CCAA): restructuring only
● Access to the CCAA only available for companies with more than
$5 million in debt
● CCAA typically used for more complex restructurings
● CCAA and the restructuring provisions of the BIA have similar, but
not identical, provisions dealing with disclaiming and assigning
contracts when restructuring
slide | 4
Introduction: Types of Processes for Insolvent
Debtors
Under the BIA
• A proposal to one or more classes of creditors may be filed; or
• A liquidation process (bankruptcy)
Under the CCAA
• A reorganization under which a plan of compromise or arrangement may be filed.
04/07/2013
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slide | 5
Overview of Contract Disclaimer: Reorganizing
Under the BIA/CCAA
● Historically no statutory provision, but courts typically used their
discretion under the CCAA to authorize the disclaiming of insolvent
debtors’ agreements when the disclaimer would facilitate
restructuring plans
● Since 2009: codified provisions
● Under CCAA
● Under proposal provisions of BIA
● Policy Rationale: facilitate restructuring and avoid value destruction
even if some harm suffered by contract counterparties
slide | 6
Overview of Contract Disclaimer: Reorganizing
Under the BIA/CCAA
● Since 2009 Amendments to BIA and CCAA have codified this
area and now provide for consistency between the acts
● Sections 65.11 of the BIA and 32 of the CCAA allow for
disclaimers in most types of agreements by delivering a
prescribed notice pursuant to a prescribed form under the acts
● Disclaimers require Monitor/Proposal Trustee approval or,
alternatively, court approval
04/07/2013
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slide | 7
Overview of Contract Disclaimer: BIA and CCAA
Provisions
CCAA
● 32.(1) …a debtor company may —
on notice given in the prescribed
form and manner to the other
parties to the agreement and the
monitor — disclaim or resiliate any
agreement to which the company
is a party on the day on which
proceedings commence under this
Act. The company may not give
notice unless the monitor
approves the proposed disclaimer
or resiliation.
BIA
● 65.11 (1) …a debtor in respect of
whom a notice of intention was
filed under section 50.4 or a
proposal was filed under
subsection 62(1) may — on notice
given in the prescribed form and
manner to the other parties to the
agreement and the trustee —
disclaim or resiliate any agreement
to which the debtor is a party on
the day on which the notice of
intention or proposal was filed.
The debtor may not give notice
unless the trustee approves the
proposed disclaimer or resiliation.
slide | 8
Overview of Contract Disclaimer: The Disclaimer
Process Under the BIA/CCAA
1. Debtor proposes to disclaim contract
2. Monitor/Trustee considers disclaimer: grants or refuses consent
3. If Monitor/Trustee consents, the disclaimer takes effect 30 days
after counterparty receives notice unless counterparty goes to
court to block the disclaimer
4. If Monitor/Trustee refuses to consent, then court approval of
disclaimer, on notice to Monitor/Trustee and counterparty, is
required
5. Counterparty can make a claim in the insolvency proceeding for
damages resulting from the disclaimer
04/07/2013
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slide | 9
Overview of Contract Disclaimer:
Factors to be Considered by the Court
● The court must consider the following factors, among others, in
deciding whether to approve the disclaimer (in circumstances where
court approval is necessary):
● Whether the Monitor/Trustee approved the proposed disclaimer;
● Whether a disclaimer would enhance the prospects of a viable proposal
or plan being made; and
● Whether the counterparty would suffer significant financial hardship as a
result of the disclaimer.
slide | 10
Overview of Contract Disclaimer:
Agreements That Cannot Be Disclaimed
● Eligible financial contracts (i.e., swaps and derivatives)
● Collective agreements
● Financing agreements if the debtor is the borrower
● Real property leases if the debtor is the lessor
04/07/2013
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slide | 11
Special Provisions: Intellectual Property Licences
● If debtor has granted an IP licence, any disclaimer by the debtor
does not affect a licensee’s ability to use the IP or benefit from a right
to exclusive use over the term of the licence, as long as the licensee
continues to perform its obligations.
● The licensee also has these rights during any period of automatic
renewal of the licence agreement.
● See BIA section 65.11(7) and CCAA section 32(6)
slide | 12
Disclaimers in Bankruptcy under the BIA
● Bankruptcy does not automatically terminate a contract other than
employment contracts and contracts of a personal nature
● However, the bankrupt typically ceases to perform the contract after
the bankruptcy and the counterparty treats the contract as terminated
● Counterparty can file proof of claim for damages arising out of
termination of contract
● Special provisions for termination of real property leases by bankrupt
lessee (discussed further later)
04/07/2013
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slide | 13
Noteworthy Cases on Assignment and Disclaimer:
Timminco Ltd.,ONSC, 2012 [“Timminco”]
● Section 32 of the CCAA permits a counter-party to a contract
disclaimed by the debtor company to apply to court for an order that
the agreement is not to be disclaimed or resiliated.
Section 32(4) sets out factors to be considered by the court,
among other things, in deciding whether to make the order:
(a) Whether the monitor approved the proposed disclaimer or
resiliation;
(b) Whether the disclaimer or resiliation would enhance the
prospects of a viable compromise or arrangement being
made in respect of the company; and
(c) Whether the disclaimer or resiliation would likely cause
significant financial hardship to a party to the agreement.‖
13October 19, 2011
slide | 14
Timminco Ltd.,ONSC, 2012 [“Timminco”]
Facts
● In 1996, Mr. J. Thomas Timmins - CEO of Timminco Limited
(“Timminco”) at the time - entered into a consulting agreement with
Timminco (the “Agreement”) offering to provide consulting services
upon his retirement or termination.
● Mr. Timmins resigned from Timminco in 2001.
● For a decade, monthly payments under the Agreement were
made consistently to Mr. Timmins.
● In March 2012, after Timminco entered CCAA proceedings, Mr.
Timmins was formally notified that the Agreement was being
disclaimed pursuant to s.32 of the CCAA.
14October 19, 2011
04/07/2013
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slide | 15
Timminco Ltd.,ONSC, 2012 [“Timminco”]
Issue
● Was Timminco entitled to disclaim the Agreement pursuant to s.32
of the CCAA, or was application of the provision barred because it
would not enhance the prospects of a viable compromise or
plan of arrangement?
● Was Timminco barred from disclaiming the Agreement because it
would result in significant financial hardship for Mr. Timmins?
Held
● Timminco was entitled to disclaim the Agreement.
● Disclaiming the Agreement with Mr. Timmins would enhance the
prospect of a viable plan of arrangement, and would not result in
significant financial hardship for Mr. Timmins.
slide | 16
Timminco Ltd.,ONSC, 2012 [“Timminco”]
Analysis
● Timminco disclaimed the Agreement to conserve its cash flow and
facilitate a successful sale of its assets with a view to restructuring
the company.
● Section 32 should be interpreted broadly to apply, not just to a
viable restructuring or plan of arrangement, but also to a sales
process requiring the business to carry on as a going-concern.
● This is consistent with the remedial purpose of the CCAA.
● Without the disclaimer, Mr. Timmins would have received an
enhanced priority over the other unsecured creditors, which would
have contravened the guiding principle of the CCAA – to treat
creditors of the same classification equitably.
04/07/2013
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slide | 17
Timminco Ltd.,ONSC, 2012 [“Timminco”]
Financial Hardship
● Determining whether the disclaimer of an agreement causes
significant financial hardship involves an analysis on the individual
circumstances and characteristics of the other contracting party.
● This is a subjective test.
● If the test were objective, debtor companies would likely be unable
to disclaim most agreements, even if the counter party was large
enough to absorb the financial loss.
● Nothing on the record established that Mr. Timmins, an
independently wealthy individual, would suffer a significant
financial hardship.
● Not disclaiming the Agreement would improve his situation at the
expense of other unsecured creditors of Timminco.
slide | 18
Aveos Fleet Performance Inc., QCCS, 2012
[“Aveos‖]
Facts
● Aveos Fleet Performance Inc. (―Aveos‖), an airplane component
manufacturer, commenced Companies’ Creditors Arrangement Act
(―CCAA‖) proceedings in March, 2012, subsequently shutting down
the day-to-day operations of the business and entering liquidation.
● In April, 2012, a court issued an order approving the sale of Aveos’
assets.
● Aveos had previously outsourced the design and installation of its
computerized human resource system to a company called N.G.A.
● Following CCAA proceedings, Aveos notified N.G.A. that they were
disclaiming their Global Masters Services Agreement (―G.M.S.A.‖)
with them pursuant to s.32 of the CCAA.
04/07/2013
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slide | 19
Aveos Fleet Performance Inc., QCCS, 2012
[“Aveos‖]
Issue
● Was Aveos permitted to disclaim the G.M.S.A. pursuant to s.32 of
the CCAA, or were they barred from doing so because they had shut
down operations and commenced liquidation, thereby negating the
prospect of a plan of arrangement?
Held
● Aveos was granted approval to disclaim their agreement with N.G.A.
slide | 20
Aveos Fleet Performance Inc., QCCS, 2012
[“Aveos‖]
Analysis
● The factors set out in s.32(4) are non-exhaustive, and new
considerations may arise with new cases.
● Aveos should not be precluded from disclaiming the agreement
merely because they had shut down operations and commenced
liquidation.
● Shedding a costly and ineffectual system would increase the
likelihood of an eventual plan of arrangement. The disclaimer
would conserve cash flow and facilitate a future going-concern sale.
● The debtor party is not required to establish the disclaimer would be
necessary to a plan of arrangement.
● The disclaimer would only need to provide an advantage in
realizing a potential plan of arrangement – the fact that the debtor is
in ―liquidation mode‖ does not preclude a disclaimer.
04/07/2013
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slide | 21
Ford Credit Canada Ltd. v. Welcome Ford Sales
Ltd, ABCA, 2011 [“Ford‖]
● (at para. 9) ―The BIA was amended on December 15, 2009 by the addition
of s. 84.1, which allows a court, upon being satisfied that certain
prerequisites are met, to grant an order assigning the rights and
obligations of the bankrupt under any agreement to a purchaser, even
without the consent of the counter-party to the agreement.‖
● (at para. 29) ―The position at common law was always that if one party
breached a condition (and not a mere warranty) in a contract, the other party
to that contract had an election, either to treat the contract as continuing
and insist on future performance, or to accept the repudiation and bring
the contract to an end.‖
● (At para. 30) ―The effect of s. 84.1 of the BIA is to override the common
law unilateral right of the innocent party to the contract to accept the
repudiation and end the contract. It has been designed to preserve the
value of the estate as a whole, even if the contractual rights of some
creditors, such as Ford in this case, are compromised.‖
slide | 22
Ford Credit Canada Ltd. v. Welcome Ford Sales
Ltd, ABCA, 2011 [“Ford‖]
● (at para. 32) ―Section 84.1 reads in part:
(1) On application by a trustee and on notice to every party to an
agreement, a court may make an order assigning the rights and
obligations of a bankrupt under the agreement to any person who is
specified by the court and agrees to the assignment.
...
(3) Subsection (1) does not apply in respect of rights and
obligations that are not assignable by reason of their nature ...
(4) In deciding whether to make the order, the court is to consider,
among other things,
(a) whether the person to whom the rights and obligations are
to be assigned is able to perform the obligations; and
(b) whether it is appropriate to assign the rights and
obligations to that person.‖
04/07/2013
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slide | 23
Ford Credit Canada Ltd. v. Welcome Ford Sales
Ltd, ABCA, 2011 [“Ford‖]
Relevant Facts
● Welcome Ford operated an automobile dealership franchise under an
agreement with Ford Motor Company of Canada (―Ford”).
● Welcome Ford was indebted to Ford for $7.7 million, and was assigned
into bankruptcy under the Bankruptcy and Insolvency Act (―BIA‖),
following an application made by one of its creditors - the Bank of
Montreal (―BMO‖).
● Relying upon section 84.1 of the BIA, the trustee in bankruptcy
marketed and sold the dealership agreement.
● Ford refused to consent to a sale, even to one of its own dealers
notwithstanding that the ultimate purchaser’s offer produced more
money for creditors than a liquidation without a sale of the dealership
agreement.
● The trustee made an application to court to approve an assignment
of the dealership agreement over Ford’s objections.
slide | 24
Ford Credit Canada Ltd. v. Welcome Ford Sales
Ltd, ABCA, 2011 [“Ford‖]
Issue
● Could Welcome Ford’s trustee compel an assignment of the
dealership agreement?
● Ford argued they could not because (a) the agreement was personal
in nature; (b) the estate would not benefit from the assignment; or (c)
the assignment would be inappropriate due to the inability of the
proposed assignee to perform the obligations under the agreement.
Held
● Welcome Ford was permitted to assign the agreement pursuant to
s.84.1 of the BIA despite the objections of Ford
04/07/2013
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slide | 25
Ford Credit Canada Ltd. v. Welcome Ford Sales
Ltd, ABCA, 2011 [“Ford‖]
Analysis
● s.84.1 was intended to preserve the value of the bankrupt’s estate by
allowing for the assignment of agreements to third parties for value, even
though the assignment might adversely affect the financial position of the
other contracting party.
● The court’s determination in permitting an assignment of a contract involves
a balancing of the relative interests and prejudices between the debtor
and creditor parties.
● This balancing involves an analysis of whether the assignment would benefit
the value of the estate, whether the proposed assignee is capable of
performing the obligations under the agreement and whether, from the
perspective of the other contracting party, it would be appropriate to assign
the agreement.
● The Alberta Court of Appeal ultimately held that an assignment of the dealer
contract was for the benefit of the estate and that the proposed assignee, an
existing and successful Ford dealer, was capable of performing the contract.
slide | 26
Ford Credit Canada Ltd. v. Welcome Ford Sales
Ltd, ABCA, 2011 [“Ford‖]
Analysis
● the assignment would benefit Welcome Ford’ estate because the
consideration was of a value sufficient to satisfy Welcome Ford’s
debts to BMO, leaving a surplus to be dispersed among the unsecured
creditors
● the franchise agreement was not personal in nature because it was
not entered into with Welcome Ford based on special personal
characteristics or confidences
● the assignee was capable of performing the agreement, evidenced
by its successful operation of a different profitable Ford dealership
● other factors to determine appropriateness include whether the
assignment would remedy earlier breaches, and if the rights and
remedies of Ford would be preserved
04/07/2013
14
Contracts in Insolvency
Preventative and Remedial Steps in
Dealing with Counterparties
Introduction
Andrea Safer
Senior Counsel, RBC Law Group
Provide legal support to Procurement as well as other RBC businesses and functional groups that enter into commercial contracts.
Draft and negotiate various business-to-business products and services contracts with a focus on information technology-related agreements, including contracts for the procurement of hardware, software and related services and outsourcing agreements
Ensure that RBC is adequately protected from risks associated with its vendor and service provider counterparties experiencing an insolvency event
04/07/2013
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Preventative Steps in Dealing with Counterparties
Before entering into a contractual arrangement, ensure that the counterparty is financially sound
Upfront risk assessment and due-diligence
Undertake risk assessment in areas such as reputational risk, information security, business continuity and financial risk:
– What is the potential impact to client should the counterparty become insolvent?
– Risk Assessment should impact the due diligence required and the internal approval level required to proceed with the arrangement
Impact of Counterparty Insolvency
Vendor vs customer impact:
Vendor:
– Impact of losing the payment stream:
– Size and scope of contract
– Structure of payments
– Ability to easily replace contract
Customer:
– impact/disruption to process or service being provided
– Negligible/some impact/significant impact:
– Size and scope of contract
– Number of other providers
– Ability to easily replace contract
04/07/2013
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Preventative Steps in Dealing with Counterparties
Due diligence:
Obtain an independent risk rating such as a credit bureau report of public debt rating
Financial disclosure at counterparty selection stage:
In the past 5 years, has your company experienced any major debt restructure or bankruptcy proceedings?
In the last fiscal year, what was your:
market value of equity
working capital
earnings before interest & tax
net sales
retained earnings
total assets and total liabilities
What level of protection is required?
Size and scope of contract
Parental Guarantee
– Vendor: payment guarantee
– Customer:
– Performance guarantee
– Financial support
– Guarantee of indemnities
Ongoing financial monitoring/disclosure
Termination rights
Business continuity provisions
04/07/2013
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Preventative Steps in Dealing with Counterparties
Post-contractual Ongoing monitoring
Access to Financial Information:
– Ongoing obligation to provide financial information about party and its affiliates, as is reasonably necessary to be able to verify party’s ability to carry out its obligations under the Agreement
– Information can include audited or unaudited information prepared by party’s external auditors
– obligation of party to make its external auditors available to answer questions you may have from time to time about the financial information
Consequences of poor financial information
– Right to guarantee
– Changes to payment terms, term of contract
– Termination rights
Remedial Steps
Termination Rights
Termination for Convenience
Termination upon occurrence of credit-related events:
– is or becomes bankrupt or insolvent
– becomes subject to the insolvency or bankruptcy laws of any jurisdiction in which it carries on business
– fails or declares its inability to pay amounts owed when they become due
– winds up or passes a resolution to wind up or otherwise ceases to carry on its ordinary business, voluntarily or otherwise
– causes the appointment of a receiver or custodian to take possession of its assets
– arranges with its creditors or applies to an administrator or court of competent jurisdiction for protection from its creditors
– becomes, or party has reasonable grounds for believing (based on the financial information provided or otherwise) that the counterparty may imminently become, for any reason, incapable of continuing to perform its obligations under the Agreement
04/07/2013
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slide | 35
Insolvency Considerations in Contract Drafting
Key Insolvency Provisions Relevant to Contracts
● Upon CCAA/BIA filing ―no person may terminate or amend any
agreement, including a security agreement, with the insolvent
person, or claim an accelerated payment, or a forfeiture of the term,
under any agreement, including a security agreement, with the
insolvent person, by reason only [of the insolvency filing or the
person’s insolvency]‖ (BIA ss.65.1(1) and 84.2(1); CCAA – ―Initial
Order‖)
● In cases of leases and licenses, the prohibition is expanded to
include non-payment of pre-filing rent, royalties or other similar
payments as excluded basis for termination (BIA ss.65.1(2) and
84.2(2))
slide | 36
Insolvency Considerations in Contract Drafting
(cont’d)
Key Insolvency Provisions Relevant to Contracts – (cont’d)
● Bankruptcy avoidance provisions in contracts are of no force or
effect: ―Any provision in an agreement that has the effect of providing
for, or permitting anything that, in substance, is contrary to [the above
sections] is of no force or effect.‖ (BIA ss.65.1(5) and 84.2(5))
● Provisions of the CCAA ―Initial Order‖ will establish an even broader
set of prohibitions and limitations under broad authority contained in
s.11.02 of CCAA
● Also general ―stay‖ established under BIA and in CCAA Initial Orders
that prohibits the exercise of any remedy that a creditor may have
against the insolvent debtor upon a BIA/CCAA filing
● Disclaimer and assignments of contracts (discussed above)
04/07/2013
19
slide | 37
Insolvency Considerations in Contract Drafting
(cont’d)
Default/Termination Rights
● While ―deemed‖ or ―automatic‖ termination or enforcement provisions
upon bankruptcy are of no force or effect, inclusion of termination and
enforcement ―rights‖ are important
● Should be obvious, but many contracts do not provide that
―bankruptcy‖ is a default
● Important to be cognizant of how ―bankruptcy‖ is defined/described:● ―assignment in bankruptcy‖
● ―application for bankruptcy order‖ (formerly ―bankruptcy petition‖)
● Filing of ―proposal‖ or ―notice of intention to make a proposal‖ under the BIA
● Application for relief/protection under the CCAA or granting of an order under the CCAA
● Appointment of ―private receiver‖
● Application for appointment of receiver or a receiver and manager or the appointment of a
receiver or receiver and manager
● Others (WURA, wind up, dissolution, etc.)
slide | 38
Insolvency Considerations in Contract Drafting
(cont’d)
Default/Termination Rights – (cont’d)
● Carefully consider what ―cure periods‖ apply to bankruptcy default
● Distinguishing cure rights between ―application for ...‖ and ―granting of ...‖
● Cure period to overturn/reverse bankruptcy events
● Be cautious of unintended ―double cure periods‖
● Express provisions creating right to legal and other fees upon default/
enforcement
● Provision for default interest
● Liquidated damages: genuine pre-estimate of damages vs penalty
clause
04/07/2013
20
slide | 39
Insolvency Considerations in Contract Drafting
(cont’d)
Set-off Rights● Law of set-off and compensation continues to apply in bankruptcy/
restructuring to the same extent and in the same manner outside of
bankruptcy/restructuring (BIA s. 97(2) and CCAA s. 21)
● Therefore, no stay on set-off; however jurisprudence under the CCAA to
―temporally‖ stay set-off rights (Re Air Canada)
● Stay of set-off not customary in receivership (not contained in Commercial
List Model Order) but may be ordered by Court in appropriate circumstances
● Preservation of set-off in BIA/CCAA includes both legal and equitable set-off
● But legal set-off complicated by ―mutuality‖ issues in bankruptcy/
receivership and equitable set-off complicated by preference considerations
● Therefore, contractual set-off provisions are best protection in event of
counter-party insolvency
slide | 40
Insolvency Considerations in Contract Drafting
(cont’d)
Securing Contractual Obligations
● Security not only for traditional loan arrangements
● Contract counterparty may grant security over all or part of assets to
secure obligations under contract or credit extended
● Grant of security must be in writing and signed by debtor (i.e., not in
unsigned standard terms and conditions)
● Grant of security less effective if not properly perfected
● Register security under PPSA
● Purchase money security interest in inventory: prior to taking possession
of the goods: (a) security interest must be perfected (i.e., registered) and
(b) notice must be given to other PPSA registrants
04/07/2013
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slide | 41
Treatment of Real Property Leases:
Proposals and CCAA Proceedings
● Insolvent lessors cannot disclaim real property leases
● BIA proposals:
● Insolvent lessees can disclaim real property leases under
the CCAA and the proposal provisions of the BIA
● the lessor can apply to the court to prevent the termination
of the lease
● In that case, the insolvent lessee must prove that it would
not be able to make a viable proposal without disclaiming
this lease and other leases that have been disclaimed,
otherwise the court will not allow the lease to be disclaimed
● CCAA: general disclaimer provisions apply
slide | 42
Treatment of Real Property Leases:
Effect of Disclaimer in BIA Proposal
● Under section 65.2 (4) of the BIA,
● The lessor has no claim for accelerated rent
● The Proposal must indicate whether the lessor may file a proof of claim
for actual losses from the disclaimer or the lesser of
i) The amount of rent provided for in the lease for the first year
following the disclaimer plus fifteen percent of the rent for the
remainder of the term after that; and
ii) Three years’ rent.
● The lessor may file a proof of claim as indicated in the proposal.
04/07/2013
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slide | 43
Treatment of Real Property Leases:
Bankrupt Lessees under the BIA
● Governed by the BIA and provincial legislation
● BIA section 136(1)(f): lessor has preferred claim for three months of
rent arrears plus three months of accelerated rent
● Section 146 of the BIA makes provincial law applicable
● Commercial Tenancies Act (Ontario) section 39(1): trustee may
disclaim commercial lease of a bankrupt lessee in writing
● Trustee must disclaim within three months of bankruptcy
● Once lease is disclaimed, the lessor has no claim for rent for the
remainder of the term of the lease
slide | 44
Treatment of Personal Property Leases in Insolvency
● CCAA/BIA filings cannot prohibit a party from ―requiring
immediate payment for goods, services, use of leased or
licensed property or other valuable consideration‖
provided after the filing [CCAA s.11.01(a)/BIA
ss.65.1(4)(a) and 84.2(4)(a)]
● Provisions to be narrowly construed so as to not unduly
give one creditor advantage over others
● Therefore, traditional insolvency approach limits the
protection to true/operating leases, not financing/security
leases
04/07/2013
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slide | 45
Treatment of Personal Property Leases in Insolvency (cont’d)
● Key issue is whether the lease is ―payment for use‖
versus a disguised security agreement or conditional sale
● Determination of the intention of the parties based on a
functional analysis of the relationship of the parties
● Substance, not form, of the arrangement to be
determinative
● Test for ―true lease‖ in insolvency different from tax and
accounting tests
slide | 46
Treatment of Personal Property Leases in Insolvency (cont’d)
Re Smith Brothers Contracting (Ont. 1991) adopted a “checklist” of factors to consider:
1. Option to purchase for nominal sum
2. Grant of equity or property interest
3. Nature of business of the lessor
4. Payment of sales taxes on acquisition
5. Payment of taxes incidental to ownership
6. Responsibility for insurance
7. Payment of license fees for operation
8. Risk of loss on lessee
9. Default acceleration and nature of remedies
10. Selection of equipment for lease
11. Substantial security deposit in lease
12. UCC financing statement
13. Nature of default provisions
14. Provision for liquidated damages
15. Disclaimer of warranties of fitness or merchantability
16. Aggregate rent approximates purchase price of equipment
04/07/2013
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slide | 47
Treatment of Personal Property Leases in Insolvency (cont’d)
● Debate over proper use of Smith Brothers checklist: equal weight to
all factors vs primary/secondary factor approach
● Re Cow Harbour Construction (Alta 2012) undertook an extensive
review of the insolvency approach to determining true vs financing
leases
● Decision reaffirmed the use of the Smith Brothers checklist and
confirmed that one factor cannot ―trump‖ the others
● But Court said that the proper approach is to be ―holistic‖ as opposed
to a ―scientific exercise‖
● The Court is to analyze the various factors that are relevant and
balance the factors in the context of the entire agreement
● In doing so, some factors might have greater weight than others
Preventative Steps
Insurance
Obligation to maintain general commercial liability insurance, professional errors and omissions insurance (and other insurance as relevant to the nature of the arrangement) with insurers licensed to do business in the United States or Canada rated at least ―A minus‖ by AM Best or Standard and Poor.
Policies to be endorsed to provide notice in the event of cancellation, termination, or expiration (for non-renewal or otherwise), of the policies.
Counterparty to provide, promptly after the date of execution of the Agreement, and on renewal of each policy, a certificate of insurance for each policy of insurance it is to maintain under this subsection
Business continuity obligations
Data back up and data feeds
Source code escrow
04/07/2013
25
Preventative Steps
Source Code Escrow Arrangement
Software licensing: ensures that customer can continue to maintain and support licensed software in the event the licensor becomes bankrupt or otherwise is unable to continue to do so
Provides for the source code (or human readable code) for the licensed software to be placed in escrow with a third party escrow agent
Escrow agreement provides that the source code will be released to the licensee upon the occurrence of certain events:
– Licensor no longer carrying on business
– Licensor becomes bankrupt or insolvent
– Licensor no longer willing or able to support the software
Summary
Customers can seek to mitigate counterparty insolvency risk through:
Up-front due diligence and risk assessment
Ongoing financial disclosure obligations
Pre-emptive contractual termination rights
Insurance requirements
Business continuity arrangements
04/07/2013
26
slide | 51
Q & A
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