Sotos LLP

Alternatives to Bankruptcy

By Anna Thompson-Amadei & John Yiokaris

The government-imposed restrictions and social distancing practices that have been implemented to combat the spread of COVID-19 have led to significant economic hardships for many businesses, especially those in the retail, hospitality, and personal services industries.  Unfortunately, many of these companies have or will become insolvent, and may eventually face bankruptcy. This article will provide an overview of some possible alternatives to bankruptcy that companies should consider if they find themselves in financial trouble.

Bankruptcy vs Insolvency

In Canada, the term “bankrupt” or “bankruptcy” refers to a legal status and process.  Bankruptcy provides protection and relief for individuals who are unable to pay off their debts. When proceedings are initiated under the Bankruptcy and Insolvency Act, R.S.C. 1985, c. B-3 (“BIA”) it does not necessarily mean that the debtor company is bankrupt – the debtor may be insolvent, but not necessarily bankrupt. For an individual to be bankrupt, they must have either made an assignment under the BIA or had a bankruptcy order made against them.

Section 2 of the BIA defines an “insolvent person” as a person (a “person” can mean a corporation or an actual individual) who is not bankrupt, is a resident or carries on business or has property in Canada, whose liabilities to creditors provable as claims under the BIA amount to at least $1,000, and:

  1. who is unable to meet obligations as they generally become due;
  2. who ceased paying current obligations in the ordinary course of business as they generally become due; or
  3. whose property is not sufficient at a fair valuation to enable payment of all obligations, due and accruing.[1]

A “bankrupt” person is defined as a person who has made an assignment in bankruptcy, or against whom a bankruptcy order has been made, or the legal status of that person. [2] Further, a bankruptcy order can be made against a person that is not insolvent. Sections 42 and 43 of the BIA list a number of “acts of bankruptcy” that can support an application for a bankruptcy order. In order to make a voluntary assignment into bankruptcy, or a proposal under the BIA (discussed below), the person must first be insolvent.

Alternatives – Debtor’s Options

There are several advantages to considering alternatives and avoid filing for bankruptcy: it allows companies to avoid the stigma associated with filing for bankruptcy, it facilitates the preservation of jobs (as much as possible) and can preserve enterprise value, and it allows businesses to maintain customer and supplier relationships.

Get organized

Companies that find themselves in financial distress should first take the time to get organized and get their affairs in order.  The following housekeeping suggestions should be considered best practice, even if a company is in good financial health:

  • Protect any loans that were made to the troubled company by affiliated or parent companies by having the appropriate security interests registered.  This ensures that the secured loan will have better standing than any unsecured creditors.  This requires establishing evidence of the loan, generally by way of a promissory note, preparing a loan agreement and general security agreement and registering the security interest with the Personal Property Security Act framework in Ontario.
  • Update and maintain a thorough inventory of the company’s assets and liabilities.  Assets include, but are not limited to, leases, trademarks, and licences.  Taking inventory of the assets includes determining which entity owns the asset – i.e., whether it is the distressed company or an affiliate.  It is important to locate and organize all relevant documents including, but not limited to, all financial statements and profit and loss statements.  Corporate documents should be located, brought up to date and reviewed for accuracy.
  • If possible, ensure that the company is current with all fees, remittances, and taxes owing to the government.

Informal Discussions

Depending on the circumstances, it may be possible for debtors to contact their creditors directly and negotiate a repayment schedule or lower interest rates. Creditors will expect debtors to present a concise plan that outlines how the debtor plans to meet its obligations.  It is important that debtors submit realistic proposals that include reasonable payment schedules, while keeping in mind that the more drawn out the repayment term, the most interest will be paid.

Creditors do not have any legal obligation to arrange alternative payment plans with debtors; therefore, it is it crucial that any informal discussions that occur are conducted in earnest and in such a way as to convince the creditor that it is in their best interest to be amenable to accepting a special arrangement.  Before considering any proposed arrangement, most creditors will require an opportunity to look at the distressed company’s financials, in order to assess the viability and reasonableness of the proposal.

Proposals

Given the current economic environment, proposals are more likely to succeed now than they were in the past. This article will discuss Division 1 proposals under the BIA and proposals under the Companies’ Creditors Arrangement Act, R.S.C., 1985, c. C-36 (the “CCAA”). The essential difference between a restructuring under the CCAA and one conducted under the BIA is that the process under the BIA has more procedural steps and is set out with strict timeframes, rules, and guidelines.  A CCAA proceeding, on the other hand, is more discretionary and judicially driven.[3]

Division 1 / Commercial Proposals

Under section 50 of the BIA, an insolvent person (which includes individuals, partnerships, unincorporated associations, corporations, cooperative societies and cooperative organizations) can make a proposal to creditors to avoid bankruptcy.  The proposal is similar to a contract that is arrived at with creditors resulting in a restructuring of debt and the orderly payment of the compromised amount in accordance with the proposal.

If a debtor wants to make a proposal under the BIA, it must do so with a licensed insolvency trustee, who will act as the “proposal trustee”.  The proposal trustee is responsible for monitoring the debtor’s affairs, since it remains in possession of its assets, and reporting to the creditors and the court.

The debtor has the option to first file a Notice of Intention to Make a Proposal (“NOI”), or to file a proposal, each of which will immediately impose a stay of proceedings on creditors.  The stay of proceedings is crucial as it allows the debtor much-needed breathing room to focus on developing and implementing its proposal to creditors.[4]

Once a proposal is filed, the proposal trustee notifies the creditors of a meeting to consider the proposal and the creditors vote on whether to accept the proposal or not. Only those creditors that have filed proofs of claim are entitled to vote.  The creditors vote in classes which are established by the proposal.  The unsecured creditors always constitute one class, but the secured creditors may be categorized into different classes.[5]

There are several benefits of making a proposal under the BIA, some of which include:

  • all legal collection actions by unsecured creditors for debts covered by the proposal are stopped;
  • it remains possible for debtors to obtain new credit or interim financing to fund the proposal process;
  • creditors cannot terminate agreements solely by reason of the insolvency;
  • the debtor can disclaim certain agreements, including premises leases, that are no longer advantageous;
  • it allows for the possible retention of employees; and
  • the debtor can sell certain assets or business lines while retaining other parts of the business. [6]

Many of the aforementioned benefits require court approval, which will, of course, affect the professional fees associated with the process.  Further, some mechanisms are also subject to the court’s discretion.  This means the court can decide whether or not a particular mechanism under the BIA is available to the distressed company, given the circumstances.

Requirements

Some of the key requirements for a Division 1 proposal are as follows:

  • It must provide a result to creditors that is better than what would be expected in a bankruptcy.[7]
  • Unless the government consents, the proposal must provide for payment in full of certain tax claims within six months of court approval.
  • If the debtor is an employer, then it must provide for payment to all employees and former employees of all unpaid wages, commissions, etc. up to $2,000.
  • If there is a prescribed pension plan, the proposal must provide for payment of certain required payments under the pension plan. [8]

Secured vs Unsecured Creditors

A Division 1 proposal may be made to secured creditors, but must always be made to the unsecured creditors.  If the proposal is made to both secured and unsecured creditors, this means there will be at least two classes of creditors who vote separately.  If not made to secured creditors, if the value of the collateral secured is valued at less than the debt, and therefore a deficiency is expected, a secured creditor may be treated as unsecured for the value of the deficiency. Further, the debtor must continue to keep the terms of any debt or security agreements in good standing throughout the proposal period.[9]

Cashflow Statements

Any debts that the debtor owes prior to the date of filing the NOI or proposal will be put on a temporary “hold”; however, the debtor is required to demonstrate that it has sufficient cashflow to meet its ongoing obligations, which may include payroll, taxes, professional fees, rent, etc. – this is done by filing a cashflow statement, which the proposal trustee must sign off on.[10]

Timeline

It is important for debtors to follow the timeline requirements as set out in the BIA, as failure to do so will result in a deemed assignment in bankruptcy.  After filing the NOI, the debtor has 30 days to file a proposal, or it must seek an extension of time from the court of a maximum of 45 days, and up to a maximum aggregate time of five months after the initial 30-day period expires.[11]

After a Proposal is Filed

In order for a proposal to be accepted, all classes of creditors (except creditors having equity claims) must vote to accept the proposal by a majority in number of creditors (with proven claims) present at the meeting (either in person or proxy), and two-thirds in value of the creditors present at the meeting.[12]

It is not unusual for a debtor to contact creditors in advance of the proposal in an effort to garner support and ensure quorum is achieved at the meeting.  It is also not unusual for amendments to be tabled at, or in advance of, the meeting, or the meeting to be adjourned if certain creditors require more information, or seek some enhancements to the proposal.  Debtors, with the assistance of the proposal trustee, may often negotiate terms of the proposal with certain creditors (usually those with significant claims) because if the proposal is voted down, the debtor is deemed to have made an assignment in bankruptcy.[13]

Proposals under the CCAA

The CCAA is federal legislation that allows financially troubled corporations the opportunity to restructure their affairs through a formal Plan of Arrangement while continuing to operate.  Similarly to Division 1 Proposals under the BIA, the CCAA offers an opportunity for the company to avoid bankruptcy and allows the creditors to receive some form of payment for amounts owing to them by the company. However, while Division 1 proposals are available to corporations and individuals alike, regardless of the amount of debt, proposals under the CCAA are available only to larger corporations that have in excess of $5 million owing to creditors. While the CCAA is a more flexible mechanism that allows for greater business and judicial discretion than proposals under the BIA, it is a complicated legal process and can involve significant costs and impair the ability of unsecured creditors to collect money from a debtor company.

Restrictions and Eligibility

A debtor company can make an application under the CCAA when it is insolvent and the total secured and unsecured claims against it and its affiliates exceed $5 million. The CCAA is not available to banks, insurance companies, trust and loan companies or railways.

As with Division 1 Proposals, under the CCAA, the debtor company is not bankrupt. The CCAA also allows a company, if it so chooses, to address its shareholders in addition to its creditors.  Typically, when the shareholders of the company are impacted by the proposal, they are often given the opportunity to vote on it.

Court-Supervised reorganizations

Applications are made in superior court, usually in the province where the head office or chief place of business of the debtor is located.  Applications can be brought by the debtor company or by other interested parties such as creditors, bankruptcy trustees, or the liquidator of the debtor.

A monitor is appointed, who must be a trustee within the meaning of the BIA.  The monitor is responsible for overseeing the business and financial affairs of the debtor company during the reorganization.

Once an application is accepted by the court, the CCAA grants wide-ranging discretionary powers to the court to craft orders and remedies appropriate to the particular reorganization before it.  The court will make orders at the instance of the company and with the support of its monitor.  This often happens over the objections of the creditors.

Commonly used actions by the court include:

  • Prohibiting parties from terminating agreements with the debtor company;
  • Disclaiming or terminating existing contracts entered into by the debtor company;
  • Authorizing post-filing security for debtors-in-possession financing or super-priority charges on the debtor’s company’s assets when necessary to allow debtor company to continue to do business during the reorganization;
  • Establishing the existence of creditors’ claims by way of a time-limited claims process to determine creditors’ claims which may be disputed by the debtor company; and
  • Approving a plan of arrangement created by the debtor company to compromise or arrange the debts owed to some or all of its creditors, including, importantly, any claims against directors and officers for their statutory liabilities.

While the court does have broad discretion in choosing what steps to take in the reorganization, there are limits on the court’s powers – specifically, an order made under the CCAA cannot compel third parties to advance any further money or credit to the debtor company; nor can it prohibit creditors from requiring immediate payment for services provided to the debtor company during a CCAA proceeding.  Further, if the reorganization is unlikely to be successful, the stay of proceedings may be lifted by the court – this would terminate the CCAA proceedings and lead to bankruptcy proceedings under the BIA.

Informal Restructurings

Informal restructurings allow distressed companies to try to arrive at consensual resolutions with their creditors and stakeholders as a first resort - before commencing formal court proceedings.

An informal restructuring can take many forms: it may address debt problems with an offer of deferred or partial payments to creditors, an exchange of debt for equity, or other forms of balance sheet solutions.  It can also address operational issues, which could include the creation of additional corporations, the transfer of assets or operations, or the sale of all or part of a business.

Other forms of informal restructurings include:

  • the partial sale of the debtor’s assets;
  • refinancing of existing debt;
  • bridge loans; and
  • creditor or stakeholder forbearance.

Benefits

The benefits of engaging in informal restructurings stem from the avoidance of undergoing any formal proceedings.  As well as avoiding the stigma that follows filing for bankruptcy, this also allows debtors to avoid paying the fees and costs associated with formal restructuring processes, as well as the risk of losing all of the company’s assets or any ongoing business shutdown.

Downsides

The lack of structure, in turn, also presents some downsides.  First, without a formal process in place, the debtor is not protected by a stay of proceedings and is vulnerable to enforcement and other action by creditors and stakeholders. Furthermore, creditors are not obligated to settle; however, they are more likely to do so if they feel the offer promises a better return than would be the case if the company either ceased to operate or filed for bankruptcy.

The level of complexity of the debtor’s financial structure will also play a role in determining the wisdom of attempting an informal restructuring - the more complex the debtor’s financial structure and the greater the number of stakeholders, the more difficult it will be for the debtor to restructure informally.

Lastly, informal proposals to creditors may require showing the creditors the debtor’s current financial statements and providing an explanation of the financial distress, and in the case of self-directed informal restructuring, the CRA will not compromise its debt, meaning interest and penalties will continue to accrue.

It is prudent when considering informal proposals to first speak with a professional advisor, especially before beginning negotiations with creditors.  Debtors need to be aware of the correct process for obtaining a full release from any remaining debt and to understand the implications of stopping payments to creditors.

Secured Creditor Imposed Restructurings -  Forbearance Agreements

In certain circumstances where a borrower has fallen into financial distress and has defaulted under the terms of a credit agreement, the creditor may propose to enter into a forbearance agreement.  Forbearance agreements typically acknowledge that the lender has the right to enforce its security at that time, but will forbear for a period of time, based on certain important considerations.

The purpose of a forbearance agreement is to give the borrower time – time that may be used to refinance the business, sell off assets, obtain an injection of equity or deal with other creditors that are essential to a successful restructuring.  During this time, the lender can also gather more information regarding the financial situation of the borrower and assess what its financial needs will be going forward.  Both parties can also take this time to engage any consultants to assist in determining possible solutions to the current financial distress of the borrower.

Some terms that are typically found in forbearance agreements include:

  • requiring additional financial reporting;
  • mandating the preparation of cash flow projections for an extended period to be updated on an ongoing basis in order to show the actual results from the borrower’s operations;
  • the grant of additional security by either the borrower or a guarantor;
  • the correction of any deficiencies in the current security agreement; and
  • rights of extension for further defined periods if certain milestones are met.

The lender may also appoint a monitor or another outside consultant that would monitor the business activity of the debtor, and assist them in ensuring that they are completing their obligations under the forbearance agreement. This would be at the expense of the debtor.

These types of agreements give the distressed company time to try to stabilize its business operations, seek alternative solutions, or sell some or all of its assets – all outside of a formal restructuring proceeding.  As with other informal processes, it is important to establish and maintain clear communications with suppliers and customers alike.

Conclusion

The most important take-away for debtors should be the importance of being proactive and engaging insolvency advice earlier rather than later.  The project of getting one’s house in order and getting organized can potentially bring alternative financial solutions to light that had not previously been considered, as well as facilitate discussions with creditors and other stakeholders.

Some things to consider when developing an action plan:

  • Act early and be proactive to get the best result.
  • Infusing more money is not necessarily the answer to financial difficulties.
  • Consider whether the management team that got the company into trouble is the management that can lead it out of trouble.

No matter what alternative approach is attempted, cooperation and a clear understanding of the debtor’s financial reality among the stakeholders will be essential. Remember, creditors are not obligated to cooperate or extend any courtesy to the debtor; however, they are more likely to do so if they feel negotiations will result in a better return than if the troubled company is forced to cease operations altogether and file for bankruptcy.  Lastly, it is important to think about problem-solving before the situation becomes dire.  The ability to recognize there is a problem and prepare a proactive action plan will maximize a debtor’s options and opportunities.

At Sotos LLP, our team of experts has been advising businesses in the automotive, restaurant, grocery, personal, home and professional services, hotel, retail, and cannabis sectors as they face challenging economic and financial issues relating to the current pandemic. Please contact John Yiokaris (jyiokaris@sotosllp.com or 416.977.3998) or Anna Thompson-Amadei (athompson-amadei@sotosllp.com or 438.827.4020) if you wish to discuss any financial issues you may be facing and determine an effective approach including alternatives to bankruptcy that may be available.

[1] Bankruptcy and Insolvency Act, s.2

[2] Bankruptcy and Insolvency Act, s. 2

[3] https://www.insolvency.ca/en/resources/IIC_Bankruptcy_Primer.pdf

[4] Bankruptcy and Insolvency Refresher and Tips for Business Lawyers, Cho and Wanniarachige, 7

[5] Bankruptcy and Insolvency Act s. 50(1.1)-(1.4)

[6] Alternatives to bankruptcy materials

[7] (Re Allen Theatre Ltd. (1922), 2 CBR 147 (SCJ).

[8] Bankruptcy and Insolvency Act, s. 60(1.1), s.60(1.3), (s.60(1.5)

[9] Bankruptcy and Insolvency Refresher and Tips for Business Lawyers, Cho and Wanniarachige, 6

[10] Bankruptcy and Insolvency Refresher and Tips for Business Lawyers, Cho and Wanniarachige, 6

[11] Bankruptcy and Insolvency Act, s. 50.4(9), 50.4(8) BIA

[12] Bankruptcy and Insolvency Act, s.54(2)

[13] Bankruptcy and Insolvency Refresher and Tips for Business Lawyers, Cho and Wanniarachige, 7

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