APRIL 2012 BANKING

Conflicts, Conflicts?? What Is My Lawyer Fussing About??

Page 1

Payment On Demand: What Is Reasonable Notice?

Page 4

“No Recourse Against Others” Are You Protected?

Page 6

Demystifying US Guarantees: A Brief Overview

Page 8

Banking LawyersBetteridge, Robert D. (Bob) 403-260-0188 ................................................................................................................................rdb@bdplaw.comChan, Byron 403-260-0240 ........................................................................................................................... bchan@bdplaw.comCramer, Nicole F. 403-260-0271 ................................................................................................................................ nfc@bdplaw.comDeLuca, G. Dino 403-260-0211 ...............................................................................................................................gdd@bdplaw.comFehr, Trish M. 403-260-0212 ...............................................................................................................................pmf@bdplaw.comGrout, David 403-260-0326 ...........................................................................................................................dgrout@bdplaw.comIonescu-Mocanu, Simina 403-260-0231 .......................................................................................................................sionescu@bdplaw.comJohnson q.c., Cal D. 403-260-0203 ................................................................................................................................ cdj@bdplaw.comLangdon, Margot D. 403-260-0205 ............................................................................................................................... mdl@bdplaw.comMartin, Christie E. 403-806-7870 ......................................................................................................................... cmartin@bdplaw.comMisri, Nathaniel S. 403-260-0165 .......................................................................................................................... nmisri@bdplaw.comPybus, Kathy L. 403-260-0196 ................................................................................................................................ klp@bdplaw.comSmith, Nancy D. 403-260-0124 ......................................................................................................................... nsmith@bdplaw.comWilmot, John A. 403-260-0117 ............................................................................................................................... jaw@bdplaw.com

Banking and other issues of On Record are available on our web site www.bdplaw.com

Banking, Editors-in-ChiefCal D. Johnson, q.c.cdj@bdplaw.com403-260-0203

Simina Ionescu-Mocanusionescu@bdplaw.com403-260-0231

Banking, Managing EditorRhonda G. Wishartrwishart@bdplaw.com403-260-0268

Contributing Writers and Researchers:Cal Johnson, Nathaniel Misri, Byron Chan and Robert Carleton

ContactFor additional copies, address changes, or to suggest articles for future consideration, please contact the Managing Editor.

General NoticeOn Record is published by BD&P to provide our clients with timely information as a value-added service. The articles contained here should not be considered as legal advice due to their general nature. Please contact the authors, or other members of our Banking team directly for more detailed information or specific professional advice.

If you would like any further information on any members of our team, such as a more detailed resume, please feel free to contact the team member or the Managing Editor. You may also refer to our website at www.bdplaw.com.

On Record Contents:

2400, 525-8th Avenue SW, Calgary, Alberta T2P 1G1Phone: 403-260-0100 Fax: 403-260-0332

www.bdplaw.com

1

CONFLICTS, CONFLICTS??WHAT IS MY LAWYER FUSSING ABOUT??By Cal Johnson, Q.C.

Frequent users of legal services may be puzzled, and sometimes dismayed, by a lawyer’s need to “check conflicts” or “clear conflicts”. Conflicts can preclude your lawyer from acting for you on a matter, or can lead to a requirement for consents to act from various parties. To understand the implications for you as a client, it is helpful to breakdown the issues that impact the decision on whether or not the law firm or lawyer is able to represent your interests.

2 BANKING

What are a Lawyer’s Duties That Could Lead to a Conflict?A law firm acting in a matter has 3 potential duties owed to its client.

A. Conflicts Arising From the Duty of Performance The first, most obvious and well recognized duty is the “Duty of Performance”. Generally this can be described as the obligation that any lawyer has to competently and diligently perform the work once the lawyer undertakes a matter. This duty arises only after the lawyer has been engaged and ends once that particular matter is completed. As an example, if the retainer was to provide an opinion on an issue, once the opinion is completed and delivered, the duty is at an end. There is no ongoing obligation to “update” or renew that opinion. The scope of the duty of performance is often, and most appropriately, defined by the terms of a retainer agreement.

A law firm about to undertake a duty of performance must, however, ensure that it does not have a “conflicting duty of performance” to another client. By way of a real life example from a reported case in Ontario, a law firm was acting for an underwriter on an equity financing for an issuer, but also accepted a retainer whereby it would be acting for another client seeking to make a takeover bid for the issuer. Not surprisingly, the issuer and the underwriter were not pleased, but was there a conflict? The Court framed the question in terms of the duty of performance and concluded that there was a conflict, since a successful takeover would have meant the end of the financing (and effectively the issuer as well). A law firm cannot undertake a duty to perform something which will subvert that which it has undertaken for another client. There is effectively a “conflict” between the two duties of performance.

Even though the duty of performance ends when the retainer ends, if the client has conveyed confidential information to the law firm, there may nevertheless be a continuing duty of confidentiality, which is examined in more detail below.

B. Conflicts Arising From the Duty of LoyaltyOnce the law firm has undertaken a duty of performance, it automatically owes a duty of “loyalty” to the client. Simply put, the duty of loyalty requires that the lawyer avoid conflicting interests of his own or other clients, provide full disclosure to the client of information and resources available to the client, provide an unequivocal commitment to the client’s position and ensure that any confidential information received is not misused. Obviously a lawyer cannot fulfil the duty of loyalty if he is torn between the client’s

interest and those of other clients of the firm, or indeed his own interest in the matters. While the duty of performance is a duty to do something, the duty of loyalty is largely concerned with what the lawyer or law firm should refrain from doing. The duty of loyalty is intended to ensure the lawyer does not compromise his duty of performance.

Unlike the duty of performance, the duty of loyalty does not necessarily completely end once the retainer ends. The duty to preserve confidential information survives, as does a much narrower definition of the duty of loyalty. This latter continuing aspect of the duty of loyalty imposes a duty on the lawyer not to attack the legal work performed for that client by accepting a subsequent retainer and not to change sides on a subsequent matter in something that is relevant and critical to the first retainer. As an example, in a major Canadian case, that coincidentally underscores the importance of a clear and detailed retainer letter, a law firm had acted as general counsel to a First Nation, including acting in respect of revenues arising from casino activities. An opportunity arose for the law firm to act for that same band and many other First Nation entities in a suit against the Province of Ontario. Before doing so, the law firm obtained a consent from its original First Nation client to enable acting for the other First Nations in this suit and in possible future litigation relating to their share of casino revenues and the imposition by the Province of Ontario of a 20% ‘win tax’ on the gross revenues. After the litigation against the Province had commenced, the law firm amended pleadings to allege that its original First Nation client breached a fiduciary duty which had the effect of the law firm’s own client becoming a defendant in the ongoing action. Not surprisingly the original First Nation client called foul and claimed a “conflict of interest” on the part of the law firm. The law firm argued the consent applied and absolved any conflict. The courts disagreed, saying that the consent was not specific enough and held that the law firm’s actions constituted “a direct attack against the honour of the client in respect of matters related to those on which the law firm had acted. The onus is on the law firm, when it wants to “attack” a former client, to ensure clarity of consent.

The duty of loyalty also means that a lawyer cannot terminate his relationship with an existing client so as to take on a new one. This has in fact been codified in the Alberta Code of Conduct for lawyers published by the Law Society of Alberta. It provides that a lawyer shall not withdraw from representation of a client except for good cause and upon notice to the client appropriate in the circumstances. The case law has also determined that if a retainer is terminated by a client because a lawyer has breached the duty of loyalty, this does not mean that the lawyer is released to take on a competing retainer.

…there is significant authority and history involved that are crucial to protecting the integrity of legal representation for clients, non-clients and third parties.

3

C. The Duty to Protect Confidentiality In the MacDonald Estate case, the leading case in Canada on a lawyer’s duty to protect client confidentiality, the Supreme Court of Canada (“SCC”) recognized the vulnerable position of a client through the frequent need for disclosure by the client to the lawyer of highly sensitive and confidential information. The SCC stated “The client must be secure in the knowledge that the lawyer will neither disclose nor take advantage of these revelations.” The SCC established a very strict standard in determining whether there has been a breach of the duty to protect confidentiality; requiring only that there be a possibility of mischief in the misuse of confidential client information.

In MacDonald Estate, a law firm was disqualified from acting in a suit where that firm hired a lawyer who, as an articling student, had assisted on the opposing side of that very same action. The SCC had no doubt that the transferring lawyer was possessed of relevant confidential information. The decision recognized that rules governing the conduct of the legal profession were more appropriately addressed by the legal bodies that govern the profession. As a result the matter was tossed back to the provincial Law Societies and the provincial branches of the Canadian Bar Association (“CBA”). A 1993 CBA Task Force concluded that properly implemented institutional confidentiality screens (more colloquially knows as “Chinese Walls” or “Cones of Silence”) would be effective and since then guidelines have developed on how and when to implement such screens to ensure that confidential information is not passed between members of the same firm when it may be prejudicial to do so.

The duty of confidentiality extends not only to clients and former clients. It can also extend to third parties for whom the law firm has not acted. This can happen where (i) confidential information of the third party has become available to the law firm in the course of acting on a matter, (ii) the third party would reasonably expect that the confidentiality would be protected, and (iii) the law firm knows or ought to know that the information is confidential. A case from Manitoba illustrates the principles. A senior financial officer of a corporation retained a law firm on his own behalf to advise him as to his responsibilities in that role when the corporation encountered financial distress. As part of that exercise, the officer disclosed confidential information concerning the finances and strategies of the corporation. The Manitoba Court of Appeal looked askance at lawyers in that same firm later acting on behalf of a creditor of the corporation, including alleging improprieties on the part of other corporate officers and directors and the sole shareholder of the corporation. Even though the corporation itself had not been a client of the law firm, the law firm was disqualified from acting on the basis of the need to protect that confidential information.

Other examples readily come to mind, where confidential information is received by a Bank’s counsel in respect of the borrower, or by an underwriter’s counsel in respect of due diligence conducted in respect of an issuer. It is important to note that these situations do not necessarily disqualify the law firm from acting, but do require strict adherence by the law firm to the requirements for timely and comprehensive implementation of confidentiality screens in order to protect and preserve that confidentiality.

The Difference Between A Legal Conflict And A Business Conflict It is often confusing for clients to understand the difference between a “business conflict” and a “legal conflict”. Legal conflicts have been described above and it is only legal conflicts that are subject to the Code of Conduct for lawyers. The legal conflict is the sole basis on which a lawyer is obligated to consider whether he can act in any situation. Business conflicts arise from circumstances in the market place which may put various parties at odds over an issue, but which do not necessarily create a conflict for the law firm. For example, a law firm may have a history of acting for a particular underwriter on various initial public offerings of small to mid-size energy firms. If, at some point down the road, a competing underwriter comes into that IPO market, it may certainly present some challenges for the existing underwriter. However, if that new participant is looking for counsel to act on IPO related work that it secures, it may reasonably look to the same firm to act for it in that regard. The competitive nature of its activities may create a “business conflict” with the existing underwriter, but without more, the law firm acting for that new participant on IPO work that it secures, should not constitute a “legal conflict”.

The little known duty of confidentiality also often rises in this same context. One of the Code of Conduct rules provides that a lawyer must hold in strict confidence all information concerning the client and can only disclose that information in very limited and specific circumstances. Unless an exception applies, or another rule from the Code requires it, a lawyer shouldn’t disclose that he has been retained on a particular matter. Thus, if the lawyer determines that there is no “legal conflict” in a matter, he has an absolute duty not to disclose that he is acting for the client even if there might still be a perceived business conflict.

So, the next time your lawyer talks about conflicts or the need to check for conflicts, you will appreciate there is significant authority and history involved that are crucial to protecting the integrity of legal representation for clients, non-clients and third parties.

4 BANKING

Payment On Demand:WHAT IS REASONABLE NOTICE?By Robert Carleton, Student-at-Law

The Nature Of A Demand LoanMonies lent by a bank to a customer are repayable either on demand or, in the case of term loans, at a specified future date. When a loan is made with no specified date for repayment, the loan is payable on demand. A promissory note or other similar evidence of debt, where no time for payment is expressed, is also payable on demand. This means that a debt due on demand is due in full the moment that

a binding contract is formed. The fact that the lender does not immediately demand payment and lets the debtor make regular payments on the debt does not make it any less of a demand obligation. The debt could still theoretically be sued for from the date the loan is advanced.

However, in Alberta it is important to note the difference between the date that the debt can be sued for and the last date by which it must be sued for (i.e. – the end of the “limitation

period”). This is because provisions within the Alberta Limitations Act1 specifically provide that the clock for the limitation period only starts ticking after there is both a demand for payment and a failure to pay.

Since a demand for repayment on a demand loan may be made at any time, very little is required to document the terms of such a loan. All that is necessary can be encompassed within a few paragraphs: acknowledgement of the debt,

5

specification of an interest rate and payment mechanism and the provision of a clear statement that the loan is payable on demand. These simple provisions will ensure that the repayment of monies advanced is enforceable on demand.

Distinguishing Between Demand And Term LoansUnlike a demand loan, a term loan usually lists events of default. The occurrence of one of these events is typically required before a demand for payment can be made. Thus, term loan documentation is necessarily more complex and will often include specific provisions for repayment that are in addition to obvious defaults — like a non-payment event — and may include, for example, events such as where the credit worthiness of the debtor has deteriorated or where the debtor has taken on other obligations that might affect the lender’s position or its security.

Requirements For A Valid DemandThe making of a valid demand is of practical importance in two contexts. First, the date of demand is normally the date from which additional interest can be claimed on overdue amounts. Second, the making of a valid demand is normally a pre-condition to the right to realize on any security that the lender holds for the debt.

MEANING OF REASONABLE TIME TO PAYEven where a debt is specified to be payable on demand, the law requires lenders to give a debtor notice of the default and a reasonable time to repay. It is only after that reasonable time that the lender can take legal steps to enforce repayment, including the seizure of any property provided as security for the debt.2 This “reasonable time” must be sufficient to allow the debtor reasonably to be able to act to satisfy the debt.3 The term loan differs slightly from the demand loan in that once the creditor gives notice of the event of default upon which the creditor is relying for

repayment, the reasonable time will depend upon whether the debt instrument provides for its own “cure period” and the time period for repayment will typically be shorter. If the loan is simply not repaid on its specified due date, then the “reasonable time” will be very short.

Reasonableness of notice depends more upon its length rather than its form. What is reasonable notice for a demand loan depends on the circumstances of the case, but it is generally a short duration, not more than a few days and typically not encompassing anything approaching 30 days.4 However, 30 days or more may be reasonable in certain circumstances. For example, the potential ability to raise the money required in a short period of time may result in the court exploring the question of how long it would take to arrange replacement financing. In determining the length of notice, courts generally consider the following:

1) The amount of the loan;

2) The risk to the creditor of losing his or her money or the security;

3) The length of the relationship between the debtor and the creditor;

4) The character and reputation of the debtor;

5) The potential ability to raise the money required in a short period;

6) The circumstances surrounding the demand for payment; and

7) Any other relevant factors.5

SHORT OR NO NOTICE - ACCEPTED It may be reasonable to proceed on little notice if there is a significant risk that the debtor will flee with secured assets, if the debtor’s assets are depreciating quickly or if a debtor is unable to meet its obligations regardless of the amount of notice given. A notice period of only 24 hours may be reasonable where the debtor could not have met the demand even if given more time.6

When a bank grants a loan to a customer in the form of a line of credit, there may be no duty on the part of the bank to give reasonable

notice of its intention to terminate the line of credit, in the absence of an express provision to the contrary.7

SHORT OR NO NOTICE – NOT ACCEPTEDThe goal of notice is to permit the debtor sufficient time to repay or to persuade the bank that the debtor has access to other funds with which to repay shortly. If the creditor fails to provide reasonable notice before it proceeds to realize on its security, the creditor may be liable in damages to the debtor. Thus, if a creditor gives what otherwise would constitute reasonable notice, but does not accompany that notice with a warning that action on the security will be taken after a certain length of time, and the creditor subsequently does in fact take action on its security after the debtor has substantially met the demand, this action by the creditor may be held as unreasonable.8

SummaryWhen entering into a debt obligation, it is important to recognize the essential difference between a demand obligation and a term obligation and, for lenders, to recognize that a demand obligation nevertheless carries with it an implied obligation to give the debtor a “reasonable time” to repay.

Footnotes

1 R.S.A. 2000, c. L-12, ss. 1(e) “injury”, 3(1)(a).2 Bank of Nova Scotia v. Dunphy Leasing Enterprises Ltd. (1994), 18 Alta. L.R. (3d) 2 (S.C.C.).3 Ronald Elwyn Lister Ltd. v. Dunlop Canada Ltd. [1982] 1 S.C.R. 726 (S.C.C.).4 Bank of Montreal v. Carnival National leasing Ltd. (2011),

CarswellOnt 896 (Ont. S.C.J.) at para. 13.5 Royal Bank of Canada v. W. Got & Associates Electric Ltd.,

[1999] 3 S.C.R. 408 (S.C.C.); Mister Broadloom Corp. (1968) Ltd. v. Bank of Montreal, 44 O.R. (2d) 368 (Ont. C.A.) (notice of 40 to 50 minutes was not reasonable in this case).

6 Pax Management Ltd. v. Canadian Imperial Bank of Commerce, [1992] 2 S.C.R. 998 (S.C.C.).

7 CIP Inc. v. Toronto Dominion Bank (1988), 55 D.L.R. (4th) 308 (B.C.C.A.), see also Inter-City Express Ltd. V. Toronto-Dominion Bank (1976), 66 D.L.R. (3d) 754 (B.C.S.C.).

8 Canadian Engineering and Surveys (Yukon) Ltd. V. Banque Nationale de Paris (Canada) (1999), 242 A.R. 61 (Q.B.).

Even where a debt is specified to be payable on demand, the law requires lenders to give a debtor notice of the default and a reasonable time to repay.

6 BANKING

IntroductionIt is a well-established principle of corporate law that corporations have a distinct legal personality and, accordingly, it is the corporation itself that is liable for the corporation’s liabilities, and not the shareholders, directors or officers of such corporation. On the basis of this principle, corporations or other limited-liability entities are often formed to enter into entity-specific contracts. These are contracts where the parent or affiliates of the entity are not named as parties and for which they have not otherwise agreed to become liable pursuant to a guarantee.1 The purpose for these entity-specific contracts is to shield the parent or affiliate corporation and its owners or principals from any potential liabilities incurred in connection with that entity-specific contract. However, as will be discussed below, this protection is not always absolute.

Exceptions to Limited Liability

(A) PIERCING THE CORPORATE VEIL

To enforce the corporate veil absolutely would allow directors to make decisions without fear of liability, increasing the propensity for risky, careless or sometimes even fraudulent decisions. As a result, courts have, in certain cases, pierced the corporate veil and held directors personally liable for their actions. This is most often done in cases involving fraud, deceit or dishonesty on the part of the directors. Absent these factors, directors are rarely liable for their conduct unless such conduct is outside the scope of their duties.2

“No Recourse Against Others”

Are You Protected?By Byron Chan

7

The corporate veil can also be pierced upon a director’s breach of fiduciary duty. At all times, the directors owe a fiduciary duty to the corporation, which includes all stakeholders. While directors do not owe a direct fiduciary duty to creditors or other third parties, directors must still consider the interests of such affected parties as a group of corporate stakeholders. Failure to do so could result in a breach of the director’s fiduciary duty to the corporation and, in some cases, lead to the directors incurring personal liability.3 Similarly, the courts have also held that where damage has been caused to third parties as a result of the actions of a corporation, directors can be held liable, notwithstanding that the directors were acting in the best interests of the corporation.4

(B) TORTIOUS CLAIMSLiability can be imposed on nonparties to a contract for their participation in a tortious activity (a civil wrong) related to entering into or performing that contract.5 Non-party parent or affiliate entities of a corporation which is party to a contract can sometimes be exposed to liability as a result of actions allegedly taken in connection with the negotiation, execution or performance of that contract.6 For example, if a party was to enter into a contract by relying, in part, on a negligent misrepresentation made by the contracting corporation (i.e. materially false or misleading financial statements), the affected party can, in some cases, bring forth a claim against the non-party parent or affiliate entities. This can be so notwithstanding that such non-party entities did not directly make the representations themselves.7 Similarly, where an entity affiliated with the corporation exercises control over the operations or decision-making of the corporation, or on the theory that the affiliated entity conducts business through the corporation, which exists solely to serve the affiliated entity, the affected party can claim against the affiliated entity directly.8

(C) BANKRUPTCY OFFENCESThe Bankruptcy and Insolvency Act (the “BIA”) codifies a number of offences for which directors are personally liable. These offences relate to directors’ conduct prior to the “date of the initial bankruptcy event” and have been enacted on the rationale that directors are well aware of the corporation’s financial circumstances while creditors are not. Section 198 of the BIA lists a number of offences for which directors may be held personally liable. These include, among others, making fraudulent dispositions of the bankrupt’s property, making false entries or knowingly making material omissions in a statement or accounting, obtaining credit or property by false representations or pledging or disposing of any property that the bankrupt has obtained on credit for which it has not paid.

No Recourse ClausesWhere the law would otherwise impose personal liability on parent or affiliate entities of a corporation, or on its directors, officers or shareholders, “no recourse against others” clauses contractually create limited liability to insulate such persons from personal liability. A typical “no recourse” clause contains the following language:

No recourse under or upon any obligation or covenant of this Agreement, or any claim otherwise based in respect of this Agreement, shall be had against any incorporator, shareholder,

officer, or director of the Corporation or any successor corporation, either directly or through the Corporation, by the enforcement of any assessment or by any legal or equitable proceeding by virtue of any statute or otherwise.9

A “no recourse” clause is different than an “exculpatory” clause because it exonerates nonparties from responsibility for the contracting parties’ obligations and liabilities, rather than attempting to address the contracting parties’ potential exposure in any way. In fact, a “no recourse” clause is more akin to a “remedies limitation” provision in that it limits the remedies that are available to the contract counterparty by excluding access to nonparty affiliates of the other contracting party for any damages.10

Historically, the standard “no recourse” clause was found only in bond indentures and solely relieved nonparties of obligations arising from the contract itself, not extra-contractual tort-based or equitable claims (i.e. veil piercing) that imposed contractual liabilities on the nonparty.11 However, modern cases of “no recourse” clauses do not necessarily involve bond indentures and are more inclined to view each “no recourse” clause on its own terms.12 In some cases, courts have expanded upon the scope of “no recourse” provisions by allowing them to reach beyond contract claims. So long as a “no recourse” provision does not contravene public policy, some courts have identified such clauses to be the result of a private, voluntary transaction whereby two parties to a contract have agreed to look to the contracting corporate entity to shoulder a risk that might otherwise have fallen on its directors, officers or shareholders.13

If it is truly the intention of two or more sophisticated contracting parties that a particular contract is to be an obligation of only the contracting entities, and that the affiliates, shareholders, directors and officers of such contracting entities are to be shielded from any and all liability, then such provisions should not be controversial. Interestingly, however, “no recourse” provisions have yet to become commonplace in most corporate agreements, including bank loan agreements.14

Footnotes

1 Glenn D. West & Natalie A. Smeltzer, “Protecting the Integrity of the Entity-Specific Contract: The “No Recourse Against Others” Clause – Missing or Ineffective Boilerplate?”(2011) 67 Bus Law 39 at 40.

2 ScotiaMcLeod Inc. v. Peoples Jewellers Ltd. (1995), 26 O.R. (ed) 481 (C.A.)3 People’s Department Stores Inc. (Trustees of) v. Wise, [2004] 3 S.C.R. 4614 Systems International Ltd. v. Valcom Ltd. (1999), 43 O.R. (3d) 101 (C.A.)5 Supra note 1 at 50.6 Supra note 1 at 52.7 DDJ Management, LLC v. Rhone Group L.L.C., 931 N.E. 2d 87 (N.Y. 201) (No. 601.8321-

2007).8 Emposimato v. CIFC Acquisition Corp., No. 601728/2008, 2011 WL 833801, at 10 (N.Y.

Sup. Ct. Mar 7, 2011)9 Supra note 1 at 46.10 Supra note 1 at 64.11 Supra note 1 at 58.12 Supra note 1 at 62.13 Farnham v. Superior Court, 70 Cal. Rep. 2d 85, 91 (Ct. App. 1997)14 Supra note 1 at 68.

8 BANKING

Demystifying US Guarantees:

A Brief Overviewby Nathaniel S. Misri

9

IntroductionRecent case-law out of the United States has emphasized important differences between Canadian and US guarantee practice. Knowing and appreciating the legal significance of these differences can be critical to a lender extending credit to Canadian parent corporations and seeking guarantees from US subsidiaries.

The Canadian LandscapePrior to repeal of the financial assistance provisions, the Alberta Business Corporations Act (the “Act”) prohibited the giving of guarantees by corporations to affiliates, absent satisfaction of a two-part solvency test: current liquidity and realizable value. In addition, upstream guarantees were further limited to corporations that owned 100% of the stock of the direct or indirect subsidiary. The rules of engagement have since changed: the Act now permits a corporation to provide financial assistance to any person, let alone an affiliate, so long as such assistance provided to an affiliate corporation is disclosed to shareholders.

A guarantee must satisfy a contract requirement: there must be consideration flowing between the lender and the guarantor. Canadian courts have held that a lender’s consideration need not benefit the guarantor directly. As the purpose of the guarantee is to ensure the provision of credit to the parent, it is sufficient that the consideration flows from the lender to parent, as is frequently the case.1

American Differences and the Tousa DecisionThe practice in the US surrounding the use of corporate guarantees is impacted by American bankruptcy and state laws. A guarantee may be invalidated if the two elements of a fraudulent conveyance are met: if the guarantor is insolvent at the time of giving the guarantee and if the guarantor does not receive reasonably equivalent value in return for the guarantee. Even with a valid business purpose and the absence of intent to defraud creditors, a guarantee may, in some circumstances still be invalidated.2 As we will see, however, this may be more apparent than

real: courts in the US have typically relaxed the equivalent value test insofar as indirect and intangible benefits may be recognized. It may be sufficient that an indirect benefit accrues to the subsidiary by virtue of being part of a financially strong group of companies.3 Moreover, it is worth noting that the fraudulent conveyance test is conjunctive; satisfaction of any one element of the test is not sufficient to strike the guarantee.

The effect of fraudulent conveyance law, however, was further muddied in 2009 when the United States Bankruptcy Court for the Southern District of Florida (“the Bankruptcy Court”) required a group of lenders to disgorge over $400 million in proceeds of a loan. In Re TOUSA, Inc. (“Tousa”), the parent company borrowed and caused its subsidiaries to provide multiple guarantees on $500 million of secured debt. The Bankruptcy Court found that the subsidiaries were insolvent before and after the guarantees were given and that no reasonably equivalent value was given in return. Though these findings were overturned on appeal, elements of the Bankruptcy Court decision remain in flux — in particular, the comments made by the Bankruptcy Court regarding the validity of the “savings clause” were not addressed in the appellate decision. Savings clauses are included in guarantees to protect guarantors and lenders from the vagaries of bankruptcy law. These clauses restrict the contractual obligation of the guarantor to the extent that satisfying the obligation would render the guarantor insolvent.4 The Bankruptcy Court held that these savings clauses were unenforceable as a matter of contract law, holding in part that savings clauses purport to contract around the core provisions of the Bankruptcy Code.

While the overall effect of Tousa may be limited to situations involving distressed companies, there is at least a concern that savings clauses as a safety net for fraudulent transfer risk, in the circumstances of a guarantee, may not be upheld. Moreover, the analysis that upstream guarantees provided by a subsidiary to its parent did not satisfy the reasonably equivalent value test, have left commentators unsurprised. After all, upstream guarantees do not give direct consideration to

the subsidiary providing the guarantee. The legal development continues. However, as scholars have opined, further appellate intervention would provide the panel of presiding judges with “an unwelcome feast” of issues.

Implications for Lenders In Canada, there is very little magic when it comes to upstream guarantees provided by Canadian subsidiary corporations: notify your shareholders, and ensure there is a benefit flowing in both directions between lender and guarantor. However, to date, Canadian jurisdictions have not held that the consideration flowing from lender to subsidiary need be entirely transparent.

In contrast, American bankruptcy law requires consideration of “reasonably equivalent value” given by the lender in exchange for the guarantee. Typically lawyers used savings clauses as an attempt to satisfy this requirement. Tousa, however, presents a minimal risk to lenders taking upstream guarantees from subsidiaries because the Bankruptcy Court called into question the validity of the savings clause. In light of these comments, commentators have suggested the following:

• solvency opinions should be prepared by independent consultants as opposed to management projections;

• lenders should be certain to thoroughly review the guarantor’s financial condition — in particular, whether the guarantee would render the subsidiary insolvent in upstream guarantees; and

• while the use of this clause may have to be revisited, its continued use is recommended.

Footnotes

1 McGuiness, The Law of Guarantee (1996) at pp. 221-222.2 In re TOUSA, Inc. – A Cautionary Tale for Canadian

Lenders, Hodgson Russ LLP (March 2010).3 Philip R. Wood, Comparative Law of Security and

Guarantees (1995) at p.315-316.4 The Terrible Tousas: Opinions Test the Patience of

Corporate Lending Practices, Jessica D. Gabel, 27 Eomry Bankr. Dev. J. 415 (2010-2011).

Recent case-law out of the United States has emphasized important differences between Canadian and US guarantee practice.

COMMON SENSE, UNCOMMON INNOVATION.BD&P is a leading Canadian law firm of over 140 lawyers skilled in virtually every aspect of business law and litigation.

2400, 525-8th Avenue SW, Calgary, Alberta T2P 1G1Phone: 403-260-0100 Fax: 403-260-0332

www.bdplaw.com