In the ever-changing landscape of Canadian insolvency law, substantive consolidation emerges as a powerful yet rare remedy with substantial implications for debtor entities and their creditors, as highlighted by a recent decision from the Manitoba Court of Appeal, which sheds light on a complex yet crucial aspect of insolvency law.
SUBSTANTIVE CONSOLIDATION
Substantive consolidation is an exceptional remedy that is infrequently granted in insolvency cases. It entails consolidating the assets of multiple related entities so that their assets are jointly available for the creditors of each of the consolidated entities. Substantive consolidation is not to be confused with its more frequently utilized and more benign cousin, procedural consolidation. As the name suggests, procedural consolidation involves consolidating multiple insolvency proceedings into a single proceeding, for procedural purposes only.
Unlike procedural consolidation, which is implemented for administrative ease, substantive consolidation can have far-reaching consequences for debtor entities and their creditors. As a substantive consolidation order means that an entity is liable to the creditors of another related entity, such an order could have the effect of depleting the asset value of the entity in the stronger financial position. That is, substantive consolidation typically benefits one debtor’s creditors at the expense of the creditors of a related party. When such a potent remedy is granted over the objection of an interested party, it is understandably the subject of much attention. When the remedy is considered and opined on by an appellate level court, the attention paid is all the more acute.
NYGÅRD
In its September 2023 decision in the receivership proceedings of Nygård Properties Ltd. (NPL) and Nygård Enterprises Ltd. (NEL, and together with NPL, the “Appellants”), the Manitoba Court of Appeal (MCA) upheld the substantive consolidation order of the lower court, which had the effect of consolidating the assets and liabilities of the Appellants and the other debtor entities within the Nygård group of companies.
The MCA’s decision provides further confirmation that the test for substantive consolidation articulated in Redstone Investment Corp. (Re) (Redstone) by now Chief Justice Morawetz of the Ontario Superior Court of Justice is the preeminent analysis for determining when substantive consolidation is appropriate. As a result, there is now greater certainty as to how courts should evaluate requests for substantive consolidation.
Additionally, the MCA indicated that in certain instances, solvent entities may be consolidated with insolvent entities. This finding potentially suggests a more expansive scope for obtaining substantive consolidation orders going forward. U.S. case law, where this subject is more well-developed, indicates that an order substantively consolidating solvent and insolvent entities should be allowed when the equities favour such an order.
The decision of the MCA also holds that whether an objecting prejudiced creditor is related to the insolvent party may impact the determination as to whether a substantive consolidation order should be granted.
BACKGROUND
The Appellants were two of several entities in the Nygård Group, which made up a retail clothing business under the ownership and control of Peter Nygård. The Appellants claimed to be solvent entities, whereas the remaining entities in the Nygård Group were indisputably insolvent. The Nygård Group had a secured credit facility pursuant to a credit agreement, but the Appellants were only guarantors of this facility and not direct borrowers.
In March 2020, two secured lenders of the Applicants (Secured Lenders) brought an application before the Manitoba Court of Queen’s Bench, as it then was, to appoint a receiver over the assets of the Nygård Group, including the Appellants. The application was granted by Justice Edmond (Motion Judge) and a receiver was appointed (Receiver). At the time, the receivership proceedings of the Nygård Group were consolidated for procedural purposes only.
Following the Receiver’s appointment, orders were made for the liquidation sale of retail inventory and for the sale of certain Canadian real property of the Nygård Group. Following the granting of these orders, it was determined that NPL was one of the three entities in the Nygård Group with substantial assets. The assets of those three entities were sold and, after payments and distributions to the Secured Lenders, roughly C$9.9-million remained to be distributed as net liquidation proceeds. NPL asserted that it held a subrogated secured claim to the credit facility’s direct borrowers because funds from the sale of NPL’s assets had gone to satisfy the claims of the Secured Lenders against those direct borrowers.
The Receiver then brought a motion for substantive consolidation of the entities in the Nygård Group on the basis that it would provide greater advantages and fairness for creditors of all Nygård Group entities, such as employees, landlords and suppliers. The Receiver argued that substantive consolidation would increase the funds available to satisfy the claims of unsecured creditors of Nygård Group entities.
The Appellants claimed that they were solvent entities, that neither the other Nygård Group entities nor their creditors had any valid claim to their assets and, therefore, that their assets should be distributed on a separate corporation basis. The Appellants submitted that an order for substantive consolidation would seriously prejudice them by stripping away value from the Appellants for the benefit of other creditor constituencies. It would also prejudice them by eliminating NPL’s potential secured claim against the Nygård Group direct borrowers and by rendering the Appellants bankrupt.
LOWER COURT DECISION
The Motion Judge determined that the entities of the Nygård Group, including the Appellants, should be substantively consolidated.
In reaching his decision, the Motion Judge applied the test for substantive consolidation first articulated in Redstone. In Redstone, Chief Justice Morawetz established a three-part test for applying substantive consolidation, which asked:
- Are the elements of consolidation present, such as the intertwining of corporate functions and other commonalities across the group?
- Do the benefits of consolidation outweigh the prejudice to particular creditors?
- Is consolidation fair and reasonable in the circumstances?
Within the first part of the test, the following seven (non-determinative) elements of consolidation should be considered when deciding whether to proceed to the second part:
- difficulty in segregating assets;
- presence of consolidated financial statements;
- profitability of consolidation at a single location;
- commingling of assets and business functions;
- unity of interests in ownership;
- existence of intercorporate loan guarantees; and
- transfer of assets without observance of corporate formalities.
The Motion Judge ruled that, based on the Receiver’s reports, the Appellants were both insolvent on a consolidated basis and there was no expert evidence filed showing that they were solvent.
The Motion Judge then determined that all three parts of the Redstone test were met and ordered that the Appellants were to be substantively consolidated with the rest of the entities of the Nygård Group.
MCA DECISION
Following the decision of the Motion Judge, the Appellants, both non-arm’s length creditors of the Nygård Group, appealed the decision to the MCA.
In its reasons on substantive consolidation, the MCA confirmed that the Redstone test, including the seven elements of consolidation, is the proper test for substantive consolidation. The MCA went on to comment that the Motion Judge had properly considered and applied the test. The MCA also reiterated that a finding of substantive consolidation is a discretionary decision and is owed a substantial amount of deference on appeal.
Additionally, the MCA gave deference to, and refused to overturn, the Motion Judge’s finding that the Appellants were insolvent. Importantly, the MCA noted that even if it was the case that the Appellants were solvent, there is nothing preventing an insolvent corporation from being substantively consolidated with a solvent corporation as long as the circumstances are appropriate. The MCA stated that there was ample support in the corresponding United States context for allowing solvent and insolvent corporations to be consolidated and that not allowing such a result would undermine the remedial goals of the Bankruptcy and Insolvency Act.
TAKEAWAYS
Redstone Test
The MCA’s decision reaffirms that the Redstone test is the proper test for substantive consolidation to be applied in Canada. Redstone has also been followed by the Ontario Superior Court of Justice in Stevens v. Hutchens. It remains to be seen, however, whether courts in provinces outside of Ontario and Manitoba will also adopt the Redstone test. The fact that a non-Ontario court of appeal has adopted the Redstone test may create momentum for courts in additional provinces to take it up as well.
Third Party Creditors
In Redstone, Chief Justice Morawetz denied substantive consolidation partially because of the prejudice it would cause to arm’s length creditors of the entity with substantial asset value. In this case, the only purported creditors that were objecting were the Appellants, who were not arm’s length creditors but instead members of the Nygård Group. As a result, the decision of the MCA appears to have less applicability where arm’s length creditors would be prejudiced and are objecting to the relief sought.
Solvent Entities
The MCA’s decision states, in obiter, that solvent and insolvent corporations may be substantively consolidated in appropriate circumstances. The MCA cited with approval a British Columbia Court of Appeal case (Kriegman v. Dill), which ordered enforcement of a U.S. judgment substantively consolidating several American and Canadian corporations. The MCA also reproduced a passage from Kriegman in which the British Columbia Court of Appeal commented on the seemingly widespread availability of substantive consolidation for solvent and insolvent entities in U.S. bankruptcy courts.
U.S. case law does indeed suggest that a bankruptcy court can substantively consolidate debtors and non-debtors. For example, AAA Bronze Statues & Antiques, Inc. finds that such relief should be granted in situations where there is “substantial identity” between the entities sought to be consolidated and when the consolidation is necessary to avoid some harm. In that regard, the MCA observed that if solvent and insolvent entities were proscribed from being substantively consolidated, a corporate group could “lodge” its debts in one company (the insolvent one) and its assets in another (the solvent one) and place itself, through this mischief, outside the purview of this equitable remedy.
This approach, however, is not without controversy. Some U.S. commentators have been critical of the practice. As axiomatic as the proposition may be, these critics submit that insolvency law is intended to deal with insolvent entities and not those that are financially sound. Indeed, there are compelling reasons, grounded in public policy and legal principle, why entities must be insolvent to seek relief under Canada’s principal insolvency statutes. Critics posit that substantively consolidating non-insolvent entities with solvent ones may deviate from such well-grounded policy and principle.
In the final analysis, courts will have to carefully consider the facts and circumstances of each case and ensure that when consolidating solvent entities with insolvent ones, all relevant factors and aspects of the case have been carefully considered.
CONCLUSION
Contested substantive consolidation orders are rare. Despite Nygård, we expect them to remain so, given the extraordinary nature of the remedy. However, Nygård suggests that the context for such orders has expanded, if only incrementally so.
The authors would like to acknowledge the support and assistance of Andrew Kupfer, Articling Student.
