publication 

the doctrine of marshalling does not apply in the Province of Quebec, but then again… 

March 2012

corporate restructuring bulletin

introduction

On February 2, 2012, the Quebec Court of Appeal rendered its judgment in the case Maisons Marcoux Inc. (Syndic de).1

This decision was eagerly anticipated by many given that the highest court of the Province of Quebec finally had the opportunity to review the application of the concept of marshalling in civil law, an equity concept developed in common law which allows the court to "marshal" or arrange the funds of a debtor derived from numerous classes of collateral, each with its own set and order of creditors, so that creditors are paid to the greatest possible extent. The last judgment of the Court of Appeal to address this issue dates back more than 30 years to the 1979 Central Factors2 case. The Court had then stated in the following unequivocal terms that this doctrine was not applicable in civil law:

The trial judge wanted to introduce the "doctrine of marshalling" into civil law, which can readily be dispensed with. Comparative law is certainly of great interest to many lawyers. Nevertheless, it is irritating to have to repeat that our civil law system is autonomous.

(unofficial translation by the author of this bulletin)

The Court was also asked to interpret an equity concept under the Civil Code of Quebec (the CCQ) which is unknown to many as its application is rare and case law relating to it almost nonexistent.

the facts

Maisons Marcoux Inc. (the Debtor) was a company specialized in the manufacture, sale and installation of prefabricated homes. It was financed by the Caisse Desjardins du Centre de la Nouvelle-Beauce (the Lender), which held conventional security over all of the Debtor's property, including several buildings forming part of a project called the Boisbriand Project.

Beset by serious financial difficulties, the Debtor obtained an initial order under the Companies' Creditors Arrangement Act3 (the CCAA). During the restructuring, the court authorized interim financing of approximately $2.1 million from the Lender in order to maintain business operations and to complete ongoing projects, including the Boisbriand Project. The interim financing was secured by a super priority charge covering all assets of the Debtor and providing a priority to the interim financing over any and all conventional security.

Despite its efforts, the Debtor was unable to effect a viable restructuring and made a voluntary assignment in bankruptcy.

Upon bankruptcy, the Debtor owed $5.5 million to the Lender, of which $2.2 million was owed pursuant to the interim financing and $3.3 million pursuant to various operating loans secured by conventional security. Creditors who participated in the realization of the Boisbriand Project and who benefited from legal hypothecs of construction against the Boisbriand Project assets (the Builders) had a claim of $1 million against the Debtor.

The realization of all the assets of the Debtor by the trustee generated $5.8 million, of which $1.2 million came from the realization of the Boisbriand Project assets. It was then established by the trustee that the interim financing of the Lender would be repaid in full.

Following the sale of the assets of the Boisbriand Project, the trustee prepared the following scheme of collocation as it relates to such assets:

 sale proceeds:
$1,200,000
 judicial costs:
($190,000)
 D&O charge:
($110,000)
 interim financing (Lender):
($900,000)
 Builders: ($0)

The Builders contested the collocation before the Superior Court and requested that their claims be paid in priority to the interim financing.

the superior court decision

The trial judge confirmed at the outset the priority of the super priority charge ordered pursuant to the CCAA over the legal hypothecs of construction. However, the Court was of the view that the presence of a come-back clause in the Initial Order gave the court the authority to consider the request of the Builders. The Court ultimately granted the relief sought by the Builders for the following reasons:

[56] By assigning the proceeds from the sale of the land in Boisbriand to repayment of the DIP [interim financing], the Trustee prejudices the Builders, since they then lose all their rights, even if they likely have contributed to the increase in value of the buildings by their work.

[57] In reality, the situation as it stands if the Court rejects the application, is such that the Lender would be paid not only its interim financing secured by a super priority charge, but a more substantial amount of its loans secured by the conventional security. This is the basis of the Lender's contestation. The Builders would be the big losers in this case.

[...]

[66] The Court considers it appropriate not to change the Initial Order, because there was an assignment in bankruptcy, but rather to grant relief to the Builders by allowing them to receive their share of the realization of assets from the Boisbriand Project.

[67] In granting the relief sought, the Court does not reverse the order of priority provided in the Initial Order or modify the Order. Rather, it orders that the super priority charge be repaid from the proceeds of realization of the other assets.

(unofficial translation by the author of this bulletin)

On the issue of the applicability of the doctrine of marshalling in the Province of Quebec, the Court was of the view that it was not necessary to adjudicate this issue since it had already decided that the Court had the power to grant the relief sought by the Builders.

The Lender appealed the decision.

the court of appeal decision

For the Court of Appeal, any proceeds of realization of the assets of the Debtor must first be used to repay the interim financing, since the charge securing this financing covers all the assets of the Debtor in priority.

While acknowledging that it seems unfair that the Builders receive nothing from the realization of the assets of the Boisbriand Project which they helped build, the Court believed that denying all participation in the proceeds of realization of this project to the super priority charge as proposed by the trial judge seemed to err in the opposite direction. Especially when the evidence showed that the Debtor had used more than $1 million from the interim financing to continue the Boisbriand Project.

The Court then considered whether the equity concept provided at Article 2574 CCQ could resolve the issue. This Article states:

2754 . Where later ranking creditors are secured by a hypothec on only one of the properties charged in favour of one and the same creditor, his hypothec is spread among them, where two or more of the properties are sold under judicial authority and the proceeds still to be distributed are sufficient to pay his claim, proportionately over what remains to be distributed of their respective prices.

The Lender argued that this Article did not apply to this case.

First, the Lender argued that the sale proceeds to be distributed in this case, i.e. $5.1 million, were insufficient to pay its debt of $5.5 million in full (i.e., $2.2 million pursuant to the interim financing and $3.3 million pursuant to operating loans), which is an essential condition for the application of Article 2754 CCQ.

The Court of Appeal was of the view that the Lender is confusing its claims into one. The Initial Order granted a super priority to the charge securing the interim financing but not to the existing conventional security of the Lender. Thus, only the super priority for the interim financing benefits from a prior rank over the legal hypothecs of construction. Therefore, when applying Article 2754 CCQ, the Court only needs to take into account the super priority charge. Since the proceeds of the realization of the assets of the Debtor were sufficient to pay the interim financing in full, the first argument of the Lender was dismissed by the Court of Appeal.

Second, the Lender argued that in order for this Article to apply, the assets of the Debtor had to be sold simultaneously, which was not the case in this instance.

For the Court, this condition is not required under Article 2754 CCQ, recognizing however that the phrase "where two or more of the properties are sold" implies a certain concurrence in the sale of the assets. While the Court acknowledged that it was possible that the sale of the Boisbriand assets and that of the other assets of the Debtor had not been made simultaneously, the Court considered that the two sales processes resulted from the liquidation of the assets of the Debtor following its bankruptcy and that both had been undertaken and pursued in parallel by the trustee. Consequently, there was sufficient proximity between the sales within the meaning of Article 2754 CCQ. The second argument of the Lender was also dismissed.

Finally, the Lender pleaded that while the sale of the Boisbriand assets had been made under judicial authority, the sale of the other assets of the Debtor had not, since it had been made by the trustee as court-appointed receiver for the Lender, and therefore Article 2754 CCQ could not be invoked.

For the Court of Appeal, a sale by a receiver appointed under the Bankruptcy and Insolvency Act (the BIA) is a far cry from a private sale in that the receiver, despite being appointed by the Lender, is acting as an officer of the court and has obligations and responsibilities determined by statute. Thus, such a sale could only have taken place "under judicial authority" within the meaning of Article 2754 CCQ. The last argument of the Lender was therefore also dismissed.

Having decided that Article 2754 CCQ applied to this case, the Court concluded by allocating as follows the proceeds of sale of the Boisbriand assets:

[36] [...] The liquidation of all assets of the Debtor generated $5.8 million, of which $1.2 million came from the Boisbriand assets and $4.6 million from the other assets, representing 21% and 79% respectively. Repayment of the interim financing, in the amount of $2.2 million, must be divided in the same fashion, 21%, or $462,000 against the $1.2 million from Boisbriand and 79% or $1,738,000 against the $4.6 million from the proceeds of the other assets.

[37] The amounts to be distributed, after deducting the costs of the sale, are $900,000 from the Boisbriand Project and $4.2 million from the other assets, for a total of $5.1 million.

[38] The table below shows the proceeds to be received by the Lender and the Builders according to three hypotheses. The trustee prepared the collocation according to the first. The second corresponds to the scheme endorsed by the first instance judgment. The third is in accordance with Article 2754:

coming from the Boisbriand Project

coming for all of the assets

to the Lender for the super priority charge

to the Builders

to the Lender in total

according to the scheme of collocation

$900,000

0

$5,1 M

according to the judgment

0

$900,000

$4,2 M

according to article 2754

$462,000

$438,000

$4,662,000

(unofficial translation by the author of this bulletin)

Finally, the Court of Appeal noted that at first glance, the position of the Lender that the doctrine of marshalling does not apply in civil law appeared to be well founded.

the case comment

To our knowledge, this decision is one of the only reported cases where Article 2754 CCQ is analyzed and applied by a court. Thus, we must welcome the fact that the Court of Appeal sheds interesting light on what may constitute a "sale under judicial authority" under this Article as well as on the issue of the timing of the sales. However, it seems to us that there is still much room for interpretation with respect to each criterion of this Article and therefore, creative barristers will quickly try to broaden or restrict the interpretation.

Furthermore, we believe it will often be possible to the prior ranking creditor to avoid the protection afforded to junior creditors by Article 2754 CCQ by selling only the property affected by the subordinated security and ensuring that the proceeds of realization are distributed before initiating any other sale. Indeed, the Civil Code contains no mechanism which would allow a junior creditor to force the sale of a property on which it has no security, the whole in order to force the application of Article 2754 CCQ.

Conflicts between the secured creditors of a debtor are not new in Quebec. However, the absence of case law interpreting or applying Article 2754 CCQ, or its predecessor Article 2049 of the Civil Code of the Lower Canada, reflects the fact that situations where all the criteria of this Article are met remain extremely rare. Do Quebec courts have other ways to resolve these conflicts? Some, like the Builders in the case, are of the opinion that the courts should apply the doctrine of marshalling.

Marshalling, a common law concept, can be defined as follows4:

[17] Marshalling is an equitable remedy that may arise when you have two creditors of the same debtor, with one creditor, sometimes referred to as the senior creditor, having the right to resort to two funds of the debtor for payment of the debt, and the other creditor, the junior creditor, has the right to resort to one fund only. The court can "marshal" or arrange the funds so that both creditors are paid to the greatest possible extent.

[18] Equity will be invoked to protect the junior creditor, make the senior creditor realize on assets in such a way that the senior creditor will not wipe out assets that would only be available to the junior creditor. The junior creditor will be subrogated and will have a charge on the second or subsequent funds.

This doctrine has clear advantages over the mechanism of Article 2754 CCQ. First, it does not require that the assets of the debtor be sold "under judicial authority". Furthermore, it can be invoked even if only one asset of the Debtor is sold, thus removing the debate relating to the timing of the sales. Moreover, unlike the mechanism of Article 2754 CCQ which establishes a process of distribution among creditors based on the proceeds of sale of the debtor's property, the doctrine of marshalling rather puts in place a process seeking to maximize the realization for the creditors in order to arrive at the most equitable result possible. Thus, as part of its analysis, the court may consider various other factors which are not contemplated by Article 2754 CCQ, such as the number of lower-ranking creditors and the value of their claims.

Nevertheless, the Court of Appeal was of the view that "at first glance, the position of the Lender that this doctrine is not applicable in Quebec law is well founded"5 and cited the extract of the Central Factors6 case reproduced in the introductory paragraph of this bulletin.

Does this mean that the doctrine of marshalling cannot be invoked in Quebec? We think not. Rather, we believe that since the Court of Appeal was of the view that Article 2754 CCQ applied to this particular case, it did not consider necessary to explore this issue further for now. Why else go through the trouble of stating the words "at first glance" in the judgment?

conclusion

Given all the problems surrounding the application of Article 2754 CCQ, we believe that it is only a matter of time before the Quebec courts are called upon again to import the doctrine of marshalling in civil law.

The fact remains, however, that it will always be possible for a junior-ranking creditor to pay off the prior ranking creditor and then realize the assets in a manner that will not impair his rights, provided however that he has the financial ability to do so.

by Marc-André Morin

1 EYB 2012-201577 (C.A.).

2 Central Factors Corp. Ltd. c. Imasa Ltd ., EYB 1979-137132 (C.A.).

3 L.R.C. (1985), ch. C-36.

4 Blockhold v. Lawson Lundell , 1999 BC S.C. 6215 (CanLII).

5 Para. 63 of the case (unofficial translation by the author of this bulletin).

6 Loc. cit., note 2.

For more information on this topic, please contact:

Montreal

Marc-André Morin

514.987.5082

marc-andre.morin@mcmillan.ca

a cautionary note

The foregoing provides only an overview and does not constitute legal advice. Readers are cautioned against making any decisions based on this material alone. Rather, specific legal advice should be obtained.

© McMillan LLP 2012