Canada

Author: | Published: 9 Oct 2003
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In the midst of two years' of ongoing governance reform, several important judicial and regulatory decisions relating to directors' responsibilities and liabilities have been released in Canada.

BUSINESS JUDGMENT IN APPROVING COMPENSATION ARRANGEMENTS - REPAP DECISION

In Canada, certain stakeholders of the corporation can take action against the directors (and against officers and the corporation itself) under the oppression remedy. Under this provision, if a court finds that the powers of the directors of a corporation, or any of its affiliates, are or have been exercised in a manner that is "oppressive or unfairly prejudicial to, or that unfairly disregards the interests of, any security holder, creditor, director or officer", the court may make any order it thinks fit to rectify the matters at issue. The scope of this remedy is very broad and allows creative courts to grant a wide range of relief where they feel that it is just to do so. In UPM-Kymmene Corp v UPM-Kymmene Miramichi Inc (the Repap decision), the court used its authority under the oppression remedy to set aside a compensation arrangement with Steven Berg, the former chair of the corporation. It refused to defer to the business judgment of Repap directors in approving these arrangements because, in its view, the directors had not exercised any business judgment.

Repap had been struggling for some time. In 1997, over-leverage and depressed paper prices forced it to dispose of most of its assets (leaving it with only a coated-paper plant in New Brunswick) and to convert a significant amount of its debt into equity. Paloma Partners became its largest shareholder as a result of this debt conversion. In 1998, Repap completed a debt restructuring, which left it cash poor. It closed its head office in Montreal, reduced head office staff from 80 to five - four of whom moved to Stamford, Connecticut, where the sales staff was located.

In late 1998, Berg developed an interest in Repap. By January 1999 he had arranged for Third Avenue Funds to acquire the Paloma Partners interest in Repap, invested some of his own funds and become a director and chair of Repap. In March 1999, Repap entered into an employment arrangement with Berg under which he became chairman and senior executive officer of Repap. Those arrangements included a five-year employment term with renewals, a signing bonus of 25 million shares, a stock option grant of 75 million shares, a market capitalization bonus, immediate pension credit of eight years, executive employee benefits and generous change of control and termination provisions. It is clear from the facts laid out in this decision that Berg used his position on the board to drive this arrangement through. The decision notes that Repap had no apparent need for Berg's services in an executive capacity.

The board turned down the proposed arrangements with Berg when they were presented to them in February 1999 and one director resigned to signal his objections. A short time later, one of the Third Avenue nominees, who had been chair of the compensation committee, also resigned. Berg recruited two new directors, one of whom became chair of the compensation committee. In March, the board approved the compensation arrangements. Two of the three members of the compensation committee met for less than 10 minutes prior to that meeting. The board itself devoted only about 30 minutes to the matter. It received a report from outside counsel (whose independence from Berg was highly questionable) that included a report from a compensation expert. The court noted that, although the compensation expert was highly qualified, she was not given all of the relevant facts or the time necessary to do the appropriate analysis. As a result, her opinion was highly qualified. None of the members of the board asked any questions about her expert report.

The court set the contract aside and in the course of its decision found that the board had not discharged its duty of care in approving the arrangements with Berg. It noted as follows:

"The business judgment rule protects boards and directors from those that might second-guess their decisions. The court looks to see that the directors made a reasonable decision, not a perfect decision. This approach recognizes the autonomy and integrity of a corporation and the expertise of its directors. They are in the advantageous position of investigating and considering first-hand the circumstances that come before it and are in a far better position than a court to understand the affairs of the corporation and to guide its operation."

ONTARIO SECURITIES COMMISSION DECISION IN YBM MAGNEX INTERNATIONAL

The decision of the Ontario Securities Commission (OSC) in YBM Magnex International was released in June 2003. It dealt with the availability of a due diligence defence for directors of a company that misled investors in a public offering. Many expected a much harsher decision from the regulator of Canada's largest capital market in this very high-profile case. It signalled good news for directors who feared that the OSC might push past the tests of diligence imposed on directors by the courts in order to trumpet its vigilance on behalf of investors.

YBM was in the business of manufacturing and selling industrial magnets. It was incorporated in 1994 as Pratecs Technologies Inc, a junior capital pool company with shares listed on the Alberta Stock Exchange. It merged with a Pennsylvania company in 1995 and listed its shares on the Toronto Stock Exchange the following year.

In August 1996, the board of directors of YBM was advised by its outside counsel that the company was the target of a US federal investigation, although it was not clear why. The board formed a special committee that retained various advisers and became aware of allegations that YBM was connected to an organized crime syndicate in Russia and that its financial records and customer lists may have been falsified. In November 1997, YBM went to the capital markets and raised $53 million under a prospectus and another $48 million in a private placement. The disclosure in connection with the prospectus offering gave rise to the action by the OSC referred to above. The OSC found that YBM had not disclosed in its prospectus what the OSC referred to as the unique risks facing the corporation: The decision states that: "[a]t a minimum, we believe some disclosure regarding what YBM knew about the US investigation and less muddled disclosure regarding the purpose of the special committee would have better informed investors about the risks facing YBM". The OSC found YBM's disclosure to be materially misleading.

Six months after the public offering (in May 1998), the YBM offices in Pennsylvania were raided by a number of US authorities including the FBI, the IRS and US Immigration. A month later, forensic auditors confirmed that YBM's customer list had been fabricated. YBM went into bankruptcy in December 1998. The receiver later pleaded guilty to charges of fraud and paid a $3 million fine. Two class actions against YBM were settled and approved by the Ontario Superior Court in May 2002. The OSC took action against YBM, its directors and officers, as well as its underwriters.

Of the eight members of YBM's board of directors, five were sanctioned. Much of the OSC's decision deals with principles of disclosure required under securities legislation. However, it also deals in considerable detail with availability of a due diligence defence to the various members of YBM's board of directors and in particular the members of the special committee. This required the OSC to review in some detail the duty of care to which directors are subject. The following are some of the highlights from this aspect of the decision:

  • The standard of care for directors and officers is not a professional standard nor is it the negligence standard. Each director and officer owes a duty to take reasonable care in the performance of his or her office and in some circumstances that duty will require a director or officer to take action. That action may in some circumstances call for a resignation.
  • Directors are not obliged to give continuous attention to the company's affairs. However, their duties are awakened when they know of information and events that require further investigation. The standard of care encourages responsibility, not passivity.
  • Directors act collectively as a board in the supervision of a company. Directors, however, are not a homogenous group. Their conduct is not to be governed by a single objective standard but rather one that embraces elements of personal knowledge and background, as well as board processes. More may be expected of persons with superior qualifications such as experienced businesspersons. As such, not all directors stand in the same position.
  • More may be expected of inside directors than outside directors. A chief financial officer who is on the board may be held to a higher standard than one who is not, particularly if he or she is involved in the public offering.
  • When dealing with legal matters, more may be expected of a director who is a lawyer-director and who may be in a better position to assess the materiality of certain facts.
  • Due to improved access to information, more may sometimes be expected of directors depending on the function they are performing, for example, those who sit on board committees, such as a special committee or audit committee. An outside director who takes on committee duties may be treated like an inside director with respect to matters that are covered by the committee's work.

DIRECTORS' DUTY TO CREDITORS - PEOPLES DECISION

Whether directors owe a duty to the corporation's creditors is an issue of continued uncertainty in Canada. Courts in other jurisdictions, including the US, have found that such a duty does exist in some cases. However, there is really no basis in Canadian law for finding that such a duty exists. Until recently, two difficult lower court decisions created the impression that the law in Canada might be moving in that direction. However, earlier this year the Quebec Court of Appeal reversed one of these decisions, finding that the court had erred in finding the directors owed any duty to the corporation's creditors.

Peoples Department Stores v Wise was a decision of the Quebec Superior Court (Bankruptcy and Insolvency Division) dealing with a petition by Caron Bélanger Ernst & Young, the trustee in bankruptcy of Peoples Department Stores (Peoples), to recover certain funds and property of Peoples paid out before its bankruptcy.

Prior to the time that it was acquired by Wise Stores, Peoples was a division of Marks & Spencer Canada (M&S). That division was subsequently rolled into a newly incorporated corporation, which was then acquired by (and subsequently amalgamated with) a wholly owned subsidiary of Wise Stores. The acquisition was highly leveraged. Of the $27 million purchase price, $5 million was financed with a bank loan and paid on closing. The payment of the balance was payable over an eight-year period and was secured against Peoples' assets. M&S also obtained the benefit of a number of restrictive covenants.

After the acquisition, the operations of Wise Stores and Peoples became increasingly integrated. Ultimately, the warehouse systems of the two retailers were physically merged into one. Peoples made inventory purchases sourced within Canada and the US for both companies. Inventory shipped to Wise Stores was charged out to those stores. The obligation of Wise Stores to pay Peoples was not documented and Peoples earned no fee for providing this service to Wise Stores. Rather than paying Peoples as Peoples was required to pay its suppliers, Wise Stores established an intercompany receivable between it and Peoples. This receivable continued to grow with no payment made by Wise Stores to Peoples. This arrangement contributed significantly to Peoples being offside its financial covenants with M&S, ultimately leading M&S to appoint a receiver. The court held that this intercompany arrangement caused the demise of Peoples.

Harold Wise, Lionel Wise and Ralph Wise (collectively the Wise brothers) were officers and directors of Wise Stores. After Wise Stores acquired Peoples, they became officers and directors of Peoples. As part of its decision, the court rendered judgment against each of the Wise brothers in their capacity as directors of Peoples, on the basis of a breach of their duty of care set out in the corporate law. In setting its reasons for this aspect of the decision, the court referred to cases in a number of jurisdictions outside of Canada responding to the proposition that creditors are stakeholders in a corporation. Greenberg J set out passages from several of these cases that referred variously to situations in which the directors should consider the interests of creditors, the duty of the corporation to creditors and whether the directors have a direct duty to creditors. He stated:

"We agree with the thrust of those judgments and find that Canadian corporate law should evolve in that direction."

Greenberg J was not specific about what he considered the thrust of those judgments to be and did not reconcile them to Canadian jurisprudence or statutes.

The Quebec Court of Appeal rejected the suggestion that it is up to the court to decide on the advisability of an evolution in corporate law that the legislators had not elected to put in the statute. It went even further, observing that the entire premise that directors may owe a duty to creditors was flawed:

"I have great reluctance in associating the rights of creditors with those of shareholders, even when bankruptcy is imminent. I note in passing that the assets of the company are not those of the shareholders, even on a practical level, and I find it difficult to understand why they would later become more so those of the creditors simply because of the possibility of bankruptcy. The pronouncement, contained in this excerpt therefore appears to me at first sight to have an excessive reach in Canadian law, although I can conceive that the interests of creditors in the manner in which directors manage the company may grow with the immanency of bankruptcy."

Still, the issue of directors' duties to creditors has not yet been laid to rest. A recent Ontario ruling in the action against the former directors of Dylex Corporation has allowed the action to proceed to trial on the basis that it is open to the court to decide that such a duty may in fact exist. Although, the Ontario court acknowledged the Quebec Court of Appeal decision, it went on to say that "it remains to be seen whether it will be followed in other jurisdictions or whether other Canadian courts will follow the lead of the British, Australia and New Zealand courts". Until this issue is finally resolved by the courts, directors can anticipate actions by unpaid creditors.


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