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Good faith, honesty, and transparency are the watchwords of Canada’s insolvency regimes. Where a debtor makes a proposal under the Bankruptcy and Insolvency Act (the “BIA”), but the Court finds that instead of acting in good faith it engaged in self-interested behavior designed to benefit other members of a corporate group, the Court will uphold the BIA’s principles and refuse to sanction the proposal. That was the result in YG Limited Partnership and YSL Residences (Re), 2021 ONSC 4178.

That case involved Toronto’s “YSL Project”, an 85-storey condominium development beneficially owned by YG Limited Partnership (“YG LP”). The YG LP’s general partner (the “GP”), a member of the Cresford group, caused the limited partnership to file a proposal under the BIA over the objections of the YG LP’s limited partners (the “LPs”) and obtained unanimous approval from the project’s unsecured creditors. The proposal provided for unsecured creditors to receive up 58% of their claims, subject to a cap on claims of $65 million. If the cap was met, unsecured creditors would receive a pro rata amount of $37.7 million (58% of the capped amount).

Justice Dunphy refused to sanction the proposal before him based on the LPs’ arguments that:

1. Cresford’s related party claims should be characterized as equity claims;
2. the proposal process was tainted by the GP’s breaches of fiduciary duty and lack of good faith; and
3. the value of the creditors’ vote as an indicator of the proposal’s reasonableness was diminished due to opaque side deals with the proposal sponsor, and the classification of lien claims in the proposal.

 

Characterization of the Cresford Claims as Equity Claims

Shortly before the proposal was filed, Cresford took the position that it had made certain advances to the YSL Project that should be treated as unsecured claims. Among other things, these advances related to amounts that Cresford borrowed in order to buy into the project, buy out the investment of a former limited partner, and for interest on such loans.

The Court rejected Cresford’s suggestion that the question of how to characterize Cresford’s claims could be left for another day, both because it would have a significant impact on the reasonableness of the proposal (para 36) and because the conclusion affected the determination of the debtors’ good faith (para 38).

Justice Dunphy held that “virtually all indicators reviewed point towards [the advances being] equity and there is little to no evidence leaning the other way” (para 49). Those indicators included:

1. Advances made or charged to YG LP “for the direct or indirect purpose of financing the purchase of an equity interest in YG LP are likely to the point of certainty to be characterized as equity claims of YG LP for the purposes of insolvency law” (para 43);
2. No loan documents governed the advances, no interest was payable on them, and they had no maturity date. Any repayments made were sporadic and were not from the YG LP’s cash flows (as it had no cash flow) (paras 45-46); and
3. There was “substantial evidence” that the advances were intended to be subordinated to the LPs’ claims (para 47).

 

The Proposal Process Was Tainted

The YG LP partnership agreement provided that the GP would be in default if it agreed to a process whereby substantially all of the property of the YG LP would be transferred to a third party without the unanimous consent of the LPs. After the YSL Project’s financial difficulties came to light in March 2020, the GP took steps to market the project for sale. The GP never obtained the consent of the LPs because each proposed transaction required the LPs to accept less than their entitlement under the partnership agreement while millions would be paid to Cresford (para 75).

The Court did not look favourably on Cresford’s attempts at self-interested dealing:

[76]        Few things are more precious in the restructuring business than time. YG LP was able to “purchase” more than a year of time with the forbearance arrangements that it worked out [with secured creditors]. That precious time appears to have been devoted solely to finding transactions that offered the greatest level of benefits for the Cresford group of companies. There is no evidence that any canvassing of the market […] took place that was not indelibly tainted by the imperative of finding value for the Cresford group of companies rather than for the partnership itself.

The Court held that the GP squandered an expensively purchased window of restructuring room,

[73]        […] looking not for the solution best able to discharge all of the obligations of the partnership but rather looking for the investor best able to secure the optimal outcome for the Cresford group of companies generally. In that process the limited partners were an obstacle to be circumvented and bankruptcy provided a possible key.

[74]        Good faith in such circumstances is not assumed but must be shown. The evidence presented to me has rather persuasively convinced me that good faith took a back seat to self-interest.

Justice Dunphy’s conclusions regarding the events leading up to and during the proposal, and that, at least for the purposes of the motion, the Cresford claims must be treated as equity claims drove a conclusion that there were “serious issues regarding the good faith with which [the proposal] has been prepared and presented” (para 84).

 

The Probative Value of the Creditor Vote Was Diminished by Opaque Side Deals

The majority of votes cast in favour of the proposal were via proxy held by the proposal sponsor. The proposal sponsor disclosed the existence of the side deals that led to acquiring these proxies, but withheld their terms. It was apparent that many, but not all, of the unsecured creditors had the benefit of these side deals.

The Court acknowledged that an agreement of a majority of creditors to accept less than what they’re owed is generally “cogent evidence of the fairness and reasonable nature of a proposal. […] It is not an indicator lightly to be ignored” (para 80). Nevertheless, the Court found that the probative value of the creditor vote to the question of whether the proposal met the test for approval was “attenuated” by the lack of transparency into “precisely what consideration was received”, among other things (para 83), and that the second-hand information from the proposal sponsor denying any side deals did little to address the Court’s concerns (para 28).

The reduced weight to be afforded to the creditor vote (among other reasons including: the dearth of evidence regarding the actual value of the property – see paras 23-26; and the fact that the deals between the proposal sponsor and creditors were not disclosed beyond a skeletal summary that didn’t permit a “reasonable understanding of the main deal” – see para 28) all affected the Court’s view that the proposal was not reasonable.

Further, Justice Dunphy found that there was a “particularly disturbing” “element of unfairness” (para 32) in the fact that lien claimants were to be unaffected creditors in the proposal, but based on side arrangements with the proposal sponsor nevertheless filed claims as unsecured creditors.

 

Evidentiary Issues

The Court considered several evidentiary issues. Among them was the proposal sponsor’s refusal to produce a witness for examination and whether an affidavit filed the night before the hearing should be admitted. The Court held that it should not, and reminded parties that “Lying in the weeds is a strategy, but it does not confer the right to spring out of them at will” (para 22).

The Court also dealt with the evidentiary weight to be afforded to a recent appraisal of the YSL Project given that it was prepared on behalf of the proposal sponsor and based on assumptions materially different from those used in prior appraisals conducted by the same appraiser (para 26). The Court attached little weight to the document, and the Court’s comments should be considered when deciding how appraisal evidence should be tendered in insolvency proceedings.

 

Take-Aways

Proposals under the BIA can be an effective restructuring tool. Courts will be careful, however, to ensure that the integrity of the bankruptcy process is upheld. On a fundamental level, that process requires certain baseline standards of fair play, honesty, and transparency. Where those features are absent from an insolvency process, and the spectre of self-interested dealing becomes apparent, the Court will dig into the conduct of the parties and concern itself with both fairness and the appearance of fairness.

Ensuring the fairness and reasonableness of a compromise imposed pursuant to insolvency proceedings is a gatekeeper role guarded by the Court, even where an overwhelming majority of creditors approve of the compromise. That is evident in this case (where there was unanimous creditor approval) and in CannTrust Holdings Inc, et al (Re), 2021 ONSC 4408, a recent decision of Justice Patillo where a plan under the Companies’ Creditors Arrangement Act was found not to be fair and reasonable despite creditor approval.

 

Subsequent Hearings in the Proceeding

Relying on a term of the proposal which permitted an amendment, Justice Dunphy permitted the debtors to amend their proposal in order to address the concerns identified by the Court. Among other things, the amended proposal properly treated lien claimants as unaffected creditors and involved an improved result for creditors. Whereas the proposal that the court rejected would have seen unsecured creditors receiving a maximum of 58% recovery, under the accepted amended proposal the unsecured creditors are expected to receive between 71-100% recovery. There may even be up to $19 million for the LPs after distributions under the proposal are complete.

 

Alexander Soutter of TGF represented the majority of the LPs in this matter.