Mixed News for Directors of Canadian Corporations Peoples v. Wise
The three Wise brothers were the majority shareholders and directors of Wise Stores Inc. and the directors of its subsidiary, Peoples Department Stores Inc. Both were incorporated under the Canada Business Corporations Act2 (CBCA) and headquartered in Quebec. Both voluntarily placed themselves in bankruptcy.
Peoples's bankruptcy trustee sued the brothers for damages, alleging they breached their duties as directors of Peoples under §122 of the CBCA by favoring Wise over Peoples, to the detriment of the creditors of Peoples. The trustee contended that the brothers ought not to have allowed the implementation of an inventory policy under which Peoples acquired inventory from North American suppliers, retained some for its own use and sold the rest to Wise on unsecured terms, and Wise did the converse for inventory sourced overseas. Because the stores carried more inventory from North American sources, Peoples was left with an unrecoverable claim against Wise.
Under §122 of the CBCA, directors (and officers) are to (a) "act honestly and in good faith with a view to the best interests of the corporation" and (b) "exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances." The first standard typically is called the fiduciary duty, although the Supreme Court of Canada said that it is more aptly described as a "duty of loyalty." The second usually is called the "duty of care."
A trial judge of the Quebec Superior Court gave judgment against the brothers for $4.4 million. In the course of doing so, he said that it was time for Canadian courts to hold that directors owe a duty to creditors when a corporation is insolvent or enters the vicinity of insolvency.
The Quebec Court of Appeal overturned the trial judge. It found that the brothers had satisfied their duties and that the inventory policy was not the cause of the companies' failures. It also said that it would be reluctant to recognize a duty to creditors, considering that to be a major change in law that ought to be left to the legislature.
The Supreme Court of Canada agreed that the brothers had not breached their duties as directors of Peoples and that a number other problems, not the inventory policy, caused the collapse of the two companies. Although these findings disposed of the trustee's case on the merits, the Court also set out to discuss the duties of directors and the question of to whom those duties are owed.
The Fiduciary Duty
To begin, the Court rejected any notion that the fiduciary duty subsumes the duty of care. They are "distinct and...designed to secure different ends." If directors prefer their own interests, they breach the fiduciary duty, regardless of whether the corporation suffers some loss (e.g., a director may be ordered to disgorge a secret profit earned by virtue of his position even if not obtained at the corporation's expense). If directors negligently cause the corporation to take a foolish action, they breach the duty of care and may be liable for any resulting loss, regardless of whether they placed the interests of the company foremost. In other words, the fiduciary duty is about serving honestly and selflessly. It is not about the quality of effort put into making a decision. That is the subject of the duty of care.
Second, the Court rejected the idea that the "best interests of the corporation" can be equated with the interests of shareholders, creditors or any other stakeholders. Directors may give consideration to the reactions of many constituencies when seeking to decide what actions might result in a "better corporation," but the latter is the focus.
In particular, the Court dismissed the idea that the interests of creditors predominate when a corporation enters the zone of insolvency (which it branded "incapable of definition" and "without legal meaning"): "The various shifts in interests that naturally occur as a corporation's fortunes rise and fall do not...affect the content of the fiduciary duty." Integrity and avoidance of conflict of interest are always required.
Third, the Court rejected any suggestion that the fiduciary duty is owed to persons other than the corporation. The Court took the reference to the "interests of the corporation" in §122 as a statement that the corporation is the beneficiary of that duty.
The Court also reasoned that, even if it had latitude to do so, it is unnecessary to extend the fiduciary duty to creditors because of the other recourses available to them, such as the ability to apply for leave to bring a derivative action under §239 of the CBCA so as to enforce, in the corporation's name, a duty owed to the company (if its directors fail or decline to do so) and to seek standing as complainants for the purpose of the oppression remedy in §241 of the CBCA.3
Because the Court's opinions on the fiduciary duty do not depend on the application of Quebec provincial law, and relate to a duty expressed in the same way in all general and specialized corporations statutes in Canada, federal and provincial, they are of national importance.
The Court's remarks about the use of the oppression remedy by creditors are important too, because many corporation's statutes in Canada contain a similar remedy.4 Whether creditors will be given complainant standing is left to the discretion of the trial judge in each case. The Court said little about the remedy itself that has not been said before. However, creditors' counsel will take heart from the Court's indication that financial distress may be a compelling reason to decide that it is appropriate to allow creditors to pursue allegations of oppressive conduct against directors.
The Duty of Care
While not exclusively so, many complaints leveled by creditors at the directors of distressed companies are not about dishonesty or personal conflict of interest, but question the wisdom of decisions or the quality of the decision-making processes. Should more inventory have been ordered on credit or additional secured debt incurred? Should the board have tried to sell the company sooner? Should the board have closed the doors rather than risking the corporation's remaining value? The Court has made it clear that it is incorrect to frame these sorts of questions by reference to the fiduciary duty, but they are still going to be asked.
The Court ruled that the CBCA "does not entitle creditors to sue directors directly for breach of their duties." However, the bankruptcy trustee of Peoples relied on a combination of the CBCA and the Civil Code of Quebec.5 Therefore, the Court asked itself whether a harmonious relationship exists between §122 of the CBCA and the principles of liability that apply in Quebec by virtue of its provincial law.
Article 1457 of the Civil Code provides: "Every person has a duty to abide by the rules of conduct which lie upon him, according to the circumstances, usage or law, so as not to cause injury to another" (emphasis added by the Court). The Court opined that "every person" includes directors, that the duty of care is a rule of conduct that applies as a matter of law and that "another" can include creditors.
After pointing out again that the fiduciary duty refers to the corporation in particular, the Court then turned to the fact that the CBCA does not identify any beneficiary of the duty of care and said simply that "it appears obvious that [the beneficiary] must include creditors." Finding this to be consistent with the civil law, the Court concluded that creditors can resort to the Civil Code to sue directors for breach of the duty of care expressed in the CBCA.
The Court's analysis is open to considerable criticism. It has been the law for over a century that directors (and officers) owe a duty of care to the corporation. The statutory formulations of this duty replace the subjective test historically applied by the courts with an objective one, but there is nothing in the record to suggest that the legislatures intended to change, or add to, the beneficiary of the duty.
If creditors go unpaid because the debtor has lost money due to a want of care on the part of its directors, the impact on them is a byproduct of the loss suffered by the corporation. The corporation is entitled to redress when directors breach that duty, regardless of whether the loss transforms it from solvent to insolvent or exacerbates its insolvency. It has long been held that shareholders cannot sue directors for a derivative loss. If need be, they can apply for leave to bring an action in the name of the corporation. The Court did not say why the result should differ where creditors incur a derivative loss. They too can apply to leave to bring an action in the corporation's name.
As well, the Court paid scant attention to the fact that it was not dealing with a suit by creditors but an action by a bankruptcy trustee. A trustee is vested with any right that the bankrupt company has against its directors, not with the rights of its creditors. The Court simply noted that a bankruptcy trustee "represents" creditors—which is casually true but strictly incorrect, as a trustee is not the creditors' agent.
However, as of now the law, at least in Quebec, is as stated. What about the rest of Canada? There is no statutory equivalent to Article 1457 of the Civil Code in the other provinces and territories. Since the CBCA does not entitle creditors to sue directors, any right to do so has to be found in the common law.
Boards are already subject to a duty of care towards the corporation. The Court did not markedly change the contents of that duty or the defenses available to individuals accused of breaching it. In practice, however, it may mean much to the directors of distressed debtors if the universe of potential plaintiffs is expanded.
Inasmuch as the duty of care runs to the corporation, post-insolvency litigation based on breach of that duty can be brought by a bankruptcy trustee or a suitably empowered receiver, or through an authorized derivative action instigated by creditors in the name of the corporation. In bankruptcy, if the trustee is unwilling to sue, an unsecured creditor can apply to take over the trustee's power to do so. The burden of that is liability for the costs of proceeding, but in return the creditor gets to retain the first dollars of any recovery until his claim is recouped (while any surplus recovery passes to the estate).
If creditors can now sue directors (or officers) for losses that are derivative of a loss to the debtor caused by breach of the duty of care, some may prefer to proceed that way. It would avoid the mechanism for taking over the position of a bankruptcy trustee (which sometimes means first causing a trustee to be appointed) or of seeking leave to enforce the duty in the corporation's name. Directors therefore may find themselves being sued over the same events by multiple plaintiffs, each of whom may have differing motivations (e.g., secured, preferred, unsecured or subordinated creditors or purchasers of distressed debt) and may seek to conduct its case in its own way.
Although the Supreme Court of Canada strictly only decided that creditors can sue on the duty of care when Quebec law applies, the decision is likely to inspire such actions, and certainly more frequent threats of the same, across Canada. Creditors' counsel are likely to feel optimistic about persuading the lower courts that the common law position ought to be the same, whether that is correct in principle or not.
3 A complainant may allege that (1) an action of the corporation effects a result, (2) the business or affairs of a corporation have been conducted in a manner or (3) the powers of a corporation's directors have been exercised in a manner "that is oppressive or unfairly prejudicial to or that unfairly disregards" his interest. A "complainant" may be a shareholder (as of right), a present or former director or officer (as of right) or any other person whom the court, in its discretion, considers proper. Return to article
4 However, the Court did not notice, or in any event did not mention, that a number of corporations in Canada are formed under statutes that do not provide an oppression remedy, such as those applicable to banks, insurance companies and nonprofit corporations. Return to article