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Bulletin | Article

Another Brick in the (Pre/Post) Wall: Non-dischargeable Claims and the Prohibition of Pre-post Compensation

Fasken
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Litigation and Dispute Resolution bulletin

On March 17, 2020, the Court of Appeal of Québec (the "Court") issued an important ruling concerning "pre-post" compensation and "non-dischargeable" debts under the Companies' Creditors Arrangement Act (the "CCAA"), by finding that the debt of a municipality arising from an agreement entered into as part of a voluntary reimbursement program ("VRP") under the Act to ensure mainly the recovery of amounts improperly paid as a result of fraud or fraudulent tactics in connection with public contracts ("Bill 26") is unsecured debt in connection with the insolvency of a co-contracting party of the municipality.[1] As such, the municipality cannot effect compensation (set-off) between this debt and the amounts it owes to the same insolvent company that arose after the start of insolvency proceedings.

Background

SM Group was a Quebec engineering, project management and consulting firm composed of a number of subsidiaries with operations in about thirty countries. In November 2017, SM Group entered into a confidential settlement agreement with the City of Montreal (the "City") in connection with a VRP under Bill 26. Pursuant to this agreement, SM Group was required to make several payments spread out over time to the City, as a "voluntary reimbursement" (the "VRP Claim"). It is important to note that under both the VRP and Bill 26, a settlement agreement entered into as part of a VRP is made on a "without admission" basis and constitute an admission of liability or of any fault committed by the company.

In August 2018, a restructuring process under the CCAA was commenced in respect of SM Group, and Deloitte Restructuring Inc. was appointed monitor (the "Monitor"). When the initial order was granted, SM Group had about 700 employees and hundreds of active contracts.

At the start of the restructuring proceedings, it was determined that the process to sell SM Group's assets should be commenced. Following discussions begun as soon as the initial order was granted, FNX-Innov Inc. and the subsidiary companies (the "Purchaser") were identified as interested purchasers. The sales transaction was quickly completed and in November 2018 the Court issued a vesting order approving SM Group's asset sale transaction and requiring the parties to return to court at a later date for authorization to assign many of SM Group's contracts to the Purchaser.

In the days following the granting of the vesting order, more than 1,739 SM Group contracts were assigned to the Purchaser (the "Contracts"). Between the initial order and the sale of the assets, SM Group performed work for the City in connection with the Contracts, which SM Group assessed at $825,892.20. This claim was assigned to the Purchaser as part of the assignment of the Contracts (the "SM Claim").

Concurrently with approval of the transaction with the Purchaser, a payment became payable by SM Group to the City with regard to the VRP Claim. This payment was not made. The City therefore took the position that it did not have to pay the SM Claim, on the basis that legal compensation (by operation of the law) had been effected between the SM Claim (a post-filing claim) and the VRP Claim (a pre-filing claim). According to the City, the principles set out by the Court of Appeal in Kitco[2] to the effect that compensation between pre-filing and post-filing claims was impossible was inapplicable in these circumstances given that the SM Claim (post-debt) constituted a non-dischargeable debt under section 19(2) of the CCAA.

In addition to the VRP Claim (pre-filing), the City also attempted to effect compensation with an additional alleged claim against SM Group, which arose from an action it filed after the start of the restructuring proceedings with regard to SM Group and the other defendants in which the City alleged the existence of a system of collusion in connection with awarding a contract to install water meters (the "Water Meter Claim"). This Claim was excluded from the VRP Claim and was the subject of a pending lawsuit before the courts.

After this action was taken by the City, the Monitor filed an application for declaratory relief in order to ask the Superior Court to confirm that the City could not effect compensation as it claimed and to order it to pay the SM Claim. The City responded by requesting a declaration that legal compensation had been effected by operation of the law between the amounts owing (the VRP Claim and the Water Meter Claim) and the SM Claim.

At trial, Justice Corriveau granted the Monitor's application, thereby dismissing the City's arguments[3] and ordering the City pay the SM Claim. However, in her reasons, Justice Corriveau stated that despite the language of Bill 26 and the VRP agreement, the VRP Claim was indeed a debt arising out of fraud within the meaning of section 19(2) CCAA that could not be compromised by a plan of arrangement without the express consent of the City. The Court nevertheless held that despite the "non-dischargeable" nature of the VRP Claim, the compensation requested by the City could not be made between pre-debt and post-debt.

The City requested and obtained permission to appeal the trial judgment. In the Appeal, the City argued that Justice Corriveau had erred in law by refusing to find compensation between the sums owed to it (the VRP Claim and the Water Meter Claim) and the SM Claim.

The respondents contested the City's position. More specifically, the Purchaser argued that while the Superior Court's conclusions were correct, the trial judge erred when she qualified the VRP Claim as "non-dischargeable", in a context where the debt arises from an agreement "without admission" and where the City has not adduced any evidence of fraud against SM Group in connection with the insolvency proceedings.

Decision

On March 17, 2020, the Court of Appeal dismissed the City's claims, thereby upholding the position of the Purchaser. In a majority decision, and relying on the principles formulated by the Court of Appeal in Kitco, the Court of Appeal also held that it was impossible to effect compensation between pre-filing and post-filing claims. Moreover, the Court of Appeal found that the VRP Claim was not a debt contemplated by 19(2) CCAA, contrary to the claims of the City and the Superior Court:

"[TRANSLATION] [41] Lastly, the confidential agreement entered into between the City and SM Group contains general provisions that are of the same effect. For example, it is stipulated that: taking advantage of the program does not constitute an admission of liability or an admission of any fault committed whatsoever; the provisions regarding the release and discharge given by the Minister of Justice only take effect when paid in full; the payment is made without any admission or acknowledgement of liability; the existence and content of the transaction as well as the facts and circumstances relating thereto are confidential.

[42] In light of these provisions and stipulations, the trial judge erred when she concluded that the fact that SM Group availed itself of a reimbursement program allows one to infer that SM Group was involved in a fraud and that the transaction entered into under Bill 26 and the VRP entitles the City to a claim relating to a debt or obligation arising from a fraud. Other than the fact that all discussions and documents exchanged in connection with the program, including the resulting transaction, are confidential, taking advantage of the VRP does not constitute an admission that any fault was committed, let alone an acknowledgement of liability arising from fraud.

 (…)

[50] The VRP Claim may not therefore be qualified as fraudulent. It constitutes an unsecured claim and is therefore compromised under section 19(1) CCAA. The argument advanced by the City does not stand up to analysis. While this determination is sufficient to dismiss this appellant's argument, I would add this with regard to the allegation of fraudulent compensation.

[51] The trial judge rightly decided that even if the debt was a result of a fraud, the principles set out in Kitco apply. The compensation may not be effected between a debt of this kind arising prior to the insolvency proceedings and a debt arising after such proceedings.

[52] Section 21 CCAA must be interpreted so as not to compromise the purpose of the restructuration sought by law. An interpretation that undermines the status quo and calls into question the suspension of the creditors' respective proceedings while preparing a restructuring plan for an arrangement would constitute a serious threat to its proper and efficient operation. The fact that a claim cannot be compromised cannot defeat the principle by which enforcement proceedings are suspended during the restructuring, except if an order is issued by the court responsible for applying the CCAA

[53] Moreover, sometimes certain aspects of the reorganization of large-scale businesses concern public interest. While no one wants fraud to be without consequences, this does not justify disregarding the rules put in place by the CCAA. These rules require, among other things, treating creditors equally, subject to any priority required by law. However, fraudulent debt does not constitute a priority claim, which the lawmakers could have otherwise provided for in the Act had they wanted to. Adopting a broad interpretation of any compensation involving fraudulent debt would have the effect of granting, in practice, an enhanced priority and significantly muddying the waters."

As for the Water Meter Claim, the Court held that legal compensation could not be effected in this regard, given that this claim was neither certain nor liquid nor exigible at the start of the insolvency proceedings[4], and especially given that the matter is still pending before the courts.

Conclusion

This is an important decision in the area of insolvency law in that the Court of Appeal has explicitly clarified the legal effect of a "non-dischargeable" debt in insolvency proceedings. While this debt may not be compromised as part of a plan of arrangement (or settlement proposal under the Bankruptcy and Insolvency Act), the general suspension of proceedings and remedies will nevertheless continue to apply. It is also an important decision regarding civil law generally, in that the Court has held that a settlement entered into on a "without admission" basis and without acknowledgement of fault may not be asserted against the other party as proof of fault.

The Purchaser was advised by a Fasken team composed of Luc Béliveau, Marc-André Morin and Nicolas Mancini.



[1] Arrangement relating to Consultants SM inc., 2020 QCCA 438.

[2] Métaux Kitco inc. (Arrangement relating to), 2017 QCCA 268 ("Kitco").

[3] rrangement relating to Consultants SM inc., 2019 QCCS 2316.

[4] Art. 1673 C.C.Q.

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