Intercreditor covenants face new challenges in Canadian insolvency proceedings

An integral element of any multi-party debt structure is the Intercreditor Agreement. The most basic Intercreditor Agreement will establish the priority ranking of the creditors' claims and security.

Often the Intercreditor Agreement will also include a far more extensive list of rules agreed as between the creditors themselves on:

• permitted amendments to their respective credit documents;
• standstills on enforcement of security;
• rights to provide priority interim financing in an insolvency proceeding; or
• creditors' rights and obligations when voting upon, supporting, or opposing insolvent restructuring transactions.

Significant time will often be spent negotiating these terms.

Creditors take great comfort in the intercreditor terms they have negotiated at the outset of a transaction. Senior secured creditors will determine they have adequately preserved their ability to control the path of an insolvency or realization scenario without undue disturbance from a junior creditor. A junior creditor will be comfortable that they have negotiated for sufficient protections to ensure their recoveries are not unduly impaired or delayed by the preferred enforcement steps of the senior creditor. These creditors will price intercreditor risks accordingly in their financing offers.

Unlike other contracts in an insolvency context, the Intercreditor Agreement is a particularly useful tool because it is enforceable between the creditors themselves, and not primarily against the debtor that may be subject to a broad stay or moratorium.

Practitioners often assume these agreements will be unimpaired by an insolvency proceeding. However, at least one recent case from the Courts of Alberta creates material questions about the scope of reliance that can be placed on Intercreditor Agreements in Canadian insolvencies.

Dynamic Technologies Group Inc.

In the insolvency proceedings of Dynamic Technologies Group Inc. and its affiliates under Canada's Companies' Creditors Arrangement Act in the Alberta Court of Kings Bench, a dispute arose regarding the rights of one secured creditor to provide super-priority interim "DIP" financing in a Canadian insolvency proceeding. In Canada, DIP financing is a common feature used to fund a debtor's cash needs during an insolvency process and is most often subject to a super-priority court ordered charge required by the lender, which can be granted in the court's discretion.

At the commencement of the proceeding, the debtor companies required DIP financing. After what was described as diligent efforts on behalf of the debtors to identify an interim lender in the market, so as to enable the debtors to execute on their restructuring efforts, the only lender prepared to step forward with an interim financing term sheet was one of the incumbent secured creditors (the DIP Lender). The DIP Lender's term sheet required that the interim financing have the benefit of a super-priority court-ordered charge on the debtor's assets.

The pre-filing Intercreditor Agreement was a problem for this transaction. In the Intercreditor Agreement the DIP Lender agreed with one of the debtor's other secured lenders that any further advances in any form would be permitted but would be subordinated. The DIP Lender's interim financing proposal offered what the Intercreditor Agreement did not permit: further advances secured on a super-priority (not subordinated) basis.

The objecting creditor took the position that the proposed super-priority interim financing was a breach of the Intercreditor Agreement, and should that interim financing be approved and implemented, any rights to sue the DIP Lender for breach of the Intercreditor Agreement should be preserved.

In the result, the Alberta Court approved the DIP Lender's interim financing proposal, granting a super-priority charge to secure that financing. The Alberta Court also extinguished any cause of action that the counterparty to the Intercreditor Agreement had as a result of this breach of the Intercreditor Agreement. In support of this decision, the Alberta Court found, among other things, that:

• The changing of the priority scheme (and here, the concurrent immunity from suit under the Intercreditor Agreement) was integral to the viability of the interim financing from the perspectives of both the lender and the debtor. Unless granted, the DIP Lender would have no reason to offer the interim financing, no reorganization would take place and a liquidation would be the likely result.
• The determination to grant this super-priority charge and insulate the DIP Lender from any liability under the Intercreditor Agreement was an exercise of the Alberta Court's discretion under the Companies' Creditors Arrangement Act.
• For public policy reasons, namely the avoidance of the economic and social cost of large business failure, the DIP Lender should be afforded special treatment in this context to facilitate the interim financing, including the immunity from any cause of action resulting from the breach of the Intercreditor Agreement.

The court acknowledged the arguments raised by the opposing creditor that the insolvency court should not affect or impair the intercreditor rights as between parties who are not debtors in the insolvency proceeding. However, the court found that in this particular case, the debtor was involved in this relationship both as a party to the Intercreditor Agreement and as the recipient dependent upon the proposed interim financing. The same could be said for debtors in substantially all intercreditor arrangements that contain restrictions on super-priority interim financing.

Notably, Canadian insolvency statutes do not have an equivalent to Section 510(a) of the United States Bankruptcy Code, which provides that a subordination agreement is enforceable in a case under Chapter 11 of the United States Bankruptcy Code to the same extent that such agreement is enforceable under applicable non-bankruptcy law.

While the Dynamic Technologies Group Inc. decision is only a single decision from the insolvency court in a single Canadian jurisdiction, secured creditors in all Canadian jurisdictions should be aware of its potential implications.

Practical issues

Lenders should be aware of the potential limitations on their contractual intercreditor protections in a Canadian insolvency proceeding based on the reasoning in the Dynamic Technologies case. In particular, any intercreditor restrictions that have a practical effect of limiting or impairing the debtor's going concern restructuring options will be most susceptible to challenge.

The following types of common intercreditor restrictions immediately come to mind:

a. Restrictions on priming DIP financing

As seen in the Dynamic Technologies case, even if a creditor has agreed it will not provide priming DIP financing, the court may create a path for the provision of that priming DIP financing notwithstanding the intercreditor restrictions, if no other viable financing options are available to fund a restructuring.

This is a particularly difficult concern to remedy for two reasons.

First, one would expect a subordinate creditor seeking to provide DIP financing will in all cases take the position that they require a super-priority position for any DIP financing; or, at the very least, not a subordinated position behind substantial senior secured pre-filing debt. If the senior lender does not itself provide the DIP financing or does not find a friendly third party to do so, Dynamic Technologies suggests the door is open for the debtor and the subordinate creditor to avoid their Intercreditor Agreement restrictions and enter into a priority DIP financing arrangement in an effort to maintain a going concern restructuring. If that is the case, then the senior lenders who have bargained for DIP financing restrictions in their intercreditor arrangements can have, at best, a right of first refusal on any priority DIP financing before the restricted subordinate creditor has the right to proceed with its priority DIP financing proposal.

Second, it is not clear how these issues would be resolved in a circumstance where an existing first lien lender offers DIP financing sufficient to complete an expedited realization process, but a subordinate creditor who is contractually restricted from providing priority DIP financing offers more favourable terms and a more substantial DIP financing package. The DIP financing alternative from the first lien lender could be provided without breaching the Intercreditor Agreement. However, that DIP financing may not satisfy the debtor company's going concern restructuring objectives. In that context, can the debtor company and the subordinate lender pursue their DIP financing package that is more favourable to the debtor company's restructuring goals, notwithstanding the Intercreditor Agreement restrictions and the availability of at least some DIP financing from the senior lender that complies with the Intercreditor Agreement?

At this time, we can only identify that there are significant questions around the enforceability of DIP financing restrictions in Canadian Intercreditor Agreements.

b. Obligations to support restructuring transactions

Intercreditor Agreements often impose obligations on subordinate lenders to proceed with restructuring transactions supported by the senior lender, and to not put forward any competing transactions.

These restrictions may be susceptible to a similar analysis as seen in the Dynamic Technologies case. The obligation of a subordinate creditor to support an expedited realization favoured by a senior lender may frustrate the going concern restructuring process the debtors seek to pursue. This is particularly true if there is a competing transaction available that better achieves a going concern outcome and ultimately (though perhaps more slowly) pays out the senior lenders. In this circumstance, the reasoning in Dynamic Technologies suggests a subordinate creditor may also be protected from opposing the senior creditor's preferred transaction in favour of the alternative going concern outcome.

c. Restrictions on the release of rights or encumbrances

Particularly in the mining context, Intercreditor Agreements will often include restrictions preventing a lender from supporting a restructuring transaction that would have the effect of extinguishing another capital provider's interest in a stream, royalty or similar right.

These types of rights and encumbrances on assets could depress the sale price in an insolvency sale as substantial value would be extracted from the assets through future stream deliveries and royalty payments. To maximize the pool of potential going concern buyers and anticipated recoveries, the debtor and its creditors will have strong incentives to attempt to sell free and clear of any such stream, royalty or similar rights.

Suppose a going concern transaction can only be completed if such stream or royalty rights and interests are extinguished. In that case, based upon Dynamic Technologies there may be flexibility for a lender to support such a transaction that extinguishes the stream or royalty interest notwithstanding the lender's agreement to not do so in its Intercreditor Agreement. This would have a material impact on the stream or royalty holder's recoveries, which may be limited only to a subordinated monetary claim rather than a continuing right in the assets post-transaction.

Key takeaways

The core provisions of the intercreditor arrangement remain unaffected by the Dynamic Technologies decision:

• One can reasonably expect that a court will uphold agreed priority waterfalls, subject to any new priorities for DIP financing advanced.
• Standstill provisions preventing subordinate creditors from taking enforcement steps ahead of senior lenders should not be affected as those provisions tend to promote a going concern scenario by limiting enforcement.
• Restrictions on credit agreement amendments, which are often included in intercreditor arrangements should also be largely unaffected by the Dynamic Technologies decision, though to the extent those provisions restrict increases to loan facilities, those restrictions may be limited to the extent necessary to facilitate DIP financing.

However, where an Intercreditor Agreement expands to include provisions aimed at pre-engineering an expedited strategy for senior lenders to realize their collateral unimpeded by subordinate creditors, significant enforceability concerns can arise. When one considers that most enforcement and realization processes in the Canadian context are implemented through some form of court supervised restructuring proceeding, this concern is heightened. Dynamic Technologies illustrates that courts will be reluctant to cede control of their restructuring process to the pre-filing negotiations of selected creditors who are parties to intercreditor arrangements.