Understanding Indalex
As we patiently await the release of the Indalex Supreme Court of Canada decision, I have been asked to describe the case and its implications in non-technical terms. That, in itself, may be a challenge.
How Indalex became insolvent
First, a bit of background. Indalex manufactured aluminum extrusions. It was the second largest supplier in the market and had, at the time it was purchased by a U.S. private equity firm (Sun Capital) in 2006, twelve plants, eleven operating in North America, one in Hong Kong. This is one of those stories in which a private equity firm sees an asset rich company and believes it can make a healthy profit by orchestrating a highly leveraged buyout.
In 2006, Indalex had an asset to debt ratio of three to one and was profitable. Sun Capital, through its affiliates, orchestrated a buyout that increased Indalex’s debt, bringing the ratio down to one to one. The terms of the purchase introduced a requirement to pay management fees to Sun Capital affiliates and a commission on any financing transactions. It was also clearly the intent of Sun Capital to sell certain of Indalex’s assets to facilitate recovery of the purchase costs through the issuance of dividends.
Since Indalex supplied a significant amount of its product to the construction sector, it naturally suffered a depression in sales as financial markets deteriorated. By the end of the first quarter of 2007, Indalex had seen a year over year decline in sales of 62%. This led the CEO to state publicly that there would be no dividends declared in the foreseeable future.
At the same time, Indalex had retained FTI Consulting to prepare a solvency report to justify the payment of 76 million dollars in dividends to Sun Capital affiliates. In short, in violation of the public announcement, prudent management of the firm and conflict of interest standards, the Board of Directors authorized the dividend payment (which, incidentally, also meant that each Board member would receive dividend payments). Add to this over ten million dollars in management fees paid to Sun Capital affiliates and the total outpouring in 2007 was over 86 million dollars. By mid-2008, Sun Capital had recovered 85% of its investment in Indalex, despite the financial market collapse and its effect on Indalex sales.
Insolvency Proceedings – First Step in setting Priority of Competing Claims
In March and April of 2009, Indalex entered into Chapter 11 bankruptcy proceedings in the United States and Companies Creditors Arrangement Act (CCAA) proceedings in Canada respectively. As part of the US proceeding, a senior consultant at FTI Consulting [the same firm that contradicted the CEO’s to not declare a dividend] was appointed as the Chief Restructuring Officer (CRO). This is a management position. In effect, the CRO worked hand in hand with the Indalex CEO and Board to assist in the development of a restructuring plan.
In the CCAA proceeding, the Canadian subsidiary of FTI was appointed as the Monitor. The Monitor acts as an officer of the Court assisting the Court in assessing the status of the debtor company, the restructuring proposals, the creditor claims, etc. It is fundamental to the workings of the CCAA process that the Monitor be independent of the debtor company. Unfortunately, there was a conflict of interest built in to this appointment since FTI also acted as the CRO in the US proceedings and had (unbeknownst to the Court) also prepared the insolvency report used to justify the 2007 dividend payout.
The pension deficits
There were two registered pension plans tied to Canadian Indalex operations. One was an executive plan. It had not been wound up at the time of the CCAA proceeding. It had a deficit of approximately 3.2 million dollars. The other plan was a salaried plan that covered both non-union and some union Indalex personnel. While the salaried plan had been wound up, it had a deficit of approximately 1.79 million dollars at the time of the CCAA filing.
The insider loans given priority
Early in the CCAA proceedings a loan was negotiated to fund ongoing operations during the restructuring. This is usually called a debtor-in-possession (DIP) loan. The loan was slightly under 28 million dollars and was guaranteed by Indalex US and by Sun Indalex, an affiliate of Sun Capital and the entity which indirectly owned 100% of the voting shares in Indalex. This loan was granted priority over the claims of creditors in the CCAA proceeding without providing notice to pension plan members. When all assets of Indalex were sold, there was a shortfall of 10 million dollars in respect of the DIP loan repayment. Indalex US advanced the ten million dollars to satisfy the shortfall.
The argument to put pensioners first
At the time the sale was approved, counsel representing both registered plans claimed that the pension deficits should take priority over other claims, including the DIP loan claim. The pension claims were based on the Pension Benefits Act protections termed “deemed trusts”. Counsel argued that the PBA provided a superpriority covering the whole of the pension deficits and that, as a result, the pension deficits should be paid prior to distribution of the sale proceeds.
The CCAA Judge approved the sale and distribution of the assets but set aside 6.75 million dollars on reserve pending consideration of the pension claims.
Rejection of pensioners’ priority by CCAA judge
On the motion before the CCAA Judge, counsel for Indalex sought leave to place Indalex in bankruptcy, a step that would defeat the PBA claim. The CCAA Judge declined to permit the filing for bankruptcy but ruled that the PBA protections did not apply since the amount payable under the salaried plan was not due at the time of the sale and the protections of the PBA did not cover the executive plan since it was not wound up.
The Court of Appeal Decision – gives priority to pensioners – pension deficiencies created trust
The CCAA decision was appealed to the Ontario Court of Appeal. There were a number of issues argued at appeal.
- No notice was provided to the pension plan members before the DIP loan priority was established.
- Sun Indalex, who claimed the amount on reserve as a result of the DIP loan guarantee, was a related party. Indalex had an obligation to defend the interests of pension plan members since it was the plan administrator. Instead it took all steps to defeat the pension plan claims and support the Sun Indalex claim, arguably in breach of its fiduciary duties.
- It was argued that the PBA provisions covered the whole of the wind-up deficit and could not be defeated by the CCAA unless evidence was put forth demonstrating a clear conflict between the CCAA and the PBA. Since no evidence had been offered during the CCAA proceeding, the PBA claim should be enforced.
The Court of Appeal decision supported all aspects of the Plan member arguments. It found that no evidence had been put before the CCAA Court to override the PBA requirements. It ruled that the PBA deemed trust covered the entire Salaried Plan deficit and that payout of that deficit takes priority over the Sun Indalex claim. For the executive plan, because it was not wound up at the time of the CCAA proceeding, the Court relied on a finding of breach of fiduciary duty to order the payment of the executive plan deficit. The Court concluded that the deficit was covered by a constructive trust which took priority over the DIP claim.
Not surprisingly, the case has been appealed to the Supreme Court of Canada by the company and the financial industry is watching very carefully for its ruling. In the meantime, the Court of Appeal decision may have already affected how the companies behave.
Unfair Dealing by Indalex key to Decision
The success at the Court of Appeal centered on procedural breaches by Indalex (lack of notice to Plan members), conflicts of interest amongst FTI and Indalex which led to decisions supporting related parties instead of Plan members (breach of fiduciary duty), a failure to present evidence of conflict between the CCAA and the PBA, and a determination of the scope of the deemed trust that supported payment of the entire deficit. It is unclear whether there would have been a deemed trust if there had not been the sharp practices or conflicts of interest.
Impact of Decision – improved behaviour by companies in trouble?
If the Supreme Court of Canada upholds the Court of Appeal ruling, it is unlikely to provide a basis that would support the general principle that pension deficits take priority. Rather, it will provide a roadmap as to what a debtor company has to do to ensure that DIP financing will take priority. After the Court of Appeal decision, we have seen debtor companies take greater care to provide notice to pension plan members early in the process, to present evidence as to why a priority granted under the CCAA should prevail over a PBA priority, and to ensure that there are no the conflicts of interest like those found in Indalex between the monitor, CRO and the debtor company. To avoid conflicts of interest, third party pension plan administrators have been appointed as part of CCAA proceedings.
In short, if companies avoid the procedural breaches and conflicts of interest found in Indalex, DIP loans may still keep their priority over pension deficits. As a result of the Court of Appeal decision, pension plan issues will be considered earlier in the insolvency proceedings and conflicts of interest are likely to be better dealt with. this provide some measure of protection for pensioners against sharp practices but does not confer a higher priority.
So, unless the SCC rules that pension deficits in all cases have priority over other creditors, nothing will have changed for pensioners of companies in trouble. A simple ruling against Sun Indalex may be limited to its own facts and may not provide any greater protection to pension plan members during insolvency and restructuring proceedings.
Darrell Brown, LL.B. and M.B.A, practices in pension, corporate governance and commercial law at Sack, Goldblatt and Mitchell LLP
