Is it Wrongful to Pay a Dividend While Facing Litigation? A Québec Court May Answer

NORTH OF THE BORDER UPDATE

This article has been contributed by Martin Desrosiers and Julien Morissette. Martin Desrosiers is a Partner in the Insolvency and Restructuring group of Osler, Hoskin & Harcourt LLP, and Julien Morissette is an Associate in the Group.

The Bankruptcy and Insolvency Act (BIA) provides that a dividend payment which renders a company insolvent, or which is made while a company is insolvent, is reviewable. The BIA extends liability to the company’s directors unless they can show diligence. While the company is solvent but facing substantial litigation, can it nonetheless be wrongful or tortious for directors to authorize payment of dividends? A Québec court may soon have to answer this question.

Domfer Metal Powders Holdings Ltd. (Domfer) was a scrap steel recycler operating on the Island of Montréal. Its main clients were car manufacturers in the U.S. In 1997, the Comité d’environnement de Ville-Émard (CEVE) filed a class action (the First Class Action) before the Superior Court of Québec. This organization represents a group of persons residing near the Domfer plant whom alleged having suffered from neighbourhood annoyances (nuisances) as a result of environmental damage linked to Domfer’s activities.

In 2002, the First Class Action was dismissed at trial. CEVE appealed. In early 2003, Domfer proceeded to a corporate reorganization, from which Kenneth G. Stodola and Gilles L’Espérance – sole directors and shareholders of Domfer (the Directors) – received about $14.2 million (the Dividend). In 2006, the Québec Court of Appeal granted CEVE’s appeal and ordered Domfer to pay the plaintiffs approximately $1.6 million. A further appeal by Domfer was discontinued. In early 2008, Domfer filed for bankruptcy, while the Court of Appeal’s award remained unpaid.

In 2009, CEVE settled with Domfer’s trustee in bankruptcy and insurance company for approximately $124,000 (the Settlement). Finally, in early 2011, CEVE filed a new class action against the Directors, alleging that they committed an extra-contractual fault in authorizing the Dividend in 2003. This new action seeks payment of about $1.5 million, i.e. the difference between the Settlement and the Court of Appeal’s award in the First Class Action. In a short judgment, Justice Perrault of the Superior Court of Québec authorized (certified) this new class action last year.

The parties debated whether or not the alleged facts seemed to justify the judgment sought on the merits. Justice Perrault’s ruling does not prejudge of the result on the merits, but it provides insight into uncharted issues that will need to be addressed unless a settlement occurs before the trial.

CEVE’s main allegations are that the Directors were careless and self-interested when they authorized the Dividend and that this Dividend substantially weakened Domfer’s financial position and ultimately caused the bankruptcy. As highlighted by the Court, several key issues of fact and law will need to be addressed:

•  Did the Settlement extinguish the claim against the Directors? Interestingly, the Settlement with the trustee specifically reserved the plaintiffs’ rights against third parties, while the Settlement with the insurer did not. This also serves as a reminder to the insolvency community that specific director releases are an issue which should not be overlooked in any settlement in a bankruptcy context.
• Should Domfer have taken a provision in its financial statements relating to the First Class Action, even if it had been dismissed at trial? If so, was the failure to do so wrongful and can this fault be imputed to the Directors?
• Does it change anything that the Directors were also the sole shareholders and beneficiaries of the Dividends? Do they as a result have a heightened duty of care under either the Civil Code of Québec (CCQ) or the Canada Business Corporations Act (CBCA)? What level of credence will be given to the fact that there was an apparently legitimate reason for the reorganization (Mr. Stodola, then 77, was preparing for his retirement) and that legal and financial professionals were involved?
• Is there a sufficient causal link between the Dividend and the bankruptcy? The Directors argued before Justice Perrault that any undistributed earnings held back by Domfer by reason of the First Class Action would simply have devolved to the trustee upon bankruptcy. While this is primarily a factual and accounting issue, the Court will have an opportunity to give its view on the causation test to be applied in a “multi-cause” bankruptcy context where many important factors were not controlled by Domfer or the Directors.
• Is it relevant that Domfer was still solvent after the Dividend was paid? Factually speaking, were the financial difficulties foreseeable? The company’s financial position started deteriorating in late 2003 as a result of a stronger Canadian Dollar and later due to the North American automotive industry crisis. This sole fact would likely be fatal to any attempts to use the BIA against the Directors, but it remains to be seen whether a stricter standard could derive from the CCQ or the CBCA.

In Québec, a judgment authorizing a class action cannot be appealed. Therefore, this matter will either settle or go to trial on the merits. By class action standards, the plaintiff group is small – CEVE represents about 500 individuals – as are the damages sought. However, the legal issues which would have to be resolved on the merits are far ranging and will be closely watched by insolvency litigators across Canada.