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February 20, 2013

Ontario Court of Appeal Confirms that Indemnity Claims of Underwriters and Auditors are Equity Claims

On November 23, 2012, the Ontario Court of Appeal released its decision in Re Sino-Forest Corporation.[1] The Court of Appeal unanimously upheld the lower Court’s ruling and confirmed that the claims of underwriters and auditors against Sino-Forest for indemnification are equity claims as defined in section 2 of the Companies’ Creditors Arrangement Act (“CCAA”).

Background

Sino-Forest Corporation (“Sino-Forest”) is a Canadian public holding company which was listed on the Toronto Stock Exchange. Between 2005 and 2009, Sino-Forest had two different auditors. During this period of time, Sino-Forest undertook a number of debt and equity offerings to the public. Several underwriters were involved in these offerings and both the auditors and the underwriters entered into agreements with Sino-Forest in which Sino-Forest agreed to indemnify the auditors and the underwriters for any damages or legal costs that could arise from these offerings.

In 2011, the Ontario Securities Commission issued a cease trade order in respect of Sino-Forest’s shares due to allegations of fraud against Sino-Forest and certain of its officers and directors. In 2011 and 2012, class actions were commenced on behalf of Sino-Forest’s shareholders and former noteholders in Canada and the United States alleging that Sino-Forest misrepresented its assets and financial situation and that the auditors and underwriters failed to detect these misrepresentations. The auditors and the underwriters claimed indemnification from Sino-Forest in respect of the claims asserted against them in the class actions.

On March 30, 2012, Sino-Forest sought and was granted protection under the CCAA. The class action claims against Sino-Forest were stayed pursuant to the initial order granted in the company’s CCAA proceeding. Sino-Forest subsequently applied for an order directing that claims against Sino-Forest arising from the ownership, purchase or sale of an equity interest in Sino-Forest, including shareholder claims and any related claims for contribution and indemnity, be classified as “equity claims” pursuant to section 2(1) of the CCAA. The auditors opposed Sino-Forest’s motion on the basis that their claims did not derive from, and were not dependent on, an equity interest in Sino-Forest. The auditors contended that their claims were stand-alone claims for breach of contract. The underwriters supported the position of the auditors and further claimed that the issue was premature for determination.

On July 27, 2012, Morawetz J. granted the order sought by Sino-Forest.[2] In his decision, Morawetz J. considered the plain language of the CCAA and recent amendments made to the CCAA in 2009 in holding that both the underlying shareholder claims and related claims for contribution and indemnity were equity claims as defined in section 2(1) of the CCAA. Both the auditors and underwriters appealed Morawetz J.’s decision.

Ontario Court of Appeal Decision

On November 23, 2012, the Ontario Court of Appeal unanimously upheld Morawetz J.’s ruling. In their appeal, the auditors and underwriters advanced three main arguments:

1. section 2(1) of the CCAA clearly defines “equity interest”. The claims for contribution and indemnity were not claims that were “in respect of an equity interest” because the auditors and underwriters did not have an equity interest in Sino-Forest;

2. the definition of the term “claim” in paragraph (e) of the CCAA definition of “equity interest” was directed towards shareholders and did not encompass the claims for which the auditors and underwriters sought contribution and indemnity; and

3. the definition of “equity claim” found in the CCAA was not sufficiently clear to have displaced the traditional common-law definition of “equity claim”.

In upholding Morawetz J.’s ruling, the Court of Appeal held that the definition of “equity claim” focused on the nature of the claim and not the identity of the claimant. The Court looked to the expansive language Parliament used in defining “equity claim” to determine that the claims for contribution and indemnity advanced by the auditors and underwriters fell within that definition. In particular, the Court focused on Parliament’s use of the phrase “in respect of”, an expression intended to convey some link or connection between two related subjects. Parliament’s use of this phrase indicated that the definition of “equity claim” should be interpreted with the widest possible scope. While paragraphs (a) – (d) of the definition provide specific examples of equity claims, paragraph (e) refers to a claim for contribution and indemnity in respect of a claim referred to in paragraphs (a) – (d). An obvious link or connection existed between the underlying shareholder claims – which were clearly equity claims – and the auditors’ and underwriters’ claims for contribution and indemnity. Consequently, the Court concluded that the claims advanced by the auditors and underwriters clearly fell within the definition of equity claims found in paragraph (e).

The Court also addressed and rejected the auditors’ and underwriters’ submission that paragraph (e) is directed towards shareholders and does not encompass the claims for which the auditors and underwriters sought contribution and indemnity. The remedies available to shareholders are clearly addressed by paragraphs (a) – (d), while paragraph (e) is directed at those claiming for contribution and indemnity related to claims addressed by paragraphs (a) – (d). As noted by the Court of Appeal at paragraphs 48 and 49 of the judgment:

Counsel for the appellants were unable to provide a satisfactory example of when a holder of an equity interest in a debtor company would seek contribution under paragraph (e) against the debtor in respect of a claim referred to in any of paragraphs (a) to (d). In our view, this indicates that paragraph (e) was drafted with claims for contribution or indemnity by non-shareholders rather than shareholders in mind.

If the appellants’ interpretation prevailed, and only a person with an equity interest could assert such a claim, paragraph (e) would be rendered meaningless...[3]

Finally, the Court concluded that in enacting section 6(8) of the CCAA, Parliament intended to prevent equity claims from diminishing the assets of an insolvent debtor available for distribution to its creditors. If a shareholder sues auditors and underwriters in respect of a loss, the auditors’ and underwriters’ claims for contribution and indemnity would diminish the assets of the debtor available to its general creditors. This is precisely the type of situation which Parliament sought to avoid in enacting



[1] 2012 ONCA 816 (CanLII) [Re Sino-Forest].

[2] Re Sino-Forest Corporation, 2012 ONSC 4377 (CanLII).

[3] Re Sino-Forest, supra note 1 at paras 48 and 49.

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