D. Classification of Creditors

Author:Roderick J. Wood
Profession:Faculty of Law. University of Alberta

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Both the BIA and the CCAA provide for the creation of classes of creditors for the purposes of voting on the plan. The legislation originally provided little guidance on the principles that were to be used in determining the appropriateness of the classification scheme. The governing principles emerged from an important series of judicial decisions dealing with disputes over the classification of creditors. The statutes have since been amended to provide additional classification rules. The BIA contains rules that govern the classification of secured creditors62but is silent as to the classification of unsecured creditors. Rules governing the classification of secured and unsecured creditors have been added to the CCAA.63These statutory rules are largely codifications of the judicially created principles, and it is necessary to review the case law on classification to comprehend fully the logic and rationale behind them.

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1) The Judicial Approach
a) The General Principles

An applicant who objects to the proposed scheme of classification may want to be placed in a separate class for the purposes of voting on the plan. Courts are wary about creating additional classes for voting purposes. The creation of a separate class greatly enhances the leverage available to a creditor in its negotiations with the debtor. The creditor obtains a veto power, and this can be used to bargain for more favourable treatment in the plan.64The creation of a multitude of classes would defeat one of the underlying principles of restructuring law.65A majority-approval rule is used to prevent creditors from using holdout bargaining strategies. Creditors who employ these strategies threaten to defeat bargains that enhance value for all creditors unless their claims are afforded special treatment. A majority-approval principle limits a creditor’s ability to adopt such strategies, but this objective is undermined if too many creditors are given the power to block the plan unilaterally.

Courts are also conscious that the classification scheme, like any voting system, is capable of being gerrymandered and abused. The classification scheme proposed by the debtor may have been deliberately devised as a means of swamping the vote of a dissenting creditor by placing that creditor in a class with other claimants that are not similarly affected by the plan. The task of the court is therefore to uphold the majoritarian principle for creditor approval of restructuring plans while at the same time preventing it from being used as an instrument to abuse minority interests.

The classic statement on the principles that are to be applied by a court in reviewing a classification scheme is found in Sovereign Life Assurance Co. v. Dodd.66The rationale for placing creditors into different classes is that "the creditors composing the different classes have different interests; and, therefore, if we find a different state of facts existing among different creditors which may differently affect their minds and their judgment, they must be divided into different classes."67The following test has been devised to determine if a classification scheme is fair and reasonable:

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It seems plain that we must give such a meaning to the term "class" as will prevent the section being so worked as to result in confiscation and injustice, and that it must be confined to those persons whose rights are not so dissimilar as to make it impossible for them to consult together with a view to their common interest.68The problem with placing creditors with different legal interests in the same class for voting purposes is illustrated in a simple example. Suppose that there are three creditors, each of whom has a claim for $100,000 against the debtor. A and B have unsecured claims, while C has a fully secured claim. A liquidation of the debtor’s assets would produce $240,000 for distribution among the creditors. C would recover $100,000, while A and B would each recover $70,000. The debtor develops a restructuring plan that avoids a liquidation and proposes that each creditor be paid $80,000 in compromise of the claims they hold. The three creditors are placed in the same class for the purposes of voting on the restructuring plan. A and B have sufficient voting power to impose the plan on C, since together they have a majority of votes representing two-thirds of value of the claims. This represents a transfer of $20,000 from the secured creditor to the unsecured creditors. The restructuring plan therefore results in confiscation and injustice to C, and a court should require that C be placed in a separate class for voting.

Courts will not endorse a classification scheme unless there exists a sufficient commonality of interest among members of the same class. Canadian courts have developed a set of principles for determining when there is a sufficient commonality of interest, and they have also rejected the idea that the legal rights of claimants must be identical.69

In the latter respect, the Canadian approach differs from that in the United States. In the United States, claimants can be placed in the same class only if their interests are substantially similar in legal character. This tends to produce more classes than is the case in Canada. However, its effect is ameliorated by the existence of a "cram down" power that permits a court to force a plan on a dissenting class if certain conditions are satisfied.70

The Canadian approach is often referred to as the non-fragmentation approach. It is premised on the idea that excessive fragmentation of classes will defeat the underlying purpose of restructuring law, and

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that some degree of difference in the legal rights held by members of the class can be tolerated. Claimants with different legal claims therefore may be placed in the same class so long as their legal rights are not so dissimilar that it is not possible for them to consult with one another with a common interest.71

In applying the non-fragmentation approach, the first step in the analysis is to determine whether the legal rights held by the various claimants within the class are the same or different. If they are the same, then there is no basis for giving the applicant the right to vote in a separate class. If the legal rights are different, the second stage of the analysis is engaged and it becomes necessary to determine whether the difference in legal rights is such that the parties do not have a sufficient commonality of interest.

b) Determination of Legal Rights

In deciding whether the legal rights of claimants within a class are the same or different, the court must look to the nature and character of the legal rights held by the claimant and must not consider external matters...

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