Recent developments questioning the protection and scope of post-filing obligations

Starting in 2015, debtors began to push more aggressively on post-filing obligations. Debtors—or their DIP lenders—always looking for opportunities to preserve liquidity, saw non-payment as a ready option.

This section summarizes two of the most significant cases: U.S. Steel and Essar Steel Algoma Inc. Both Ontario steel producers sought to stay payments for local, municipal taxes. The debtor in Essar Steel Algoma also sought to stay its obligations for its cargo handling payment.

Case study: U.S. Steel Canada Inc

In 2014, U.S. Steel Canada Inc. (USSC) filed for CCAA protection after its American parent company diverted work away from the Hamilton-based plant. After filing for protection, USSC continued to pay its municipal realty taxes as it developed a Business Preservation Plan (BPP) to present to the court. The eventual BPP provided for continued operations at the Hamilton plant, but at a significantly reduced level for 12 to 15 months.

Under the proposed BPP, USSC sought a suspension of further property tax payments to the City of Hamilton and the County of Haldimand to ensure sufficient liquidity. In response, the municipalities argued that section 11.01 prevented the court from approving the BPP, as the suspension of property taxes would amount to either a provision of post-filing services without compensation, or the advancement of further credit to USSC.

Justice Wilton-Siegel disagreed, relying heavily on the 2001 Alberta Court of Appeal decision of Smoky River Coal Ltd, which considered, outside the context of 11.01, whether municipal taxes are paid for “services.”

Smoky River operated a coal mine and, after experiencing financial difficulties, obtained protection under the CCAA, including a stay of all proceedings against it. In the process, the court created an express charge and priority over Smoky River’s assets in order to encourage regular trade creditors to continue provision of goods and services. The order stated that “Post-Petition Trade Creditors shall be entitled to the benefit of and are hereby granted a charge.” The judge did not define who the post-petition trade creditors were. The issue in this case was whether the municipality could benefit from this charge for the payment of property taxes.

The Court found that, for the purposes of the charge, government services funded by taxes could not be considered “services.” The Court rejected the notion that property taxes constituted selling something for money. The municipality was incapable of denying services funded by property taxes if a company did not pay: “Property taxes are not the purchase price for the services provided by [the municipality]; instead they are the means of generating the revenue to provide those services.” While the court held that it was conceivable that a taxation authority could be a creditor in other contexts, this municipal property tax regime was definitively not a debtor/creditor relationship. While Smoky River was cited in many significant reported CCAA decisions in the years following its release, its holding on the nature of taxes and services was not revisited. Indeed, courts continued to issue initial orders that required the payment of post-filing municipal taxes.²¹ As a result, conflicts over the payment of these taxes often centered around arguments regarding the enforceability of initial orders, not the definition of “services” under section 11.01.

Based on Smoky River, Justice Wilton-Siegel made two notable findings. First, he agreed with Smoky River that property taxes did not constitute services:

I do not think that municipal realty taxes are properly characterized as a payment for the provision of post-filing services as the concept of “services” is understood for the purposes of section 11.01. Rather, municipal realty taxes are a levy imposed on property owners to fund the operations of a municipality exercising its authority and obligations as a local government body.

Justice Wilton-Siegel also held that the relationship between a company and a municipal taxation authority could not be characterized as that of debtor and creditor. Looking to section 11.01, Justice Wilton-Siegel noted that the phrase “‘further advance of money or credit’… assumes a pre-existing credit relationship which is maintained on an involuntary basis after the commencement of CCAA proceedings.” In this regard, Justice Wilton-Siegel treated property taxes in a similar fashion to how the court treated financing agreements in Smith Brothers. His description of property taxes essentially holds that, like the vehicle leases in Smith Brothers, payment of these taxes by the debtor was going towards something other than “use.” Using the words “a levy imposed on property owners to fund the operations of a municipality exercising its authority,” seemingly removed the direct relationship between the taxation given and the services received. Under such a conception, no protection can be given under the accepted interpretation of section 11.01.

Barring a statutory prohibition, Justice Wilton-Siegel then considered whether he should exercise his discretion under section 11 to grant the suspension of property tax payments. The municipalities argued that the payment of property taxes was necessary for valuable public services including education, recreation, housing, and social support. If Justice Wilton-Siegel allowed USSC to stop payment of these taxes, the municipalities would have to cover the amount owing to pay for certain commitments like provincial education taxes.²²

Justice Wilton-Siegel rejected this line of argument. He pointed to the fact that the municipalities had access to remedies in the event of non-payment of taxes, including statutory liens. Nothing in the BPP would strip the municipalities of those rights. Furthermore,

There [was] no evidence that the Municipalities’ security [would] be eliminated or materially reduced in the event of a liquidation of USSC as a result of the proposed suspension of payment of municipal realty taxes.

While noting the significance to the municipalities of a loss of tax revenue, Justice Wilton-Siegel then noted that failure to approve the BPP would likely result in the failure of USSC:

Such a result would have permanent consequences for the Municipalities, which would not be limited to the permanent loss of realty tax revenue… On balance, I think it is clear that continuation of USSC’s operations pursuant to the Business Preservation Plan is in the best interest of the Municipalities as well as of the other stakeholders.

In other words, better for the municipalities to suffer through a short-term suspension of taxes than for the business to fail and the municipalities to lose the tax stream altogether. This comment—also present in the Essar Steel Algoma case below—is problematic. It presumes that the CCAA court is better placed to determine the long-term interests of the municipality than its elected representatives.

Case study: Essar Steel

Essar Steel Algoma Inc (ESAI) was a large steel producer located in the municipality of Sault Ste. Marie.²³ It sought protection under the CCAA in November 2015 and, at the time this piece was written, it had not yet emerged.

In the spring of 2016, ESAI was in the midst of a sales process. The winner of the process emerged as a bid in which the parties making up the DIP loan played a significant role. At the same time, two separate issues arose regarding post-filing obligations: the payment of municipal taxes and the payment of fees to a related party for cargo handling. Each is addressed in turn below.

No municipal taxes owing in Essar Steel

The initial order in Essar Steel was in the form of the model order, which is to say that it required the payment of municipal taxes:

[ESAI] that shall remit, in accordance with legal requirements, or pay:

any amount payable to the Crown in right of Canada or of any Province thereof or any political subdivision thereof or any other taxation authority in respect of municipal realty, municipal business or other taxes, assessments or levies of any nature or kind.

The City of Sault Ste. Marie (City) brought a motion for an order requiring the CCAA debtor, ESAI, to pay post-filing municipal property tax obligations. Without seeking Court approval, ESAI had not paid these taxes. Unlike U.S. Steel, where the debtors sought to suspend municipal property tax payments during the prospective 12 to 15-month preservation plan period, ESAI never made any post-filing payments to the City nor had any timeline for the resumption of payments. The City emphasized that ESAI’s property tax payments formed a large part of the City’s tax base and that the continued accumulation of arrears would create significant difficulties for the City. In response to the City’s motion, ESAI sought retroactive and prospective suspension of the tax obligations.

The City emphasized that ESAI’s property tax payments formed a large part of the City’s tax base and that the continued accumulation of arrears would create significant difficulties for the City.

Justice Newbould dismissed the City’s motion and allowed ESA’s motion. Section 11.01 did not play any role in the decision. While the City sought to distinguish U.S. Steel,²⁴ it argued the motion on different grounds.

In this motion, the City emphasized the importance of initial order and the debtors’ obligations to pay municipal taxes from that order. The City argued that the debtor could not deviate from the order at will. Relying on the recent decision of Justice Morawetz in Target, the City argued that the debtors could not ignore post-filing obligations when counter-parties, like the City, had relied on debtors’ Court-ordered obligations to fund these taxes. This would in effect, change the rules mid-stream to benefit the debtors and its DIP lenders and retroactively suspend payments that were already supposed to have been paid under the initial order.²⁵

In response, ESAI pointed to the constraints on its cash flow given the liquidity requirements in its DIP facility. It needed to preserve sufficient cash level through its sales process to implement a restructuring plan. The post-filing tax obligations would put any such plan at risk.²⁶

Justice Newbould balanced the prejudice to the debtor and the City and exercised his discretion under section 11 to suspend the payments. Justice Newbould relied upon many of the same factors as in U.S. Steel. ESAI faced a serious liquidity crisis with a sale process in the balance. On the other hand, while Justice Newbould recognized the City’s needs, he also pointed to its lien under the Municipal Act, its commercially high rate of interest for unpaid taxes and that the survival of the debtor would ultimately be in the City’s long-term benefit. The monitor’s approval of the non-payment and its concern about the debtor’s dwindling cash cushion bolstered Justice Newbould’s conclusion.²⁷

The proposed asset purchase agreement had fallen apart in the summer of 2016, but ESAI continued to operate and continued to not pay its municipal tax obligations. The City renewed its motion approximately one year later. Justice Newbould recognized that the “lack of payment of taxes is causing great difficulty to the City” but refused to order the post-filing back taxes to be paid. Instead, as supported by the monitor and the DIP lenders, the debtors were ordered to pay approximately half of the monthly tax obligation. The City sought leave to appeal but then abandoned the appeal in favour of a settled resolution.

No payments owing for related party services

A port located adjacent to ESAI’s steel plant, the Port of Algoma (Port), was considered by ESAI to be essential to its operations. The great lakes port ESAI brought in much of its inputs and exported its products through the Port.

Before 2014, ESAI owned and operated the Port. In November 2014, Algoma sold its port assets located to an affiliate, Port of Algoma Inc. (Portco) and leased to Portco the real property upon which the Port is located (Port Transaction). ESAI raised much needed liquidity through the Port Transaction.

As a result of the Port Transaction, Algoma and Portco entered into three long-term material contracts to govern their ongoing relationship: (i) a lease, (ii) a cargo handling agreement and (iii) shared services agreement.

First, under the lease, Algoma leased Portco the Port lands, including all of the structures, roads, and outdoor storage spaces sitting on the Port lands. The term of the Lease was 50 years. The lease provided for ESAI to retain access to the Port lands provided that ESAI met its obligations under the cargo handling agreement.

Second, under cargo handling agreement, Portco agreed to provide cargo handling services at the Port to Algoma for a 20-year term and Algoma would pay approximately $3 million per month for the services.

Third, under the shared services agreement, ESAI agreed to provide Portco with operational and maintenance services necessary at the Port. During the Port Transaction none of the employees who operated the Port were transferred to Portco, so Portco paid ESAI for services, including the labour to operate the Port. It would pay approximately $1 million per month. The cargo handling payments, net of the shared services payments, would total approximately $25 million a year and were used by Portco to pay the secured lender who funded the Port Transaction.

When ESAI filed for CCAA protection, the initial order (as amended and restated) contained three provision relevant to continuing services generally or the Port services. First, the order provided for ESAI to have continuing “unimpeded access” to the “Port and use of all equipment used in connection with the operation of the Port.”

Second, the Court ordered continuing services from all suppliers. Anyone with an agreement for the supply of “goods and/or services” are:

[H]ereby restrained until further Order of this Court from discontinuing, altering, interfering with or terminating the supply of such goods or services as may be required by the [ESAI], and that [ESAI] shall be entitled to continued use of their current premises… provided in each case that the normal prices are paid by [ESAI] in accordance with normal payment practices of [ESAI]… or as may be ordered by the Court.

The order did not define goods or services, but enumerated examples of types of applicable services, including “port services.” However, nowhere did the order provide for the immediate payment of suppliers.

Third, the Court specifically provided for the continuing payment of fees to Portco:

This Court orders that, in accordance with the DIP Agreement, the Definitive Documents and the Approved Budget, and except as otherwise provided to the contrary herein, the Applicants shall be entitled but not required to pay all reasonable expenses incurred by the Applicants in carrying on the Business in the ordinary course prior to, on or after this Order, and in carrying out the provisions of this Order, which expenses shall include, without limitation:

(a) all expenses and capital expenditures reasonably necessary for the preservation of the Property or the Business, including, without limitation, payments on account of insurance

(b) payment for goods or services actually supplied to the Applicants following the date of this Order

For greater certainty, the Applicants shall continue to pay the normal prices or charges payable to Portco that accrue and become payable from and after the date of this Order in accordance with the relevant agreements in effect between Portco and the Applicants or such other practices as may be agreed upon by Portco and each of the Applicants and the monitor, in accordance with the Approved Budget, or as may be ordered by this Court.

After the CCAA filing, Algoma initially continued to make regular payments to Portco under the cargo handling agreement. However, on May 16, 2016, Algoma failed to make the scheduled payment under the Cargo Handling Agreement for services provided in April 2016. Algoma subsequently informed Portco that it would not be making future payments under the Cargo Handling Agreement because its DIP lenders would not approve a budget contemplating payments to Portco while a promissory note due to ESAI remained outstanding.

Portco brought a motion to compel payment. It argued that ESAI and its DIP lenders were required by the initial order to continue payments. It also argued that such payments were required under section 11.01 of the CCAA because it was clear that ESAI expected to continue using the Port and Portco’s cargo handling services. Portco was not designated a critical supplier and could not be expected to be compelled to continue to supply services without payment. Justice Newbould rejected these arguments and dismissed the motion.

First, Justice Newbould held that the initial order did not require continuing payments to Portco. ESAI could not make the payment without the approval of the DIP lenders. And there was nothing in the initial order that precluded the DIP lenders from deciding not to fund payments to Portco.

Second, Justice Newbould held that there were no services provided by Portco to ESAI and therefore section 11.01 did not apply:

The persons providing the services are not Portco employees but employees of Algoma. Under the Shared Services Agreement, [ESAI] provides all of the services as may be necessary for Portco to fulfill its obligations under the Cargo Handling Agreement. Those services are paid for by [ESAI].

In subsequent reasons, Justice Newbould elaborated on the reasons why Portco did not provide “services” as protected under section 11.01 of the CCAA:

There is no management or direction given by Portco to Algoma. Portco has no operating management at all. It is insolvent. As stated in my prior decision, under the Shared Services Agreement it is Algoma that provides all of the services as may be necessary for Portco to fulfill its obligations under the Cargo Handling Agreement.

In short, there were services being provided, but Portco was not providing them. The labour was paid for by ESAI and therefore the services were being provided by itself.

Portco had also argued that the use of Portco’s land, for Portco it had a longterm lease from ESAI, and the use of the Port equipment, which Portco owned, were protected under the “use of leased or licensed property” clause of section 11.01. Justice Newbould too rejected this argument. The lease provided ESAI with express, non-exclusive access to the Port, which was necessary because it was ESAI that provided all of the services to be provided under the cargo handling agreement: “There is no mention in the Cargo Handling Agreement of any licence from Portco to Algoma.” Because this access was provided for in the lease, ESAI’s access to the Port could not be considered a license that was protected by section 11.01:

Portco argues that a licence is merely a right that allows a licencee to do some act upon the land that would otherwise constitute a trespass. Thus it says the right of access to Algoma to the Portco facilities that were leased to Portco amounts to a licence that should be paid for. I do not agree. In the lease from Algoma to Portco, it expressly reserves to Algoma in section 6.2 the right to enter the Portco premises, including the docks, to exercise its access rights under the Cargo Handling Agreement. Algoma is required under the Shared Service Agreement to provide the services required by the Cargo Handling Agreement. There can be no issue of any trespassing.

While this logic appears slightly circular—there is no license because the lease permits access and therefore there is no need to provide payment for the right of access under the lease—the real motivation was made clear later in the decision: Portco was not an independent supplier of ESAI. Portco was not at arm’s length because it was an affiliate of ESAI and the same parent controlled the 2014 transaction. The relationship between the parties was a bar to the application of section 11.01. The nature of this relationship itself was under a cloud; the monitor had raised concerns that the Port Transaction was oppressive. Therefore, no payment would be ordered.

Portco asked that, in the alternative, if no payment was to be forthcoming, Portco should be permitted to cease the operations of the Port and the stay be lifted to permit Portco to sue on the breach of the agreement. This remedy was also denied. Noting that the concerns regarding the Port Transaction still had to be resolved, Justice Newbould held:

To permit Portco to effectively shut down the operations of Algoma would be completely contrary to the interests of all stakeholders, not the least of which are the employees and retirees, none of whom have supported the position of Portco on this motion. Such an order would have the effect of giving Portco complete control of this entire proceeding.

Citing no section 11.01 case law in any of the decisions, Essar Steel Algoma presents yet another unprecedented narrowing of section 11.01. If followed, this case would provide that to fall under section 11.01 “services” may have to be (a) provided by a bona fide third party and (b) under direct management and control of that third party. A license may have to be (a) provided by a bona fide third party and (b) expressly stated in a lease or license agreement.²⁸ None of these requirements are found in the statute and have the potential to reshape the section 11.01 protections. Will IP licenses provided by foreign non-debtor affiliates be protected? Will transportation or logistics services be covered if the contracting party subcontracts for those services? The ramifications of Essar Steel Algoma are unclear.

What is clear is that Essar Steel Algoma perhaps best demonstrates the risk of the narrow drafting of section 11.01 instead of the broader approach to section 503 of the Bankruptcy Code. At the time of the writing of this piece—more than two years after the cargo handling payments stopped—payments for the cargo handling services have not resumed and Portco’s secured lender has not received payments. ESAI retains access to the Port, the Port equipment and ESAI’s employees continue to operate the sending and receiving of cargo for its benefit. Portco was nonetheless barred from exercising its self-help remedy of barring access to its premises. Yet, despite the years of use and access to the Port, essential to the debtor’s operations, there is no protection for Portco. It may never get paid, even if the secured creditors—who benefited from the debtor’s use of the Port—recover in full. Under the Bankruptcy Code, such an actual and necessary expense may not be paid immediately but it would have an administrative charge to be paid out before emergence.

Whether Essar Steel Algoma is the right or wrong result depends on a fundamental policy question: to what degree should the debtor’s ability to reorganize be at the cost of post-petition creditors, suppliers or counterparties? We try to address this question in the final section of this paper.

_________________________

²¹ See e.g., Target, supra note 11 at para 10.

²² The Factum and Brief of Authorities of the Responding Party, City of Hamilton dated September 25, 2015 at para 25.

²³ One of the authors of this paper represented the direct and indirect parents of ESAI as well as an affiliate, Port of Algoma Inc, in these proceedings including with respect to the matter discussed in this section. Any views expressed here are of the authors alone.

²⁴ Factum of The Corporation of the City of Sault Ste Marie dated June 6, 2016 at para 47.

²⁵ Ibid at para 40.

²⁶ ESA’s Responding Factum dated June 10, 2016.

²⁷ Neither of the U.S. Steel and Re Essar (6459) decisions address another protection for municipalities—i.e., a municipality’s status as a preferred creditor under section 136(1)(e) of the BIA, (65.1(4)) and (84.2(4)). In the event of a distribution of assets under the BIA, a municipality is entitled to preferred status for all municipal taxes assessed or levied within the two years immediately preceding the bankruptcy not exceeding the value of the debtor’s interest in the property.

²⁸ It is also possible to read these decisions as completely sui generis, driven solely by the concerns about the potential concerns with the Port Transaction. This too has no root in the statute itself, nor was it made express in the decisions. However, such a reading of the decisions would greatly narrow their subsequent impact on the section 11.01 case law.

To discuss these issues, please contact the author(s).

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