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Outsourcing to Canada: Legal & Tax Considerations

Since many U.S. outsourcing deals have "cross-border" aspects involving Canadian subsidiary companies, we want to provide an overview of issues arising when a service provider or a buyer (i.e. a customer) files for bankruptcy protection under Canadian law, which is different from U.S. law in a number of material respects.

Canada has two levels of government that regulate creditors' and debtors' rights. The federal government has exclusive jurisdiction regarding "bankruptcy and insolvency" and the various provincial governments have exclusivity over "property and civil rights." For example, provincial laws include statutes that provide for the creation of security interests and priorities among secured creditors (similar to Article 9 of the U.C.C.).¹

This dual federal-provincial regime creates a cross-over of jurisdiction in some instances but, as a general rule, where a party is insolvent, federal legislation will take precedence over provincial law.

In addition, even though Canadian federal insolvency laws allow a debtor to "stay" (i.e. suspend) a secured creditor's rights and remedies in some situations, a secured creditor that is opposed to a debtor's restructuring efforts is more likely to prevail in efforts to enforce its security (often through the appointment of a receiver²) as compared to a secured creditor in a typical proceeding under Chapter 11 of the United States Bankruptcy Code (the "U.S. Code").

The Two Main Federal Bankruptcy and Insolvency Statutes

There are two federal statutes in Canada³ applicable to an insolvent party:

• The Bankruptcy and Insolvency Act ("BIA"), which includes both a bankruptcy and a proposal (restructuring) framework under which a party may reach compromises with its creditors; and
• The Companies' Creditors Arrangement Act ("CCAA"), which permits reorganization of insolvent companies and compromise of creditors' claims through a plan of arrangement (roughly analogous to Chapter 11 of the U.S. Code).

Because of its flexible provisions, the CCAA is the statute of choice for most large insolvent corporations: it contains few prescribed rules and allows a Court to exercise considerable judicial discretion to fill in gaps in the legislation.⁴

Our comments below focus primarily on the CCAA.

No Specific Rules in Canada for Executory Contracts

One of the main differences between Canadian and U.S. bankruptcy law is this: there is more certainty regarding the rights of the parties to "executory contracts" (i.e. contracts that contain on-going obligations between both parties) in the U.S. because of specific rules in the U.S. Code.

Although Canadian contract law recognizes the concept of an executory contract, our bankruptcy and insolvency laws currently do not provide specific rules for dealing with the parties' rights under such a contract.⁵

For example, both the CCAA and the BIA are silent on the right to assume or assign executory contracts. In Ontario, however, there have been cases in which a court permitted assignment of such contracts (even where the specific wording of the contract prohibited assignment) in the context of a CCAA proceeding involving the sale of a business.

In Canada, therefore, while a creditor may obtain the same results vis-à-vis an insolvent debtor as a creditor under U.S. bankruptcy laws, as a general rule, the end result is far less predictable because Canadian courts have broad discretion under the CCAA to grant "orders" affecting the substantive rights of the parties.

Rights to Terminate Outsourcing Agreement

In the early stages of a CCAA proceeding, such as the application for an initial court order, the specific provisions of the contract are often not taken into consideration. At a later stage in the proceedings, the contract itself may become subject to judicial consideration, but it is often dealt with on an ad hoc basis.

The following table is a quick-reference guide regarding possible outcomes for an outsourcing Buyer or Service Provider that applies to a Canadian court for termination of an outsourcing contract.

Where a buyer commences court action under the CCAA, the presiding court is likely to preserve the status quo (at least in the initial order) and prevent the provider from terminating the agreement based on any pre-bankruptcy defaults.

Section 11.3 of the CCAA, however, provides that no CCAA order shall have the effect of

• Prohibiting a person from requiring immediate payment for goods, services, use of leased or licensed property or other valuable consideration provided after the CCAA Order is made, or
• Requiring the further advance of money or credit.

Basically, this section simply means that the buyer will be held to timely payment for continuing services in accordance with the contract if the buyer wants to keep the contract alive. If not, the service provider would likely succeed in modifying the initial CCAA order to permit termination of the contract.

In some cases, however, the insolvent buyer may also seek a court order permitting it to terminate the contract with the provider--with the proviso that damages will be addressed under the plan of arrangement. Whether the court will grant this type of order depends on whether the court is convinced that the buyer will not be able to carry out its restructuring plan if such relief is not granted.

For the initial order under the CCAA, we can state one thing with certainty: a court is likely not to take into account or even consider the provisions of the outsourcing agreement, even if those provisions that specifically address what happens in the context of a bankruptcy filing. Typically, an order will have a "comeback" clause allowing a party to apply to the court, at a later date, for leave to exercise a particular remedy under the contract (which is still subject to the court's broad discretion).

What Can Service Providers Do in Canada?

There is no express right of providers to "assume and assign" an outsourcing contract under Canadian bankruptcy and insolvency law. However, Ontario courts have permitted assignments even though there were contractual provisions restricting assignment.

This result is far from certain. Until an appellate court decides the issue or the anticipated reforms to Canada's insolvency laws are enacted, the situation will remain subject to considerable uncertainty.

Set-off Rights

Both the CCAA and the BIA include provisions which specify that the law of set-off applies to claims by or against a debtor company.

The usual rules applicable to set-off in a non-insolvency context continue to apply. Parties may set-off pre-filing debts against each other where the prerequisites to set-off at law (e.g. mutuality) can be met.

Conclusions & Recommendations

There are two major conclusions when comparing Canadian and U.S. bankruptcy and insolvency law in this area:

• No Specific Rules Regarding Executory Contracts: Canadian law does not currently include specific rules relating to executory contracts (although the law may be reformed in the near future); and
• Court Outcomes More Uncertain: Under Canadian law, even though a creditor may often obtain the same results vis-à-vis an insolvent debtor as under the U.S. Code, Canadian courts have broader discretion to make orders affecting the rights of the parties.

Here are two recommendations for addressing the differences between Canada and U.S. bankruptcy and insolvency laws in outsourcing agreements that are cross-border in scope:

• The Canadian agreement (or schedule to the U.S. master agreement) should include specific "Canadianized" bankruptcy and insolvency provisions to address some of the fundamental differences in the Canadian law (bearing in mind that Canadian courts, under the CCAA, will maintain their broad discretion in spite of specific provisions in the contract); and
• If the outsourcing deal is structured using local entities for delivery, the buyers' Canadian entities should seek guarantees of the obligations of the local provider entities from the parent corporation (although this will not address the situation of the parent's bankruptcy).

George Atis (george.atis@mcmillanbinch.com) is chairman of the firm's technology and outsourcing practice groups. Jeff Gollob (jeff.gollob@mcmillanbinch.com) is a senior partner in the restructuring group. McMillan Binch LLP, dubbed "America's Canadian law firm," is based in Toronto.

¹There are 10 provinces with slightly different statutes regarding property and civil rights. McMillan Binch is based in the province of Ontario and this article discusses federal bankruptcy and restructuring statutes and laws as they are applicable in Ontario only.
² Receivers may be appointed privately (through a contractual right of appointment under a security agreement) or by a court upon the application of a secured creditor. Receivers are also faced with difficulties in attempting to deal with executory contracts.
³There is also the federal Winding-up and Restructuring Act, but it applies only to the liquidation and restructuring of certain types of companies, including banks, insurance companies and trust companies.
⁴The indebtedness threshold for proceeding under the CCAA is Canadian $5,000,000.
⁵The Canadian federal government is considering reforming its bankruptcy and insolvency laws. A report submitted to the government by the joint task force of the Insolvency Institute of Canada and the Canadian Association of Insolvency and Restructuring Professionals includes a recommendation to revise the laws to include specific provisions dealing with "executory contracts", a concept which is not mentioned in the current versions of the CCAA and BIA.

Publish Date: April 2003

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Copyright © 2003 - Everest Partners, L.P.

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