The denizens of Canada's financial districts ended the workweek feeling upbeat on Oct. 29, 2004. Earlier that day, the Supreme Court of Canada announced its eagerly awaited decision in Peoples Department Stores Inc. v. Wise, and the initial reports had been promising.
According to the Canadian business press, the high court ruled that directors and officers do not owe a fiduciary duty to a corporation's creditors, even when the company is insolvent or on the verge of insolvency. The suit sought to show that Section 122(1)(a) of the Canada Business Corporations Act (CBCA), which requires directors to "act honestly and in good faith with a view to the best interests of the corporation," created a duty to creditors.
But for those who had nothing better to do Saturday morning than read the complex decision, the weekend quickly turned sour. The media reports had been accurate, but hardly complete.
"Officers and directors of financially troubled corporations will find little reason to celebrate Peoples," says Arthur Peltomaa, a partner in Bennett Jones' Toronto office. "The Supreme Court left wide open the possibility of unpaid creditors asserting claims based on the oppression remedy and a statutory duty of care."
Found in Section 241 of the CBCA, the oppression remedy authorizes courts to grant a wide range of discretionary remedies to creditors, shareholders and other stakeholders when directors have exercised their powers unfairly. And the duty of care, articulated in Section 122(1)(b), requires directors to exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances.
As it turns out, then, the only ones celebrating the Peoples decision may be the Wise brothers.
Alex Wise founded Wise Stores Inc. in 1930 when he opened a small clothing store in Montreal. By 1992 the enterprise had grown to 50 locations in urban areas in Quebec, had sales of $83 million and was listed on the Montreal Stock Exchange.
Alex's three sons--Lionel, Ralph and Harold--were directors and officers of the company and controlled 75 percent of its equity.
In 1992 Wise Stores acquired Peoples Department Stores Inc., an 81-store chain in Eastern Canada with $133 million in sales. Peoples became a direct subsidiary of Wise. The companies' directors thought the merger would make both chains more efficient in the highly competitive retail market. However, it created internal problems that had the opposite effect.
In particular, the parallel bookkeeping and shared warehousing arrangements that the brothers instituted caused a great deal of confusion. The actual situation in the warehouse often didn't mirror the reported state of the inventory in the system, and the goods of one company often were inextricably commingled and confused with the goods of the other.
To remedy the situation, the Wise brothers introduced a joint inventory procurement program for the two companies in 1993. Under that program, Peoples--which had better cash flow than Wise--purchased and paid for most of Wise's inventory, subject to reimbursement by Wise.
Unfortunately for the family-controlled enterprise, the giant American retailer Wal-Mart entered the Canadian market in 1994, intensifying the competition with its acquisition of 100 Woolco stores from Woolworth Canada Inc.
Wise's finances deteriorated, and Peoples--albeit under financial pressure itself--extended increasingly larger amounts of trade credit to Wise under the joint procurement program. By June 1994 Wise owed Peoples $15 million.
Both companies declared bankruptcy in 1995. Following liquidation, many of Peoples' trade creditors remained unpaid. Peoples' trustee, representing the creditors, sued the brothers, alleging the joint procurement program favored the parent company in breach of the Wise brothers' duty to protect the interests of Peoples' creditors.
The trial judge awarded $3.66 million to the creditors in December 1998, but the Quebec Court of Appeal reversed that ruling in February 2003.
"It's important to note that the Wise brothers committed no fraud or dishonesty," says Francine Swanson, president of the Canadian Corporate Counsel Association and senior legal counsel at BP Canada Energy Co. "Ultimately, that's what stood in the way of a finding that they had breached their fiduciary duty."
The Supreme Court sided with the appeal court. The six judges who heard the case in the high court made it clear that the Wise brothers' fiduciary duty was to the corporation, and that the duty didn't vary with the company's financial fortunes.
"The interests of the corporation are not to be confused with the interests of creditors or other stakeholders," the court wrote. "The directors' fiduciary duty does not change when the corporation is in the nebulous 'vicinity of insolvency.'"
The court went on to explain the reasons for its ruling. When it finished doing so, however, little else was clear.
The Court's Decision
Creditors and shareholders didn't need the protection of the statutory fiduciary duty, the Supreme Court reasoned, because they had other avenues of redress.
"If the stakeholders cannot avail themselves of the statutory fiduciary duty (the duty of loyalty) to sue the directors for failing to take care of their interests, they have other means at their disposal," the court wrote.
The court made note of several such alternatives. The oppression remedy, the court observed, offers the broadest redress of its kind in the common law world. The creditors in Peoples, however, hadn't relied on the oppression remedy, and so the court didn't comment on its applicability in the case.
The court also noted that stakeholders could rely on the duty of care. But the duty of care didn't demand "perfection" from directors and officers, the court noted. Rather, they were entitled to the benefit of the "business judgment rule," an American doctrine the court endorsed for the first time and expressed as follows: "Courts are ill-suited and should be reluctant to second-guess the application of business expertise to the considerations that are involved in corporate decision-making."
On the facts in Peoples, the Wise brothers hadn't breached their statutory duty of care.
"We agree with the Court of Appeal that the implementation of the new [procurement] policy was a reasonable business decision that was made with a view to rectifying a serious and urgent business problem in which no solution may have been possible," the court wrote.
While closing the door on the fiduciary duty remedy, the court left open several others. The Wise brothers were off the hook, but future defendants may not be so lucky.
A Warning Shot
"Peoples is certain to encourage future creditors to refocus their efforts to hold directors personally responsible for their losses," Peltomaa says.
Complicating matters is the pronouncement by the Supreme Court in Canada that the interests of creditors increase in relevancy as a corporation's finances deteriorate, rejecting the Court of Appeal's view that the interests of creditors have no bearing on the conduct of directors.
"While the Supreme Court has emphasized that directors' fiduciary duty is to the corporation and not to a single stakeholder or group of stakeholders, creditors [relying on the oppression remedy or the duty of care] can continue to insist that the directors act in a manner that recognizes the economic reality of whose interests are most at risk when a corporation is in financial trouble," says Kevin McElcheran, co-chair of Blake, Cassels & Graydon's restructuring and insolvency group.
Similarly, what constitutes the "best interests of the corporation" may involve the interests of a broad range of stakeholders, including shareholders, employees, suppliers, creditors, consumers, governments and even the environment.
"There's a warning shot from the Supreme Court about just how broadly directors' duties can extend," says Barry Fisher, vice president, general counsel and corporate secretary at Toronto-based SAP Canada, a subsidiary of the German software company.
What all this means is that in-house counsel must do a business-case analysis for any large transaction.
"The analysis should clearly explain the transaction, its purpose, the options considered, the pros and cons of the transaction and the impact on stakeholders," Swanson explains. "It should also state the sources of support for the transaction, with particular attention to the views of professional advisers."
Directors may take some comfort in knowing that the CBCA absolves directors of liability under Section 122 if they rely in good faith on a report of professionals such as lawyers or accountants.
However that may be, directors and officers remain at risk.
"There are people who were looking to Peoples to provide absolution for directors," says Dana Fuller, partner and chair of the litigation group at Ogilvy Renault in Toronto. "But they sure didn't get it."
Governance Headaches Creep Across The Border
The attention the media, legal and business community has given to Peoples v. Wise gives credence to a recent survey conducted by Ipsos-Reid, a Canadian market research group. The July survey, "Corporate Governance/Investor Relations Study," indicated that corporate governance and disclosure are having the greatest impact on the way Canadian public companies operate.
The research group interviewed 680 individuals who were responsible for investor relations at their companies in Canada. Forty-eight percent of respondents cited governance compliance as having the greatest effect on their business. Growth and survival issues, which ranked second, got the nod from only 11 percent of those surveyed.
Respondents pointed to increased workloads, additional costs, larger staffs and a greater need for professional guidance as some of the key consequences of the changing governance requirements.
Perhaps even more telling is the finding that two-thirds of those surveyed believed they had to make changes to their boards as a result of the new governance standards, as well as media and shareholder pressure.
"As directors' responsibilities increase they have to ensure they remain ahead of the curve on emerging governance issues to enhance board performance," says Bernard Wilson, chairman of the Institute of Corporate Directors, one of the survey's sponsors.
Thirty-two percent of respondents believed that transformation of corporate governance guidelines into hard-and-fast rules would have the most important impact on the conduct of public companies in the future. CEO or CFO certification of disclosure controls ranked second at 24 percent, while creation of a national securities regulator stood third at 12 percent.