Unreal Indemnity 

Legal Notes

Unreal Indemnity

Buyers of a failing business's assets could be left with the seller's debt, even if it exceeds the purchase price, if they try to get indemnified from non-compliance with bulk sales legislation.

FROM: JAN-FEB 2003 ISSUE | BY RICHARD W. POUND

Unsecured creditors of a business rely on the business's ability to generate enough cash flow to pay their claim. If the business goes sour, unsecured creditors will get paid only if there's anything left after the secured creditors receive what's owed them. Even then, unsecured creditors have to share the resources the business has to service its debt with all the other unsecured creditors.

This situation can get even more troublesome if the business is sold to another party. What happens to the debt owed unsecured creditors when a business's assets are sold? This is the question dealt with in National Trust Co. vs. H & R Block Canada Inc. [18 B.L.R. (3d) 172], in which the Ontario Court of Appeal had to assess whether a business's new owners were liable for amounts owed to a creditor of the previous owners.

The Law

When a failing business is sold, the buyer sometimes assumes some of the debts associated with the business. The secured creditors' claims follow the assets into the hands of the buyer. However, if the buyer has not assumed the debt, the creditors must rely on the seller to settle their claims with the proceeds of the asset sale.

In the province of Ontario, the Bulk Sales Act, like similar legislation in other provinces, provides a certain degree of protection for creditors of a business when its assets are sold. The Bulk Sales Actrequires the buyer to obtain a sworn statement from the seller listing the amounts of its indebtedness to its secured and unsecured trade creditors. The buyer then has a number of choices: he or she can proceed with the sale if the seller provides a sworn statement that the creditors have all been paid in full; the seller makes provision for immediate payment in full to all creditors after the sale's completion; or the seller obtains consent for the sale from the unsecured creditors and deposes in an affidavit that his or her sworn statement has been delivered to those creditors. If both the buyer and seller do not follow this procedure, the sale could be declared void if challenged by one of the creditors. The buyer then becomes personally liable to account to the creditors for the value of the assets.

But what happens when the procedure set out in the Bulk Sales Actis not followed, and the sale proceeds would have covered only the debts to secured creditors? This is the issue the Court had to deal with in National Trust Co. vs. H & R Block Canada Inc.

The Sale

In 1991, H & R Block purchased the assets of Tax Time Services Limited for $800,000; however, H & R Block did not obtain a sworn statement from Tax Time listing its creditors, and Tax Time did not obtain its creditors' consent. Instead, Tax Time indemnified H & R Block for any liability resulting from non-compliance with the Bulk Sales Act. Tax Time used all of the proceeds from the sale to pay its two first-ranking secured creditors. Other secured and unsecured creditors remained unpaid.

At the time of the sale, Tax Time and National Trust Co. were engaged in litigation. Previously, Tax Time had borrowed funds, on an unsecured basis, from National Trust. Tax Time later sued National Trust for a breach of a contract unrelated to the loan. National Trust counterclaimed for the unpaid loans, with accrued interest.

Tax Time's claim for breach of contract was dismissed in 1993, and judgment was awarded to National Trust on its counterclaim, with costs. Tax Time's appeal to the Ontario Court of Appeal was also dismissed in 1996, with costs. By that time, Tax Time was out of business and could not pay National Trust.

National Trust challenged the 1991 sale to H & R Block under the Bulk Sales Act, seeking an order declaring the sale void and requiring H & R Block to pay for the amount Tax Time owed as of the date of the 1993 judgment, which, according to National Trust, amounted to almost $800,000, with accrued interest and costs. The application judge granted both orders sought by National Trust, so H & R Block appealed to the Ontario Court of Appeal.

National Trust did not claim that H & R Block or Tax Time had acted dishonestly. Tax Time had paid its first-ranking secured creditors, and there were no funds remaining for any of its other creditors. National Trust was an unsecured creditor and would not have received any payment even if there had been compliance with the Bulk Sales Act — that is, assuming that none of the creditors would have attempted to block the proposed sale. The issue before the Court of Appeal was whether the requirement in the Bulk Sales Act that the buyer must account to the creditors if the proper procedure was not followed meant H & R Block had to pay Tax Time's debt to National Trust — even if this may put National Trust in a better position than it would have been in had H & R Block and Tax Time complied with the legislation in the first place.

H & R Block argued that Tax Time's payment to first-ranking secured creditors constituted an appropriate accounting as required by the legislation; therefore, the sale could not be challenged. H & R Block also argued that, if it did have to pay anything at all to National Trust, it could not be forced to pay for more than what Tax Time owed at the date of the sale, plus accrued interest. It should not be obligated to pay for costs awarded to National Trust after the sale date since these were not Tax Time's debts when H & R Block bought the assets.

The Decision

The dissenting judge in the Court of Appeal considered it inappropriate to allow National Trust to recover its debt because, in his view, National Trust would not have recovered anything if Tax Time and H & R Block had followed the legislated procedure. He said that to find in favour of National Trust would be tantamount to imposing a penalty on H & R Block for failure to comply with the Bulk Sales Act. This, in his view, was not the object of the legislation.

The majority of the Court of Appeal, however, concluded otherwise. The payment to first-ranking secured creditors did not, in their view, constitute an appropriate accounting. As stated earlier, if the proceeds of a sale are insufficient to pay all creditors in full, the Bulk Sales Actrequires that the seller obtain consent for the sale from the unsecured creditors. Those creditors may, for any number of reasons, withhold their consent. The unsecured creditors in this case were effectively denied their statutory right to contest the sale.

The Court of Appeal decided that H & R Block was liable to National Trust for the amount of the unpaid loans, plus accrued and unpaid interest. H & R Block was not liable to National Trust for costs of litigation in its dispute with Tax Time since these debts were incurred after the 1991 sale. Protecting creditors does not extend to protecting debt that didn't exist at the time of the sale.

The judgment in this case should serve as a warning to those who want to avoid the sometimes time-consuming procedures in bulk sales legislation. The buyers of a business could find themselves with a lot of bills to pay to the seller's creditors without any real protection under an indemnity given by a defunct seller.

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Richard W. Pound, QC, is a partner with Stikeman, Elliott, Barristers & Solicitors, in Montreal.