Rise of the phoenix

Companies formed out of the ashes of bankruptcy may not be liable for statutory obligations of terminated employees

What happens when the principals of a bankrupt company create a new company, a so-called “phoenix rising,” to take over the assets and employees of the bankrupt? Is the new company liable to the former employees of the bankrupt in respect of employment standards obligations such as termination and severance pay? Are companies related to the “phoenix” also liable?

These were the questions facing the Ontario Court of Appeal in Novaquest Finishing Inc. v. Abdoulrab, where Cat-Dip, an electroplating company in Brampton, Ont., was purchased by David Lund. Lund was already the owner of Novaquest, a similar company in Mississauga, Ont., and a holding company, 406, which was incorporated to hold the shares of both Cat-Dip and Novaquest.

Shortly after Lund took ownership, Cat-Dip began experiencing financial difficulties and was forced to terminate a large number of employees. Cat-Dip made a proposal in bankruptcy to the terminated employees, as the company’s debt to them was its primary unsecured liability. The employees rejected the proposal and Cat-Dip was placed into bankruptcy. The effect of Cat-Dip's bankruptcy was to wipe out its obligations to former employees for severance and termination pay.

Owner’s new company bought assets of bankrupt company

A few hours after Cat-Dip went bankrupt, a new company incorporated by Lund, Cat Inc., purchased the assets of Cat-Dip from the bankruptcy trustee at their appraised value. This new company engaged in the same operations as Cat-Dip, with the company's remaining employees, but on a smaller scale.

Section 4 of the Ontario Employment Standards Act, 2000 (ESA), provides that parties who are found to be related through “associated or related activities or businesses” will be treated as one employer for the purposes of the ESA. If this is the case and the new companies were formed with the intention of avoiding paying employees their statutory entitlement, the related companies become jointly and severally liable for any wages, including termination and severance pay, owing to employees under the ESA.

There was no doubt Novaquest, 406 and Cat Inc. were related businesses of Cat-Dip, as all four companies were under common management, ownership and financial control. The issue before the court, however, was whether 406 and Cat Inc. were created to prevent the terminated employees from getting their severance pay.

The director of employment standards urged the court to adopt a broad line of authority which, the director maintained, was consistent with the ESA’s purpose to insure minimum employment standards for a vulnerable class of non-unionized workers.

Must be a link between new company and intention to avoid ESA: Court

The court, disagreed, finding the ESA ought not to be broadly interpreted as a simple “deep pockets” provision. It found related companies will not be treated as a “single employer” by virtue only of the relatedness between a company that can meet its employment standards obligations and a company that cannot. There must be a causal relationship between the related companies’ corporate structure and the defeat of the intent and purpose of the ESA, the court said.

This was not the case in Novaquest. It was not a situation, for instance, where the operating parts of a single business had been artificially divided into separate corporations to shield assets, nor was it a situation where the related companies bled funds or corporate opportunities from the struggling company, thereby causing or contributing to its bankruptcy.

On the contrary, the court found there was no improper conduct. The principals of Cat-Dip made every reasonable effort to prevent the company's bankruptcy and neither the “phoenix,” Cat Inc., Novaquest nor 406 could be held liable for Cat-Dip's employment standards obligations to its former employees.

Novaquest signals a greater emphasis on whether there was intent to avoid employment standards obligations, with a corresponding reduced weight placed on the fact the effect of a given corporate structure is to directly or indirectly deny the employees their legislative entitlements.

Novaquest indicates a shift to a more narrow approach to the interpretation of section 4. It is clear the courts will not permit section 4 to be used as a strict liability provision by piercing corporate veils of related companies to hold them liable for the ESA obligations of a related bankrupt employer. This approach in earlier cases was criticized, as it attached liability from the simple fact of relatedness.

Following Novaquest, any ambiguity in the law is resolved. The mere fact one company is solvent and the other is not does amount to an “effect” under section 4 of the ESA. There must be some connection between the relationship and the insolvency. Thus, while the purpose of the ESA is to safeguard minimum employee protections, the legislation provides no guarantees to employees in respect of termination and severance pay in the event of an employer's bankruptcy.

It should be noted the federal government-administered program under the Wage Earner Protection Program Act was recently amended to expand its guaranteed compensation for employees of bankrupt employers to include termination and severance pay for bankruptcy or receivership on or after Jan. 27, 2009.

Novaquest is an important decision in an age where corporate organizations have become increasingly complex, and mazes of shell, trust and holding companies are used as a matter of course by businesses to conduct their affairs. For employers, the decision provides reassurance that, absent evidence of bad faith or a causal connection between a particular corporate structure and the bankruptcy, companies related to a bankrupt, including those with deep pockets, will not be held liable for severance and termination pay obligations of the bankrupt under the “single employer” provisions of the ESA.

For more information see:

Novaquest Finishing Inc. v. Abdoulrab, 2009 CarswellOnt 3474 (Ont. C.A.).

Julia Falevich practices in the areas of labour and employment, bankruptcy and insolvency and construction litigation at Bennett Jones LLP in Toronto. She can be reached at (416) 777-6519 or at falevichj@bennettjones.com.

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