Volume 43 | Number 3

Canadian Preference Law Reform

by Anthony Duggan & Thomas G.W. Telfer

Summary

Introduction

The Evolution of Preference Law and Policy
Current Canadian Law
Law Reform Initiatives

Conclusion

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I. Introduction

The preference provisions in the Canadian Bankruptcy and Insolvency Act¹ (BIA) have been virtually unchanged since the legislation was enacted in 1919,² and many of their features derive from the nineteenth century and earlier English law. There have been various reform proposals over the years, but until now they have come to nothing. Most recently, in 2003 a Senate Committee recommended amendments “to ensure consistent and simplified rules for challenging fraudulent preferences,” but without explaining what was wrong with the current laws and how they should be changed.³ Recently enacted amendments aim to put the Senate Committee’s recommendation into effect, but there is still no clear sense of the underlying objective.⁴ In any event, there are drafting problems, which will be explained later, and these will have to be fixed if the amendments are to have any impact at all. The drafting problems were at least in part a function of the failure to address policy objectives.

This paper argues that: (1) the current Canadian preference provisions are deficient because: (a) they lack a clear policy foundation, (b) judicial glosses on the statutory text mean that the statute itself is an incomplete statement of the law; and (c) the amount of discretion the provisions give the courts results in inconsistent and unpredictable case outcomes; (2) these problems should be fixed, but meaningful reform is impossible unless we first decide what we want the preference laws to achieve;⁵ and (3) Canada’s lawmakers should address the policy choices before proceeding further with the current reform initiative.

Part II surveys the evolution of preference law in common law countries and the competing policy objectives. Part III provides an overview of the current Canadian provisions and critically analyzes them with reference to the policy objectives identified in Part II. Part IV describes the most recent reform initiative and critically analyzes it with reference to the policy objectives identified in Part II. Part V concludes.
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II. The Evolution of Preference Law and Policy

A. The Debtor Deterrence Rationale

Broadly speaking, a preference is a payment of money or a transfer of property made by a debtor to a creditor on the eve of the debtor’s bankruptcy, representing more than the amount the creditor would recover in the debtor’s bankruptcy distribution. Early preference law developed through case authority. In The Case of Bankrupts (Smith v. Mills), Lord Coke stated the rationale for the avoidance of preferences in terms of the need to preserve the principle of equal distribution underlying the bankruptcy laws: “there ought to be an equal distribution . . . [for] if, after the debtor becomes a bankrupt, he may prefer [a creditor] and defeat and defraud many other poor men of their true debts, it would be unequal and unconscionable, and a great defect in the law.”⁶ Lord Mansfield expressed a similar view in Alderson v. Temple.⁷ According to Dickson J. in Hudson v. Benallack, this is still the policy of Canadian preference law:

The object of the bankruptcy law is to ensure the division of the property of the debtor rateably among all his creditors in the event of his bankruptcy . . . . The Act is intended to put all creditors upon an equal footing. Generally, until a debtor is insolvent or has an act of bankruptcy in contemplation, he is quite free to deal with his property as he wills and he may prefer one creditor over another but, upon becoming insolvent, he can no longer do any act out of the ordinary course of business which has the effect of preferring a particular creditor over other creditors. If one creditor receives a preference over other creditors as a result of the debtor acting intentionally and in fraud of the law, this defeats the equality of the bankruptcy laws.⁸

The following statement from Re Norris, an Alberta Court of Appeal decision, makes the point even more clearly:

. . . [the fraud lies in] the accompanying intent of the insolvent debtor who in the face of imminent bankruptcy is moved to prefer or favor, before losing control over his assets, a particular creditor over others who will have to wait for and accept as full payment their rateable share on distribution by the Trustee in the ensuing bankruptcy. It is called fraudulent because it prejudices other creditors who will receive proportionately less, or nothing at all, and upsets the fundamental scheme of the Act for equal sharing among creditors.⁹

Although these explanations are all framed in terms of equal distribution in bankruptcy, they cannot mean that the objective of preference laws is to ensure equal distribution per se. The emphasis on the debtor’s state of mind and the reprehensibility of the debtor’s conduct is inconsistent with the objective of preserving equality of distribution per se. All transactions having the effect of favouring a particular creditor disrupt the equal treatment of creditors in bankruptcy, regardless of whether the debtor intended that result and regardless of the moral character of the transaction. Lord Coke’s statement discloses the real concern, namely that it is wrong for the debtor to play favourites among creditors in defiance of the bankruptcy laws: paying out friends,¹⁰ relatives and business connections ahead of other creditors is wrong because, given the debtor’s impending bankruptcy, it deprives “other poor men of their true debts.” This is where the fraud lies. Another way of making the same point is to say that the debtor may not “set himself up as the law-giver in bankruptcy distribution.”¹¹ That is how Lord Mansfield expressed it in Alderson v. Temple.¹²

In summary, according to the old cases the rationale for the preference laws is “debtor deterrence.” Under this model, it is the debtor’s conduct that is viewed with suspicion.¹³ The debtor deterrence rationale presupposes sanctions against the preference-giving debtor. The main burden of the preference laws falls on the creditor rather than the debtor. What penalty does the debtor suffer? In former times, the giving of a preference was a criminal offence for which the bankrupt would be pilloried and have an ear cut off.¹⁴ This, along with other barbaric features of the bankruptcy laws, has long since disappeared, but there are vestiges of a penal strategy in the modern law. For example, in Canada the giving of a preference is a ground for denying or suspending the debtor’s right of discharge.¹⁵

B. The Creditor Deterrence Rationale

Jackson offers a quite different justification for the preference laws.¹⁶ In his view, the debtor’s insolvency creates a common pool problem. In the absence of bankruptcy laws, once individual creditors learned about the debtor’s insolvency, each creditor would have an incentive to engage in a race for the debtor’s assets both to make sure of being paid in full and also because, if a creditor does not race and the other creditors do, it will be left with nothing. This self-interested behaviour is against the interests of the creditors collectively because it is likely to result in the piecemeal dismemberment of the debtor’s estate, and it is often the case that the debtor’s estate will be worth more if it can be sold intact. Moreover, the prospect of a race to judgment would require creditors to engage in costly monitoring of not only the debtor’s financial situation but also other creditor’s activities to make sure they did not gain a head start if a race were to eventuate. Bankruptcy law addresses theses concerns by substituting a mandatory system of collective debt collection for the individual, winner-take-all collection system that operates outside bankruptcy. The preference laws are an integral part of the transition from one system to the other. This is because, in the absence of the preference laws, creditors who find out about the debtor’s impending bankruptcy may take advantage of the information to have their own claims satisfied, thereby opting out of the collective proceeding altogether. “By the time the bankruptcy petition is actually filed, those creditors that remain would have to share in the ‘tag ends and remnants’ of the [debtor’s] assets.”¹⁷ In short, preference law is “part of the attempt to ameliorate the effects of a common pool problem that justifies a collective proceeding in the first place.”¹⁸

Lord Coke’s justification for the preference laws looks to the debtor’s conduct in giving the preference. By contrast, Jackson’s justification looks to the creditor’s conduct in receiving it. While Lord Coke’s approach provides a debtor deterrence rationale for the preference laws, Jackson’s approach provides a creditor deterrence rationale.¹⁹ Under the creditor deterrence model it is the creditor’s conduct that is viewed with suspicion.²⁰ In the United States over the years, “the focus of the preference laws has shifted from the culpability of the debtor, to the culpability of creditors, to the present day standard of strict liability.”²¹ These changes all reflect different ways of thinking about the preference laws: debtor culpability is consistent with the debtor deterrence rationale; creditor culpability is consistent with the creditor deterrence rationale; strict liability is consistent with the idea that the purpose of the preference laws is to promote equality of distribution per se.

C. The Equal Sharing Rationale

In 1978, the United States moved away from a creditor culpability model. Congress eliminated the requirement that the creditor recipient have reasonable cause to believe that the debtor was insolvent and, in its place, introduced a strict liability regime. The move was justified in the following terms:

Whether or not a creditor knows or believes that his debtor is sliding into bankruptcy is important if the only purpose of the preference section is to deter the race. However, a creditor’s state of mind has nothing whatsoever to do with the policy of equality of distribution, and whether or not he knows of the debtor’s insolvency does little to comfort other creditors similarly situated who will receive that much less from the debtor’s estate as a result of the prebankruptcy transfer to the preferred creditor. To argue that the creditor’s state of mind is an important element of a preference and that creditors should not be required to disgorge what they took in supposed innocence is to ignore the strong bankruptcy policy of equality among creditors.²²

In other words, strict liability supports a policy of equal sharing. The reference to equality cannot be taken literally because the principle of equality, as embodied in the pari passu rule, is largely a myth in modern bankruptcy law. The exceptions (insolvency set-off, preferential claims, deferred claims and so on, in conjunction with the prevalence of secured credit) are so extensive that they all but swallow the rule. The only claimants subject to the pari passu rule are the general unsecured creditors, but in the overwhelming majority of bankruptcy cases there is nothing left to distribute among the general unsecured creditors once secured and preferred creditors have been paid out. Bearing these considerations in mind, the equal sharing rationale presumably means that creditors should share in accordance with the overall scheme of distribution provided for in bankruptcy laws.²³

In any event, contrary to the impression the quoted passage creates, the current United States preference provisions do not unequivocally embrace the equal sharing rationale (whatever equal sharing might mean). The Bankruptcy Code, § 547(c)(2) creates an exception to preference liability for transfers in the ordinary course of business. The purpose of the ordinary course exception has been explained in the following terms:

The purpose of this exception is to leave undisturbed normal financial relations, because it does not detract from the general policy of the preference section to discourage unusual action by either the debtor or his creditors during the debtor’s slide into bankruptcy.²⁴

In other words, “only extraordinary behavior by creditors who are seeking to ‘opt out’ of the bankruptcy scheme should be condemned by preference law.”²⁵ So, it seems that the aim of the preference laws is not to promote equal distribution between creditors. Creditor deterrence is still the objective. It is true that the 1978 law eliminated the “reasonable cause to believe” test on the express ground that the creditor’s intentions are irrelevant to the goal of equal distribution. However, “by creating the ordinary course exception in the 1978 law, Congress indirectly resurrected the same core principle of culpability.”²⁶

There is similar ambivalence in other common law countries about the goals of the preference laws. For example, according to the Australian Law Reform Commission, the preference laws reflect “two fundamental principles of insolvency law – that of equal sharing between creditors and that of promoting an orderly process both during and immediately preceding the formal insolvency administration.”²⁷ However, the Australian preference provisions focus on creditor culpability and this is inconsistent with the equal sharing rationale.²⁸ The ALRC went on to say that abandoning the preference laws “would deliberately favour and encourage creditors who quite legally extracted payments from the debtor – even at the eleventh hour.”²⁹ This last statement implies that creditor deterrence is the real objective and that current legislation is consistent with the creditor deterrence rationale. By contrast, the English preference provisions focus on debtor culpability,³⁰ reflecting a commitment to the debtor deterrence rationale.³¹ However, the English provisions have been criticized for being out of step with modern bankruptcy policy.³²

D. Finality of Transactions

There is tension between the goals of preference laws and the need for finality of transactions. “From a commercial perspective, it is appropriate to encourage debtors to pay creditors. It is also important that a creditor be able to rely on the validity of a payment. Commercial transactions should not be lightly interfered with.”³³ Another possible explanation for the ordinary course exception in United States preference laws is that it represents a trade-off between the goals of equal sharing and finality of transactions.³⁴ A strict liability preference law threatens the finality of transactions because it means that creditors can never be sure that their payments will be immune from attack. This uncertainty adds to creditors’ costs and it is likely to be reflected in the cost and availability of credit. The ordinary course exception addresses this problem in part by limiting liability to cases where the creditor knows about the debtor’s insolvency.

It has been suggested that a better response to the finality of transactions concern might be to shorten the review period.³⁵ However, while a shorter review period may limit creditors’ exposure, it does not assist them in managing the risk. This is because creditors may have no way of knowing at the time of receiving the payment whether it falls within the review period.

E. Facilitating the Provision of Credit to Financially Distressed Debtors

The finality of transactions concern is a function of the strict liability preference law model. It does not arise if the law requires proof of either debtor or creditor culpability because in both these regimes creditors have the means of knowing in advance whether a payment may be subject to attack. A possible conclusion is that an ordinary course exception is unnecessary unless strict liability is the rule.

However, this presupposes that the purpose of the ordinary course exception is to facilitate the provision of credit outside the review period. There is an alternative construction, namely that the purpose is to facilitate the provision of credit inside the review period. “Allowing creditors to obtain ordinary course payments actually encourages them to do business on a credit basis with a financially distressed debtor. As a result, the debtor may be able to stay afloat and avoid bankruptcy entirely, or at least hold a stronger financial condition when it does go into bankruptcy.”³⁶ In other words, the function of the ordinary course exception is to maximize the value of the debtor’s estate for the benefit of all the creditors and current United States bankruptcy law trades off this objective against the equal sharing goal.

On this analysis, the ordinary course exception is not simply a function of the strict liability rule and may have a role to play in other regimes as well. For example, lawmakers who opt for a debtor culpability regime may want to incorporate an ordinary course exception in order to strike a trade-off between debtor deterrence on the one hand, and facilitating the provision of credit to financially distressed debtors on the other. Likewise, the incorporation of an ordinary course exception in a creditor culpability regime may signal a willingness to sacrifice some creditor deterrence in exchange for the stimulus to lending the exception provides.

Still, it is not certain that such trade-offs yield net benefits. Some commentators argue that the ordinary course exception may have perverse incentive effects and that, far from encouraging creditors to deal with financially distressed debtors, it may actually discourage them. The argument is that a creditor who gets paid in the ordinary course need not co-operate further with the debtor because if the debtor goes into bankruptcy, the creditor can simply keep the payment and not extend more credit.³⁷ A related argument is that the ordinary course exception may have a chilling effect on the provision of credit to financially stable debtors, and this more than offsets the benefits of more freely available credit to debtors who are financially distressed.³⁸

F. The Trade-Offs

There are different schools of thought in the United States on the trade-offs the ordinary course exception involves. Some favour the present law, with or without relatively minor modifications.³⁹ Others argue that the exception should be repealed to recognize the goal of equal sharing among creditors is paramount.⁴⁰ At the opposite end of the spectrum, some argue for a repeal of preference laws on the ground that they are not cost-effective.

For example, McCoid contends that the objective of preference laws is creditor deterrence, but the laws fail to deter because the sanction is inadequate. If the trustee brings a successful preference action, the only consequence is that the creditor must return the payment. Except to the extent that the creditor has expended resources either obtaining the preference in the first place or defending the action, it is no worse off after returning the preference than it would have been had it never received the preference in the first place.⁴¹ A possible rejoinder is that the argument over-states the case for abolition. Creditors’ expenditure on obtaining the preference in the first place and subsequently fighting to keep it are dead-weight costs. The prospect of incurring these costs has some deterrent effect, and so the problem is one of under-deterrence rather than no deterrence at all. Under-deterrence is better than no deterrence at all, which would certainly be the result if the preference laws were repealed.⁴²

In the course of its General Insolvency Inquiry, the Australian Law Reform Commission received a submission from Justice Pincus, a judge of the Federal Court of Australia, recommending repeal of preference provisions on the ground that the costs of litigating preference claims defeat the underlying policy objectives.⁴³ Alan Schwartz offers a more sophisticated version of the same argument:⁴⁴

(1) The creditor deterrence rationale for preference laws is misguided because creditors cannot force a financially distressed firm to pay preferences. Creditors can threaten attachment to try and force the debtor to pay, but the debtor can credibly respond by threatening to file for bankruptcy and thus stay all attachments. Therefore, if preference laws were repealed, distressed debtors would pay preferences because they wanted to, not because they had to;

(2) The debtor deterrence rationale has no purchase unless the debtor expects to be liquidated. Otherwise, the debtor will want to settle with its creditors, and non-preferred creditors will not accept in settlement an amount less than their pro rata bankruptcy payoffs. In other words, “the pro rata rule precludes a firm interested in survival from paying today what are defined as preferences. Consequently, a separate prohibition against preferences does not materially increase a financially distressed firm’s commitment to the pro rata rule”;⁴⁵

(3) If a debtor firm expects to be liquidated, it will be indifferent as to how its assets are distributed among creditors because the firm will disappear with certainty. However, the firm’s principals may not be indifferent. They may cause the firm to pay particular creditors to ensure goodwill for themselves, in consequence of a personal relationship or to avoid liability exposure if a principal has guaranteed the firm’s debt;

(4) Actions to recover preferences paid in these circumstances are inefficient both ex post and ex ante. They are ex post inefficient because they cost money, thereby diminishing the value of the bankruptcy estate: “redistributing the assets of a failed firm among its general creditors amounts to redecorating the Titanic’s salon”;⁴⁶

(5) Abolition of the preference laws would save the costs of redistributing the firm’s assets, thereby increasing the collective returns to creditors in future. The prospect of higher collective returns in bankruptcy should result in lower borrowing costs. Conversely, preference laws increase borrowing costs and are ex ante inefficient.

Critics might take issue with step (1) of Schwartz’s argument on the ground that it too readily assumes a debtor’s willingness to play the bankruptcy card. Unless the debtor expects to be liquidated, it will want to maintain good relations with its key suppliers and creditors. Threatening to file for bankruptcy in response to a creditor’s demand for payment is not conducive to maintaining good relations. Of course, if the debtor realizes its hopes of staying in business, the preference question will go away. On the other hand, the debtor’s hopes may not be realized. Financially distressed debtors have a tendency to over-estimate their chances of recovery and creditors may exploit the debtor’s self-deception to extract preferential payments.⁴⁷ Step (4) amounts to an implicit rejection of both the debtor deterrence rationale and the equal sharing rationale for the preference laws; critics might take issue with this because it summarily discounts non-economic arguments in support of preference laws.⁴⁸ It is worth noting that the Australian Law Reform Commission rejected Justice Pincus’s proposal for repeal of preference laws on the ground that it “would do much to undermine two fundamental principles of insolvency law – that of equal sharing between creditors and that of promoting an orderly process both during and immediately preceding the formal insolvency administration.”⁴⁹
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III. Current Canadian Law

A. Introduction

The Bankruptcy and Insolvency Act, § 95 provides in part as follows:

(1) Every transfer of property, every charge made on property, every payment made, every obligation incurred and every judicial proceeding taken or suffered by any insolvent person in favour of any creditor or of any person in trust for any creditor with a view to giving that creditor a preference over the other creditors is, when it is made, given, incurred, taken or suffered within the period beginning on the day that is three months before the date of the initial bankruptcy event and ending on the date the insolvent person became bankrupt, both dates included, deemed fraudulent and void as against, or in the Province of Quebec, may not be set up against, the trustee in the bankruptcy.

(2) If any transfer, charge, payment, obligation or judicial proceeding mentioned in subsection (1) has the effect of giving any creditor a preference over other creditors, or over any one or more of them, it shall be presumed, in the absence of evidence to the contrary, to have been made, incurred, taken, paid or suffered with a view to giving the creditor a preference over other creditors, whether or not it was made voluntarily or under pressure and evidence of pressure shall not be admissible to support the transaction.

Section 96 provides:

If the transfer, charge, payment, obligation or judicial proceeding mentioned in section 95 is in favour of a person related to the insolvent person, the period referred to in subsection 95(1) shall be one year instead of three months.⁵⁰

These provisions have survived virtually unchanged for nearly a century, and they have generated a substantial amount of litigation.⁵¹

The main features of the provisions, as amplified by the case law, are as follows:⁵²

(1) For the sections to apply, there must be both a preference in fact and an intention on the debtor’s part to prefer the creditor;

(2) The test for determining the debtor’s intention is an objective one, in other words, the courts infer the debtor’s intention from its conduct and the surrounding circumstances;⁵³

(3) It follows that “fraudulent” does not mean actual fraud, but constructive or legal fraud. Constructive fraud is conduct the law characterizes as fraudulent, not because it is actually dishonest, but because it is against the public interest;⁵⁴

(4) The evidentiary burden is on the trustee to prove a preference in fact, but it is on the creditor to prove that the debtor did not have the necessary intention;⁵⁵

(5) A creditor cannot rebut the presumption of intention by leading evidence that the creditor pressured the debtor into making the transfer;⁵⁶

(6) On the other hand, the law does not penalize a diligent creditor and evidence showing that the debtor made the payment to stay an aggressive creditor may be enough to rebut the presumption;⁵⁷

(7) Alternatively, the creditor may rebut the presumption of intention with leading evidence to show that the transaction was in the ordinary course of the debtor’s business.⁵⁸ There is an element of tautology here because the absence of an intention to prefer is a sine qua non of the conclusion that the transaction was in the ordinary course of business. Typically, payments in the ordinary course of business are made for one of two reasons: (1) so that the debtor can take advantage of favourable payment terms; or (2) to ensure that the creditor continues to supply the debtor with goods or services so the debtor can continue in business;⁵⁹

(8) The debtor’s belief that the payment will allow it to continue in business must be a reasonable one. The reasonableness of the debtor’s belief is a matter for the court, having regard for the evidence;⁶⁰

(9) Proof that the debtor did not know it was insolvent at the time of the transaction is admissible to rebut the presumption of intention, but it is not conclusive given that’ the courts apply an objective test in determining the debtor’s intention;⁶¹

(10) Proof that the creditor intended to receive a preference is neither a necessary nor a sufficient requirement for avoidance of the transaction;⁶²

(11) On the other hand, evidence that the creditor knew of the debtor’s insolvency is admissible as tending to show that the transaction was not in the ordinary course of business and that the debtor’s intention was to prefer the creditor;⁶³ and

(12) If the creditor is related to the debtor, the review period is one year instead of 3 months and, in addition, the courts will require stronger evidence to support the bona fides of the transaction.⁶⁴

B. Pressure and Diligence

As indicated above, a creditor cannot rebut the presumption of intention by demonstrating that the creditor pressured the debtor into making the payment. This is a statutory rule, and its legislative history is instructive.

Parliament eliminated the doctrine of pressure in 1920.⁶⁵ The doctrine enabled a more aggressive, active or insensitive creditor to “reap the benefits of his harassment of the debtor” at the expense of more patient or hesitant creditors.⁶⁶ Fraudulent preference law, as developed by Lord Mansfield, required the debtor’s transfer or payment to be a voluntary one. According to Lord Mansfield, if a creditor demands payment, “or sues [the debtor], or threatens [the debtor], without fraud, the preference is good.”⁶⁷

Prior to 1920 Canadian courts followed the English doctrine of pressure holding that there was no voluntary act on the part of the debtor where payment is “brought about by the active influence of the creditor.”⁶⁸ However, what amounted to pressure in any particular case was “always a question of fact and one difficult to make out.”⁶⁹ A mere request by a creditor, which induces action on the part of the debtor, might amount to pressure in the eyes of the court.⁷⁰ Where the debtor and creditor knew each other and were familiar with the law collusion remained a real possibility.⁷¹ Courts accepted that the doctrine of pressure validated the transaction even if this had the effect of giving one creditor a preference over another.⁷²

In 1919, Parliament debated a comprehensive bill to restore a national bankruptcy regime.⁷³ Bill 18 proposed to “eliminate entirely the doctrine of pressure as a defence to a preferential transaction.”⁷⁴ However, abolition of the doctrine did not prove easy and legislative history of the ‘no pressure’ clause provision illustrates the extent to which the doctrine of pressure had benefited creditors. In the course of parliamentary hearings, the “‘no pressure”‘ clause was struck out leaving the doctrine of pressure as the status quo.⁷⁵ During the hearings, commercial groups and the banking industry objected to the abolition of the doctrine. They advocated the retention of the English model which would enable creditors to invoke the doctrine to validate transactions.⁷⁶ In 1920 Parliament restored the “no pressure” clause, and since then the statutory preference provision has largely remained the same.⁷⁷

Although Parliament intended to eradicate the doctrine of pressure by specifically legislating that evidence of pressure is not admissible to support the transaction, the courts have since allowed indirect evidence of what might otherwise be considered pressure. For example, the courts have read a creditor diligence defence into the statute: a creditor may lead evidence of its own diligence to rebut the presumption of the debtor’s intention to prefer. In Re Totem Painting Company Limited,⁷⁸ the court attempted to distinguish between diligence and pressure. A creditor had accepted an overdue payment on account with knowledge of the debtor’s financial position. The court concluded that the creditor:

. . . may have applied some pressure but, while pressure is no longer a defence to a charge of fraudulent preference, it has not yet been shifted to the opposite pole of being considered proof of fraud. Creditors may be penalized for dishonesty, but surely not for diligence.⁷⁹

On the other hand, contrary to what this statement implies, there is no sharp dividing line between pressure and diligence and so the creditor diligence defence may be a means of reintroducing the doctrine of pressure by the back door.⁸⁰ However, the scope of the defence is unsettled. In Re Hewston & Thornton,⁸¹ the court concluded that

there was no intention on the part of the debtors to prefer the two respondents. I find that the debtors were hopeful . . . that they would be able to keep their business in operation. The only reason for making the payment to the respondents was because the respondents were pressing more vigorously than other creditors for payment of their accounts.⁸²

So stated, the diligent creditor defence is inconsistent with the express statutory provision excluding evidence of pressure. On the other hand, in Re Norris,⁸³ the court held that for the diligent creditor defence to apply, there must be an imminent threat of crisis unless the debtor responds to the creditor’s demand. In Re Norris itself, the defence failed because the court found that the creditor had not acted aggressively enough.⁸⁴ In other words, evidence of pressure may or may not be admissible to support the transaction depending on the amount of pressure the creditor has applied.

The courts have also been prepared to excuse transactions in the ordinary course of business and this trend, too, compromises the rule that evidence of pressure is not admissible to support the transaction. For example, a creditor may refuse to ship goods until the debtor pays for earlier deliveries. This is clearly a form of pressure, but the court may uphold the transaction on the ground that the payment was not to prefer the creditor but, rather, to obtain the supply of goods or services.⁸⁵

C. Assessment

According to Dickson J. in the Benallack case, the policy underlying the Canadian preference provisions is debtor deterrence.⁸⁶ However, while it is true that § 95(1) makes debtor culpability the focal point, in some other respects the provisions are inconsistent with the debtor deterrence rationale. The following are some examples of the ambivalence in § 95.

(1) Liability turns on proof of the debtor’s intention and this is consistent with the debtor deterrence rationale. On the other hand, to the extent that courts determine the debtor’s intention objectively, they treat the reference in § 95(1) to fraud as meaning constructive fraud.⁸⁷ This approach dilutes the key requirement of debtor culpability. The more readily the courts are prepared to infer the debtor’s intention from the surrounding circumstances, the closer they move the regime towards strict liability, where the goal is equal sharing, rather than debtor deterrence.⁸⁸

(2) Once the trustee has proved a preference in fact then, by virtue of § 95(2), the burden shifts to the creditor to prove that the debtor did not intend to give a preference. At first glance, this looks like no more than an evidentiary concession in the trustee’s favour. On the other hand, some courts have taken a harder line than others in reaction to evidence the creditor leads.⁸⁹ The more difficult it is for creditors to rebut the presumption, the closer the evidentiary concession comes to a rule of law. Dilution of the debtor culpability element is inconsistent with the debtor deterrence rationale, but it might make sense in terms of either the creditor deterrence or the equal sharing rationales.

(3) Section 95(2) states that evidence of pressure is not admissible to support the transaction. This provision is inconsistent with the debtor deterrence rationale because evidence of pressure negates the debtor’s culpability, which is the key element from a debtor deterrence perspective.⁹⁰ The provision would make sense if the creditor deterrence rationale applied, because evidence of pressure goes to the creditor’s culpability, which is the key element from a creditor deterrence perspective. On the other hand, as previously mentioned, the express reference in § 95(1) to the debtor’s state of mind and the characterization of the debtor’s conduct as fraudulent are inconsistent with the creditor deterrence rationale.

(4) The creditor diligence defence compromises the rule that evidence of pressure is inadmissible to support the transaction, but the scope of the defence is uncertain as indicated by Re Hewston & Thornton and Re Norris.⁹¹ In Re Hewston & Thornton, the court applied the defence robustly. This approach supports the debtor deterrence rationale but it is inconsistent with the express statutory provision excluding evidence of pressure. On the other hand, in Re Norris,⁹² the court attempted to limit the defence to cases of extreme aggression on the creditor’s part. This approach cuts both ways in policy terms. In so far as it limits the diligent creditor defence, it supports the creditor deterrence rationale. On the other hand, in so far as it ties the availability of the defence to the creditor’s level of aggression, it is perverse from a creditor deterrence perspective because it means that the more culpable the creditor’s actions, the more likely it is that the court will uphold the transaction.⁹³

(5) Liability does not turn on the creditor’s state of mind in receiving the preference. This is consistent with the debtor deterrence rationale. On the other hand, evidence of the creditor’s state of mind is admissible as tending to show that the transaction was not in the ordinary course of business. The more weight a court attaches to such evidence, the further it pushes the regime in the direction of the creditor deterrence rationale.

In summary, the current law lacks a clear policy foundation and in this sense it is indeterminate. Judicial glosses on the statutory text mean that the statute itself is not a complete statement of the law; this is a second sense in which the law is indeterminate. For example, there is no ordinary course of business defence in the statute, nor is there any reference to diligent creditors. However, the courts have imported both concepts, and there is a large body of cases, not all of them reconcilable, on the evidence a creditor must produce in order to establish the defences.

A third source of indeterminacy is inconsistency in the way the courts exercise the discretion given to them by the judicially glossed statute. For example, in connection with the ordinary course of business defence, evidence is admissible to show that the debtor made the payment with a view to staying in business. However, the courts require proof that the debtor’s hope of staying in business was a reasonable one, and the question of what amounts to a reasonable hope is one on which courts may differ.⁹⁴ As Wilson J. noted in Re Totem Printing Company Ltd., many of the fraudulent preference decisions are “so divergent in thought as to offer a wide scope of choice to a court seeking a precedent.”⁹⁵

There is a fourth sense in which the current law is indeterminate. Bankruptcy and Insolvency Act, §§ 95 and 96, are not a complete code. Provincial fraudulent preference laws apply concurrently. This means that if a transaction falls outside the review period §§ 95 and 96 specify, the trustee may still be able to attack it relying on the provincial laws instead. The concurrent operation of provincial law is open to criticism on at least two grounds: first, it potentially undermines the policies reflected in the federal provisions; and secondly, it raises the possibility of non-uniform case outcomes from province to province.⁹⁶ In the Senate Committee’s words, the concurrent operation of provincial law results in “a lack of fairness, uniformity, and predictability.”⁹⁷
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IV. Law Reform Initiatives

The Senate Committee in its 2003 Report recommended amendments to “ensure consistent and simplified rules for challenging fraudulent preferences.”⁹⁸ In part, this recommendation was directed to the repeal of the provincial provisions with a view to establishing a “national standard”⁹⁹ for preference challenges.

However, it is clear that the committee also had in mind amendments to §§ 95 and 96 of the BIA themselves. The report touched on the question of whether the debtor’s intent should continue to be the test, or whether it would be better to move to an effects-based test as other jurisdictions have done but it reached no conclusion, save for noting a concern expressed by the IIC and CAIRP Joint Task Force that “transactions made in good faith are not necessarily protected from an ‘effects-based’ standard . . . .”¹⁰⁰

In the wake of the Senate Committee Report, a Joint Task Force Working Group formulated detailed recommendations for preference law reform, the central features of which are as follows:¹⁰¹

(1) In the case of a non-arm’s length transaction, the review period would be five years from the date of the original bankruptcy event or the initial application, while in the case of an arm’s length transaction, the review period would be one year.

(2) In the case of a non-arm’s length transaction occurring within one year before the date of the initial bankruptcy event or the initial application, the trustee or monitor would need to prove only that the transaction amounted to a preference in fact.

(3) In the case of a non-arm’s length transaction occurring between one and five years before the date of the initial bankruptcy event or the initial application, the trustee or monitor would need to prove that: (a) the transaction amounted to a preference in fact; and (b) the debtor was insolvent at the time of the transaction or the transaction made the debtor insolvent.

(4) In the case of an arm’s length transaction, the trustee or monitor would need to prove that: (a) the transaction amounted to a preference in fact; and (b) the debtor intended to prefer the counterparty. There would be a rebuttable presumption of intention in the three months preceding the date of the initial bankruptcy event or the date of the initial application.

(5) It would be a defence for the counterparty to prove that: (a) the debtor was solvent on the transaction date and not rendered insolvent by the transaction; or (b) the counterparty was entitled to receive the transfer in priority to other creditors.

Recently enacted amendments, not yet in force, replace § 96 of the BIA with the following provision:

If the transfer, charge, payment obligation or judicial proceeding referred to in section 95 has the effect of giving a creditor who is not at arm’s length a preference over other creditors, the review period referred to in subsection 95(1) is one year instead of three months.¹⁰²

Under the previous version, the extended review period applied if the creditor was related to the debtor. Under the new version, the extended period applies if the creditor is not at arm’s length, whether because it is related to the debtor or for some other reason. That is the extent of the change. The new provision does nothing to address the concerns outlined in Part III. However, it seems that the amendment was supposed to go further and that the real intention was to implement the JTF Working Group’s Recommendation (3) by substituting an effects-based test for non-arm’s length transactions.¹⁰³ Even if the new version is amended to reflect the actual intention, it still goes nowhere near addressing the concerns raised in Part III. There would still be the same indeterminacy problems as there are now. The only reason given in support of the proposed change was that it would “make it considerably easier for trustees to recover preferences from non-arm’s length parties.”¹⁰⁴ It is impossible to know whether this would be a good or bad thing in the absence of a benchmark for the desirable amount of recovery.¹⁰⁵ In any event, if the policy objective really is to facilitate preference recovery, the more logical response would be to move to a strict liability regime with no defences. It is also worth noting that the government’s reason for the amendment conflicts with the JTF Working Group’s main concern, which was to draft a set of provisions that did not unduly threaten the finality of transactions.

For these reasons, it was a mistake for the government to cherry-pick from the JTF Working Group’s model. This raises the question of whether the government should instead adopt the model in its entirety. There are several reasons why it should not do so. The main one is that the Working Group failed to articulate what it thought the governing policy considerations should be and this lack of a clear policy direction flows through into its recommendations. The JTF’s stated concern was to “strike a balance between the ability of the debtor to conduct its affairs in the period prior to the commencement of insolvency proceedings and the ability of trustees, receivers and creditors to recover value where a transaction has given a preference contrary to the statute.”¹⁰⁶ However, this statement fails to specify the purpose the preference laws are supposed to serve. The purpose might be one of debtor deterrence, creditor deterrence or equal sharing. As the discussion in Part II indicates, a choice must be made because the purpose determines the shape of the legislation. An even more basic choice is whether to retain the preference laws at all. It is surprising that the JTF does not appear to have canvassed this option, given the importance it attached to the finality of transactions.

The most distinctive feature of the JTF Working Group’s model is that it requires proof of the debtor’s intention to prefer, but only if the transaction is an arm’s length one. In the case of a non-arm’s length transaction, the test is an effects-based one. No reasons were given in support of this approach. A possible explanation is that, if the transaction is a non-arm’s length one, the debtor is more likely to have intended a preference.¹⁰⁷ However, this consideration at most supports a rebuttable presumption of intention.¹⁰⁸ It might be argued that an irrebuttable presumption saves litigation costs by forestalling inquiry into the debtor’s state of mind. On the other hand, an irrebuttable presumption, like all bright-line rules, is potentially over-inclusive and the Working Group does not address the competing costs and benefits.

A more fundamental concern is that, on this reading of the Working Group’s model, the underlying rationale is debtor deterrence. However, the Working Group does not explain why it favours the debtor deterrence rationale over creditor deterrence or equal sharing. One challenge advocates of the debtor deterrence rationale face is to explain the absence of sanctions against the preference-giving debtor.¹⁰⁹ If the preference laws put the burden on the creditor, rather than the debtor, how can it be plausibly claimed that the objective is debtor deterrence? Another challenge is to address Schwartz’s point that preference laws based on the debtor deterrence rationale are inefficient.¹¹⁰ Advocates of the debtor deterrence rationale might claim that the objective is not efficiency, but fairness.¹¹¹ However, this would require a balancing of fairness gains against efficiency losses which the Working Group does not do.

An alternative explanation of the Working Group’s model is that the requirement for proof of the debtor’s intention in the case of arm’s length transactions was motivated by finality of transaction concerns, rather than debtor deterrence. If this is right, though, it takes us back to the starting point: assuming finality of transactions matters, and debtor deterrence is not the objective, why have preference laws at all? The creditor deterrence and equal sharing rationales are both possible explanations, but the Working Group does not say which of these it had in mind. If it was creditor deterrence, the model is deficient because there is no element of creditor culpability. If equal sharing, rather than creditor deterrence, was the goal there are efficiency concerns which should have been addressed. Furthermore, one way of reducing the finality of transactions concern is to shorten the review period: the shorter the review period, the lower the creditor’s exposure.¹¹² The Working Group does not explain why it did not take this step instead of, or perhaps as well as, relying on the proof of intention requirement as a controlling factor. As it happens, the Working Group’s model substantially lengthens the standard review period from the current three months to one year. By way of contrast, in the United States, the standard review period is three months, and in Australia, England and New Zealand it is six months. The Working Group does not explain how the longer review period is reconcilable with its concern for finality of transactions.

Professor Cuming has proposed an alternative model, based substantially on the United States approach: an effects-based preference test coupled with various safe harbour provisions, the most important being an exception for “non-exceptional payments.”¹¹³ The following are non-exceptional payments: (1) the payment of a business debt under a running account arrangement; (2) the payment of a business debt if made within thirty-five days from the date the debtor received the property or service to which the debt relates; and (3) the payment of a loan where the period between the date the obligation was incurred and the date of the payment is not greater than thirty-five days.¹¹⁴ The non-exceptional payments exception replaces the United States ordinary course of business defence, which Cuming rejected as being too imprecise.¹¹⁵

There are grounds for this concern. For example, in 1993 New Zealand implemented an effects-based preference test coupled with an ordinary course of business exception, the immediate consequence of which was to substantially increase the volume and complexity of preference litigation. Among other things, the courts struggled with the questions of: (1) whether the ordinary course of business was to be assessed by reference to the debtor’s industry at large or by reference to the debtor’s relationship with the creditor in particular; and (2) what are the relevant variables for determining ordinariness.¹¹⁶ The government is now in the process of repealing the ordinary course of business exception.¹¹⁷

In the United States, the ordinary course provision has recently been amended to clarify the law in relation to Question (1).¹¹⁸ In Canada, where the courts have read an ordinary course of business defence into the statute, Question (2) is addressed in part by reference to whether the debtor made the payment in the expectation of being able to stay in business and, if so, whether the debtor’s expectation was a reasonable one. The level of case-by-case inquiry involved makes litigation outcomes difficult to predict.¹¹⁹

The Cuming model rests on the equal sharing rationale. Cuming says that a preferential transfer:

if left intact, frustrates implementation of the policy of bankruptcy legislation, equitable treatment of all creditors. The fact that the debtor intended or did not intend this result should not be relevant. The actual or presumed intentions of the debtor when making a preferential transfer are not important. What is important is the effect that such a transaction has on the position of creditors with claims in bankruptcy. What matters to them is that a central policy of bankruptcy law is not frustrated by a preferential payment or transfer which, by definition, results in material loss to them.¹²⁰

The preference provisions in the Australian Corporations Act of 2001 (Cth), which are based on recommendations the Australian Law Reform Commission made in its General Insolvency Inquiry Report, provide yet another model for reform. The Australian model incorporates an effects-based preference test coupled with a broadly stated good faith defence: it is a defence to a preference action if the creditor proves that: (1) it acted in good faith; (2) it had no grounds for suspecting that the debtor was insolvent or close to insolvency on the transaction date and a reasonable person in the creditor’s circumstances would have had no reasonable grounds for so suspecting; and (3) the creditor provided valuable consideration or changed its position in reliance on the transaction.¹²¹ The Australian approach is different from the Cuming model in two important respects: (1) whereas the Cuming model rests on the equal sharing rationale, the goal of the Australian provisions is creditor deterrence as the good faith creditor defence makes clear;¹²² and (2) the Cuming model’s non-exceptional payments defence is rules-based, whereas the Australian good faith creditor defence is a standards-based one.

Jackson claims that “preference law has never felt comfortable with any balance between a rule and a standard. During this century, the basic thrust of preference law has been in the direction of a rule.”¹²³ However, as he goes on to point out, in the United States the commitment to rules is substantially eroded by the ordinary course of business exception.¹²⁴ The Australian approach is also standards-based, with the various costs that a standards-based approach entails, but it is more specific about what the creditor must prove and, for this reason, it is arguably better targeted than the ordinary course of business exception.¹²⁵ The Cuming model’s rules-based approach avoids the case-by-case inquiry the Australian provisions involve and so it is more predictable. On the other hand, the thirty-five day cut-off point, like all bright line rules, is potentially both over- and under-inclusive. To the extent that it is over-inclusive, it threatens the finality of transactions; to the extent that it is under-inclusive, it undermines the objective of the preference laws.¹²⁶

The JTF Working Group made no reference to either the Cuming model or the Australian model. Perhaps the Working Group rejected the Cuming model because it disagreed with the equal sharing rationale or perhaps it thought that Cuming’s non-exceptional payments exception was an insufficient safeguard for the finality of transactions. However, this is not explicitly provided by the Working Group. Likewise, the Working Group may have disliked the Australian model because it disagreed with the creditor deterrence rationale or, alternatively, because it thought that the good faith creditor defence was too imprecise. Again, though, these are simply speculations in the face of the Working Group’s silence.
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V. Conclusion

Preference law design implicates five key questions:

(1) What is the objective: debtor deterrence, creditor deterrence or equality of distribution?

(2) How much weight should the law give to competing concerns, such as finality of transactions and facilitating the provision of credit to financially distressed debtors?

(3) What, if any, evidentiary concessions should the law make in favour of either the trustee or the creditor?

(4) What form should the law take: bright-line rules, at the risk of over- and under-inclusiveness, or standards, at the risk of increased uncertainty?

(5) What role, if any, is there for the concurrent application of provincial laws?

Current Canadian preference law suffers from the failure to have systematically addressed any of these questions. The government’s most recent reform initiatives are subject to the same criticism. The purpose of this paper has been to demonstrate that wholesale reform is necessary, and that tinkering of the kind the most recent reforms represent is at best insufficient and at worst counter-productive. There seems to be a general consensus on the need for reform, but there is as yet no consensus on how the questions listed above should be answered. Perhaps that is because until now policy makers and stakeholders have not given them sufficient thought. If this paper succeeds in raising the level of awareness about what the choices are, then it will have done its job. The choices themselves can then be left to others.

Footnotes

For complete footnote citations, download the PDF.

Texas International Law Journal