Construction insolvencies: Further guidance on construction liens and priming charges for insolvent contractors and their suppliers

Introduction

The Ontario Superior Court of Justice (the “Court”) recently issued a decision in Waygar Capital Inc. v Quality Rugs of Canada Limited, discussing situations where statutory liens and trusts created under Ontario’s Construction Act can be primed by lenders within insolvency proceedings. This case is noteworthy for all construction contractors, subcontractors, and suppliers, as they should be aware of situations where the usual Construction Act lien and trust process can be overridden by insolvency law. The Court ultimately held that the suppliers’ lien and trust claims against the insolvent contractor’s accounts receivable, its only remaining asset, ranked below the liens granted by the Court to lenders in the insolvency process.

Background on Insolvency Law

Insolvent Canadian companies and their creditors have a variety of tools available to help them attempt to restructure their debts and either return to solvency as a going concern or wind down in an orderly fashion. Returning to solvency often involves creditors being paid less than the face value of their debt.

Without delving into an exhaustive discussion of these tools, one common approach is for an insolvent company to commence proceedings under the Companies’ Creditors Arrangement Act (the “CCAA”). The CCAA allows the insolvent company’s management to remain in control of the company, provides a stay of proceedings (meaning the company cannot be sued, and ongoing litigation is paused), and permits the company to obtain “interim” or “debtor-in-possession” (“DIP”) financing from new or existing creditors to fund the proceedings and potentially pay out existing creditors. In certain circumstances, and with a court order, DIP financing can take priority over or “prime” the debtor’s existing debts, thus ensuring it is paid out first. The court can also order other “priming charges,” which similarly take priority over the debtor’s existing creditors. These priming charges can be used to fund operations, cover directors’ personal liability, and pay for the professionals needed to administer the restructuring.

Alternatively, a creditor wishing to take control over an insolvent entity can ask the court to appoint a third-party professional, usually an accounting firm, to act as a “receiver” of the insolvent company. In this situation, the receiver will replace the insolvent company’s management and typically aim to sell the insolvent company quickly. A receiver can also seek DIP financing.

Facts

This case concerned the insolvency proceedings of the Quality Sterling Group (the “QSG”). These proceedings were initially commenced under the CCAA before later being converted into a receivership. As of August 2023, QSG was the largest flooring contractor in Canada, with operations in Ontario, Alberta, and British Columbia.

When QSG sought CCAA protection, it estimated that it owed up to $11,000,000 to its suppliers. This amount was subject to a statutory trust pursuant to section 8 of Ontario’s Construction Act, which creates a statutory trust over all funds received by a contractor on account of a contract for an improvement, in favour of suppliers who provided services or materials for that improvement.

When QSG sought insolvency protection, and throughout the entire insolvency proceeding, its sole meaningful asset was its accounts receivable. These accounts receivable were subject to a statutory trust in favour of QSG’s suppliers. No one disputed that such a trust existed – the issue was whether the statutory trust could be primed within the CCAA.

At the outset of its CCAA proceeding, QSG sought and obtained a $5,000,000 DIP loan, secured by a court-ordered priming lien over the company (the “DIP Charge”). QSG also advised the Court that it would be financing its operations, in part, through its accounts receivable. If the accounts receivable were not available to pay QSG’s obligations as they came due during the CCAA proceedings, QSG would have then required a much larger DIP loan, of approximately $10,000,000.

Issues

QSG’s insolvency proceeding continued for months, and it became clear to all parties that its accounts receivable would become the centerpiece of the dispute. Accordingly, the main issue became whether the DIP Charge took priority over the statutory trust.

Arguments and Analysis

The suppliers argued that the statutory trust took priority over the DIP Charge because the accounts receivable subject to the trust were not, technically, QSG’s property. Pursuant to Ontario’s Construction Act, the accounts receivable were simply held by QSG in trust for the suppliers. As a result, the suppliers argued that neither QSG nor its creditors, including the DIP lender, had the right to force them to involuntarily fund QSG with funds that technically belonged to the suppliers.

The Court rejected this argument, holding that court-ordered priming charges can take priority over a statutory trust because the priming charges were created by federal law, while the statutory trust was created by provincial law. Citing several recent cases, including a decision from the Supreme Court of Canada, the Court held that it is now accepted that federal insolvency law takes priority over provincial law, including trusts established under a provincial statute. As a result, statutory trusts under Ontario’s Construction Act can be collapsed by operation of the CCAA, allowing the funds held in trust to be subject to a DIP Charge or other priming charges. Consequently, the suppliers’ trust claims ranked below the DIP loan.

Key Takeaways

This case provides several important lessons for contractors, subcontractors, and suppliers. First, subcontractors and suppliers should always act promptly to assert and perfect their lien and trust claims. Second, in the event that a contractor commences CCAA or other insolvency proceedings, subcontractors and suppliers should consider working together to provide DIP financing within the insolvency proceeding – effectively becoming the DIP lender and gaining control over the priming charges. DIP financing can be provided in a creative manner, only for certain portions of the business, and secured in creative ways. Acting as the DIP Lender allows suppliers to avoid being primed by another DIP Lender.

Subcontractors and suppliers should also be proactive in insolvency proceedings from the outset. In the face of a priming charge, they need to be prepared to demonstrate why such a charge would be detrimental to all of the insolvent contractor’s stakeholders – such as lenders, employees, project owners, and higher-tier contractors – not just to specific suppliers. They also should be prepared to propose an alternative path towards project completion, which might involve contributing additional funds themselves.

Contractors and subcontractors, meanwhile, should consider the fact that DIP funding and insolvency proceedings, in general, can be very useful when facing an acute cash-flow crisis and accumulating trust and lien claims. A debtor-led insolvency proceeding, such as a CCAA proceeding, maintains management control over operations while restructuring the balance sheet and streamlining operations. DIP lending can be a tool that leads to creative outcomes in acute situations. In this case, the DIP lender was effectively able to take control of QSG and prime the trust claims, thanks to the flexibility of DIP financing.

Should you have any questions, please do not hesitate to contact a member of Miller Thomson’s Construction and Infrastructure, Commercial Litigation, or Restructuring & Insolvency groups.