When Sino-Forest Corp. collapsed after a short-seller alleged the company was a "Ponzi scheme," fingers were quickly pointed at the gatekeepers – the big-name auditors and underwriters that okayed the company's financial statements and promoted its stock offerings.
That's why the class-action lawyers who filed a potential $9-billion lawsuit on behalf of burned investors in Sino-Forest also took aim at the deep pockets of the company's former auditors, BDO Ltd. and Ernst & Young LLP, and a long list of the company's Bay Street underwriters.
However, lawyers for those auditors and underwriters were before the Ontario Court of Appeal last week, in a bid to try get what's left of Sino-Forest to cover their legal bills and any damages that result from the litigation against them. The battle centres on how to interpret recent, and untested, amendments to the Companies' Creditors Arrangement Act (CCAA). The court is expected to issue a ruling soon.
At stake for Sino-Forest's former auditors and underwriters are their already hefty legal bills and potentially millions more in damage awards if the allegations of negligence in the potential class-action lawsuit are proven. They deny those allegations. The lawsuit has not been certified by a judge as a class action.
But the issue in Sino-Forest's CCAA proceedings is also being watched closely by insolvency lawyers on Bay Street, as it could set a precedent for other auditors and underwriters caught up in litigation after a company collapses.
"This is an important question which is of interest to the insolvency community, because it is an issue that will come up time and time again," said Derrick Tay, a lawyer with Gowling Lafleur Henderson LLP who represents FTI Consulting Canada Inc., the court-appointed monitor overseeing Sino-Forest's restructuring.
Sino-Forest's auditors and underwriters all had indemnity clauses in their contracts with the company that were meant to force Sino-Forest to pay any legal costs or damages they might face as a result of dealings with the company.
Sino-Forest, facing probes by the Ontario Securities Commission and the RCMP, sought protection under the CCAA from its creditors earlier this year. It had planned to sell its assets, held by its subsidiaries, to a third party. But a suitable buyer could not be found, and the company now plans to transfer its remaining assets to its debt holders, who must first vote on the deal.
In a CCAA, equity interests, or shareholders, are ranked after secured and unsecured creditors, often leaving them with nothing when a company is sold off. And as part of Sino-Forest's restructuring deal, the judge overseeing the process ruled that those claims for indemnity from Sino-Forest's auditors and underwriters would be considered equity claims.
The auditors and underwriters challenged this decision before the Ontario Court of Appeal, in a dispute that centres on the meaning of recent changes to the CCAA. In 2009, Parliament added a clause, meant to clarify the legislation, which defines equity claims as including "a contribution or indemnity in respect of" an equity claim.
Lawyers for Sino-Forest's underwriters and auditors argued that this clause should only apply to those who actually owned shares, not to "third-party contractors" like them.
Sheila Block of Torys LLP, acting for the underwriters, said there was no evidence Parliament intended to include their type of claim when it rewrote the Act. She said the amendments were meant to address "mischief" from shareholders who tried to "dress up" their equity claims as debt claims with things like indemnity clauses, for example.
Allowing the previous ruling to stand alters the long-established pecking order in an insolvency, she told the three-judge panel of the Court of Appeal: "Shareholders know this … as do lenders and suppliers. They know that they come first."
The underwriters named in the potential class action against Sino-Forest include: Credit Suisse Securities (Canada) Inc., TD Securities Inc., Dundee Securities Corp., RBC Dominion Securities Inc., Scotia Capital Inc., CIBC World Markets Inc., Merrill Lynch Canada Inc., Canaccord Financial Ltd., Maison Placements Canada Inc., Credit Suisse Securities (USA) LLC, and Merrill Lynch, Pierce, Fenner & Smith Inc.