Court File and Parties

Court File No.: 234/09

Released: 20090703

ONTARIO

SUPERIOR COURT OF JUSTICE

DIVISIONAL COURT

Re: 167986 CANADA INC. (Applicant) v. GMAC COMMERCIAL FINANCE CORPORATIONS CANADA, BLACK SAXON QRC INC. et al (Respondents)

Before: Karakatsanis J.

Counsel:

A. Lenczner, Philip Cho, for the Applicant, the moving party

Alan B. Merskey, for the Respondent GMAC

Daniel S. Murdoch, for the Respondent Black Saxon QRC Inc

Heard at Toronto: June 4, 2009

ENDORSEMENT

[1] The moving party, 167986 Canada Inc. (167), seeks leave to appeal the decision of Morawetz J. dated May 14, 2009, dismissing 167’s motion under Rule 45.02 for an order preserving a “Cash Collateral” in the amount of 3.5 million dollars. The motions judge also directed payment of the Cash Collateral, currently held by the Escrow Agent, to the Respondent Black Saxon. That Order has been stayed pending disposition of this motion for leave to appeal.

[2] The moving party 167 entered into a Letter of Credit Agreement (LC Agreement) with GMAC and SAAN Stores. Pursuant to that agreement, 167, a supplier of SAAN, (the Investor), agreed to provide a Letter of Credit as security to GMAC (the Lender), for the indebtedness of SAAN (the Borrower), pursuant to a Loan Agreement between GMAC and SAAN. GMAC drew upon that Letter of Credit upon its expiry pursuant to the terms of the LC Agreement and the money became “Cash Collateral” to secure SAAN’s indebtedness. GMAC assigned the Cash Collateral and the LC Agreement to Black Saxon.

[3] The position of 167 in the application is that it was a guarantor under the LC Agreement and there is a serious issue as to whether its guarantee obligations have been terminated because of material changes to the Loan Agreement between GMAC and SAAN.

[4] 167 sought an interim preservation order under Rule 45.02 on the basis that it had a right to a specific fund. Rule 45.02 permits the court to order the fund be paid into court or otherwise secured “where the right of a party to a specific fund is in question” and the claim raises a serious issue to be tried.

[5] The motions judge found that 167 did not have a proprietary interest in the Cash Collateral; the Cash Collateral was not a specific fund; and the law of guarantee did not apply to the LC Agreement. He concluded that “167 had failed to establish a right to any specific fund.” The motions judge found that even if 167 was a guarantor, 167 had ratified any forbearance. He concluded that as a result there was no serious issue to be tried.

[6] The moving party submits that there is good reason to doubt the correctness of the decision because he erred

a) in failing to recognize that the LC Agreement created a guarantee between 167 and GMAC;

b) in failing to recognize the Cash Collateral was a specific fund;

c) in finding that the guarantor ratified material amendments by determining the ultimate merits rather than determining whether there was a serious issue to be tried.

Test on Leave to Appeal

[7] Under Rule 62.02(4), the applicant must show that either (a) there is a conflicting decision by another judge or court in Ontario or elsewhere; or (b) that there is good reason to doubt the correctness of the decision in question. The applicant must also show that the issues are of such general importance, beyond the interests of the parties, such that it is desirable that leave be granted. Leave to appeal should be granted on questions of broader significance that warrant consideration and resolution by an appellate court, on matters relevant to the development of the law and the administration of justice.

a) Determination that 167 was not a guarantor and had no proprietary interest or claim to the Cash Collateral under the LC Agreement.

[8] The motions judge found that the moving party did not have a claim or a proprietary interest in the Cash Collateral, because the funds were derived from the Letter of Credit and the law governing letters of credit is clear that funds paid on a Letter of Credit are the property of the issuing bank, not of the party who obtained the Letter of Credit from the bank. He found therefore that 167 had no proprietary interest in the funds drawn from the bank on the Letter of Credit by GMAC.

[9] The motions judge reasoned that pursuant to well-established precedent the law of guarantee did not apply where the parties chose to use a standby Letter of Credit as security, notwithstanding that it may function as a guarantee or use that word. The intention of the parties is evidenced by their choice of the Letter of Credit as the vehicle; they import the entire substance of letter of credit doctrines and the certainty they provide when they choose that vehicle. Letters of credit create a primary obligation and are autonomous to and independent of the underlying transactions to which they relate. The obligation of the issuer bank to the beneficiary GMAC rests upon letter of credit law and is a primary obligation, upon presentation of the required documentation. It is not dependant upon the merits of the claim between the Borrower and the Lender under the Loan Agreement (see Fuji Bank Canada v. 1440 Ste Catherine Street Developments Inc., [1997] O.J. No. 1906 (C.A.)).

[10] The motions judge further relied upon Westpac Banking Corporation v. Duke Group Ltd. (1994), 20 O.R. (3d) 515 (Gen. Div.) and the American case of Carley Capital Group Inc., and found that there was no reason to apply different principles to the party who requested the Letter of Credit from the issuer bank, since neither has control over the underlying transaction. The obligation of the bank issuing the Letter of Credit, or the fourth party requesting the Letter of Credit, is based upon a primary obligation.

[11] The moving party relies, however, on the existence of the LC Agreement, separate from the Letter of Credit, as giving rise to a relationship of guarantee. The Letter of Credit is not the only evidence of the intentions of the parties in this case. Westpac determined that the obligations of the parties arose as a result of their choice of the Letter of Credit as the form of security. This case is unlike both the Westpac and the Carley Capital cases, in that the LC Agreement directly addresses the obligations as between 167 and the Lender GMAC and its terms arguably create a secondary obligation, dependant upon the primary obligation of the Borrower SAAN.

[12] Sections 2.01, 2.05, 2.06, 2.07, and 2.11 of the LC Agreement provide that the Investor guarantees the indebtedness of the Borrower under the Loan Agreement; the Letter of Credit, or the Cash Collateral drawn from the Letter of Credit upon its expiry, may be held as security against any ultimate shortfall in recovery of the borrower’s indebtedness. The Lender may draw on the Letter of Credit, or apply against the Cash Collateral, the amount of the ultimate shortfall only after all inventory has been disposed of by the Lender, and any remaining balance of the Cash Collateral will be returned to 167.

[13] The agreement also permitted the lender GMAC to draw on the Letter of Credit upon its expiry pursuant to section 2.05 and where it does so section 2.11 provides:

To the extent that GMAC is, in accordance with section 2.05, to hold the Cash Collateral, 167 hereby irrevocably assigns, pledges, hypothecates, transfer and sets over to GMAC, and grant to GMAC a security interest in, hypothec on, and right to set off (compensate) against the Cash Collateral. The Cash Collateral shall be held by GMAC, without interest, in an account designated by GMAC for such purpose in its books and records and may be commingled with GMAC’s own funds.

[14] The motions judge extended the law of documentary letters of credit to the terms of the LC Agreement itself. The motions judge concluded that as a result, 167 entered into a contract to supply a standby Letter of Credit and 167’s only subsequent rights were to have the Letter of Credit drawn upon in accordance with the terms provided. He held that 167 was not a guarantor and that the underlying transaction, here the Loan Agreement, is irrelevant to the obligations created by a Letter of Credit. He concluded that any changes to the Loan Agreement, including a forbearance agreement, are irrelevant to the LC Agreement.

[15] I need not decide whether the decision is wrong, or even probably wrong. It seems to me however that it is open to serious debate that apart from the doctrines imported by the Letter of Credit, 167’s obligation to GMAC is dependant upon the liability of the primary debtor SAAN and is secondary in nature. As a result, 167 may be entitled to examine the underlying transaction and the law of guarantee may apply.

[16] This would not affect GMAC’s right to draw upon the Letter of Credit based upon its statement that it was owed money under the LC Agreement as a primary obligation of the Issuer Bank. However, in this case the funds were drawn on expiry of the Letter of Credit and the Lender’s right to apply the Cash Collateral is governed by the terms of the agreement, including section 2.11.

[17] In these circumstances, the question of whether the LC Agreement creates the obligations of a Guarantor and whether 167 has a proprietary claim to the Cash Collateral pursuant to the terms of the LC Agreement is open to serious debate.

[18] As a result, I am satisfied that there is good reason to doubt the correctness of the decision on the issue of whether the law relating to guarantee applies pursuant to the terms of the LC Agreement, and thus whether there is a serious issue to be tried in relation to the claim of 167 to the Cash Collateral.

b) Specific Fund

[19] It was not disputed that a specific fund for the purposes of Rule 45.02 means “a reasonably identified fund earmarked to the litigation in issue.” In other words, it is the right to the fund itself, and not just a right to damages, that is the subject of the litigation. The motions judge found that there was no ‘specific fund’, based upon his finding that 167 could have no ownership or proprietary interest in the cash drawn from a Letter of Credit; the fact that section 2.11 transferred title to the Cash Collateral; and because the LC agreement permitted commingling of the cash collateral with the Lender’s own funds and did not require that the Cash Collateral be an indivisible or traceable fund.

[20] In this case the Lender drew on the Letter of Credit at its expiry under section 2.05 of the LC Agreement and section 2.11 of the LC Agreement addresses the parties’ interest in those proceeds. All parties rely upon different language in section 2.11 to support their position. For the reasons outlined above, 167’s interest in the Cash Collateral under section 2.11 is open to serious debate.

[21] Section 2.11 provides that “the Cash Collateral shall be held by GMAC, without interest, in an account designated by GMAC for such purpose in its books and records and may be commingled with GMAC’s own funds.” This arguably provides for a “reasonably identified fund earmarked to the litigation in issue.” There was no evidence of how those funds were actually held, or that they were actually co-mingled.

[22] In any event, the issue of whether the Cash Collateral is a specific fund flows in part from the determination of whether 167 may have a claim or a right to the return of the Cash Collateral. For the reasons set out above, I have concluded that this question is open to serious debate and there is good reason to doubt the correctness of the decision. As a result, the issue of whether there is a specific fund is also open to serious debate.

c) Ratification of forbearance

[23] The moving party claims that GMAC committed acts of forbearance to SAAN without 167’s consent, thereby prejudicing the guarantor and vitiating its obligations under the guarantee. GMAC submitted that the actions did not constitute material changes within the meaning of guarantee law. The motions judge concluded that even assuming the LC Agreement to be a guarantee and assuming any changes to the loan structure were material amendments, 167 was not entitled to a release under the law of guarantee as 167 ratified any forbearance by GMAC because it knew about the changes and remained silent to await the most favourable outcome.

[24] The moving party concedes that ratification can be express or implied but argues that implied ratification must be clear and unequivocal and the motions judge did not point to unequivocal evidence of ratification.

[25] The motions judge had supervised the CCAA Proceedings and was familiar with the facts. The motions judge was required to review the merits of the application on a preliminary basis in order to determine whether there was a serious issue to be tried. He reviewed the facts and made a finding of fact that 167 had ratified any acts of forbearance. He therefore concluded that any claim that obligations under a guarantee had been discharged was not a serious issue to be tried.

[26] The moving party submits that the motions judge did not apply the low threshold to determine if the issue of ratification was frivolous or vexatious but rather determined the ultimate merits on the issue. The respondent submits that a low threshold does not mean there is no threshold and the motions judge was entitled to apply settled law to undisputed facts.

[27] A motions judge’s finding of fact is entitled to deference. However the motions judge was not required to make factual determinations to resolve the issues in dispute in the application. The motions judge was required to determine if the evidence raised a serious issue to be tried on the moving party’s claim that acts of forbearance had occurred, without its consent or implied ratification. The threshold is low and requires only that the claim not be frivolous or vexatious. In this case, the motions judge set out the evidence relied upon and the arguments of the respondents at length, assessed the evidence and made findings of fact. He did not review whether there was at least an arguable case to advance that there had been no implied ratification.

[28] In my view, it is open to serious debate whether the motions judge erred by determining the merits of the ultimate application rather than determining whether there was a serious issue to be tried on the issue of ratification.

Should leave to appeal be granted?

[29] As a result, I am satisfied that there is good reason to doubt the correctness of the of the motions judge’s decision under Rule 62.02(4)(b). I must determine whether the proposed appeal involves matters of such importance that, in my opinion, leave to appeal should be granted.

[30] This is an interlocutory motion, although the decision effectively suggests that 167 cannot succeed in its application. However, issues must be of broader or general importance and extend beyond the interests of the parties.

[31] The issue of whether there was a serious issue to be tried in relation to ratification does not raise an issue of such importance that leave to appeal is desirable. Even if the motions judge failed to consider an agreement disclosed after the commencement of these proceedings, or if he effectively erred in his application of the threshold test by resolving the merits rather than determining whether the evidence raised a serious issue to be tried, the legal principles in these areas are well-established and the result of the application of those legal principles depends upon the specific facts of this case.

[32] The issue of whether the law of guarantee can apply where a standby Letter of Credit is used to secure indebtedness in the context of an underlying Letter of Credit Agreement between the three parties is, however, an issue of broader significance that in my opinion merits review by an appellate court. I was advised that there are no Canadian cases dealing with a Letter of Credit in the context of an underlying agreement between all three parties or with the relationship between a Letter of Credit, a Cash Collateral drawn from the Letter of Credit, and an underlying agreement. This is an issue of broader significance that warrants consideration and resolution and is relevant to the development of the law in this area.

Stay of the Order

[33] Given my conclusions above, it follows that I am satisfied that there is a serious issue to be addressed in the appeal.

[34] Irreparable harm refers to the nature of the harm and usually requires harm that cannot be quantified in monetary terms. Given the very nature of the motion under appeal, if the funds are not preserved, the appeal is effectively frustrated. There would be serious prejudice to 167 if its claim to the Cash Collateral as a specific fund is foreclosed before the appeal is heard. In this context, I am satisfied that irreparable harm will ensue if the order is not stayed.

[35] Finally, there is no evidence of harm to Black Saxon and the money is in an interest bearing account. I am satisfied that the balance of convenience favours the granting of a temporary stay.

Conclusion

[36] Leave to appeal is granted. The order is stayed pending the disposition of the appeal. Costs are reserved to the panel hearing the appeal.

Karakatsanis J.

Released: July , 2009