C.I.F. Furniture Limited (Re), 2011 ONCA 34

CITATION: C.I.F. Furniture Limited (Re), 2011 ONCA 34

DATE: 20100118

DOCKET: C51633

COURT OF APPEAL FOR ONTARIO

Laskin, Armstrong and Juriansz JJ.A.

In the Matter of the Proposal of C.I.F. Furniture Limited

David R. Byers and Maria Konyukhova, for the appellant, Kari Holdings Inc.

Steven L. Graff, for the respondents, The VenGrowth Traditional Industries Fund Inc. and The VenGrowth II Investment Fund Inc.

Heard: October 28, 2010

On appeal from the order of Justice Geoffrey B. Morawetz of the Superior Court of Justice, dated January 21, 2010.

Laskin J.A.:

A. Introduction

[1] This appeal concerns a priorities dispute between two secured creditors of an insolvent corporation. The insolvent corporation is C.I.F. Furniture Limited. The sale of its assets in a receivership did not generate enough money to satisfy its secured creditors. The two competing secured creditors are Kari Holdings, the holding company of the corporation’s founders, Hans and Elizabeth Kamin, and The VenGrowth group of investment funds, which financed the purchase of Kari’s shares in 2004.

[2] Kari claims priority for a $1 million secured note received as vendor take back financing on the sale of its shares. VenGrowth claims priority for a $4.35 million senior subordinated debenture, used to finance the share purchase.

[3] The case turns on whether a theory of complete subordination or a theory of partial subordination should be used to resolve the dispute. Under the complete subordination theory, Kari succeeds; under the partial subordination theory, VenGrowth succeeds.

[4] The motion judge, Morawetz J., applied a partial subordination theory and so found in favour of VenGrowth. On its appeal, Kari submits that the motion judge erred in two ways. First, having regard to the factual and contractual matrix, the motion judge erred by not applying a complete subordination theory. Second, the motion judge erred in his application of s. 38 of the Personal Property Security Act (PPSA).

[5] I agree with Morawetz J.’s reasons, which I have appended to this judgment. I add brief reasons of my own to address the arguments made in this court. I will first briefly review the financing agreements that led to this dispute, then the two competing theories, and finally why I agree with the motion judge and reject Kari’s submissions.

B. The Financing Agreements

(i) Background

[6] The Kamins started C.I.F. in the 1960s and incorporated their business in 1969. The corporation manufactured and supplied custom laboratory systems for laboratory and educational markets in North America.

[7] In 2004, the Kamins retired and sold their shares in Kari. As part of the sale price, Kari took back a $1 million secured note, in turn secured by a general security agreement. The purchase of Kari’s shares was financed by VenGrowth funds, which included $4.35 million secured by a senior subordinated debenture.

[8] On November 30, 2004 Kari perfected its security interest in the note by registration under the PPSA. Two days later, on December 2, 2004, VenGrowth perfected its security interest in its senior debenture by registering its security interest under the PPSA. However, Kari’s priority of registration under the PPSA was superceded by an inter-creditor agreement made at the end of December 2004.

(ii) The inter-creditor agreement, December 31, 2004

[9] On December 31, 2004, the Bank of Nova Scotia (C.I.F.’s operating lender), Kari and VenGrowth entered into an inter-creditor agreement. They agreed on the following priorities among them, regardless of the order of registration under the PPSA:

• First, the Bank of Nova Scotia to the extent of its loans to C.I.F. (the bank was paid out in December 2006);

• Second, VenGrowth to the extent of its $4.35 million senior subordinated debenture;

• Third, Kari to the extent of its $1 million secured note;

• Fourth, VenGrowth to the extent of the additional loans it had advanced on the purchase of Kari’s shares.

[10] Thus, under the inter-creditor agreement, the VenGrowth senior debenture had priority over the Kari note, and the other VenGrowth debt was subordinate to the Kari note. The priority dispute between Kari and VenGrowth arose in 2008 when Comerica Bank agreed to provide secured financing to C.I.F.

(iii) The 2008 financing of C.I.F.

[11] In 2008, Comerica Bank agreed to provide secured financing to C.I.F. The financing took the form of a revolving credit facility. To implement the financing, the parties signed several documents of which three are relevant to this appeal: a commitment letter signed by Comerica, a credit agreement between Comerica and C.I.F., and, most important, an inter-creditor agreement between Comerica and VenGrowth.

(a) The commitment letter

[12] Comerica committed to provide a revolving credit facility to C.I.F. The commitment letter contains two provisions on which Kari relies in support of its appeal. First, the commitment letter expressly provides that the Kari $1 million note is “to rank ahead of the Bank.” This provision reflects Kari’s prior registration under the PPSA. Second, the commitment letter also required VenGrowth to provide Comerica with a $1 million guarantee, which would terminate on repayment of the Kari note. VenGrowth delivered this guarantee to Comerica.

(b) The credit agreement between Comerica and C.I.F.

[13] Under this agreement, Comerica agreed to loan C.I.F. up to $2.5 million, secured by a general security agreement. Comerica perfected its security interest by registering a financing statement under the PPSA. At April 2009, the balance owing on Comerica’s loan was approximately $1.3 million.

[14] The credit agreement, like the commitment letter, recognized the Kari $1 million note as a “first priority lien” and Comerica’s security interest as a “second priority lien.” Moreover, Comerica’s obligations under the agreement were conditional on, among other things, delivery to it of the VenGrowth guarantee.

(c) The 2008 inter-creditor agreement between Comerica and VenGrowth

[15] Under this agreement, VenGrowth agreed to subordinate its security to Comerica’s security.

C. The Dispute and the Two Competing Theories

(i) The dispute

[16] The various financing agreements created what has been called a “circularity problem.” The problem arises because there is no document in which all three parties – Comerica, Kari and VenGrowth – agreed among themselves on which security interest has priority. Instead, the key agreements were entered into by one or two but not all three parties. The three important agreements are the 2004 inter-creditor agreement to which Comerica was not a party, the 2008 creditor agreement to which neither Kari nor VenGrowth was a party, and the 2008 inter-creditor agreement to which Kari was not a party.

[17] Under the 2004 inter-creditor agreement, the VenGrowth $4.35 million senior subordinated debenture has priority over the $1 million Kari note. Under the 2008 creditor agreement (and the 2008 commitment letter) the Kari $1 million note has priority over Comerica’s security. Under the 2008 inter-creditor agreement, Comerica’s security has priority over VenGrowth’s security.

[18] In short form, these three agreements provide:

• V ($4.35 million) ranks ahead of K ($1 million) – 2004 inter-creditor agreement

• K ($1 million) ranks ahead of C – 2008 creditor agreement

• C ranks ahead of V – 2008 inter-creditor agreement

[19] How then is this priority dispute to be resolved? Both sides accept that it should be resolved by applying either a theory of complete subordination or a theory of partial subordination. The two theories are discussed in the reasons of the motion judge. I will review how the application of each theory affects the priorities among VenGrowth, Kari and Comerica.

(ii) Complete subordination

[20] Under complete subordination, VenGrowth gives up its priority to Comerica: in other words, VenGrowth agrees not to assert a claim against the fund generated by the sale of C.I.F.’s assets until Comerica’s claim is satisfied. But because Kari’s security interest was registered under the PPSA before Comerica’s security interest was registered, Comerica’s claim cannot be satisfied until Kari’s claim is paid. Kari therefore benefits indirectly from the agreement between VenGrowth and Comerica: Kari goes to first priority and VenGrowth falls to last priority. If the theory of complete subordination is applied, the priorities are:

• First, Kari;

• Second, Comerica;

• Third, VenGrowth

(iii) Partial subordination

[21] Under partial subordination, VenGrowth gives the benefit of its first priority to Comerica. The amount of VenGrowth’s claim – $4.35 million – is set aside out of the fund. That amount is used to satisfy Comerica’s claim. If Comerica’s claim is less than $4.35 million, it will get all of its claim paid and VenGrowth will get the balance. If Comerica’s claim is greater than $4.35 million it will get the entire $4.35 million, but will receive the remainder of its claim only after Kari is paid.

[22] Partial subordination has no effect on Kari. It remains in second priority after VenGrowth’s first priority to the extent of $4.35 million. While under complete subordination, VenGrowth completely steps aside, under partial subordination VenGrowth steps aside only to the extent of Comerica’s claim. Accordingly, if the theory of partial subordination is applied, the priorities are:

• First, Comerica, to a maximum of $4.35 million, and then VenGrowth, to a maximum of $4.35 million less Comerica’s claim;

• Second, Kari;

• Third, Comerica for any claim in excess of $4.35 million;

• Fourth, VenGrowth for all of its remaining claims.

D. Discussion

[23] The motion judge applied a theory of partial subordination for two main reasons. First, partial subordination produced an equitable result because it meant “Kari is neither burdened nor benefited by the 2008 Inter-Creditor Agreement,” whereas complete subordination “would result in a windfall benefit to Kari at the expense of VenGrowth.” Second, complete subordination could be justified only if supported by “clear and explicit language,” and “such clear and explicit language is not found in the documents”: see paras. 50-51 of the motion judge’s reasons.

[24] I turn to Kari’s two submissions.

1. Having regard to the factual and contractual matrix, did the motion judge err by not applying complete subordination?

[25] Whether complete or partial subordination should be applied turns on VenGrowth’s intention, as disclosed by the various agreements. Do the agreements show that VenGrowth intended to wholly step aside and go to the bottom of the queue, or do they show that VenGrowth intended to step aside only to the extent of Comerica’s interest?

[26] Kari submits that the agreements, and the factual context in which they were signed, show that VenGrowth intended to go to the bottom of the queue. In making this submission, Kari relies mainly on five contractual provisions: the negative covenant in s. 8.2(b) of the Kari note, repeated in Kari’s general security agreement; sections 4(d) and 11 of the 2004 inter-creditor agreement between Kari and VenGrowth; the 2008 credit agreement between Comerica and C.I.F.; the VenGrowth $1 million guarantee; and article 4 of the 2008 inter-creditor agreement between VenGrowth and Comerica. I do not think that singularly or collectively these five contractual provisions support Kari’s position.

[27] Section 8.2(b) of the Kari note contains a negative covenant precluding C.I.F. from granting additional encumbrances without Kari’s consent. Kari says that the 2008 Comerica financing was done without its knowledge and thus breaches s. 8.2(b). Whether the 2008 financing amounts to a breach of this covenant need not be decided on this appeal. The important point is that VenGrowth was not a party to the note or to the financing in 2008. They therefore do not speak to VenGrowth’s intentions; nor can they affect its priority position. Kari’s corollary argument that VenGrowth arranged the financing is not supported in the record.

[28] Sections 4(d) and 11 of the 2004 inter-creditor agreement stipulate that nothing in that agreement shall be construed as conferring any rights on a third party. Comerica is a third party, and therefore Kari argues that these provisions precluded Comerica from taking the benefit of VenGrowth’s priority. In my opinion, these provisions do not assist Kari. The priority given to Comerica was conferred not in this 2004 agreement, but in the 2008 inter-creditor agreement.

[29] Nor does the 2008 credit agreement or the commitment letter assist Kari. As VenGrowth was not a party to this agreement, or to the commitment letter, their terms cannot demonstrate any intention on VenGrowth’s part to go to the bottom of the queue. These documents do no more than acknowledge that the Kari note ranks ahead of Comerica’s security interest. They do not establish any agreement between Kari and VenGrowth or between VenGrowth and Comerica that puts Kari in first priority.

[30] Kari’s strongest argument rests on the $1 million guarantee given by VenGrowth in connection with the Comerica financing. The guarantee stipulated that it would terminate on payment of the Kari note. Kari contends that this guarantee and its termination provision make no sense under partial subordination. Kari says that Comerica insisted on this guarantee because it did not have a subordination agreement with Kari. Functionally, Kari says that the guarantee puts it in first priority until it is paid.

[31] I do not accept Kari’s contention. The record is silent on why Comerica insisted on this guarantee. I agree with VenGrowth that banks ask for many pieces of security, some they need and some they may not need, to protect their position. It is just as plausible that Comerica asked for this guarantee because the guarantee made its interest more secure. Perhaps more important, there is no term in the guarantee from which one can say that by giving it VenGrowth intended to entirely cede its priority to Kari.

[32] Finally, Kari relies on article 4 of the 2008 inter-creditor agreement between Comerica and VenGrowth. Article 4 states:

Priorities of Indebtedness; Subordination of Junior Creditor Indebtedness

Junior Creditor hereby subordinates, to the extent and in the manner provided in this Agreement, all of its rights of payment of all of the Junior Creditor Indebtedness to the full and final payment of all of the Senior Creditor Indebtedness and the termination of all financing arrangements and commitments between the Debtor, the Guarantor and the Senior Creditor.

[Comerica is the Senior Creditor and VenGrowth is the Junior Creditor.]

[33] Kari submits that article 4 means VenGrowth is not to be paid until Comerica is paid in full. However, because Kari’s security interest was registered before Comerica’s security interest, Comerica cannot be paid until Kari is paid. So, implicitly, by article 4, VenGrowth agreed to step aside completely.

[34] Kari’s submission does not give effect to the qualifying phrase in article 4, “to the extent and in the manner provided in this Agreement”. Other provisions of the agreement show that VenGrowth did not intend to subordinate its entire priority position to Kari. For example, articles 2 and 3 state that no third party – and Kari is a third party under this agreement – may benefit from anything contained in the agreement. Article 7a explicitly recognizes that VenGrowth agrees to step aside only to the extent of Comerica’s interest:

Under any circumstances … the Collateral shall be applied first to the Senior Creditor Indebtedness until all of the Senior Creditor Indebtedness has been fully and finally paid and all of the financing arrangements and commitments between the Debtor, the Guarantor and Senior Creditor have been terminated, and then to the Junior Creditor Indebtedness.

[35] For these reasons, I do not agree that the various contractual provisions on which Kari relies argue for complete subordination. Moreover, there are several compelling reasons to apply partial subordination.

[36] First, it would be unreasonable to find that VenGrowth intended complete subordination. By 2008, Kari’s financing had already been spent. Comerica was providing new financing to keep the corporation afloat. As VenGrowth had a big investment in the corporation, it made sense for VenGrowth to subordinate its interest to Comerica’s interest. By contrast, it would have made no sense for VenGrowth to subordinate its interest to Kari’s interest.

[37] Second, as the motion judge pointed out, complete subordination would confer a windfall on Kari. It would go from second to first priority. Partial subordination leaves Kari in second position. It gets exactly what it bargained for in 2004.

[38] Third, there is no document where VenGrowth agreed to subordinate its interest to Kari’s interest. Thus, to give effect to Kari’s position, one would have to infer that VenGrowth intended to go to the bottom of the queue. To draw that inference, one would expect some clear and unequivocal language in one of the documents, or at the very least, an exchange of correspondence between VenGrowth and Kari. Nothing of that sort exists.

[39] I would not give effect to Kari’s main ground of appeal.

2. Did the motion judge err in his application of s. 38 of the PPSA?

[40] Section 38 of the PPSA states:

A secured party may, in the security agreement or otherwise, subordinate the secured party’s security interest to any other security interest and such subordination is effective according to its terms.

[41] Section 38 recognizes that a secured party can, by agreement, subordinate its interest to other security interests in the same collateral, and a third party, not privy to that agreement, can rely on and enforce that subordination.

[42] Kari argues that as a third party, it can rely on section 38 to enforce what it claims is the priority given to it by the 2008 credit agreement between Comerica and C.I.F., and the 2008 inter-creditor agreement between Comerica and VenGrowth. This argument simply recasts in the context of s. 38 of the PPSA, the main argument Kari advanced on this appeal, which I have already rejected. The motion judge did not give effect to Kari’s argument under s. 38 and I would not do so either.

[43] VenGrowth was not a party to the 2008 credit agreement, and therefore the parties to that agreement – Comerica and C.I.F. – could not by themselves subordinate the priority interest of the VenGrowth senior debenture to the Kari note. Further, as I have already discussed, nothing in the 2008 inter-creditor agreement shows an intention on VenGrowth’s part to go to the bottom of the queue. I would not give effect to this ground of appeal.

E. Conclusion

[44] The motion judge was correct in applying the theory of partial subordination to resolve the priority dispute between Kari and VenGrowth. I would therefore dismiss Kari’s appeal, with costs fixed in the agreed upon amount of $17,500, inclusive of disbursements and applicable taxes.

RELEASED: Jan. 18, 2011 “John Laskin J.A.”

“JL” “I agree Robert P. Armstrong J.A.”

“I agree R.G. Juriansz J.A.”

Appendix A

CITATION: C.I.F. Furniture Limited (Bankruptcy of), 2010 ONSC 505

COURT FILE NO.: 31-1194593

DATE: 20100121

SUPERIOR COURT OF JUSTICE – ONTARIO

(COMMERCIAL LIST – BANKRUPTCY AND INSOLVENCY)

RE: IN THE MATTER OF THE PROPOSAL OF C.I.F. Furniture Limited, Applicants

BEFORE: MORAWETZ J.

COUNSEL: Steven L. Graff and Sandra A. Vitorovich, for The VenGrowth Traditional Industries Fund Inc. and the VenGrowth II Investment Fund Inc.

Paul G. Macdonald and Myriam M. Seers, for Kari Holdings Inc.

ENDORSEMENT

[1] This matter involves a priority dispute arising from the sale of assets of C.I.F. Furniture Limited (“CIF”) for proceeds that are insufficient to satisfy the security interests of certain secured creditors. The dispute is between Kari Holdings Inc. (“Kari”) and The VenGrowth Traditional Industries Fund Inc. (“VenGrowth Traditional”) and The VenGrowth II Investment Fund Inc. (“VenGrowth Investment”) and together with VenGrowth Traditional, (“VenGrowth”).

[2] The parties are in agreement that a secondary issue, namely, whether the VenGrowth Security Interest only covered the principal amount owing to VenGrowth and does not include any payments of interest is moot and consequently need not be determined.

Summary of Facts

[3] CIF carried on business for the manufacture and supply of custom laboratory systems for markets across Canada and the United States.

[4] The business was established in the early 1960’s by Mr. Hans J. Kamin and his spouse, Mrs. Elizabeth M. Kamin. In 1969, the Kamins incorporated CIF to continue the business.

[5] Upon retiring in 2004, the Kamins sold CIF to an affiliate of VenGrowth (the “Purchaser”) pursuant to a share purchase agreement dated November 23, 2004. On the closing date (December 7, 2004), the Purchaser and CIF amalgamated and continued as CIF. The purchase price was $7,057,060. At the time of closing, VenGrowth indirectly held 53% of the issued and outstanding shares in CIF. At the time of the motion, VenGrowth was CIF’s 95% majority shareholder and a substantial secured creditor.

[6] As part of the share purchase, Kari (the holding company of Mr. and Mrs. Kamin) provided the Purchaser with $1,000,000 in vendor take-back (“VTB”) financing (the “Kari Note”), secured by a general security agreement dated December 1, 2004 (the “Kari GSA”), for which a financing statement was registered under the Personal Property Security Act (Ontario) (“PPSA”) on November 30, 2004 (the “Kari Security Interest”).

[7] VenGrowth also financed the share purchase by advancing the Purchaser the principal amount of $4,350,000, secured by a senior subordinated debenture dated December 2, 2004 (the “VenGrowth Senior Debenture”) for which a financing statement was registered under the PPSA by VenGrowth on December 2, 2004 (the “VenGrowth Security Interest”).

[8] VenGrowth also advanced significant additional capital to CIF on a junior and/or subordinated basis to Kari, with certain of these additional advances being made in December 2004 to finance the share purchase.

[9] Following the share purchase, Bank of Nova Scotia (“BNS”) agreed to be the operating lender of CIF. All parties funding the share purchase recognized and agreed that BNS was in priority to all other secured creditors. CIF repaid its obligations to BNS in December 2006.

[10] Subsequently, Comerica Bank (“Comerica”) became the operating lender. Pursuant to a credit agreement between Comerica and CIF dated November 28, 2008 (the “Comerica Credit Agreement”), Comerica provided CIF with a revolving credit facility to a maximum of $2,500,000. The facility granted pursuant to the Comerica Credit Agreement was secured by a security agreement dated November 28, 2008 (the “Comerica Security”), for which a financing statement was registered under the PPSA on November 13, 2008 (the “Comerica Security Interest”).

[11] Both VenGrowth Traditional and VenGrowth Investment guaranteed a portion of the Comerica facility pursuant to the following guarantees (the “VenGrowth Guarantees”):

(a) a guarantee dated November 28, 2008 granted by VenGrowth Traditional in favour of Comerica and limited to $462,571; and

(b) a guarantee dated November 28, 2008 granted by VenGrowth Investment in favour of Comerica limited to $537,429.

[12] VenGrowth submits that the guarantee of VenGrowth Traditional was amended and restated by a guarantee dated April 29, 2009 limited to $601,342 and that the guarantee of VenGrowth Investment was amended and restated by a guarantee also dated April 23, 2009 limited to $698,658.

[13] The PPSA registrations are filed in the following order of priority:

(i) Kari – November 30, 2004;

(ii) VenGrowth – December 2, 2004;

(iii) Comerica – November 13, 2008.

[14] In 2004, CIF, Kari and VenGrowth entered into the following priorities agreements:

(a) an inter-creditor agreement dated December 3, 2004 (the “2004 Inter-Creditor Agreement”);

(b) a subordination agreement dated December 7, 2004 (the “2004 Subordination Agreement”); and

(c) separate postponement and subordination agreements in favour of Kari from each of VenGrowth Traditional, VenGrowth Investment, as well as various other CIF creditors, namely, Cinitel Corp., Fallbrook Holdings Limited (“Fallbrook”), Mr. Bruce Andrew, Mr. Stephen Dulong and 1639662 Ontario Inc. (“Holdco”).

[15] The 2004 Inter-Creditor Agreement granted the VenGrowth Security Interest, to the extent of the debt under the VenGrowth Senior Debenture, priority over the Kari Security Interest.

[16] Under the 2004 Subordination Agreement, VenGrowth Investment and VenGrowth Traditional agreed to postpone and subordinate their security interests, pursuant to their respective security, to the Kari Security Interest, except that neither of VenGrowth Investment or VenGrowth Traditional postponed or subordinated the VenGrowth Security Interest. As stated by counsel to VenGrowth, “in other words, all advances made by VenGrowth, other than the VenGrowth Senior Debenture, were subordinated to Kari”.

[17] Comerica was not a party to the 2004 Inter-Creditor Agreement.

[18] In 2008, CIF secured financing from Comerica. The terms of the financing were set out in a commitment letter dated June 5, 2008 pursuant to which Comerica committed to provide a $2.5 million revolving credit facility to CIF (the “Commitment Letter”).

[19] The Commitment Letter expressly states that the Kari Security Interest will rank in priority to the Comerica Security Interest and that the VenGrowth Security Interest will be subordinated to the Comerica Security Interest.

[20] The Comerica Credit Agreement recognizes the Kari Security Interest as a first priority lien and that the Comerica Security Interest as a second priority lien.

[21] The Comerica Credit Agreement included the Kari Note as a “Permitted Debt”, the Kari Security Interest as a “Permitted Lien” and required a subordination of the VenGrowth Security Interest but not the Kari Security Interest to the Comerica Security Interest.

[22] VenGrowth was not a party to either the Commitment Letter or the Comerica Credit Agreement.

[23] Also, on November 28, 2008, CIF provided Comerica with the Comerica Security Agreement.

[24] The Comerica Security Interest also provides that each of the VenGrowth Guarantees will terminate upon the payment in full of the Kari Note.

[25] On November 28, 2008, VenGrowth and Comerica entered into an inter-creditor agreement whereby VenGrowth agreed to fully subordinate the VenGrowth Security Interest to the Comerica Security Interest (the “2008 Inter-Creditor Agreement”).

[26] Kari did not know about the Comerica Security Interest until CIF served it with motion materials in these proceedings on April 21, 2009.

[27] CIF is insolvent and on April 21, 2009 it filed a Notice of Intention to Make a Proposal under the Bankruptcy and Insolvency Act (the “BIA”).

[28] On April 29, 2009, A. Farber & Partners Inc. (the “Interim Receiver”) was appointed interim receiver of CIF and by order dated May 15, 2009, the Interim Receiver was authorized to market and sell the assets.

[29] There is no inter-creditor agreement to which Comerica, VenGrowth and Kari are all parties that set out the priorities among them. There is no inter-creditor agreement or subordination agreement in which VenGrowth subordinates or postpones the VenGrowth Security Interest to the Kari Security Interest.

[30] Kari and Comerica have not entered into any agreement between themselves which governs the relative priorities of the Kari Security Interest and the Comerica Security Interest.

Analysis

[31] Kari submits that the Kari Security Interest ranks in priority to the Comerica Security Interest and the VenGrowth Security Interest by operation of the Commitment Letter, the Comerica Credit Agreement, the Comerica Security Agreement, the Comerica Security Interest and the 2008 Inter-Creditor Agreement (collectively the “Comerica Agreements”) and s. 38 of the PPSA.

[32] Counsel to Kari submits that an objective interpretation of the relevant documents demonstrates that both VenGrowth and Comerica intended that, as a result of the Comerica Agreements, the Kari Security Interest would rank in priority to the Comerica Security Interest and, therefore, the VenGrowth Security Interest. Counsel to Kari submits that this position is supported by the repeated references in the Commitment Letter and the Comerica Credit Agreement to the first priority position of the Kari Security Interest and VenGrowth’s voluntary agreement to step out of the priority queue and back in behind Comerica.

[33] There is, in my view, a fundamental weakness in this argument. VenGrowth is not party to either the Commitment Letter or the Comerica Credit Agreement. These are contractual agreements between CIF and Comerica. Although VenGrowth is the substantial controlling shareholder of CIF, this does not mean that the contractual agreements of CIF are agreements that bind VenGrowth. There is no stated intention in any document that establishes that VenGrowth intended to cede its priority position in all respects to the Kari Security Interest.

[34] When read together, the 2004 Inter-Creditor Agreement and the 2008 Inter-Creditor Agreement create a circularity issue as between Kari, VenGrowth and Comerica.

[35] Professor Wood commented on this issue in “Circular Priorities in Secured Transactions Law” at pages 7 – 8:

The real controversy concerns the proper interpretation of the subordination agreement. In the United States, the issue is framed as whether SP1 intended a complete subordination of its claim or only a partial subordination. A complete subordination occurs if the subordination agreement is interpreted as an agreement by SP1 not to assert its claim against the collateral until SP3’s claim is satisfied. It does not involve an agreement by SP1 to turn over the benefit of its priority to SP3. Rather, it is essentially an agreement by SP1 to step aside and not assert its claim until SP3’s claim has been satisfied. On this view, the competition is resolved by giving first priority to SP2, second priority to SP3, and third priority to SP1. SP2 is the indirect beneficiary of the subordination agreement because SP3 cannot satisfy its claim until the claim of SP2 is fully satisfied.

Under the competing partial subordination theory, a subordination agreement is interpreted as an agreement under which SP1 agrees to turn over the benefit of its priority to SP3. The priorities are therefore resolved in the following manner. First, the amount of SP1’s claim is set aside out of the fund. Second, the fund is used to satisfy SP3’s claim. If there is anything left over, it is paid to SP1. Third, SP2’s claim is satisfied out of the fund. Fourth, any remaining balance is distributed to SP3 and then to SP1.

[36] The duelling approaches were also the subject of commentary by Professors Cumming, Walsh and Wood in Personal Property Security Law where the authors explained as follows:

The priority competition is resolved by setting aside the amount of SP1’s claim. From this fund, SP3’s claim is satisfied. If a surplus remains after SP3’s claim is satisfied, it is paid over to SP1. SP2’s claim would next be satisfied from the remaining funds. If there is anything left, it is then distributed to SP3, then SP1. In other words, the subordination agreement between SP1 and SP3 is effective only as between those parties, and has no effect on the relative priority of SP2.

Most subordination agreements provide for a postponement of the subordinating creditor’s claim. Under a “step-aside” agreement, a secured party may instead agree that it will not make a claim in respect of a subordinated debt until the benefiting creditor is paid in full. If this form of agreement is used, there is a greater likelihood that it will have the effect of elevating the priority of an intervening party. In the above scenario, SP1 would renounced its claim until SP3 is paid in full. This would seem to have the effect of placing SP1 at the end of the queue, with the result that SP2 would obtain first priority followed by SP3.

[37] At issue is whether the circularity problem should be resolved in favour of VenGrowth or Kari. A resolution in favour of VenGrowth would require the application of the partial subordination theory. A resolution in favour of Kari would require the application of the complete subordination theory.

[38] In considering which of these two approaches should be applied in these circumstances, in my view, it is necessary to consider the impact of agreements to which VenGrowth, Kari and Comerica are parties.

[39] As a result of the 2004 Inter-Creditor Agreement, the Kari Security Interest is subordinate to the VenGrowth Security Interest. The issue is whether this situation changed as a result of the Comerica Agreements. In my view, it has not.

[40] VenGrowth entered into the 2008 Inter-Creditor Agreement with Comerica, the result of which is that VenGrowth subordinated payment under the VenGrowth Senior Debenture to Comerica. It does not follow that VenGrowth intended that its entire priority position would be subordinated to that of Kari.

[41] The Commitment Letter states that the VTB from Kari in the amount of $1,000,000 is to rank ahead of Comerica. This statement, at most, provides the understanding on the part of Comerica that Kari’s interest ranks ahead of Comerica’s position, but there is no agreement or acknowledgement by VenGrowth that the Kari Security Interest ranks ahead of the VenGrowth Security Interest.

[42] Further, the Comerica Credit Agreement does not recognize or state that the Kari Security Interest shall constitute a priority claim to the VenGrowth Security Interest.

[43] Section 38 of the PPSA provides that a secured party may, in the security agreement or otherwise, subordinate its security interest to any other security interest and the subordination is effective according to its terms and a third party who is not privy to the security agreement or other agreement which contains the subordination clause can enforce it.

[44] Counsel to VenGrowth submits that s. 38 applies only in instances where the secured creditor itself subordinates, explicitly or implicitly, its security interest vis-à-vis a third party. Counsel cites Sun Life Assurance Co. of Canada v. Royal Bank, 37 C.B.R. (4th) 169 in support of this submission. I agree with this position.

[45] In this case, the Commitment Letter and the Comerica Credit Agreement are the documents that Kari submits evidences the intention of VenGrowth to subordinate the VenGrowth Security Interest to the Kari Security Interest. I am in agreement with the submission of counsel to VenGrowth that evidence of an understanding involving Comerica and CIF in respect of the priority between Kari and Comerica does not establish a subordination agreement as between VenGrowth and Comerica in favour of Kari.

[46] The only documents in the Comerica Agreement to which VenGrowth is a party are the 2008 Inter-Creditor and the VenGrowth Guarantees. These documents, do not, in my view, result either clearly or explicitly, in a subordination of the VenGrowth Security Interest to the Kari Security Interest.

[47] Counsel to VenGrowth submits that the effect of the 2008 Inter-Creditor Agreement is to provide that a portion of any fund paid by CIF to VenGrowth under the VenGrowth Senior Debenture would be paid by VenGrowth to Comerica and any funds available for payment by CIF after repayment of the amount owing under the VenGrowth Senior Debenture would be paid to Kari next in satisfaction of the indebtedness under the Kari Note. A proper interpretation is that under the 2008 Inter-Creditor Agreement, any payments received by VenGrowth from CIF pursuant to the VenGrowth Senior Debenture (up to a maximum of the VenGrowth Indebtedness) would be shared as between VenGrowth and Comerica as follows:

(a) first, payment would be made to Comerica in satisfaction of the Comerica indebtedness; and

(b) secondly, the remaining funds, of the total of the VenGrowth Senior Debenture (inclusive of amounts paid in sub (a)), would be payable to VenGrowth in satisfaction of the VenGrowth indebtedness. The total distributed under both sub (a) and sub (b) would not be greater than the VenGrowth indebtedness.

[48] Counsel to VenGrowth submits that this interpretation is consistent with the analysis set out by Grant Gilmore in Security Interests in Personal Property, where he discusses a situation with three creditors, A, B, and C where A and C enter into a subordination agreement, the secured assets are sold and there are insufficient funds to satisfy the claims of all three creditors. The ensuing distribution was explained by Gilmore as follows:

There is a comforting unanimity, among courts and commentators, on the proper distribution of funds:

1. Set aside from the fund the amount of A’ claim.

2. Pay the amount set aside to

a) C, to the amount of his claim;

b) A, to the extent of any balance remaining after C’s claim is satisfied.

3. Pay B the amount of the fund remaining after A’s claim has been set aside.

4. If any balance remains in the fund after A’s claim has been set aside and B’s claim has been satisfied, distribute the balance to

a) C,

b) A.

Thus C, by virtue of the subordination agreement, is paid first, but only to the amount of A’s claim, to which B was in any event junior. B receives what he had expected to receive: the fund less A’s prior claim. If A’s claim is smaller than C’s, C will collect the balance of his claim in his own right, only after B has been paid in full. A, the subordinator, receives nothing until B and C have been paid except to the extent that his claim, entitled to first priority, exceeds the amount of C’s claim, which under his agreement, is to be paid first.

[49] Counsel to VenGrowth also referenced the decision of the Newfoundland and Labrador Court of Appeal in Hickman Equipment (1985) Ltd., Re, 2006 CarswellNfld 245, leave to appeal to Supreme Court of Canada refused, [2006] S.C.C.A. No. 462. Counsel to VenGrowth submitted in their factum as follows:

42. The Newfoundland and Labrador Supreme Court was recently asked to decide whether by virtue of a subordination agreement between party A and C: (i) C moved up to stand in the place of A and thereby gains priority over B; or (ii) while A ranks in priority behind C, nonetheless B retains priority over C.

43. Quoting several texts, including the passage from Gilmore above, and Canadian jurisprudence, the Appellant in Hickman argued that “the ranking of the claims and distribution of proceeds is determined apart from the operation of the subordination agreement” with the subordination agreement applying to determine the extent of the share of the distribution that should be paid to the party in whose favour the subordination was granted. Moreover, a creditor in second position (such as Kari) should not receive the benefit of a subordination agreement to which it is not a party and on which the parties to the subordination agreement intended the second position creditor to rely.

44. The central proposition of the case of the Appellants in Hickman [and the position advanced by VenGrowth herein] was:

Where a subordination is enforced by the benefiting creditor [RBC] for its benefit, the amount secured by the subordinated security interest simply goes toward satisfying in whole or in part two claims as opposed to one: the benefiting creditor’s claim [RBC’s] and the subordinated creditor’s claim [CIBC’s]. The benefiting creditor shall receive payment in full of its claim, before the subordinated creditor receives any payment on the subordinated debt. Where there is an intervening security interest [GMAC], the result is equitable, because the intervening creditor will receive what it expected to receive, the fund less the amount secured by the higher ranking subordinated security interest. Otherwise, the intervening creditor receives a windfall and the statutory rights bestowed on the subordinating creditor to subordinate its security interest and the benefiting creditor to enforce the subordination for its benefit are thwarted.

The court, finding the arguments set out by the Appellant persuasive, adopted the Appellant’s reasoning.

[50] I am in agreement with the submissions of counsel to VenGrowth. The 2008 Inter-Creditor Agreement can only have an impact on determining the extent to which the monies paid to CIF pursuant to the VenGrowth Senior Debenture should be paid in favour of Comerica. In this manner, Kari is neither burdened nor benefited by the 2008 Inter-Creditor Agreement. On the other hand, the argument put forward by counsel to Kari would result in a windfall benefit to Kari at the expense of VenGrowth. The result preferred by VenGrowth produces, in my view, an equitable result.

[51] It seems to me that the result preferred by Kari, namely, that of a complete subordination, could only be justified if there is clear and explicit language that would result in a complete subordination agreement. Such clear and explicit language is not found in the documents.

Disposition

[52] In this case, in the 2008 Inter-Creditor Agreement, VenGrowth subordinates only to and for the benefit of Comerica, while at the same time preserving its priority position as against third parties. In my view, it is especially telling that s. 2 of the 2008 Inter-Creditor Agreement provides that all agreements and representations are solely for the benefit of the creditors (VenGrowth and Comerica) and that no other parties are intended to be benefited in any way by the 2008 Inter-Creditor Agreement. In the face of such explicit language, it seems to me that it cannot be said that there was the intention on the part of VenGrowth to effect a complete subordination in favour of Kari. Rather, the effect of the 2008 Inter-Creditor Agreement is that, with all the priorities remaining the same, VenGrowth is to set aside a portion of the funds it receives in trust to be paid to Comerica pursuant to the 2008 Inter-Creditor Agreement and that it will not receive its priority payment until Comerica has been paid in full from payments it receives in its position.

[53] In the result, I find that the VenGrowth Security Interest is in priority to the Kari Security Interest to the extent of principal owing under the VenGrowth Senior Debenture. The issue of whether priority extends to interest need not be determined.

[54] VenGrowth is to have its costs of this motion, as agreed, in the amount of $42,500 inclusive of disbursements and GST.

MORAWETZ J.

Date: January 21, 2010