7.01  This chapter provides an overview of the law of set-off in Canada both outside and within insolvency proceedings. It also considers issues that arise when the law of set-off is applied in a cross-border context, including in cross-border insolvency proceedings.

7.02  Canada has a federal system of government, with a national federal government and ten provinces.¹ Under Canadian constitutional law, legislative authority is divided between federal and provincial governments.

7.03  Property and civil rights, including contract law, are matters within provincial jurisdiction. For the most part, therefore, the law of set-off is a matter of provincial law. Depending on the context in which the claim is asserted, federal law also may apply. For example, banking and insolvency are matters within the exclusive jurisdiction of the federal government.

(p. 102) 7.04  The legal system in nine of Canada’s ten provinces is based on English common law. The law relating to set-off is similar throughout these common law jurisdictions. The one Canadian province that does not have a legal system based on English common law is Quebec, a civil law jurisdiction. This chapter will focus on the law of set-off in the common law provinces and thus will apply in most Canadian jurisdictions.²

7.05  Set-off is a monetary cross-claim raised as a defence to a monetary claim that, to the extent of the cross-claim, reduces or eliminates the amount payable on the claim.³ The courts in Canadian common law jurisdictions recognize four types of set-off: (i) legal, (ii) equitable, (iii) statutory, and (iv) contractual.⁴

7.06  In Canada, the availability of legal set-off originates in statute.⁵ Today, the relevant provisions are found in civil procedure legislation and Rules of Court.⁶ In Ontario, for example, section 111 of the Courts of Justice Act provides:

(p. 103)

1. (1)  In an action for payment of a debt, the defendant may, by way of defence, claim the right to set off against the plaintiff’s claim a debt owed by the plaintiff to the defendant.

2. (2)  Mutual debts may be set off against each other, even if they are of a different nature.

3. (3)  Where, on a defence of set-off, a larger sum is found to be due from the plaintiff to the defendant than is found to be due from the defendant to the plaintiff, the defendant is entitled to judgment for the balance.

7.07  For legal set-off to apply, two conditions must be met: (i) the cross-claims must be debts and (ii) both debts must be mutual.⁷

7.08  This first condition of legal set-off requires that the reciprocal cross-claims be ‘debts’; that is, they must be money obligations that are liquidated, enforceable, and payable (whether immediately or at a future time).⁸ A claim is ‘liquidated’ if it is for a sum certain or if it can be ascertained with certainty based on a formula or reference to data.⁹ Debts are to be distinguished from unliquidated claims (such as damages), which cannot be the subject of legal set-off.

7.09  To meet the second condition of mutuality, the cross-obligations must arise between the same parties acting in the same right. Assignment destroys mutuality and precludes legal set-off.¹⁰ Canadian courts also have held that the following cross-claims lack mutuality, as the parties are not acting ‘in the same right’:

• •  a person owes a debt in an individual capacity and is owed a debt in a different capacity (eg as a trustee or in another fiduciary role on behalf of others);

• •  a person owes a debt to a special-purpose account and is owed a debt by a different (or no) special-purpose account;

• (p. 104) •  joint debtors owe a debt jointly to a person and the person owes a debt to only one of the joint debtors.¹¹

7.10  There is no requirement in legal set-off that the debts themselves be connected or related in any manner. In many cases the cross-obligations will arise from separate transactions.

7.11  In its leading decision on equitable set-off, Telford,¹² the Supreme Court of Canada held that the following five principles apply in determining whether the conditions for equitable set-off have been met:¹³

1. (1)  The party relying on the set-off must show some equitable ground for being protected against the adversary’s demands.¹⁴

2. (2)  The equitable ground demonstrated by the defendant to impeach or reduce the plaintiff’s demand must go to the very root of the plaintiff’s claim before set-off will be allowed.¹⁵

3. (3)  A cross-claim must be so clearly connected with the demand of the plaintiff that it would be manifestly unjust to allow the plaintiff to enforce payment without taking into consideration the cross-claim.¹⁶

4. (4)  The plaintiff’s claim and the cross-claim need not arise out of the same contract.¹⁷

5. (p. 105) (5)  Unliquidated claims are on the same footing as liquidated claims. Equitable set-off (unlike legal set-off) is available where there is a claim for a money sum whether that sum is liquidated or unliquidated.¹⁸

7.12  In most cases concerning equitable set-off, the key issue is whether there is such a close relationship between the claims of the parties that it would be unconscionable or inequitable not to permit set-off.¹⁹ In order to determine whether equitable set-off is permitted on this ground, courts first look at the connection between the claims involved. If the claims are closely connected, the next step is to consider the equities between the parties.²⁰

7.13  In Cam-Net Communications v Vancouver Telephone Co.,²¹ for example, the British Columbia Court of Appeal upheld a creditor’s right to set off a liquidated debt owed to a company against damages owed to the creditor for failure to provide services of a sufficient quality (as required by the contract under which the liquidated debt was incurred). The Court held that the obligations were so closely connected that it would be inequitable to permit the company to collect its debt while preventing the creditor from setting off amounts owed to the creditor for breach of contract.

7.14  Equitable set-off relaxes both of the requirements of legal set-off. It can apply not only where the cross-obligations are not debts, but also where mutuality is lost (for example, by assignment) or never existed.²² Where mutuality never existed, however, the lack of original mutuality may be a relevant factor in the court’s assessment of whether there is a sufficiently ‘close connection’ between claims for purposes of equitable set-off.²³

7.15  Statutory set-off refers to set-off rights enacted by legislation. Both federal and provincial governments are often the beneficiaries of this type of set-off. The federal government and some provincial governments have enacted broad provisions that may permit set-off that may not otherwise be available. For instance, the Province of Saskatchewan enacted section 42 of the Financial Administration Act 1993,²⁴ which reads:

42(1) Notwithstanding The Enforcement of Money Judgements Act or any other Act or law, the Crown and every public agency have the right to retain as a set-off, out of moneys due or payable to a person by the Crown or a public agency:

1. 1. (a)  any amount the person owes to the Crown or a public agency;

   2. (b)  any overpayment that has been made by the Crown or a public agency; or

   3. (c)  any advance made to the person under section 41 that has not been repaid or accounted for.

2. (2)  The rights in this section are in addition to and not in derogation of any right of set-off that the Crown or a public agency may have at law.

3. (3)  The board may make any orders and issue any directives with respect to the exercise of the Crown or a public agency of its rights pursuant to this section.

7.16  Few courts have discussed the issue of statutory set-off. Fewer still have considered the provisions of the Saskatchewan Financial Administration Act 1993 and similar legislative provisions that provide the government with a broad power of set-off.²⁵

7.17  Contractual set-off arises from contract terms that grant the parties express set-off rights. The Federal Court has approved the following commentary about contractual set-off:

7.18  In general, therefore, parties to a contract can dictate their terms of set-off without concern for meeting the technical conditions for legal and equitable set-off. However, the necessary elements required by contract law (ie offer, acceptance, consideration, intention to create legal relations, and capacity) must all be present to give rise to valid contractual set-off.²⁷

7.19  Historically, Canadian courts have not characterized a bank’s right to combine a customer’s current accounts as a form of contractual set-off. Instead, they have characterized the bank–customer relationship as creating a single debt, represented in the bank’s records by separate book entries. When the bank exercises its current-account combination right, and ‘moves’ funds between accounts, Canadian courts have held that, at law, no transfer is taking place. The bank is merely moving ‘its own money’.²⁸ This single-debt approach to a bank’s combination rights may be evolving. Recent academic commentary has suggested that account combination is ‘a form of implied contractual set-off’ with ‘a self-help component’.²⁹ As discussed further below, the Supreme Court of Canada has held that set-off provisions in a contract between a financial institution and its customer, together with the creation of a ‘flawed-asset’ deposit account, created a security interest in the customer’s deposit account.³⁰

7.20  As discussed above, legal set-off requires mutuality. The cross-claims must be between the same parties in the same right. Under Canadian law, incorporated subsidiaries exist separately from their parent corporations, regardless of the extent of the parent’s ownership interest.³¹ Thus, the mutuality required for legal set-off is absent in the context of ‘triangular set-off’ amongst a corporation, the corporation’s affiliate, and a third party, and of ‘square set-off’ amongst two corporations and their respective affiliates. Absent rare circumstances that would (p. 108) warrant piercing the corporate veil,³² each parent corporation and affiliate will be treated as a separate legal entity for purposes of set-off. Mutuality will not exist, for example, if a debt is owed by a parent corporation and a separate debt is owed to its affiliate.

7.21  In considering mutuality in this context, the Alberta Court of Queen’s Bench in Compton Petroleum Corp. v Alberta Power Ltd ³³ held that cross-claims must be between the same parties to satisfy the mutuality requirement for legal set-off. Justice Paperny rejected Alberta Power’s argument that it was entitled to set off amounts owed by NESI Energy Marketing Inc. (NESI) to Alberta Power’s affiliate (CUGL) with amounts owed by Alberta Power to NESI, stating:

7.22  The Vancouver County Court of British Columbia rejected a similar argument in Royal Bank of Canada v Wallace Investments Limited.³⁵ The defendant had submitted

The Court in Royal Bank found that unless the Court of Appeal or other judicial authority overturned the decision in Salomon v Salomon & Co.,³⁷ the arguments of the defendant would be rejected.

(p. 109) 7.23  Unlike legal set-off, equitable set-off does not require mutuality and, in theory, may give effect to triangular or square set-off. However, such a claim will face significant hurdles on its facts. The lack of original mutuality between the parties will be a relevant factor tending to indicate that the cross-claims are not sufficiently closely connected to qualify for equitable set-off.³⁸

7.24  Triangular and square set-off may, however, be available by contract. The Court alluded to this possibility in the above quote from Compton Petroleum when it noted that, absent an agreement, ‘cross-claims owed between a company and its subsidiary to a third party will not be mutual’. Accordingly, agreements providing for set-off between a corporation, the corporation’s affiliate, and a third party (and, in the case of square set-off, the third party’s affiliate), which otherwise would not provide grounds for legal or equitable set-off, may be upheld under contractual principles. In Re McMurtry & Co. Ltd, ex parte MA James & Sons,³⁹ for example, the Court upheld an agreement permitting set-off in the absence of mutuality. The Court found that it was unnecessary to consider the doctrine of mutual dealings and the right of set-off as there was a bona fide agreement between the parties providing that payment could be made by way of offset of third-party obligations. The Court reasoned that the contract did not create a set-off in the ‘true’ sense of the term (ie legal or equitable), but created an agreed means of payment by contract, and therefore was enforceable. Thus, where parties have agreed to certain set-off arrangements by contract, the court need not consider the traditional elements of set-off in deciding whether to uphold the agreement.

7.25  Complications arise if an affiliate seeks to enforce its own set-off rights, or a party seeks to enforce set-off rights against the affiliate, and the affiliate is not a party to the contract. Under the common law doctrine of privity, a contract only binds its parties. Canadian courts have relaxed the importance of privity in recent years, and third parties may take the benefit of a contract in certain circumstances.⁴⁰ However, third parties continue to face hurdles when seeking to enforce contracts and, in any event, cannot be forced to assume the burdens of the contract (including payment of a debt).⁴¹

7.26  The right of legal, equitable, and statutory set-off is not considered a security interest for the purposes of provincial personal property security (PPSA) legislation.⁴² Accordingly, it is not subject to the requirements a creditor must satisfy in order to obtain, maintain, and enforce a security interest in personal property. The PPSA statute enacted in each province that provides for the attachment and perfection (by registration) of security interests is irrelevant to the validity and enforceability of a right of legal, equitable, and statutory set-off.

7.27  The issue is less certain, however, in the case of contractual set-off. Personal property security legislation applies to any transaction, regardless of form, that in substance creates a security interest in any type of personal property. For example, under Ontario’s PPSA,⁴³ a ‘security agreement’ means an agreement that creates or provides for a security interest. A ‘security interest’ means an interest in personal property that secures payment or performance of an obligation.⁴⁴ An agreement, such as a general security agreement, may expressly create or grant a security interest in a debtor’s collateral. An agreement also may create a security interest in substance, even if the document does not purport to do so expressly or disclaims such an intention. If a set-off agreement is construed as creating a security interest in personal property, the agreement will be subject to the requirements under the applicable provincial PPSA legislation that a creditor must satisfy in order to obtain, maintain, and enforce a security interest in personal property. This would include, for example, registration requirements under applicable legislation.

7.28  Whether a set-off agreement is characterized as a security agreement will depend upon a fact-specific determination. In its recent decision in Caisse populaire Desjardins de l’Est de Drummond v Canada,⁴⁵ the Supreme Court of Canada held that a contract providing for contractual ‘compensation’ (analogous to contractual set-off in Quebec) in the context of a flawed asset arrangement had created a security interest for purposes of section 224(1.3) of the Canadian Income Tax Act. That provision defined security interest as ‘any interest in property that secures payment or performance of an obligation and includes an interest created (p. 111) by or arising out of … a[n] … encumbrance of any kind whatever, however or whenever arising, created, deemed to arise or otherwise provided for’. On the facts of that case, a customer obtained a line of credit from the financial institution. The customer made a five-year fixed-term deposit in a certain amount which was neither negotiable nor transferable, which the financial institution was entitled to retain for the duration of the customer’s indebtedness. The customer agreed that, if it defaulted, there would be ‘compensation’ between the credit agreement and the term deposit. The Court determined that, in substance, the parties intended to create an interest in property to secure a debt. The five-year term of the deposit, the financial institution’s maintenance and retention of the deposit, the customer’s agreement not to transfer or negotiate the deposit, and the limited use of the deposit to ‘secure’ the line of credit, created the security interest. The Court stated at paras 23–5:

7.29  Although Drummond was decided under a tax statute, its reasoning may well apply in the context of creating security interests as defined by the provincial (p. 112) PPSAs. In the immediate aftermath of Drummond, industry representatives expressed concern about its implications for a bank’s priority over competing secured creditors under PPSA legislation. This question has not yet been tested in court. However, the prevailing view is that a properly drafted contract can create set-off rights between a bank and its customers that operate independently of any security interest and that supersede most interveners, including competing security interests.⁴⁶

7.30  Under Canadian constitutional law, insolvency is an area within the exclusive jurisdiction of the federal government. Canada’s Bankruptcy and Insolvency Act (BIA)⁴⁷ and Companies Creditors’ Arrangement Act (CCAA)⁴⁸ are federal statutes that apply across Canada. Both these statutes expressly preserve set-off rights. The law of set-off is also a matter within the exclusive jurisdiction of each province over property and civil rights within the province. Accordingly, the law of the province where the insolvency proceedings take place applies in determining whether a claim for set-off is available, valid, and enforceable.⁴⁹

7.31  Insolvency proceedings in Canada may take a variety of forms. The assets of a business may be liquidated by a trustee in bankruptcy appointed in bankruptcy proceedings under the BIA; a receiver appointed privately or by a court; the exercise of other private remedies of a secured creditor under its security; or, most commonly, a combination of these procedures. Alternatively, the business may be rehabilitated by a restructuring or reorganization of the corporation and its debts under one or more corporate reorganization statutes, such as the CCAA.

7.32  Few issues are as important in insolvency as creditors’ access to set-off rights against insolvent corporations. Set-off may, for example, permit a creditor with an unsecured claim to effectively satisfy that claim on a dollar-for-dollar basis out of amounts the creditor owes to an insolvent company at the expense of other unsecured creditors.

(p. 113) 7.33  The policy considerations regarding set-off in an insolvency context were described by the Ontario Superior Court (General Division) in Citibank Canada v Confederation Life Insurance Co. (Liquidator of), as follows:

7.34  Despite these competing concerns, the BIA and the CCAA expressly preserve the general law of set-off in proceedings under those respective statutes. Section 97(3) of the BIA states:

7.35  Similarly, section 21 of the CCAA states:

7.36  The discussion in this section will be limited to set-off in three scenarios: (i) bankruptcy proceedings under the BIA, (ii) receiverships, and (iii) reorganization proceedings under the CCAA. In general, the same principles of set-off apply within an insolvency proceeding as those that apply outside insolvency.⁵¹ This approach differs from that of other jurisdictions where the principles of set-off applied in insolvency can be quite different from those applied in solvent situations.⁵²

7.37  BIA proceedings for the liquidation of a debtor’s assets may be brought in Canada against any person (including a corporation, partnership, or individual) who resides, has an office or assets, or carries on business in Canada, (p. 114) except banks, insurance companies, trust or loan companies, and railway companies.⁵³

7.38  Upon bankruptcy proceedings under the BIA, the assets of the insolvent debtor (including debts owed to the insolvent) are assigned to a trustee in bankruptcy. Pursuant to section 97(3) of the BIA, cross-claims that have accrued between a party and the insolvent prior to the bankruptcy, for which set-off would be available absent bankruptcy, may be set off in bankruptcy.⁵⁴ Accordingly, the bankrupt’s estate includes only the net amount of a debt owing to the bankrupt after proper allowance for the recognized right of set-off.⁵⁵

7.39  In order to assert a claim for set-off against the bankrupt estate, the rights of set-off must exist at the date of bankruptcy.⁵⁶ The set-off referred to in section 97(3) of the BIA includes legal, equitable,⁵⁷ and contractual⁵⁸ set-off.

7.40  The assignment of the insolvent debtor’s assets to the trustee in bankruptcy may affect the availability of legal set-off in certain circumstances. This was described by the Ontario Superior Court of Justice (Commercial List) as follows:

In a bankruptcy, the trustee is inserted into the proceedings. Post-bankruptcy dealings of a creditor with the trustee in bankruptcy do not involve the same party, namely the debtor, before the condition of bankruptcy. When a bankruptcy occurs, there is a new estate created: there is the estate of the debtor under the direction and control of the debtor before bankruptcy which is a different estate than the one post-bankruptcy where there is an estate of the bankrupt under the direction and control of the trustee in bankruptcy. Thus, creditors who incur post-bankruptcy obligations to trustees in bankruptcy cannot claim legal set-off to avoid paying such obligations by setting-off such obligation against their proven (pre-bankruptcy) claims against the bankrupt. The same parties are not involved so there cannot be mutual cross-obligations.⁵⁹

(p. 115) Accordingly, a party cannot assert rights of legal set-off against a trustee in bankruptcy where the party wishes to set off obligations incurred post-bankruptcy against proven pre-bankruptcy claims.

7.41  As alluded to above, the object of set-off in bankruptcy is to avoid the perceived injustice to a party which has had mutual dealings with a bankrupt of having to pay in full what it owes to the bankrupt while having to rest content with a dividend on the amount owed to it by the bankrupt.⁶⁰ At the same time, however, the effect of the set-off is to prefer one creditor over the general body of creditors. Accordingly, the set-off right is limited by the provisions in the BIA and provincial legislation dealing with fraudulent preferences.⁶¹

7.42  To successfully attack a transaction as a fraudulent preference under the BIA, the following three elements must exist: (i) the debtor must have been insolvent at the time of the transfer, (ii) the debtor must have intended to give the creditor a preference, and (iii) the transaction must have taken place within a ‘review period’ of three months (or twelve if to a ‘related person’)⁶² of the date of the initial bankruptcy event. The date of the ‘initial bankruptcy event’⁶³ is essentially the date proceedings commenced under the BIA, ie the earliest of the date of an assignment in bankruptcy,⁶⁴ the filing of a bankruptcy petition,⁶⁵ the filing of a proposal, or the filing of a notice of intention to make a proposal.⁶⁶ Once the trustee in bankruptcy has established that the debtor was insolvent at the time of the transaction, that the transaction occurred during the review period, and that it had the effect of preferring one creditor over another, a presumption arises that the transaction was made with the intent of giving that creditor a preference. The onus is then shifted to the creditor to rebut the presumption.

7.43  Whether a fraudulent preference exists is a very fact-specific determination. Although set-off creates a preference ‘in fact’, the issue of whether or not it creates (p. 116) a preference ‘in law’ rendering it ineffective depends upon the purpose for and circumstances in which the offsetting transactions were entered into. If the transactions were entered into in the ordinary course of business for legitimate business reasons, the transactions will generally not be fraudulent preferences and the set-off rights will survive the bankruptcy event.⁶⁷

7.44  If money is owing to a bank and, at the date of bankruptcy, the bank has money on deposit to the credit of the bankrupt in another account, subject to certain exceptions, the credit balance can be applied against the debit balance without creating a fraudulent preference for the purposes of the provisions in the BIA, as such transfer is merely a bookkeeping entry disposition by the bank of its own money.⁶⁸ Exceptions to this, however, include circumstances where (i) the bank and bankrupt have made an actual agreement to prefer the bank above other creditors in the knowledge of the impending insolvency, and (ii) the bank has received funds from the bankrupt and applied the funds with actual knowledge, or knowledge sufficient to put the bank on notice, of the bankrupt’s insolvency.⁶⁹

7.45  In addition to attacking a transaction as a fraudulent preference under the BIA, a transaction may also be challenged as a fraudulent preference under provincial legislation dealing with fraudulent preferences.⁷⁰ Although the elements required for attacking a transaction as a fraudulent preference under provincial legislation are very similar to those under the BIA, there are important differences. For the purposes of provincial legislation in the common law jurisdictions, the trustee in bankruptcy or challenging creditor must prove that both the debtor and creditor intended to make a preference. In addition, unlike the BIA, there is no review period under provincial legislation. Because of the higher onus of proof, proceedings under provincial legislation are typically commenced when the impugned transaction occurred outside the review period. The defences available to persons in response to an attack under provincial legislation are similar to those under the BIA.

7.46  The appointment of a receiver and manager (commonly referred to as a ‘receiver’) is a remedy frequently used by a secured creditor that holds comprehensive security over the assets of the debtor created by a general security agreement.⁷¹ This remedy is commonly used where the continued operation of the debtor’s business after the enforcement of security is desired, for example so that the business can be marketed as a going concern. Another variation which has been used in a number of recent cases is the appointment of an ‘interim receiver’. While the title suggests a temporary role, interim receivers are often given a mandate similar to that of an ordinary receiver. Interim receivers are most commonly applied for in cases where the debtor has assets in several provinces or where the debtor has operations in Quebec.⁷²

7.47  As in bankruptcy proceedings under the BIA, in a receivership, the rights of legal, equitable, and contractual set-off continue to be available.⁷³ Like proceedings under the BIA, the main issue in the case of legal set-off will be the issue of timing. In a receivership, an equitable assignment of the insolvent’s property occurs upon the appointment of a receiver. Mutuality will be lost for obligations incurred after the equitable assignment. Thus, whether legal set-off rights accrued before or after the appointment of a receiver will determine whether legal set-off is available in the circumstances.⁷⁴ If legal set-off rights accrued before the appointment, mutuality should not be an issue in determining whether legal set-off is available.⁷⁵ If legal set-off rights accrued after the appointment, mutuality has been destroyed with the result that legal set-off is not available against pre-appointment debts.⁷⁶ The presence of an equitable assignment will be irrelevant, however, for purposes of determining whether a claim for equitable or contractual set-off can be supported.

7.48  The immediate availability of set-off in a receivership may be limited by courts’ common practice of including a stay provision in receivership orders which prohibits a party from exercising set-off rights without leave of the court. It is debatable whether such provisions ought properly to be included in such orders, and (p. 118) the issue has yet to be determined. In any case, if and to the extent leave is required, it should be given where a valid and enforceable claim to set-off exists.

7.49  In Canada, the CCAA is the principal statute for reorganization of insolvent corporations and the closest Canadian equivalent to Chapter 11 of the United States Bankruptcy Code. An insolvent corporation can reorganize under the CCAA where the total of the claims against the debtor or affiliated debtor corporations included in the proceeding exceeds CDN$5 million and where the debtor is incorporated in Canada or has assets in Canada.⁷⁷ As under the BIA, banks, insurance companies, trust companies, and railway companies are excluded from the CCAA.⁷⁸

7.50  Pursuant to section 21 of the CCAA, legal and equitable set-off rights are recognized and preserved in CCAA proceedings.⁷⁹ Although the case law is very limited in this regard, contractual set-off likely is also available.⁸⁰ The CCAA’s impact on set-off rights differs from that under the BIA and a receivership in that there is no statutory or equitable assignment that destroys mutuality upon filing an application under the CCAA. Thus, the impact of an assignment on legal set-off in bankruptcy and receivership proceedings (discussed above) has been held not to occur in CCAA cases. However, the Quebec Court of Appeal, in the context of civil law ‘compensation’, recently found that the CCAA and BIA regimes should be integrated and pre-filing claims should not be capable of being set off against post-filing claims because (i) the CCAA imports the definition of a ‘provable claim’ under the BIA, (ii) allowing set-off in such circumstances can jeopardize the successful reorganization of an insolvent corporation, and (iii) the availability of set-off should be narrowly construed because it is contrary to the well-established principle in insolvency law of treating unsecured creditors equally. It remains to be seen whether this reasoning is adopted in insolvency proceedings in the other provincial jurisdictions of Canada.⁸¹

(p. 119) 7.51  It is common to include, in the initial CCAA order, a stay of proceedings against the exercise of set-off rights without leave of the court. The court will exercise its discretion to maintain the stay in the face of objections if the court concludes that (i) it is necessary to preserve the status quo to effect the restructuring and/or (ii) the stay is necessary to balance the relative prejudice to the creditor asserting the set-off right and the debtor’s other stakeholders.⁸² One factor that will cause a court to be particularly cautious about lifting the discretionary stay is when an existing creditor obtains post-filing services or supplies from the debtor, or otherwise incurs post-filing debt, and seeks to avoid paying the debt by invoking its pre-filing set-off rights. In such a situation, G B Butler J of the BC Supreme Court exercised his discretion to continue a stay of set-off rights for the following stated reasons:

1. 1.  In order to preserve the status quo to effect a restructuring, a stay of the set-off is, and was, absolutely essential.

2. 2.  The amended initial order and the extension order were based on a detailed program. I need not highlight all of the aspects of it, but these included a reduction in the underground mining, cost cutting, disposal of equipment, and an orderly closure and maintenance of the Cantung Mine, all of which was predicated on cash flow. The cash flow was based on the continuation of the two supply agreements. Obviously, that would be thrown into disarray if the stay was not continued.

3. 3.  GTP had notice of all steps which had been taken along the way and was indeed actively consulted. It never raised any issue about set-off for 45 days following the initial order. Indeed, its only position was that assets should be put up for sale. It said nothing about exercising its right of set-off with respect to pre-filing debt.

4. 4.  Great prejudice to the other stakeholders would flow if GTP was now permitted to exercise its set-off. The status quo would be significantly altered and the restructuring would effectively be at an end. I accept that Callidus would very likely not extend any further credit at this point.

When I consider all of those factors, as well as my view that there is no prejudice to GTP, it is appropriate to continue the temporal stay of GTP’s set-off rights for so long as the stay granted by the amended intial order continues, which is to October 31, 2015.⁸³

7.52  The BC Court of Appeal unanimously dismissed GTP’s application for leave to appeal, noting that the application lacked merit and that the exercise of set-off rights would have a devastating effect on the company’s restructuring.

7.53  The stay of set-off rights in the case law has been criticized because, despite purporting to be ‘temporal’, the stay often does, effectively, eliminate the rights. (p. 120) Depending upon how these cases are applied in future cases, it is uncertain whether they will only be applied in egregious factual circumstances of a creditor abusing or manipulating the insolvency proceeding to gain a priority over other creditors, or whether they will be applied more broadly and, in the interests of preserving companies’ ability to restructure and equality between unsecured creditors, render the statutory preservation of set-off rights under the CCAA effectively moot.⁸⁴

7.54  As in many other jurisdictions, in Canada both the BIA and the CCAA provide safe harbours from the stay of termination rights and other remedies under derivatives contracts (ie enumerated ‘eligible financial contracts’) including netting, set-off, determination of net termination value, replacing contracts upon the insolvency of a party, and enforcing against the collateral.⁸⁵ Parliament has also legislated a safe harbour for netting agreements between financial institutions, whether domestic or foreign, which applies notwithstanding any bankruptcy or insolvency law.⁸⁶

7.55  Canadian courts have jurisdiction to hear proceedings, including set-off claims, that involve cross-border parties and/or events. A court in a common law province has jurisdiction over a dispute if (i) the defendant is present in the province, (ii) the defendant consented to the jurisdiction of the courts in the province, or (iii) the subject matter of the proceeding has a ‘real and substantial connection’ with the province.⁸⁷

7.56  The ‘real and substantial connection’ test is a fact-specific inquiry determined on a case-by-case basis.⁸⁸ In a debt action, for example, factors demonstrating a ‘real and substantial connection’ include the domicile of the parties, the parties’ choice of the law governing the interpretation and enforcement of the contract, the place where the contractual obligations were incurred and/or performed, and the place where the parties carry on business.

(p. 121) 7.57  If the parties, by their contract, have chosen an exclusive forum for the adjudication of their disputes, Canadian courts will respect the choice of forum absent extraordinary circumstances constituting ‘strong cause’ for ignoring it.⁸⁹

7.58  If a Canadian court accepts jurisdiction over a dispute, it normally should have jurisdiction to also hear set-off claims asserted as defences or counterclaims to the main action. Indeed, there is a risk in not asserting a set-off claim in an action over which a Canadian court has taken jurisdiction. Failure to do so could result in the set-off claim being estopped or found to be res judicata if it arises out of, or is so closely connected to, the main action that it creates an equitable set-off.⁹⁰

7.59  Under Canadian conflict-of-laws principles, matters that are considered ‘procedural’ are governed by the domestic law of the local forum, while matters that are considered ‘substantive’ are governed by the law applicable to the dispute.

7.60  Questions of set-off are considered to be procedural, rather than substantive, and thus are determined according to the law of the Canadian province in which the set-off claim is asserted. The law of the local forum will apply in determining whether set-off is available in that proceeding and, if so, the criteria for establishing whether a party has made out a case for legal, equitable, contractual, or statutory set-off.⁹¹

7.61  The law, whether domestic or foreign, that applies to the debt underlying each cross-claim is considered substantive and will be applied to determine whether the debt exists and whether it is capable of being reduced or extinguished by set-off.⁹² The substantive law that applies to the creation and enforceability of a debt or the interpretation of the contract giving rise to the debt will be either the law chosen by the parties in the applicable agreement or, in the absence of a choice-of-law clause, the law that has the ‘closest connection’ to the contract or circumstances that created the debt.

7.62  Where substantive issues, including issues underlying a set-off claim, are to be determined by foreign law, the law must be proved as a fact through sworn expert testimony in the Canadian proceedings. If the foreign law is not properly proved, the court is entitled to assume that the foreign law is the same as the domestic law and to decide the case as though domestic law applied.⁹³

(p. 122) 7.63  Subject to narrow defences,⁹⁴ foreign judgments can be recognized and enforced in Canada without the need to establish a real and substantial connection with Canada or to engage in a reconsideration of the merits.⁹⁵ Attempts to raise a set-off claim in Canada as a defence to the recognition and enforcement of a foreign judgment have been largely unsuccessful. If the claim arises out of, or is so closely connected to, the foreign action that, if successful, it would warrant an equitable set-off, and if the claim could have been raised in the foreign proceedings, it will be estopped in Canada under res judicata principles. If there is an argument that the claim is not so closely connected to the foreign action, the Canadian court will proceed with the recognition and enforcement of the foreign judgment without prejudice to the defendant’s right to commence a fresh action in Canada on the claim.⁹⁶

7.64  In 1997, both the BIA and the CCAA were amended to enact provisions for the coordination of Canadian and foreign insolvency proceedings. They gave authority and discretion to Canadian courts to grant relief in Canada to facilitate or provide assistance to foreign proceedings ‘on such terms and conditions as the Court considers appropriate’.⁹⁷

7.65  Effective 18 September 2009, further amendments to Canada’s insolvency regimes came into force that more formally recognize and facilitate the conduct of cross-border insolvency proceedings based on (but not identical to) the UNCITRAL Model Law on Cross-border Insolvency.⁹⁸ The provisions set out rules for recognizing foreign proceedings, classifying them as either ‘foreign main proceedings’ or ‘foreign non-main proceedings’ (based on the debtor’s centre of main interests or ‘COMI’) and providing appropriate relief and cooperation to facilitate the administration of cross-border insolvencies.

7.66  The foreign representative may apply to the Canadian court for recognition of the foreign proceeding. If the foreign proceeding is ‘main’, a Canadian stay must be ordered, subject to such terms and conditions as the court thinks appropriate, that precludes the debtor from disposing of its assets. If it is ‘non-main’, the stay is in the discretion of the court, as necessary to protect the debtor’s property (p. 123) and the interests of creditors.⁹⁹ If the court grants an order recognizing a foreign proceeding, the foreign representative may commence and continue proceedings in Canada as a creditor or as the debtor (depending on its authority) and the Canadian court must cooperate to the maximum extent possible with the foreign representative and the foreign court.

7.67  There is little case law or guidance to date on how the new cross-border insolvency regimes will affect creditors’ set-off rights. In the context of the BIA, Houlden and Morawetz, Canada’s leading commentators on insolvency law, suggest that if a corporation is subject to bankruptcy proceedings in Canada that are ancillary to insolvency proceedings in the country of incorporation, and if the law of set-off is different in the foreign jurisdiction from that of Canada, a Canadian court should apply Canadian laws of set-off first to the claims of Canadian creditors before remitting the realization of Canadian assets to the foreign trustee.¹⁰⁰ Canadian courts have not yet ruled on whether this approach could be challenged under the current cross-border regime applicable to a foreign main proceeding.

7.68  Case law under the CCAA to date suggests a different approach to set-off where a debtor is engaged in international proceedings to restructure its operations and continue its business. In Tucker,¹⁰¹ one of the first cases under the current cross-border regime in Canada, two insolvent companies that provided procurement and inventory management services in the aerospace industry were placed under administration in the UK under the Insolvency Act 1986. The UK administrators sought an order in Canada under the CCAA to recognize the foreign proceedings as foreign main proceedings. The CCAA court gave the order sought, holding that the companies’ COMI was in the UK and that the UK administration orders were foreign main proceedings.

7.69  The UK debtors provided inventory and procurement services to two Canadian customers, one of which kept approximately nine months’ worth of the debtors’ inventory at its own premises. That customer provided services to the debtors under a management agreement and had set-off rights against the companies arising from the relationship. The UK administrators applied to the Canadian court requesting that the customer’s set-off rights be stayed. The Canadian court considered the provision of the CCAA that preserved set-off rights (section 21) and the provisions that gave broad powers (sections 49(1) and 50) to make any order considered appropriate in the circumstances. The court stayed the exercise of set-off rights in Canada, accepting that it could temporarily stay the right of set-off (p. 124) protected under section 21 of the CCAA. The court noted the following relevant factors in the evidence:

• •  The financial position of the debtors was ‘extremely distressed’ with the threat of creditor enforcement action in key countries.

• •  The supply of airline parts was ‘time-critical’ and had to continue uninterrupted.

• •  There was a risk that if the stock was not secured quickly, it would disappear and become very difficult to access.

• •  Creditors would not be unreasonably prejudiced by the proposed set-off relief. It would operate only to prevent fresh inventory of the foreign debtors from being appropriated by third parties without payment. The relief would not affect the position of the parties on the date of the recognition order, but would ensure that no further prejudice would be caused to the foreign debtors’ estate.

• •  If the foreign debtors’ inventory were in their possession, rather than in the possession of the Canadian customer, they could control and minimize potential prejudice by obtaining assurance of payment before providing new supplies.

• •  Any refusal to supply inventory by the Canadian customer that had physical control of the inventory could ground several aeroplanes, thereby causing prejudice to the foreign debtors’ customers.

The Canadian court concluded that having regard to the circumstances of that case and the need to cooperate with the foreign court to maximize the value of the debtor’s property, the stay of set-off rights should be granted to protect the inventory and enable the foreign debtors to attempt to continue as a going concern.

7.70  In general, legal set-off is mechanical in nature, and may be defeated by formalities such as lack of strict mutuality or liquidated status of the cross-debts. While equitable set-off is more flexible, its application is uncertain because it depends on a judicial finding that the cross-claims are sufficiently closely connected to merit equitable set-off. To avoid these drawbacks, market participants are well advised to use foresight and draft the terms of their set-off arrangements with those parties with whom they contract. Generally speaking, rights of set-off are preserved in insolvency, with certain exceptions relating to the loss of mutuality for purposes of legal set-off in bankruptcy proceedings under the BIA and receiverships, the limitations relating to fraudulent preferences, and the discretionary temporary stay that may be imposed in CCAA proceedings. In the context of cross-border insolvencies, set-off rights against a debtor’s Canadian assets also may be affected by a discretionary temporary stay.