At what point are corporate directors obliged to consider the interests of a corporation's creditors? And at what point must the same corporate directors choose between the interests of the subsidiary corporation, for which they serve as directors, and those of the larger corporate group of which the subsidiary is a member? These were two of the important questions that Justice Benjamin J. Greenberg considered in a comprehensive and precedent-setting judgment given in Peoples Department Stores Inc.: Caron Belanger Ernst & Young Inc. v. Lionel Wise, Harold Wise, Ralph Wise and Chubb Insurance Company of Canada. The case was heard in the spring of 1998 in the bankruptcy and insolvency division of the Quebec Superior Court, and judgment was rendered in December 1998.

Peoples Department Stores Inc. was a wholly-owned subsidiary of Wise Stores Inc. The Wise brothers, Lionel, Harold and Ralph, served as Peoples' sole directors and were also members of the board of directors of Wise Stores, a publicly traded corporation. At year end, January 1994, Peoples recorded a profit in excess of $4 million, had $23 million in retained earnings, $10 million cash in the bank and an available but completely unutilized bank line of credit. At the same time, Wise Stores was losing money. It had a deficit of some $1 million, no working capital and a fully extended bank line of credit.

Both Wise Stores and Peoples operated a chain of junior department stores throughout Quebec, Ontario and the Maritime provinces, selling essentially the same product lines. Prior to February 1994, each corporation maintained separate domestic purchasing facilities and, consequently, each maintained its own accounts payable to domestic suppliers. Starting in February 1994, however, Wise Stores ceased making any purchases from domestic suppliers. At the same time, Peoples began purchasing not just its own merchandise but also merchandise for Wise Stores. Peoples then sold to Wise Stores the merchandise purchased on its behalf.

The Wise brothers not only didn't consider the financial impact that the new domestic purchasing policy would have on Peoples, but evidence showed that they also failed to monitor its effects. From February 1994 onward, Peoples sold merchandise to Wise Stores Inc., and the inter-corporate account that resulted between the two - i.e., the account receivable owing to Peoples by Wise Stores - grew to significant and uncollectible proportions.

In early December 1994, less than one year after implementation of the new purchasing policy, both Wise Stores and Peoples went bankrupt. As a result of unpaid inventory purchases, Wise Stores ended up owing a significant amount of money to Peoples. The court concluded that the root cause of Peoples' insolvency was the implementation and continuation of the new domestic purchasing policy and the consequent growth of an uncollectible account receivable from Wise Stores. In essence, Peoples' retained earnings had been stripped into Wise Stores.

In light of this, the bankruptcy trustee of Peoples sued the Wise brothers and their insurer of director liability, Chubb Insurance Company of Canada, for the value of Peoples' uncollectible account receivable from Wise Stores. The trustee claimed that the Wise brothers had acted negligently toward Peoples and were "privy" to a "reviewable transaction" in Peoples' bankruptcy.

The ostensible purpose of the new domestic purchasing policy was to ensure proper inventory controls through a sole distribution warehouse. The evidence showed that the Wise brothers did not consult with the Wise Stores' and Peoples' auditors, attorneys or other professionals, and they failed to consider the financial impact on Peoples of this new purchasing policy. The court characterized this new policy as "a major and drastic departure from the prior policy, with potentially disastrous financial consequences for Peoples."

It had little problem concluding that the Wise brothers had breached their obligation to act as prudent directors of Peoples, stating quite simply: "Clearly, a reasonably prudent and diligent person would have realized that the new process would strip hard assets (inventory) away from Peoples and it would receive in return an account receivable from Wise Stores which likely would not be collected and would be uncollectible, seeing Wise Stores' cash flow problems ... as well as the fact that Wise Stores was seriously undercapitalized."

One of the defences offered by the Wise brothers was that they, as Peoples' directors, had made a proper business judgment and should not be condemned simply because that judgment turned out to be wrong. Backing up their defence, they cited the long-standing "Business Judgment Rule" established by the courts, and stressed that they had acted at all times in the best interest of the Wise Stores corporate group, namely Wise Stores and Peoples taken as a whole.

On the Business Judgment Rule, the court noted that such defence is available only to corporate directors who have exercised their business judgment in a reasonably informed manner. The Wise brothers' ability to invoke this defence was negated by their failure to have obtained material information about, or to have made reasonable inquiry into, matters surrounding their decision to make Peoples the domestic purchaser for Wise Stores. The court was also unimpressed with the brothers' contention that the interests of the corporate group were paramount to those of Peoples. It stated: "... directors of a wholly-owned subsidiary may consider the best interests of the parent and, where those and the best interests of the subsidiary overlap or coincide, they may act accordingly. Where those respective interests are not concurrent, they must attempt to conciliate the two. Hence, where there is a mutuality of interests, there is no problem. However, where the best interests of the subsidiary are in direct conflict
with those of the parent, the former must prevail in regard to the actions of the directors of the subsidiary."

Of equal importance was the court's recognition of Peoples' creditors as stakeholders of that corporation. The court said that corporate directors should not sacrifice the interests of the corporate creditors when the going gets tough. It concluded that in taking the actions they did, the Wise brothers ought to have taken into account the interests of Peoples' creditors, not just the interests of Peoples' sole shareholder, Wise Stores.

The court also held the Wise brothers liable as persons "privy" to a "reviewable transaction" under Section 100 of the Canadian Bankruptcy and Insolvency Act, by having made the decision and allowed the practice, within the 12 months preceding Peoples' bankruptcy, of Peoples selling inventory to Wise Stores for an uncollectible account receivable from Wise Stores. Justice Greenberg first characterized these sales as "reviewable transactions," and then held that the Peoples' bankruptcy trustee was entitled to recover the resulting unpaid inter-corporate account (i.e., the difference between what Peoples sold to and collected from Wise Stores) from the Wise brothers, as persons "privy" to the reviewable transactions.

The Peoples' bankruptcy trustee sued the Wise brothers as well as their liability insurer, Chubb Insurance Company of Canada, which had issued a directors' liability policy to the directors of Wise Stores and Peoples. The court held that, indeed, the liability of the Wise brothers as directors of Peoples was covered by the policy and therefore condemned Chubb Insurance along with the Wise brothers.

In assessing the amount of the award, the court attempted to determine the true amount of the inter-corporate account owing on the date of bankruptcy by Wise Stores to People. The Wise brothers contended that Wise Stores, in the periods prior to the bankruptcies, had borne a disproportionate share of overhead in the Wise Stores / Peoples operations in order to take advantage of tax losses. The court agreed in part with these contentions. The fact that the unconsolidated financial statements of both Wise Stores and Peoples were the object of unqualified auditors' opinions was not accepted by the court as conclusive in the determination of a proper overhead allocation between the two companies. Mr. Justice Greenberg drew a distinction between the roles of auditors and management. While the auditors certify that expenses were incurred and paid, the nature and the allocation of these expenses were within the domain of management.

The judgment ordered the Wise brothers and Chubb Insurance Company to pay the Peoples' bankruptcy trustee $4,437,115 plus interest, indemnity and costs. Both the Wise brothers and Chubb have separately appealed the judgment. The Peoples' bankruptcy trustee has cross-appealed, seeking an increase in the judgment award.