The vote on December 9 by unsecured creditors to accept Stelco's proposal was improper and should be overturned. This issue turns on the classification of creditors. If Stelco enters into parallel arrangements with certain creditors for the sale of assets (equity) they should not be included in the same class as those creditors not similarly favoured.

The arrangement proposed by Stelco for its unsecured creditors (insofar as it affects those creditors) consists of:

first, a distribution of assets to all the unsecured creditors

secondly a parallel sale of shares in a "new" Stelco to just some of the unsecured creditors -- Sunrise and Appaloosa.

As such it's inappropriate that Sunrise and Appaloosa vote in the same class of creditors as the other unsecured debtholders. (And the same would be true for any creditors benefiting, like Sunrise and Appaloosa, from parallel deals with regard to those shares.)

On Nov. 17 2005, the Court of Appeal rendered a decision arising from an action brought by some holders of Stelco's convertible debentures. These creditors argued that the convertible debentures should form the basis for a separate class of creditor, distinct from holders of other unsecured debt.

Their request was denied. However, from that decision, the basis for establishing classes of creditor is a "common interest" test vis-à-vis Stelco (par. 16). "Common interest" in turn is based upon whether creditors are characterized by different "states or facts" (reference to Sovereign Life, par.21) vis-à-vis Stelco. Clearly, with the agreement to purchase equity (extending arguably to control) in the restructured Stelco, Sunrise and Appaloosa face a different set of facts and have a different interest in the continuation of Stelco than do the other unsecured creditors.

The obviously relevant precedent is Elan Corp. vs. Comiskey, cited approvingly by the Appeals Court (par. 26) In that case Roynat and the bank were placed in separate classes despite sharing similar claims (in varying proportions) because Roynat's interest in maintaining the debtor as a going concern was clearly different than the bank's interest in realizing the debtor's receivables. (That is there were differing commercial interests arising from the differing legal interests.)

In addition to the "commonality-of-interest" test, the Appeals Court notes that classification of creditors should be alert to the confiscation of legal rights (par.28). Consider the set of facts surrounding the proposed sale of equity to Sunrise and Appaloosa.:

Sunrise' and Appaloosa's holding of convertible debentures;

Sunrise' and Appaloosa's participation in the unsuccessful attempt to declare those debenture holders a separate class of creditor;

the perception (indeed the argument made by the debenture holders) that the debenture holders would be far less likely than other creditors to support less-than-full recovery for debt holders given the subordinated position of the debentures;

Subsequently, Stelco's difficulty in obtaining agreement to a settlement for creditors;

Subsequently, Stelco's last-minute negotiations to sell equity to Sunrise and Appaloosa;

the signing and acceptance of the agreement to settle and to sell equity to Sunrise and Appaloosa and the associated precipitous decline in the market value of the convertible debentures (ste.db on the tse).

With this set of facts, it's hard to avoid suspecting strongly that confiscation of legal rights was the point of the agreement to sell equity, giving control of Stelco to Sunrise and Appaloosa. That is, the sale of equity was made precisely with a view to dividing the unsecured creditors in a manner designed to sustain the proposed arrangement.

Similarly, as a matter of economics, if equity in a "new" Stelco forms part of a settlement with the unsecured creditors, it's hard to see why that equity is not distributed directly to those creditors to be sold as and when desired (or why the control block is not put up for auction). Instead the equity is sold directly to only some of those creditors (Sunrise and
Appaloosa) and the proceeds of that sale distributed to all creditors. While the economic justification for this is obscure, it does raise an obvious possibility of conferring a benefit on Sunrise and Appaloosa not available to the other creditors.

Several further points in random order:

The fact that Stelco styles the sale of equity to Sunrise and Appaloosa as financing (in part) the benefits to all unsecured creditors does not change the essential conflict of interest that arises with regard to the continuation of Stelco.

The fact that the settlement does allow for certain shares in the "new" Stelco to be made available to all unsecured creditors does not alter the conflict of interest. These other shares are made available in quantities and at prices which differ substantially from those sold to Sunrise and Appaloosa.

The Appeals Court cites approvingly Paperny on the classification of creditors (par. 23). Paperny speaks rather narrowly of the legal interests of "(creditors qua creditors)". In light of the purpose of the classification " community of interest " it seems clear that in the present case this should be broader and encompass other, parallel legal interests like the agreement to sell equity. That is, the earlier broader formulation cited by the court (par. 21) -- "different states or facts" " is more relevant.

I've got to add that it's hard to believe that the different treatment of holders of the same securities (convertible bonds, for example) does not also offend securities law in some manner.