Can preferred shareholders be considered debt claimants if they deliver redemption notices?
Prior to its insolvency, the Debtor carried on business as a registered mortgage investment corporation. Its business was to loan funds to third party owners of commercial and residential property, mostly to be secured by mortgages, from a pool of funds it received from time to time from individuals and corporations who invested in the Debtor by purchasing preferred shares.
Some of the Debtor’s preferred shareholders delivered redemption notices to the company prior to the commencement of this Companies’ Creditors Arrangement Act (“CCAA“) proceeding in an effort to be paid an amount equal in value to their original share subscription price. These Redeeming Shareholders claimed to be creditors of the Debtor. They asserted that all of the other shareholders, both preferred and common, ranked lower in priority since they were equity claimants.
The core issue on this application was whether the Redeeming Shareholders were creditors of the Debtor as opposed to equity claimants. The Redeeming Shareholders argued that they were properly characterized as lenders from the outset who were debt claimants because their funds were pooled by the Debtor and then loaned out to borrowers. They asserted that their individual redemption requests should be viewed as akin to demands on a promissory note. They distinguished themselves from the non-redeeming preferred shareholders on the basis of the redemption notices they delivered to the Debtor prior to the commencement of this CCAA proceeding.
The non-redeeming preferred shareholders disagreed that the Redeeming Shareholders were debt claimants. They argued that all preferred shareholders were equity claimants from the outset, and that nothing had changed to alter their status. They also claimed that they would be significantly prejudiced if the Redeeming Shareholders’ claim to be debt claimants prevailed, because they would recover little to nothing.
The Debtor’s shareholders are divided into two groups: common voting shareholders and preferred shareholders. The Debtor’s preferred shares contain numerous rights, including a right of redemption to receive a return of the purchase price paid for shares, as well as the right to receive dividends so long as an investing subscriber remains a preferred shareholder.
Approximately 540 preferred shareholders, comprising 27,587 preferred shares with a capital value of $27,587,000, issued redemption notices to the Debtor before this CCAA proceeding was commenced. Preferred shares to the value of $1,380,500 were redeemed and paid out prior to the initial order, leaving a balance of unsatisfied share redemptions of $26,207,000. Due to defaults on loans it made to certain third parties, the Debtor was unable to pay all of the redemption notices it received from preferred shareholders. It sought protection under the CCAA.
In a proposed plan of arrangement or compromise submitted for court approval under the CCAA, a debtor company may divide its creditors into different classes. Equity claimants are treated as a single class, unless otherwise ordered. They rank behind creditors. Because of the superior position of debt claimants over equity claimants, it has become necessary for courts to distinguish between the two.
Preferred shares are regarded as hybrid instruments that may contain rights and conditions attributable to both equity and debt. In the context of a CCAA proceeding, the mere existence of redemption rights does not equate preferred shareholders as creditors. As a result of the 2009 amendments to the CCAA, the expanded definition of equity claims includes redemption claims. An “equity interest” is also defined, and includes a share in the company and a warrant to acquire additional shares.
No plan or arrangement may be sanctioned by the court where equity claimants have priority to creditors. The rationale is that equity claimants are considered to take a higher degree of risk in a company’s economic fortunes than creditors, who do not share in any of the risks or profits of the company. However, redeemable preferred shares are viewed in the case law to be “somewhat different than conventional equity capital”. Invariably the conditions attaching to preferred shares contain attributes of equity and, at least in an economic sense, attributes of debt. Over the years, financiers and corporate lawyers have blurred the distinction between equity and debt by endowing preferred shareholders with rights analogous to the rights of creditors. Examples include the right of redemption and the right of retraction.
Section 2(1) of the CCAA is clear that in the context of a CCAA proceeding, a redemption claim is not indicative of a debt relationship. As well, redemption rights on their own do not create a debtor-creditor relationship. They are to be considered, along with risk-taking, profit sharing, and the right to participate in the assets of the company on liquidation after creditors are paid, as “hallmarks” of a shareholder relationship and an equity interest. To establish a debt relationship, either or both the company’s articles or the transaction documents must make it clear that a shareholder’s redemption is repayment of a loan. Language consistent with a debt obligation upon redemption must be reflected in the transaction documents.
- The specific language contained in the company’s articles and the transaction documents.
- The right of a shareholder to redeem their shares. The absence of this right is inconsistent with a creditor relationship. A right of redemption is particularly compelling as an indicia of a creditor relationship where the articles or transaction documents expressly provide that the redemption is for the repayment of a loan.
- Whether the shareholder had upside potential in the return of their investment, which indicates an equity relationship and also shared in the downside risk of a lower return.
- Whether the shareholder had the right to receive dividends, which is a strong indicia of an equity relationship.
- Treatment on liquidation, dissolution, or winding up.
- Whether the shares are treated as equity or debt in the financial statements of the corporation.
The risks of the investment were clearly outlined to potential investors. Each Offering Memoranda contained a detailed discussion of numerous risk factors associated with an investment with the Debtor. The Offering Memoranda also described the purchase of preferred shares as a speculative risk that should be considered only by subscribers who are able to withstand the loss of their total investment. Unlike a promissory note, which typically contains a promise to pay by a certain date or the happening of a certain event(s), the Debtor’s obligation to honour redemption requests was always in the sole discretion of its directors.
Unsatisfied redemption requests do not of themselves change the substance of the relationship from an equity interest to a debt claim. The Redeeming Shareholders whose redemption requests were not honoured, retained their rights and privileges as shareholders. They continued to receive a share of the profits of the Debtor from dividend payments through to 2016.
The Court held that the claims of all of its preferred shareholders fell within the ambit of equity claims as defined in s. 2 of the CCAA.
Counsel: Jeremy West of Watson Goepel LLP for the Petitioner, John Whyte of Lakes, Whyte LLP for the Redeeming Shareholders, Mark Davies of Richards Buell Sutton LLP for the Non-Redeeming Shareholders, Vicki Tickle of McMillan LLP for the creditors, James Hancock and 1083163 Alberta Ltd. and Douglas Hyndeman of Kornfield LLP for the monitor.