When will a shareholder loan be considered an equity investment?
The plaintiff and the individual defendants were shareholders of the corporate defendant from 2010 until 2014, when the plaintiff left the company. As part of the parties’ separation agreement, the plaintiff transferred his shares to the two defendants at no cost. They, in turn, agreed to repay a $75,000 loan made by the plaintiff to the company in 2012. They also agreed to release the plaintiff from his personal guarantees to the company’s institutional lenders.
A year after leaving the company, the plaintiff demanded repayment of $100,000 that he had advanced to the company in 2010. The company refused and the plaintiff sued to recover the amount. The company contended that although the plaintiff’s advance was called a “loan” in the company’s books, it was actually an injection of capital—matched by similar capital contributions by the defendants—which the shareholders never expected the company to pay. Alternatively, the company argued that if the advance was indeed a loan, the debt was extinguished because the plaintiff tacitly waived his claim when he left the company.
The Court was tasked with determining whether the plaintiff’s advance was a loan or a capital contribution, and, if it was a loan, whether he tacitly waived his right to repayment. The literature notes that the distinction between debt and equity is that a lender’s expected return is not contingent on the performance of the company, whereas an equity holder assumes the risk that the value of his investment will depend on the company’s performance.
In characterizing a claim as either debt or equity, Canadian courts generally take a contextual, intention-based approach that favours a determination of a claim’s substance rather than its form. When conducting a debt versus equity analysis, courts ought to look at the circumstances of a shareholder’s payment and the surrounding economic realities. A transaction may have characteristics of both a loan and a capital contribution, and courts need not give equal weight to all of its features.
In Canada Deposit Insurance Corp. v Canadian Commercial Bank, Mr Justice Iacobucci stated that the correct approach is to determine the “substance” or “true nature” of the transaction under review.
More recently, in U.S. Steel Canada Inc., the Ontario Superior Court held that where a transaction occurs between related, or non-arm’s length parties, “there can be no certainty that the language of the agreements reflects the underlying substantive reality of the transaction”. The court added: “In other words, the task of a court is to determine whether the transaction in substance constituted a contribution to capital notwithstanding the expressed intentions of the parties that the transaction be treated as a loan.”
Similarly, the British Columbia courts have looked to the circumstances of a shareholder’s payment, and to the surrounding economic realities, when conducting a debt versus equity analysis. In Tudor Sales, the variable nature of the interest payments, which fluctuated with the company’s profitability, pointed to an equity claim. In Ghassemevnd, the court held that attention should be given to the circumstances of the payment, rather than to the terms of the parties’ written agreement or the opinion of the company’s accountant.
Here, the shareholders described their advances as loans. Since the plaintiff’s and defendants’ respective shareholder advances in 2010 were made between related parties, their description of the transaction is not determinative of their true nature. The advances were referred to as “long-term debt” in the company’s unaudited financial statements and as a “loan payable to shareholders, non-interest bearing and without specific terms of repayment” in a note to the statements. The reason provided by the defendants for the advances was that the institutional lenders required additional cash injections from the shareholders in order to establish an acceptable “debt-to-equity ratio” to secure their lending. The plaintiff added that the shareholders’ intention was to repay themselves as soon as the company could do so without breaching its covenants to its institutional lenders—in financing agreements with the company’s institutional lenders, the shareholders agree to subordinate their debts to the lenders’ claims.
- The shareholders’ respective $100,000 advances were non-interest bearing, had no terms for repayment, and were unsecured;
- The advances were made in order to satisfy the institutional lenders’ capitalization requirements;
- The advances were subordinated to the claims of the institutional lenders;
- The company could not repay the advances without the consent of its lenders;
- The shareholder defendants personally repaid the plaintiff’s $75,000 advance in order to prevent the company from breaching its equity requirements; and
- The shareholder defendants did not consider it necessary to ask for a release of the plaintiff’s claim to the $100,000 when he left the company.
Given the plaintiff’s testimony that the shareholders had agreed not to repay their advances until the company could do so without breaching its borrowing covenants, it was incumbent upon the plaintiff to demonstrate that the company is presently able to repay his advance without breaching its equity requirements. He failed to do so, and the Court concluded this was fatal to his action, regardless of the nature of his claim. The Court dismissed the plaintiff’s action with costs.
Counsel: David Brian Wiseman for the plaintiff and Tomy Markakis of De Louya Markakis for the defendant and mis en cause