Shareholders often overlook the need to properly document loan advances in their haste to provide funds to the company, without being aware of the significant consequences that can result. One such consequence arises from the provisions of the BIA which operate to allow the trustee in bankruptcy to reject proofs of claim where advances have not been properly documented or are structured in a manner that makes the advances appear like an equity injection. A recent Québec Court of Appeal decision addressed the potential pitfall arising from Section 139 of the BIA in the circumstances of undocumented shareholder loans.
In Doorcorp Installations, the court examined the decision of a trustee to disallow a proof of claim tendered by Ballylickey Investments Inc. (Ballylickey), the sole shareholder of the bankrupt Doorcorp Installations Inc. (Doorcorp). Ballylickey had made advances to Doorcorp between 2006 and 2007 in a total amount of $1,762,500 and had submitted a proof of claim in the amount of $1,502,906.39. The complicating factor in this case was that there was no loan agreement or other documentation setting out the terms of the advances apart from a notation in Doorcorp’s accounting records and financial statements stating that a portion of the funds were loans that were non-interest bearing and with no specific terms of repayment.
At issue was whether these amounts advanced by Ballylickey to Doorcorp should be considered to be (i) interest-free loans, in which case Ballylickey would be an unsecured creditor with the same ranking as other unsecured creditors of Doorcorp, (ii) capital contributions ranking subordinate to the unsecured creditors, or (iii) loans at a variable interest rate based upon the profits of Doorcorp which would constitute postponed claims within the meaning of Section 139 of the BIA.
Section 139 of the BIA states:
Postponement of claims of a silent partner - Where a lender advances money to a borrower engaged or about to engage in trade or business under a contract with the borrower that the lender shall receive a rate of interest varying with the profits or shall receive a share of the profits arising from carrying on the trade or business, and the borrower subsequently becomes bankrupt, the lender of the money is not entitled to recover anything in respect of the loan until the claims of all other creditors of the borrower have been satisfied.
Both the Québec Superior Court and the Québec Court of Appeal held that Section 139 could be applied in the absence of a formal contract as it is possible to infer from the conduct of the parties and the circumstances of each case whether or not the money advanced was intended to receive a return on investment similar in nature to participating in the profits of the bankrupt and therefore attracting the application of this Section. The main factors to consider in making this determination are whether or not the interest rate varies according to the profits of the borrower, and whether or not the absence of repayment terms and an interest rate likens the lender to a silent partner of the borrower.
The Court of Appeal however chose to interpret Section 139 narrowly, rejecting the broad interpretation utilized by the Superior Court. Justice Bouchard held that the fact that no term, interest rate, or repayment terms were documented was insufficient evidence to conclude that the advances were in fact capital injections. The fact that the loans were repayable once Doorcorp had taken the path to profitability did not make them loans with interest rates tied to profits.
The Court of Appeal ultimately held in favour of Ballylickey only with respect to an amount equal to $740,406.39 of its overall claim of $1,502,906.39. It would not be a surprise if this ruling is ultimately limited to its particular fact situation as much weight was given to the reference to those advances in the accounting records and financial statements.
However, there are four clear lessons to be learned from this case that can assist a shareholder lender to avoid facing the situation that Ballylickey found itself in:
Have a written loan agreement or promissory note to document each advance. This will be the first line of defence against any claim that each advance was an investment.
Set a clear interest rate that is in no manner linked or related to the profits of the company.
Have clear repayment terms. Even if the repayment terms have to be amended at a later date, their existence can constitute clear evidence that the advance is to be repaid in the manner of a loan.
Obtain a general security agreement to secure repayment of the advances. In addition to this further bolstering the evidence of the loan, registering a general security agreement under the PPSA will also place the lender in the position of a secured creditor, unlike Ballylickey who, even for the amounts that were not rejected, ranked as an unsecured creditor. The general security agreement can always be subordinated to the borrower’s operating lender or other senior creditors.
If a shareholder lender is careful and follows the simple lessons outlined above, it will increase its chances of establishing the secured loan nature of an advance as well as its chances of avoiding an equity characterization that is subordinated to unsecured creditors in a bankruptcy.