Appearances Can Be Deceiving: A Re-Characterization of a Secured Creditor’s Debt Claim as an Equity Contribution

In a recent decision^[1], the British Columbia Supreme Court (the “Court”) determined that purported secured loans made by a shareholder were properly characterized as equity contributions to the subject company and therefore subordinate to the claims of the company’s creditors.

In November 2013, Tudor Sales Ltd. (“Tudor”) assigned itself into bankruptcy.  Tudor’s most recent financial statements at the time of its bankruptcy recorded loans owed to Tavi Eggertson, a shareholder of Tudor and its sole officer and director. The liability for the shareholder loans resulted from two advances to Tudor by Mr. Eggertson in 2005 and 2006.  Mr. Eggertson submitted a claim as a secured creditor for the repayment of shareholder loans, relying on a general security agreement (the “GSA”) executed by Tudor in Mr. Eggertson’s favour some years prior to the bankruptcy.  The largest unsecured creditor of Tudor, Cascade Steel Rolling Mills Inc. (“Cascade”) challenged the validity of Mr. Eggertson’s claim and sought to have the shareholder loans subordinated to the claims of all Tudor’s other unsecured creditors.

The Court ultimately found that Mr. Eggertson’s claim was an equity contribution to Tudor and not a debt claim therefore subordinating Mr. Eggertson’s claim to the claims of the other creditors pursuant to the Bankruptcy and Insolvency Act (Canada).  To arrive at this conclusion the Court considered the following factors: (i) the variable nature of the interest payments made to Mr. Eggertson, meaning that the amount of the payments could not have been determined each year until all current liabilities to secured and unsecured creditors had been satisfied, (ii) the nature of Tudor’s liability to Mr. Eggertson was more consistent with equity than debt in that no schedule for repayment existed and there was no certain formula to determine interest amounts, and (iii) concurrently with the advances Mr. Eggertson increased his shareholdings in Tudor for little or no consideration.

Further, the Court found that the existence of the GSA did not assist Mr. Eggertson in his claim as it did not refer to the advances of the purported shareholder loans.

Interestingly, the purported shareholder loans were not described as secured loans in Tudor’s financial statements until 2011.  This fact further convinced the Court that the advances were not originally intended as secured debt.  For guidance on a court’s role in characterizing, or recharacterizing, such payments the Court relied on the recent decision of the Ontario Superior Court of Justice^[2]. As a result the Court determined that the issue is not the superficial appearance of a transaction, but the manner in which a transaction is actually implemented in the circumstances of the economic reality.

The decision in Tudor is a message to shareholders that a general security agreement will not, in and of itself, convert what are essentially equity contributions into secured debt.