Written By David Gruber, Geordie MacDonald and Jackson Spencer

It has long been established that where the circumstances in which funds are advanced by a shareholder to the company in which they own shares is unclear, the court must consider the "surrounding circumstances" when determining how to characterize the advance. Historically, "surrounding circumstances" were understood to be the circumstances extant at the time the transaction was effected: (e.g., Ghassemvand v. Premium Weatherstripping Inc., 2017 BCCA 309 [Ghassemvand]).

Recently, in Broer v. Multiguide GmbH, the British Columbia Court of Appeal (BCCA) affirmed a decision of the Supreme Court of British Columbia (BCSC), where in the absence of a written agreement, and where the parties' own understanding was ambiguous, the trial judge looked to shareholders' conduct several years after an advance was made to determine whether to characterize funds as a shareholder's loan or capital contribution.¹ This appears to be a relaxation of the principle that the "surrounding circumstances" ought to be temporally limited to those circumstances surrounding the formation of a contract (e.g., Wade v. Duck, 2018 BCCA 176 [Wade] and Sattva Capital Corp. v. Creston Moly Corp., 2014 SCC 53).

A capital contribution, or equity interest in a corporation, is distinguished from a shareholder loan, or a debt interest, through the payment of dividends versus the payment of interest.²

The characterization of an advance as one of debt or equity is of critical importance in the context of bankruptcy. Section 139 of the Bankruptcy and Insolvency Act (the BIA) states:

Where a lender advances money to a borrower engaged or about to engage in a 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 arise 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.³

A person who loans money under the conditions stipulated under s. 139 of the BIA is considered to be a silent partner in the business of the debtor, and as a result will be barred from recovering anything in respect of his or her loan until all other creditors, including those with debt interests, have been satisfied.⁴ Additionally, section 140.1 of the BIA holds that a creditor is not entitled to a dividend in respect of an equity interest until all claims that are not equity claims have been satisfied.⁵

As discussed below, in the absence of a written agreement, and where the parties' own understanding is ambiguous, it seems that courts will have broader latitude to consider the parties' conduct years after the transaction occurred.

Background

In December 2014, Multiguide GmbH (Multiguide) transferred Multiguide Technologies Inc. (MTI) €100,000—identifying the transfer as "Initial equity capital Multiguide GmbH" (the Advance).⁶ This contribution was then reported in Multiguide's ledger as "Participation in Stock Corporations" and referred to as "Equity contribution for MTI" in contemporaneous email exchanges.⁷There was no dispute that at the time the investment was made the parties "understood their respective €100,000 contribution was equity", as that was what was required by the laws of Germany.⁸ There was, however, no written agreement to evidence that intention.⁹

In March 2015, the nature of the Advance became unclear when MTI's external accountant sought clarification as to whether the Advance should be treated as a loan or capital.¹⁰ Mr. Kraus, who at the time controlled one-third of the shares of MTI, stated he initially thought the Advance was equity; however, MTI's directors went on to classify the Advance as a loan in MTI's 2014 financial statements (the 2014 Financial Statements).¹¹ The evidence was unclear as to whether MTI's shareholders discussed the characterization of the Advance in the 2014 Financial Statements at MTI's annual general meeting (AGM),¹² but on April 24, 2015, Mr. Kraus sent Multiguide's accountant an email confirming the Advance was a shareholder loan.¹³

At trial, Mr. Broer gave evidence that he merely signed "whatever was put in front of him", including the 2014 Financial Statements.¹⁴ In rejecting this evidence, the trial judge considered the fact Mr. Broer also executed MTI's 2015 and 2016 financial statements which also characterized the Advance as a shareholder loan.¹⁵ He did so even though the relationship between the parties' had deteriorated to the point that, by the time the 2016 financial statements were approved, Multiguide had already demanded repayment of the Advance.

The court's reliance on conduct more than two years after the Advance may indicate a greater willingness to consider subsequent conduct evidence in the absence of a written agreement.

MTI appealed the trial judge's decision on the basis Justice Blake ought not to have considered subsequent conduct. In so doing, it relied heavily on paragraph 35 of Ghassemvand for the proposition that the characterization of a shareholder advance "is primarily a question of fact, or perhaps mixed fact and law…to be determined by reference to all the circumstances at the time of the advance."¹⁶

Court of Appeal Decision

In Multiguide, the BCCA expanded the temporal scope of the language in paragraph 35 of Ghassemvand. It did so in two ways:

First, it relied on a later passage of the same decision which states "the characterization of advances as loans or as capital contributions requires that the 'substance of the transaction' be examined and that all the surrounding circumstances—not only the words used in documenting the transaction—be considered".¹⁷For the BCCA, the trial judge was alive to the "clear line of authority" that words used in documenting a shareholder advance as equity or a loan are not determinative.¹⁸

This line of authority includes U.S. Steel Canada Inc. (Re), 2016 ONSC 569 (U.S. Steel), which reads:

[168]   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. It is therefore not appropriate to limit the inquiry into the intentions of the parties to a review of the form of the transaction documentation. Such an exercise reduces to a “rubber stamping” of the determination of a single party to the transaction, i.e., the sole shareholder, and it does not address the substance of the transaction as it was actually implemented. In such circumstances, the determination of whether a particular claim is to be treated as debt or equity must address not just the expressed intentions of the parties as reflected in the transaction documentation but also the manner in which the transaction was implemented and the economic reality of the surrounding circumstances.

Second, the BCCA identified that the parties' own understanding of the characterization of the advance (at the time the funds were advanced) was sufficiently ambiguous for the trial judge to consider the parties' subsequent conduct.¹⁹

Here, the BCCA could have upheld the trial judge's decision based solely on the findings that there: (1) was no written agreement; and (2) any agreement between the parties was ambiguous, and therefore the parties' subsequent conduct was relevant.

Instead, the BCCA relied on Wade for clarification as how courts should consider evidence of subsequent conduct, explaining that: "evidence of subsequent conduct should only be admitted if the contract is found to be ambiguous after one has considered its text and the factual matrix surrounding the creation of the contract".²⁰ The court elected not to identify the preceding paragraphs in Wade, which set out the use of surrounding circumstances must be time-limited given the danger inherent in the use of subsequent conduct in contractual interpretation.²¹

Multiguide suggests the BCCA reads Ghassemvand, Wade, and U.S. Steel to stand for the proposition that, in the absence of a written agreement, and where the parties' original understanding is ambiguous, courts may look to those circumstances surrounding the execution of the transaction—even years after the transaction took place—to better understand its substance.

Conclusion

The BCCA's decision evinces a shift away from restricting courts to looking at only the circumstances extant at the time a shareholder advance is made should a dispute arise. Instead, in the absence of a clear, written agreement, and where the parties own understanding is ambiguous, it appears courts in British Columbia are trending towards a greater willingness to consider subsequent conduct evidence. This can seriously impact the rights of both creditors and debtors.

Accordingly, before advancing funds to a company, shareholders should seek legal advice as to how they wish to structure their investment so that the rights and remedies available to them are clearly understood in the event it becomes necessary to take steps to protect your investment.

If you are planning to advance monies to a company, or need assistance with protecting your investment, please contact David Gruber, Geordie MacDonald or Jackson Spencer.

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