Canada: "Just Friends" Or Something More? Court Finds Shareholders In Closely-Held Corporation Were Dealing At Arm's Length

Last Updated: June 19 2019
Article by Philip Cho

In 1085372 Ontario Limited v. Kulawick, 2019 ONSC 2344, the Honourable Justice Penny dismissed an action to set aside a transaction under s. 96(1) of the Bankruptcy and Insolvency Act1 (the "BIA") as a transfer at undervalue or under s. 2 of the Fraudulent Conveyances Act2 (the "FCA") as a fraudulent conveyance. In its analysis, the court decided whether two shareholders were dealing at arm's length or not, and in so doing, relied on the leading case of the Alberta Court of Appeal in Piikani Nation v. Piikani Energy Corp, 2013 ABCA 293 ("Piikani"). Piikani has been cited approvingly by the Ontario Court of Appeal in Montor Business Corp. (Trustee of) v. Goldfinger, 2016 ONCA 406 ("Goldfinger"). Kulawick provides more comfort to clients in closely-held corporations that the court will not, simply by the nature of the parties' relationship, find that a transaction was non-arm's length.

The plaintiff was a creditor of Michael Shumak ("Shumak"), who had filed an assignment in bankruptcy on January 23, 2013. The trustee in bankruptcy originally commenced the action seeking relief under s. 96(1) of the BIA and s. 2 of the FCA, and this action was later assigned to the plaintiff. The defendant, Geoff Kulawick ("Kulawick"), was a shareholder of the other defendant, Linus Entertainment Inc. (the "Company"). Kulawick was also the President/CEO of the Company and ran it with full authority and control. Shumak was also a shareholder of the Company, having invested $1,000,000 in the Company in 2000, and had a shareholding interest equal to Kulawick's. There was also a third shareholder with a very small interest of 7% of the Company.

In 2010, Shumak (by then in financial trouble) sought to extract his investment back from the Company and between June 2010 and January 2011, received about $100,000 from Kulawick. These payments were not booked as dividends or return of capital, but Kulawick gave evidence that he considered them in substance a return of capital. Ultimately, the two agreed to an arrangement where Kulawick advanced a further $100,000, and an additional $150,000 to be paid over five years as "consulting fees". The documents (dated March 2011) to support this transaction included a letter agreement documenting the loan and security, a promissory note repayable on December 1, 2011, and a share pledge agreement. Although the initial $100,000 was advanced as contemplated, Shumak could not wait for the consulting fees and the parties agreed to an accelerated payment of the consulting fees at a discount. In that regard, $77,000 was paid to Shumak.

The loan came due on December 1, 2011. Shumak defaulted and on December 20, 2011, Kulawick foreclosed on Shumak's shares. The plaintiff challenged the transaction that led to Kulawick acquiring Shumak's shares for only $277,000.

One of the threshold issues for Penny J. was whether Shumak and Kulawick were dealing at arm's length. Recall that the date of bankruptcy was January 23, 2013, more than one year after the loan and security agreement and, also more than one year after the foreclosure. Section 96(1) of the BIA provides:

96 (1) On application by the trustee, a court may declare that a transfer at undervalue is void as against [...] the trustee [...] if

(a) the party was dealing at arm's length with the debtor and

(i) the transfer occurred during the period that begins on the day that is one year before the date of the initial bankruptcy event and that ends on the date of the bankruptcy,

(ii) the debtor was insolvent at the time of the transfer or was rendered insolvent by it, and

(iii) the debtor intended to defraud, defeat or delay a creditor; or

(b) the party was not dealing at arm's length with the debtor and

(i) the transfer occurred during the period that begins on the day that is one year before the date of the initial bankruptcy event and ends on the date of the bankruptcy, or

(ii) the transfer occurred during the period that begins on the day that is five years before the date of the initial bankruptcy event and ends on the day before the day on which the period referred to in subparagraph (i) begins and

(A) the debtor was insolvent at the time of the transfer or was rendered insolvent by it, or

(B) the debtor intended to defraud, defeat or delay a creditor.

In this case, because of the time between the date of bankruptcy and the transaction, if the parties were dealing at arm's length, the one-year period stipulated in s. 96(1) of the BIA would have expired and the plaintiff would not have any remedy under this provision.

Although the term "arm's length" is not defined, sub. 4(5) of the BIA provides that for the purpose of 96(1)(b), related persons are deemed to be not dealing at arm's length, in the absence of evidence to the contrary. Subsections 4(2) and (3) provide guidance on the meaning and scope of "related persons", and by these provisions, Kulawick and Shumak are not "related persons". Subsection 4(4) provides that it is a question of fact whether persons not related to one another were dealing at arm's length. However, there is no express guidance on determining when two persons who are not related are or are not dealing at arm's length.

Thus, in this case, Penny J. referred to the case of Piikani, which was approved by the Ontario Court of Appeal in Goldfinger. In the Piikani case, the Alberta Court of Appeal was also asked to look at this term within the context of the BIA (in that case, in relation to s. 95). The Alberta Court of Appeal disagreed with the trial judge who had referred to the definition of "insider" within the meaning of the Securities Act. Rather, the Alberta Court of Appeal held that the jurisprudence under the Income Tax Act ("ITA") provided appropriate principles for determining whether two parties were dealing at arm's length. The term "arm's length" had existed in the ITA for many years before it was incorporated into the BIA.3 The Court of Appeal stated that this approach relies on the logical assumption that Parliament knows what other statutes say when it incorporates a term that has been defined in the courts in another context. This approach also minimizes the potential for unnecessary conflicts in interpretation.

As a result, the court in Piikani adopted, as appropriate guidance, the criteria summarized by the Supreme Court in McLarty v. R., 2008 SCC 26, an ITA case. In that case, Rothstein J. explained that the general concern in non-arm's length transactions is that there is no assurance that the transaction will reflect ordinary commercial dealing between parties acting in their separate interests. Rothstein J. also referred to a CRA tax bulletin that outlined useful criteria developed by the courts: (i) was there a common mind which directs the bargaining for both parties to a transaction; (ii) were the parties to a transaction acting in concert without separate interests; and (iii) was there de facto control.4

A few years later, in Ontario, the Court of Appeal approvingly referred to Piikani in the Goldfinger decision, affirming the trial judge's decision finding that a $2.5 million settlement payment to an investor by the bankrupt company, controlled by a close friend, was a transaction where the parties were dealing at arm's length. This finding put the transaction outside of the one-year reviewable period. The Court of Appeal noted that (i) there was no common mind directing the investor and the company, or its principal; (ii) the parties were adverse and on the verge of litigation; and (iii) neither party had de facto control over the other.

Turning back to the Kulawick decision, the relationship at issue was between two shareholders – one with control of the company, the other without. However, because the transaction was between two individuals and not between a shareholder/director and a corporation, the criteria of "common mind" or "de facto control" set out in McLarty were of limited value. Thus, Penny J. extracted additional guidance from the cases. He cited Rothstein J.'s comments in McLarty that provisions dealing with non-arm's length parties are intended to preclude artificial transactions from conferring benefits on one or more of the parties.5 In addition to the criteria established in McLarty, Penny J. referred to Juhasz (Trustee of) v. Cordeiro, 2015 ONSC 1781 for the proposition that in the context of s. 96(1):

the concept of a non-arm's length relationship is one where there is no incentive for the transferor to maximize the consideration for the property being transferred in negotiations with the transferee. It is intended to address situations in which the economic self-interest of the transferor is, or is likely to be, displaced by other non-economic factors that result in the consideration for the transfer failing to reflect the value of the transferred property.6

In other words, rather than focusing on a common mind or control, which are concepts that are apt when considering a transaction between a corporation and a shareholder or director, Penny J. focused on value/benefit and incentive, which relate to the second McLarty criteria. The goal of s. 96 is to prevent inappropriate benefits being conferred on a party; to prevent transactions where the incentive is something other than economic self-interest and results in the consideration not reflecting the value of the property. It is presumed that parties that are dealing at arm's length will not be motivated to confer benefits on one party, and will be self-interested to maximize the value realized in any transfer.

As a result, applying the principles to the facts of the case, the concept of a "common mind" or "control" were considered by Penny J., but very briefly. Rather, Penny J. looked carefully at the different incentives of the parties – Shumak wanting to monetize his investment in the company for as much, and as quickly as possible; Kulawick wanting to pay Shumak as little as possible, over a period of time, to acquire his shares. Penny J. elaborated on the various motives underlying Shumak's decision in the transaction – "no interest" in the business of the company, "maximize his return", "not willing to wait for payment", "in exchange for faster payment".7

The plaintiff argued that Shumak's financial trouble negated his independent economic interest in his shares, or his ability to negotiate at arm's length on the basis of that independent economic interest. Justice Penny disagreed. While acknowledging that Shumak had a need for money quick, that need did not result in the overbearing of Shumak's will – it led to a rational economic choice.8 Justice Penny recognized that in the circumstances faced by Shumak, economic self-interest could lead to the acceptance of a lower amount for the shares, if paid sooner. This is not unusual in business.

Further, Penny J. found that the lack of consultation with accountants on the transaction, the structure of the transaction (that some of the loan was advanced through "consulting fees"), or the involvement of a lawyer/friend/director of the Company did not support a finding of a non-arm's length relationship.

In other words, in determining whether, under s. 96(1) of the BIA, parties are dealing at arm's length, one must look deeper than just the relationship between the parties. One must examine the relationship and the manner in which they are "dealing" with each other. The plaintiff in Kulawick appears to have relied primarily on the close nature of the relations between the persons involved in the transaction, and the fact that such relationships often result in less formalities.9

However, determining whether the parties were dealing at arm's length requires a review of whether, in all of the circumstances, including the nature of their relationship, there was a "common mind" directing the transaction; whether the parties were "acting in concert without separate interests"; and whether any party had "de facto control". In certain cases, particularly as between two individuals in a closely-held corporation, the second criteria will be the most informative. The relationship is not determinative. Rather, it is only the context through which the conduct (i.e. the "dealing") is examined. Understanding the arm's length/non-arm's length part of s. 96(1) in this way shows that the types of transactions that will be found to be non-arm's length under the BIA are narrower than one may have initially thought.

Footnotes

1 R.S.C. 1985, c. B-3.

2 R.S.O. 1990, c. F.29.

3 Piikani at para. 23.

4 Piikani at paras. 28-29.

5 Kulawick at para. 47 citing McLarty v. R, 2008 SCC 26.

6 Kulawick at para. 49.

7 Kulawick at para. 53.

8 Kulawick at para. 56.

9 See the list of factors put forward by the plaintiff at para. 44 of the decision.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Events from this Firm
28 Sep 2019, Other, Toronto, Canada

WeirFoulds is proud to support the SickKids Foundation’s GetLoud corporate challenge once again in 2019. Partners Krista Chaytor and Michael Swartz, along with other team members, will participate in the walk on September 28.

6 Oct 2019, Other, Toronto, Canada

The Women’s Brain Health Initiative will host its annual “From Her Lips to Our Ears” conversation and cocktail event on October 6, 2019.

28 Oct 2019, Conference, Toronto, Canada

The Canadian Network of Agencies for Regulation (CNAR) conference, which will be held on October 28 to 30, will bring together delegates from across the country to discuss challenges and share ideas and best practices related to a wide range of issues relevant to organizations engaged in the self-regulation of professions and occupations.

Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions