Investment in start-up companies: issues related to shareholder loans

This article sets out case law to support a number of propositions of law relating to shareholder loans. The propositions, which are set out in the introduction of the article, relate to the formalities required for shareholder loans and the circumstances under which purported shareholder loans may be found to actually be capital contributions. The priority of shareholder loans on bankruptcy is also briefly mentioned.

 

When starting new business ventures, entrepreneurs will often decide to incorporate a company to run the business. Incorporation offers many advantages such as limited liability, perpetual succession, flexible ownership structure etc. If the business is not expected to generate any income for a while, the owners may want to avoid the hassle and expense of maintaining a bank account before income starts rolling in, but will need to pay expenses during the start-up of the business. 

 

Shareholder loans are the obvious way to finance such expenses, but what formalities are required for shareholder loans? Do such loans have to be made in a lump sum to the company, or can the shareholders pay expenses out of their own pocket and then treat the expended amounts as shareholder loans? What records must be kept? Do shareholder loan agreements have to be in writing?

 

This article aims to answer some of those questions by setting out legal authority for the following propositions:

After setting out legal authority for the above propositions points, the article briefly comments on s. 139 of the Bankruptcy and Insolvency Act, R.S.C. 1985, c. B-3 which shareholders making loans should be aware of.

 

The recent case of Glacier Creek Development Corp. v. Pemberton Benchlands Housing Corp., 2007 BCSC 286 [Glacier Creek] considered payments made by a shareholder, using his own money, on behalf of a company.

 

Glacier Creek involved a dispute between shareholders of a property development corporation named Pemberton Benchlands Housing Corp. [“Pemberton”]. Glacier Creek Development Corp. [“Glacier”], which was controlled by Mr. Cote, and Whistler Service Park Ltd. [“Whistler”], which was controlled by Mr. Den Duyf, were equal shareholders in Pemberton. The parties had a falling out, and the British Columbia Supreme Court ordered a shotgun sale. “Under a shotgun sale, shareholder A is required to offer his or her shares for sale to shareholder B at whatever price A sees fit. Shareholder B can then either purchase A's shares at the stated price, or require A to purchase B's shares at the same price per share”: Glacier Creek at para. 13. In the result, Whistler purchased all of Glacier’s shares.

 

Before problems arose between the Pemberton shareholders, Glacier made a number of expenditures on behalf of Pemberton. After Glacier sold its shares to Whistler in the shotgun sale, it sought to recover the expenditures it had made on the basis that they were shareholder loans. Den Duyf, who now owned all of Pemberton, asserted there was no agreement that the payments advanced by Glacier to Pemberton, or to third parties on behalf of Pemberton, were shareholder loans that would be repaid. Pemberton argued that those expenditures were capital investments made in the expectation that Glacier would share in the profits of the company. Glacier said that the amounts were shareholder loans which Pemberton had to pay on demand.

 

Glacier argued that when a shareholder provides funds to, or on behalf of, a corporation, those advances are either to acquire equity in the company, or to loan money to the company which then becomes a liability or indebtedness of the company to the shareholder. Wedge J. accepted that categorization and went on to hold that the payments in that case were shareholder loans. At para. 48 Wedge J. said:

 

[A]lthough Glacier advanced considerably more funds to Pemberton during the material time than did Whistler, there is no suggestion that Glacier's equity in Pemberton increased. Glacier and Whistler remained, at all times, equal shareholders.

 

Essentially, Wedge J. held that it was unlikely that Glacier would contribute proportionally more capital to Pemberton that Whistler did without requiring a greater proportion of the equity in the company. 

 

It is possible that payments made to, or on behalf of, a corporation will be a gift to the corporation, although such intention would have to be clear on the evidence. Glacier Creek confirms that generally, payments made by a shareholder to a company will be either shareholder loans or capital contributions. Other cases, such as Laronge Realty Ltd. v. Golconda Investments Ltd. et al. (1986), 7 B.C.L.R. (2d) 90 (C.A.) [Laronge] and In The Matter of the Bankruptcy of Marsuba Holdings Ltd., [1998] B.C.J. No. 956 (S.C.) (QL) [Marsuba] also treated payments by shareholders as being either shareholder loans or capital contributions.

 

In Glacier Creek, Wedge J. held at para. 59 that “whether an advancement of funds by a shareholder to his or her company is a loan or an investment of capital is a question of fact to be determined by reference to all of the surrounding circumstances”.

 

This is illustrated by comparing the results in the different cases discussed in this article. In the cases considered, shareholders made payments to, or on behalf of, companies without explicit agreements classifying those payments as either shareholder loans or capital contributions. In some cases the payments were found to be shareholder loans, and in others they were capital contributions.

 

The payments made by Glacier in Glacier Creek were found to be shareholder loans despite the lack of an express agreement describing them as such.

 

In resisting classification of the payments as shareholder loans, Pemberton argued that it had no agreement with Glacier that funds advanced by Glacier to Pemberton, or to third parties on behalf of Pemberton, would be repaid as shareholder loans. Nevertheless, the court found that the conduct of the parties confirmed that the payments were shareholder loans. Critical to that finding was the fact that Den Duyf, who controlled 50% of the shares in Pemberton, had acknowledged the legitimacy of many of the payments made by Glacier by co-signing the cheques which were used to pay for the expenses. Furthermore, the expenses paid by Glacier were listed in the company’s books as liabilities of Pemberton owing to Glacier. Den Duyf had ongoing knowledge of this, and never objected to treatment of the expenses as such. Given those circumstances, Wedge J. said at para. 45:

 

[N]o express agreement by Den Duyf to repay the funds was necessary. The absence of such an agreement is not probative of whether the expenditures were in the nature of loans or investments.

 

Thus, Glacier Creek stands for the proposition that where the conduct of the parties confirms the nature of the payments as shareholder loans it is not critical that the payments were made without explicitly agreed upon terms for repayment or the accrual of interest.  

 

As noted above, the payments made by Glacier in Glacier Creek  did not increase the equity Glacier held in Pemberton, and that supported the finding that the payments in that case were shareholder loans. Conversely, the payments in Laronge, supra,did affect the equity held by the shareholders making the payments, and that contributed to the finding that the payments in Laronge were capital contributions.

 

The British Columbia Court of Appeal explained the financial arrangement between the shareholders in Laronge as follows at para. 4:

 

They all made advances to the company which ultimately totalled something in the order of one and a half million dollars. The shareholdings were in different proportions ranging from as low as 2.5% to as high as 20%. The advances were essentially made in the precise proportion to their shareholdings. In the early period the advances were in precise proportion; in the later period some contributed slightly more and some slightly less than the percentage indicated by their shareholdings.

 

The company went bankrupt and it had to be decided whether the advances were shareholder loans or capital contributions: if the advances were shareholder loans, the shareholders would share in the distribution of funds upon bankruptcy, if the advances were capital contributions, the shareholders would get nothing.

 

Although the advances by the shareholders were shown on the books of the company as loans, there was no evidence of any agreement to repay the advances. The Court of Appeal held that the advances were capital contributions, partly because the rights the shareholders obtained to the expected profits were in proportion to the amounts they had each advanced.

 

Thus, Glacier Creek and Laronge suggest that payments are more likely to be shareholder loans if they do not affect the equity held by the payor, and the terms for repayment are not affected by the profitability of the company.

 

The terms for repayment of advances being linked to the profitability of the company is also relevant to priority in the event of bankruptcy. This is discussed in more detail below.

 

As noted above, in Glacier Creek the fact that the payments made by Glacier were recorded in the books of Pemberton as liabilities contributed to the finding that the payments were shareholder loans. In particular it was Den Duyf’s knowledge of such accounting treatment that countered his contention that the amounts were shareholder loans. Conversely, the payments in Laronge were found to be capital contributions despite them having been recorded in the books of the company as shareholder loans. This confirms that how payments are recorded in the books of the company is not determinative of the nature of the payments.

 

However, this does not mean that accounting records are not important. As mentioned above, every case turns on its own facts, and the parties agreeing, or acquiescing, to particular accounting treatment of payments will often be relevant when determining the character of the payments.

 

Although accounting records may be relevant in some cases, payments need not be recorded in the company’s books to be shareholder loans. In Rockwell Developments Ltd. v. Newtonbrook Plaza, [1972] 3 O.R. 199 (Ont. C.A.) [Rockwell Developments], the defendant corporation was sued for specific performance of a real estate contract. The claim against the defendant was dismissed and the trial judge ordered, Samuel Kelner, a director and shareholder of the plaintiff corporation, to pay costs personally. The issue considered by the Ontario Court of Appeal was whether Kelner was actually the party to the alleged real estate deal, or whether the corporation, Rockwell Developments Ltd., was the party. The defendant argued that the corporation kept no accounting records and that Kelner used his own money to finance corporate expenses, and so Kelner should be required to pay the costs of the litigation the company was involved in. Kelner argued that such expenditures were shareholder loans, that the party to the contract was his corporation, and that the corporate veil protected him from personal liability for the costs of the litigation.

 

The Court of Appeal summarized the facts as follows:

 

There was no resolution of the directors of Rockwell authorizing Kelner to enter into the offer to purchase on its behalf; the deposit of $10,000 was advanced by Kelner and his partner Cooper from their own funds, direct to [the defendant] or its agent, and did not go through the bank account of Rockwell nor was there any entry in Rockwell's books of account respecting it. The tendered sum of $28,000 which preceded the action was also advanced by Kelner and Cooper, and did not go through the bank account or books of Rockwell. …There was no resolution respecting the retainer of solicitors, although solicitors were retained to prosecute Rockwell's action and to defend Newtonbrook's action against it. …[The money to pay the solicitors went] direct from Kelner and Cooper to the solicitors, with no entry in the books of account of the company.

 

Kelner described the putting up of the deposit, the tender money, and the amount required to pay Rockwell's solicitors as being "shareholders' loans", and stated that "our accountant would pick this up in due course". There is no reference anywhere in the books or records of Rockwell to any shareholders' loans.

 

Regarding the absence of accounting records, the Court of Appeal said:

 

Unquestionably, the handling of the corporate records, both as to the minute book and as to the books of account, was slipshod, but no one connected with Rockwell was in a position to complain except Kelner himself.  

 

Thus, Rockwell Developments is authority for the proposition that funds expended on behalf of a corporation by a shareholder need not be processed through a company bank account, and need not be recorded in the company accounting system. However, the expenditures must be made on behalf of the company and the state of mind of the payor of the expenses is relevant.

 

Every case depends on its facts, and simply because the expenditures in Rockwell Developments were found to be shareholder loans does not mean that similar findings would be made in other cases. Accordingly, it is best to create evidence of the payor’s intention at the time the expenditures are made. This should be done by recording such expenditures in the accounting records, listing assets purchased in the company books, mentioning the nature of the payments in the minutes of meetings etc. 

 

The payments in Rockwell Developments and Glacier Creek discussed above were both found to be shareholder loans despite not being processed through company bank accounts. The key issue is whether payments made directly to third parties were made on behalf of the company, and were not in the nature of capital contributions.

 

The case of Marsuba decided that particular advances by shareholders to a company were shareholder loans and not capital contributions. Like in Laronge, the company in Marsuba had gone bankrupt and the shareholders wanted to share in the distribution upon bankruptcy. The shareholders in Marsuba had agreed that their capital contributions would be repaid when the company became profitable, but that never occurred. Instead, the company was petitioned into bankruptcy by certain of the shareholders who wanted their loans repaid at a time when the company had insufficient capital to do so.

 

The court in Marsuba noted at para. 7 that in an earlier decision dealing with the same parties, Paris J. considered whether the shareholder loans were payable on demand. The court in Marsuba quoted the following passage from the decision of Paris J.:

 

Firstly, it is said that the loans of the principal petitioners, who are also shareholders, are not due and payable. That is so, it is said, because two of the creditors have testified that they expected that they would be repaid only when the company began making a profit. However, such an expectation may exist in the mind of a creditor without its being a term even implied of the agreement with the debtor.

 

In this case, it is clear that there were no terms as to time for repayment. At law, such a debt is always due and owing and payable on demand. I have no doubt that the loans in question in this matter are payable on demand.

 

Thus the decision of Paris J. confirms that where a loan agreement does not specify the time for repayment it is presumptively a debt due and owing and is payable on demand. This conclusion was confirmed by Shaw J. in Marsuba at para. 34.

 

As is evident from the cases of Laronge and Marsuba discussed above, shareholder loan issues often arise in the context of bankruptcy. In fact, in Marsuba the bankruptcy was caused by fearful shareholders calling in their loans when they became afraid that the company might never become profitable.

 

In the event of bankruptcy, the priority of shareholders who have made advances to the company may be influenced by s. 139 of the Bankruptcy and Insolvency Act, R.S.C. 1985, c. B-3 which reads as follows:

 

139. 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.

 

Thus, claims for repayment of shareholder advances which are capital contributions such as those in Laronge will be subordinate to the claims of regular creditors of the company. Although the advances in Marsuba were found to be shareholder loans, the effect of s. 139 was clearly explained by Shaw J. at para. 21:

 

The practical side of this appeal is that if Mr. Wosk is successful, he and all the other unsecured creditors, including his fellow shareholders, will be paid approximately 33 cents on the dollar.  On the other hand, if Mr. Wosk is unsuccessful, then the remaining unsecured creditors (including S, P & P) will be paid approximately 38 cents on the dollar and Mr. Wosk will receive nothing.

 

Therefore, shareholder loans with terms of repayment which incorporate a bonus depending on the success of the company will provide a greater return on investment if things go well, but are more risky in the sense that if the company fails the shareholder advancing the funds will likely lose their entire investment.  

 

This article does not purport to be an exhaustive analysis of the issues set out in the introduction, but merely provides some authorities supporting the propositions mooted.

 

The conclusions that follow from the case law considered are that shareholders do not need to pay money they advance directly to the corporation for such advances to be shareholder loans. The money can be paid directly to third parties so long as it is paid on behalf of the corporation.

 

Although accounting records are not determinative of the character of advances made by shareholders, and creating such records is not a prerequisite for advances being shareholder loans, accounting records may be used to counter arguments by other shareholders, or the company, that the payments were capital contributions. 

 

Every case depends on its own facts, but advances are more likely to be capital contributions if the payor’s equity in the company increases because of the payments, or amount of repayment depends on the success of the company.

 

Advances may be found to be shareholder loans even in the absence of explicit agreements to that effect. Nevertheless, it is always best to avoid the risk of litigation by setting out, in clear contracts, the terms under which advances are made.