The difference between debt and equity claims can cause confusion among lenders, creditors, and insolvency professionals alike. In Tudor Sales Ltd. (Re), the British Columbia Supreme Court provided further judicial guidance on this distinction. In this case, non-arms-length secured loans were determined to be in substance equity contributions and were subordinated to all other creditors despite the existence of a General Security Agreement (“GSA”). In reaching this conclusion, the court emphasized the importance of assessing the substance of a transaction over its form.

Background of the Case

Tudor Sales Ltd. (“Tudor”) was a steel distributor in British Columbia. Mr. Eggerston, one of the company’s shareholders and its sole officer and director, advanced approximately $1.37 million to Tudor in 2005 and 2006 with the GSA in favour of Mr. Eggerston executed in March 2006.

On November 20, 2013, Tudor made an assignment in bankruptcy. The bankruptcy trustee reported that there would be no funds available for unsecured creditors after payment of Mr. Eggerston’s secured claim. One of the unsecured creditors challenged the validity of Mr. Eggerston’s security and sought an order expunging or subordinating it to the claims of other unsecured creditors.

The Decision

In determining whether the amounts advanced by Mr. Eggerston should be considered debt or equity, the judge emphasized the importance of looking beyond the express intentions of the parties to the substance of the transaction. In conducting this analysis, a number of factors suggested that the amounts could not be considered debt including:

  • the fact that interest payments made were variable and based on the company’s profitability (functionally subordinating the payment of interest to all of Tudor’s other liabilities); and
  • the proximity of the advances to Mr. Eggerston’s various acquisitions of shares.

The decision in Tudor relied on the 2016 Ontario decision in the insolvency proceeding in U.S. Steel Canada Inc. (Re) and quoted this key passage: “[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…

The absence of a repayment schedule or a formal loan agreement was not considered a significant factor because the relationship of a wholly-owned company to its shareholder obviates the need for some formalities. However, the variability of the interest payment was found to strongly support the conclusion that the monies advanced were really equity and not true loans. As a result, despite the existence of the GSA, the judge concluded that the amounts advanced by Mr. Eggerston constituted equity contributions and should be subordinated to all other creditor claims.

Key Takeaways

This decision provides guidance on how to protect a non-arms-length loan from being challenged within an insolvency proceeding:

  • The existence of a security agreement is not sufficient in and of itself to protect against a challenge that a loan is really an equity contribution.
  • Advances of funds should be documented and repaid in accordance with the documentation.
  • Loan documentation should set a maturity date, an interest rate and payments that do not vary based on the corporation’s profitability.
  • Any waiver or alteration of the terms of the loan documentation by the lender should be expressly documented at the time.