When structuring a new financing for a corporate borrower, lenders typically obtain postponements from all other creditors and shareholders advancing loans to the proposed borrower. Postponements establish the lender’s priority to receive payment from the borrower vis-à-vis these other known creditors.
However, some shareholders who have not actually advanced loans to the borrower may still hold shares that contain a right of retraction that will require the borrower, at the shareholder’s option, to purchase the retractable shares at a pre-arranged price following the issuance of an exercise notice. The retraction serves to create a new debt obligation out of what was originally an equity holding.
Ontario courts have held in some cases like Itak International Corp. v. CPI Plastics Group Ltd., that the existence of negative covenants in a loan agreement between a borrower and a lender prohibiting the making of any payment in connection with the retraction of shares are not effective as against the shareholder. Those negative covenants will not preclude a shareholder from issuing a retraction notice and independently creating the debt obligation, and they cannot be used by the borrower to justify a refusal to make the payment.
Thus, it is important to determine at the outset of a financing if the borrower is authorized to issue retractable shares, and if so, whether any such shares have actually been issued. Lenders should then ensure that any holder of retractable shares provides a satisfactory postponement that will become operative if the retraction option is ever exercised. This will avoid any surprise payment being made to an unexpected creditor that cannot be recovered by the lender from the shareholder in the absence of a direct contractual obligation created by a postponement.