On January 25, 2017, the British Columbia Supreme Court rendered its decision in Tudor Sales Ltd. (Re), 2017 BCSC 119. The case deals with an attempt to recharacterize a creditor’s claim in bankruptcy from debt to equity and the subordination of that claim under sections 137, 139 and 140.1 of, the Bankruptcy and Insolvency Act (Canada). Those sections provide that the claims of creditors who are not at arm’s length from the bankrupt, silent partners (i.e., lenders who receive an interest rate varying with profits or representing a share of profits) and “equity claims,” may be postponed until all other claims have been satisfied.

There is a relative abundance of judicial authority in the United States dealing with recharacterization and subordination of claims in bankruptcy. The issue has not arisen as often in Canada and it has been unclear, until recently, to what extent this body of American law should be followed in Canada. This case is part of a new and growing line of authority articulating a distinct Canadian test.

The facts of the case are simply stated. In November 2013, Tudor Sales Ltd. (“Tudor”) assigned itself into bankruptcy. At the time, Tudor’s financial statements recorded shareholder loans owed to its sole officer and director, Tavi Eggertson. Mr. Eggertson submitted a proof of claim for repayment of those loans as a secured creditor, relying on a general security agreement he had caused Tudor to execute in his favour years before the bankruptcy. Tudor’s largest unsecured creditor challenged the validity of Mr. Eggertson’s claim and sought to have them subordinated to the claims of all other creditors, relying on those provisions.

Ultimately, the Court found that Mr. Eggertson’s claim was properly recharacterized as an “equity claim” and as such, subordinated under section 140.1. In reaching that conclusion, the Court relied primarily on two main considerations: first, the variable nature of the interest payments that Mr. Eggertson caused Tudor to pay, which were shown to have been discretionary and to have fluctuated with Tudor’s profitability. Second, it was shown that at around the same time as Mr. Eggertson made the advances, he also acquired or increased his shareholdings in Tudor for little or no other apparent consideration.

In addition to recharacterizing the claim from debt to equity, the Court also found that even if it were properly characterized as a claim in debt, it should nevertheless still be subordinated under section 139, as Mr. Eggertson was found to be a “silent partner” who received interest varying with Tudor’s profits.

Some of the advances were ordered to be subordinated under section 137, which states that a non-arm’s length transaction will justify a dividend only if it is found to have been a “proper” one. The Court found that expenses incurred in support of Mr. Eggertson’s side tequila venture, which he had run through Tudor, were really for his own personal benefit, and therefore were not “proper” transactions within the meaning of that provision.

The decision is one of the first to apply the new test for recharacterization, as recently articulated in the judgment of the Ontario Superior Court in Re U.S. Steel, 2016 ONSC 569. Both decisions are currently under appeal.