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BUSINESS ASSOCIATIONS Joshua Krane BUSINESS ASSOCIATIONS ................................................................................. 1 1. Partnerships ................................................................................................. 5 2. Cooperatives ................................................................................................ 7 3. Corporations ................................................................................................ 7 4. Normative theories of corporate law .......................................................... 10 Legal Personality ............................................................................................... 11 Saloman v. Saloman Inc. (1897) HL ......................................................... 11 Lee v. Lee’s Air Farming (1961) HL......................................................... 12 ACCOUNTABILITY ............................................................................................ 15 Corporate Governance – How do we balance authority and accountability? ............................................................................................................................ 15 The Duty of Care - Informed Business Decisions .......................................... 16 R. v. Soper (1997) FCA ............................................................................. 17 Smith v. Van Gorkom (1985) Del. S.C. .................................................... 19 Fiduciary Duty – Duty to the Company .......................................................... 22 Martel – Duties of Loyalty in Quebec ....................................................... 23 1. Interested Party Transactions .................................................................... 25 Nozetz c. Habitations CJC Inc. (1986) S.C. .............................................. 25 Gray v. New Augarita Porcupine Mines Ltd. (1952) HL .......................... 26 2. Benefiting from Corporate Assets .............................................................. 27 Bank of Montreal v. Ng (1989) SCC ......................................................... 27 Perlman v. Feldman (1954) C.A. 2nd Cir. ................................................. 28 3. Taking Corporate Opportunities ................................................................ 29 Regal (Hastings) Ltd. v. Gulliver et. Al (1941) HL ................................... 30 Peso Silver Mines v. Cropper (1966) SCC ................................................ 31 Canadian Aero Services Ltd. v. O’Malley (1973) SCC ............................ 32 4. Generalized Fiduciary Duty ....................................................................... 34 1 Peoples v. Wise (2004) SCC ..................................................................... 34 TAKEOVERS ........................................................................................................ 37 1. Acting in the Interest of the Corporation (Leave it to the directors) .......... 39 Teck v. Millar (1972) BCSC ..................................................................... 39 Unocal v. Mesa (1985) Del. S.C. ............................................................... 40 2. Acting in the Interests of Shareholders ...................................................... 42 347883 Alberta Ltd. v. Producers Pipelines Inc. (1991) SCA ................... 42 Revlon v. McAndrews (1986) Del. S.C. .................................................... 43 3. Where the Two Interests Converge (The shareholders and directors want the same thing) ............................................................................................... 44 Maple Leaf Foods v. Schneider (1998) OCA ............................................ 44 SHAREHOLDERS ................................................................................................ 47 Participation ...................................................................................................... 48 1. Direct participation - voting....................................................................... 48 2. USAs ........................................................................................................... 49 3. Indirect Participation – Shareholder Proposals ........................................ 49 Dodge v. Ford (1919) Mich. Sup. Ct. ........................................................ 50 Paramount v. Time (1990) Del. Sup. Ct. ................................................... 51 JUDICIAL SUPERVISION .................................................................................. 55 Derivative Action .............................................................................................. 55 Daniels v. Daniels (1977) Ch. Div., UK .................................................... 56 Oppression Remedy .......................................................................................... 58 1. No breach of the legal duty required .......................................................... 59 2. Broad Remedial Powers ............................................................................. 59 3. Justifying the Oppression Remedy ............................................................. 59 4. Development of Standards ......................................................................... 60 Naneff v. Con-Crete Holdings Ltd. (1995) O.C.A. ................................... 61 5. Bringing an Oppression Claim to Court .................................................... 62 6. Distinguishing Between the Two Remedies ................................................ 64 First Edmonton Place v. 315888 Alberta Ltd. (1988) Alta. Q.B. .............. 64 Personal Liability of the Directors in an Oppression Claim ......................... 66 2 Budd v. Gentra (1998) O.C.A.................................................................... 66 Winding Up in Quebec: The Corporate Death Penalty ................................. 68 Candiac v. Combest (1993) Qc. C.A. ........................................................ 69 Lutfy v. Lutfy (1996) Qc. Sup. Ct. ............................................................ 70 PIERCING THE CORPORATE VEIL ............................................................... 73 1. Impleading persons behind the corporate veil ........................................... 74 Transamerica Life v. Canada Life Assurance (1996) OCGD .................... 74 Walkovszky v. Carlton (1966) N.Y.C.A. .................................................. 76 2. Accessing the assets of the corporation...................................................... 76 National Bank v. Houle (1990) SCC ......................................................... 76 Kosmopoulos v. Constitution Insurance Co. (1987) SCC ......................... 78 Marzell v. Greater London Council (1975) Lands Tribunal ...................... 80 3 4 What is the study of business Associations? It is the study of entrepreneurial activity involving more than one individual. Business structures distribute risk of contractual or extra-contractual liability, return on the investment, and authority over the business in different ways. Business associations/corporate law is truly a trans-systemic study because legal tradition has only a marginal effect on the development of the corporate form (Hansmann & Krakman). Modern, capital markets with liberalized economies and political institutions all share the corporate form. The differences between Ontario and Quebec, too, are marginal. Although, for example, Ontario has legislated an “oppression remedy” for persons with an interest in the corporation, Quebec civil law uses the civil procedure to achieve the same result (see art. 33 CCP). SOLE PROPRIETORSHIP – one person going into business for himself; the proprietor bears all of the risk, gets all of the return, and has all of the authority. He does not need to conform to a “legal form” but does have to comply with other laws (incl. business name registration laws, intellectual property laws, etc.). 1. Partnerships A partnership forms when the partners (1) contribute to the enterprise, (2) share the profits, and (3) have an intention to cooperate (Art. 2186 C.C.Q.). In the common law, a partnership forms when the partners carry on a business (1) involving the provision of goods or services for remuneration, (2) “in common” and (3) with a view to a profit. In reality, there is not much of a difference between these characterizations. GENERAL PARTNERSHIP – every partner bears the risk, gets the returns, and shares the authority. Partners are agents/mandataries for each other and therefore, they can bind other partners in contract (and in tort).1 The law presumes that the partners share the profits 1 A limited liability partnership places the risk of contractual liability on the general partners, but the risk of extra-contractual liability on the individual partner. This helps to promote checks and balances between the partners and reduces the risk of loss. 5 and losses equally, although the default rules of partnership are subject to contractual change. Partnerships are not legal persons. They have “legal individuality” which allows them to gain standing before a court and to hold property in the name of the partnership and not necessarily in the name of the partners. As to issues of liability, that depends upon the legal system. Common Law Joint liability Joint and liability several Contractual YES (Partnership Act (Ont.) s. 10) YES, if the partner dies, then the estate is liable. Tortious NO YES (s. 13) The reverse is true in civil law. Civil Law Joint liability Solidarity liability Activity of the Enterprise NO (Art. 1525 C.C.Q.) YES Other activities YES NO LIMITED PARTNERSHIP – only the general partners have authority, but they also take the risk of liability. The limited partners trade off control for reduced risk. Both general and limited partners share the returns. Limited partnerships require at least one general partner. This form of business association closely approximates a corporation. LIMITED LIABILITY PARTNERSHIP – for professionals only; protects professionals’ personal assets from the extra-contractual liability of their partners. These partnerships emerged in the U.S. and have spread to Ont., Que. (not in the C.C.Q.), and B.C. Lawyers use LLPs to protect personal assets against the negligence of other partners; the firm’s assets are still vulnerable, though. DE FACTO/UNDECLARED PARTNERSHIP – for all intents and purposes, the partners are acting in a partnership, though the partnership is not named legally. 6 A key difference between a partnership and a corporation involves the liability of the stakeholders. Another difference is that partnerships have few mandatory rules. The rules primarily deal with allocation of liability. 2. Cooperatives COOPERATIVE – has legal personality but the system of voting is detached from the system of shareholding. Cooperatives have “members” with an interest in the profits of the enterprise. Unlike a corporation where votes are determined generally by proportion of the shares, in a cooperative, every member has one vote. A person may have a different membership status depending upon the amount of capital invested in the cooperative. This gives the member a larger share of the profit. The members of the cooperative often tend to be the consumers of the business (see e.g. Desjardins Bank, Mountain Equipment Coop, Co-operators Insurance.) In a cooperative income should equal expenses. Any profits can be remitted to the members in the form of a patronage refund or they are reinvested in the cooperative. The cooperative is intended to generate savings, and not profit. One problem with cooperatives is that the absence of a profit motive reduces the incentive for their creation. The voting structure also prejudices the interests of those who invest more in the cooperative. In part, cooperatives reflect an ideology that people should share the costs and benefits of a certain product or service and that profit should not cycle through the market. 3. Corporations CORPORATION – the authority vests with the directors and officers. The return goes to the shareholders, but the corporation itself bears the risk of loss. A limited liability company allows entrepreneurs to encourage capital flow, because the shareholders are not responsible for the company’s civil fault. This is a passive form of business, because all of the management functions vest with the directors and officers. The corporation is a “relatively” new investment vehicle. Until the 1850s, only people with a lot of capital could invest in the market, 7 because an investor was prohibited from collecting interest on a loan with a fixed rate of return (usury). Therefore, an investor had to have a proprietary stake in an enterprise to make a profit, and this the return was variable. This also meant that the investor bore the risk of liability created by the enterprise (set up generally as a partnership). Corporate law, therefore, emerged from partnership law – and many of the ideas in partnership law still linger as historical anachronisms in the jurisprudence. Partnerships are not adequate for raising massive sums of capital. Corporations allow entrepreneurs to tap smaller investors on the promise of return with no risk beyond the invested amount. This allowed Western capitalist economies to develop large scale infrastructure and commercial projects. As a result, corporate law is concerned only with the relationship between the investors, the managers, and the corporate entity; the other social questions involving employment, the environment, and business practices are left to other areas of law. One unanswered question that persists in the study of corporate law: how do you define the “interests of the corporation”? Is it the interests of the employees? The shareholders? The community at large? The corporation is a piece of paper; yet, it has rights and interests (i.e. the right to be free from unreasonable search and seizure), as well as obligations (i.e. to pay taxes). Consider the example of the unprofitable manufacturing plant. Although closing the plant might save money for the company, it would put some of the employees out of work. Cost savings might render the company more profitable, which increases share value. 8 When considering risk and the corporation, voluntary creditors (such as in Saloman v. Saloman Inc. discussed below) are aware that shareholders have limited liability. They choose to lend money or goods at their own risk. Involuntary creditors, that is those people injured by the tortuous actions of corporations, are not better off, because the shareholders have no authority to supervise or manage the company. Are shareholders the “owners” of the corporation? Scholars will often refer to shareholders as “owners”, although this is a misnomer. A corporation is a legal person and by law, one legal person cannot own another. This is a legal impossibility. Shareholders have rights against the corporation, called shares, which entitles the shareholders to vote at the annual general meeting, to dividends (if issued), and to collect on the sale of corporate assets on windup. A share is a speculative piece of property, in that it cannot generally be redeemed against the corporation itself, but is traded. Shareholders benefit by virtue of an increased price per share (“buy low, sell high”). Today, shares are often held by professional investment firms, and “shareholders” have units in the investments (which are often set up as trusts). A share confers three basic rights, which are discussed below: 9 (1) The right to the remaining property on windup (creditors take first, because otherwise shareholders could pull property out of the bankruptcy) (2) The right to vote for directors and at meetings (3) The right to dividends if they are issued. 4. Normative theories of corporate law (1) Nexus of contracts: the corporation provides an “off the shelf” legal device that allows thousands of individual investors to transact together without thousands of contracts. Corporate law provides a default set of rules, knowable to all of the parties in advance, which reflects the implicit bargain made by the shareholders, directors, and to some extent, the creditors. Corporate law, therefore, should enable implicit bargaining. (2) Shareholder primacy: the shareholders “own” the corporation and therefore they are protected in case of default by the corporation. Corporate law, therefore, should promote the interests of the shareholders (return). (3) Stakeholder theory: corporations are more than business entities; they impact how people live their lives. The directors must make decisions that reflect the interests of members of the community, including consumers. Corporate law, therefore, should strive to ensure that corporations are goods citizens. (4) Team production: the corporation is a collaborative project; the shareholders and creditors provide the capital, the employees provide labour, the directors provide management. Corporate law, therefore, should strive to promote team building between interested parties (see Stout below). We can take a trans-systemic approach to corporate law by looking at features characteristic of corporations in all legal systems. For example, corporations have legal personality, and can have “extrapatrimonial rights” as well. Corporations provide for asset partitioning or limited liability for creditors. They have transferable shares, which makes this a more flexible investment vehicle than a 10 partnership.2 Corporations also have boards of directors, which are statutorily defined bodies set up to run the corporation. Lastly, corporations are funded by institutional investors to promote large scale economic activity. How do you start a corporation? During the 19th century, entrepreneurs required letters patent from the government granting permission to start a corporation. The government was worried that corporations would be used to defraud creditors. Now, anyone can start a corporation, provided they fill out the appropriate paperwork and pay the start-up fee. The board of directors can issue shares that are either privately traded or traded publicly on the stock exchange. Legal Personality Sections 41 and 123.29 of the Quebec Companies Act confer legal personality on corporations (rights and shareholder immunity). Section 298 of the C.C.Q. also recognizes legal personality. Sections 15 and 45 of the Canada Business Corporations Act do the same. Does the law take the issue of legal personality seriously? Yes. Saloman v. Saloman Inc. (1897) HL Facts: Saloman set up a corporation, where he, and six of his family members owed shares. Saloman was the majority shareholder, owning 20000 of the 20006 shares. He also held debentures in the company. The business was a going concern when he incorporated; however, the business went into financial difficulty and became insolvent. Saloman redeemed his debentures, leaving little capital left to pay off the unsecured creditors. The creditors sued Saloman personally. Issues: Is Saloman personally liable for the debts of the corporation? Holding: No. Saloman, as a shareholder, is immune from liability. Reasoning: The legislation provides that a corporation is a legal person, which means that it is solely responsible for its own obligations. Saloman made no effort to disguise the nature of his 2 Joint stock corporations did not have transferable shares, because there were no stock markets in the 1860s. 11 business nor did he attempt to defraud his creditors. The creditors knew the risk of contracting with an incorporated entity without too many assets. It did not matter whether Saloman held the debentures himself, or someone else did. It is up to the creditors to determine the risk of loss. Rationale: A shareholder is not liable for breach of contract by a corporation. Companies must give notice to creditors that they are incorporated entitles (such as LLC, Inc., or Corp.). Lee v. Lee’s Air Farming (1961) HL Facts: Lee was the director, sole shareholder, and employee of Lee’s Air Farming. He took out employment insurance (as required by law) for the company. Lee died in a plane crash while doing business for the company. The insurance company refused to pay the indemnity to Lee’s wife, explaining that Lee was a director and not an employee. Issues: Can Lee be both a director and employee of a corporation? Holding: Yes. A person can have multiple offices/roles. Reasoning: Again, what does it matter if Lee died, or someone else did. A person can have multiple offices; the corporation contracted with Lee to hire him as an employee. It is up to the creditor, the insurance company, to determine the risk of Lee’s death. In this case, Lee was a contractual employee of the corporation. He earned a living by piloting for the business. Rationale: A person can hold multiple roles in a corporation. 12 Additional Notes: What do you do about the 1-person corporation? Nothing. Although this may be conceptually problematic because an “association” should include more than one person, at what number do we set the minimum? One-person corporations are inconsistent with the idea of a corporation, which is a joint-economic enterprise. 13 14 ACCOUNTABILITY If we invest authority in the directors and officers to manage the corporation, there is a risk that they will use that power for their own benefit (“agency cost”, see Hansmann & Kraakman). However, if we impose too many rules on the directors and officers then we simply shift accountability elsewhere (i.e. to the shareholders). There are advantages to centralizing decision-making: lower transaction costs, concentrated information, use of specialized expertise, etc. Notwithstanding any liability that the law provides, there are other forms of accountability: peer influences, media, share price, auditors, lawyers, etc. We have to recognize that business decisions get made quickly and with limited information. The law should not constrain directors so much that they will not take advantage of business opportunities (see Van Gorkom and the Delaware legislature’s response, below). Corporate Governance – How do we balance authority and accountability? The decision-making process for a corporation is confined generally to its directors and officers. At the first shareholders’ meeting, the shareholders compile a list of directors, who then appoint officers. For smaller and more concentrated corporations, however, the shareholders can dispense with the board of directors under a Unanimous Shareholders Agreement. The Board will meet periodically to discuss the affairs of the corporation. The purpose of the Board is to supervise the officers. The problem, though, is that members of the Board are not always versed in the affairs of the corporation (or in business altogether). Sometimes Board members are officers of the corporation, who also may engage in unlawful acts. The Enron example demonstrates how officers can mislead the Board into believing that the company is in a better financial state than it actually is. The shareholders will elect the directors, who appoint the officers. The directors cannot have unconstrained power. The judicial branch enforces and monitors the “elected” officials, when they act beyond 15 the scope of their authority. There are other constraints, including the market, reputation effects, and consumers. Auditors and lawyers used to also serve as “gatekeepers.” Auditors would examine the company’s financial statements to see if those statements accurately represented the company’s earnings. Following Enron, however, US legislation restricted auditors from acting as consultants for the corporation, so as to limit conflicts of interests. No longer is it that law firms act on behalf of a corporation in relation to all of its legal needs. Firms compete for contracts and as such, they cannot determine whether a particular transaction is part of an overall corporate fraud scheme. The Directors have two bases for liability: the duty of care (negligence) and the duty of loyalty/fiduciary duty. The duty of care is secondary liability since the directors, themselves, are often not the direct causes of the loss. It is by virtue of their negligent supervision of the officers that they can be held liable. The Duty of Care - Informed Business Decisions Either the legislature can set down specific powers ex ante (inflexible) or set a standard of care ex post. It used to be that the courts held Directors to a subjective standard of care: what is the best that you could have done? This standard lowered the obligation for Directors, who could rely upon officers of the corporation to act honestly. The standard was so low that Delaware abolished monetary liability for the negligence of Directors. Under Arts. 321-322 C.C.Q., directors and officers have same obligations (see also s. 122(1)(b) CBCA). A subjective standard, which was applied by the common law, is really no standard at all. There must be an intentional disregard of the obligation. Until the Peoples decision, the standard in common law Canada was a modified objective standard: the directors must act like a reasonably prudent person bearing in mind the characteristics of the director him or herself (how well did you use the skill that you have?). This places a greater obligation on a skilled director than on an 16 unskilled one and creates a disincentive for skilled directors to join boards. The problem with this standard is that highly skilled directors will leave Boards at the earliest signs of trouble, because they could be held liable if the situation worsens. The standard should be objective (as it is in Quebec): what would the reasonable director do in the same situation? This would allow the courts to apply a professional standard to the management of larger corporations and a reduced standard for “ma-and-pa” businesses. When you create a system of accountability, who is the director accountable to? (1) Shareholders (2) Creditors (3) Employees (4) Public, or (5) Corporation. The corporation is owed the duty, because the corporation is a legal person. In practice, however, the shareholders stand in for the corporation. Shareholders may bring a DERIVATIVE ACTION or they can seek a personal remedy. There are several defences available to directors. The directors can demonstrate that they took due diligence. The QCA deems a director diligent if the director relied, in good faith, on someone credible who gave professional advice. The court will determine whether a director is liable by looking at whether the director informed himself. The courts will review the process, not the result, although sometimes the court will conflate the two. The court does not care whether the idea was good, only that the process in coming to the conclusion was sound.3 You can justify the objective standard because less experienced directors will be required to get help. R. v. Soper (1997) FCA Facts: Soper was indicted for failing to remit employee’s taxes contrary to the Income Tax Act. Soper became a director when the company was in financial difficulty. Directors are liable under the act for remitting employees’ taxes, unless they can show that they were 3 Consider the Ford Pinto example. Ford considered the losses to the company because of the exploding engines. They considered the cost to the company. Therefore, they probably would not be liable for this decision in negligence. 17 diligent in the execution of this duty. This tempers the severity of the legislation. Issues: Was Soper diligent? Holding: No. Reasoning: Robertson JA reviews the development of the duty of care. Judges have adopted a “subjective standard”, although Robertson explains that the language of the CBCA does not justify this standard. He cites City Equitable to outline the three propositions of the subjective standard: (1) a director is expected to perform his duties based on his own level of knowledge and expertise, (2) the director is not bound to give continuous attention to the affairs of the company, and (3) absent grounds for suspicion, the director can rely on the advice of experts. Robertson explains that the statutory standard is a modified objective one (in which the director is held to act in accordance with the reasonable person, in light of the director’s own competencies). Although Robertson explains that the standard does not benefit less experienced directors, that reasoning is hard to justify – especially in light of the holding in this case. The committee in charge of drafting and revising the CBCA selected the “prudent person” and not “prudent director” standard, which demonstrates that the court is not placing a professional standard of care on directors. Directors lobbied Parliament not to change the standard. In this case, Soper merely relied on the assurances of others that the taxes were remitted; however, he was told that the company was in arrears to Revenue Canada. Soper took no further efforts to find out how much money was owed and why. The court distinguished R. v. Sanford, to explain that the director in that case asked for a cheque to be remitted to Revenue Canada and she took “active steps” to ensure that the agency received payment. Soper could have asked for regular financial reports, confirmed regular remittance with the accountants, or made further inquiries to ensure that RBI remitted its taxes. Instead Soper did nothing. 18 Soper was an experienced business person (unlike Sanford), who should have known about the tax problem. As an experienced business person, he should have taken steps to ensure payment. There was no evidence that Soper’s fellow board members conspired not to tell him about the tax liability. Rationale: A modified objective standard applies to corporate director’s liability under the Income Tax Act (and CBCA). Smith v. Van Gorkom (1985) Del. S.C. Facts: Transunion (TU) could not make use of its tax credits since it did not generate enough income. The company was a going concern, but in order to benefit from the tax credits it would have to “merge” with other businesses. The chairman, Van Gorkom, consulted Pritzker on the possibility of a leveraged buyout. This would allow Pritzker to buy the company with funds from a loan. The value of the company would be determined by how much debt the acquirer can carry (basically, how well TU could finance the loan with its profits). TU’s shares traded at about $30/share, and the buyout would pay the shareholders, $55/share. Smith complained that Van Gorkom undersold the company. Issues: Did the directors make an informed business decision? Holding: No. Reasoning: The directors did not have an independent valuation/appraisal of the company’s assets and therefore the decision was not informed. The Board’s only source of information was Van Gorkom. The court discounted Van Gorkom and the Board’s expertise. “Experienced” directors should have gotten other appraisals. The Board never opened up the sale to competition in the market. They did not solicit other offers. They relied on the advice of their legal counsel not to (the actual agreement was never admitted, which would seem to support the majority and contradict the directors’ claims). Although the shareholders of the sale, the proxy information was inaccurate. It did not tell the shareholders about how the valuation of the company was made. 19 Rationale: Under Delaware common law, the directors must obtain an independent valuation of a company before selling it. Critique: The majority is effectively questioning the business rationale of an expert board of directors. No one knew TU better than the directors. An independent valuation was unnecessary. This was a simple transaction which did not require much time. The dissent accepted the directors’ evidence that they had agreed to solicit offers and put the company on the market. Van Gorkom raises questions about how much weight the court places on the information that the directors considered, how deep their investigation/contemplation was, the amount of information considered, etc. Delaware responded – allowing corporations to exempt directors from liability. They deferred to the market, which is what corporate law aims to do. Final thoughts on the duty of care: is it really necessary? Arguments in favour of removing the duty of care The duty has been abolished as mandatory law in Delaware and by virtue of the number of corporations who have opted out in their articles of incorporation, it shows that it is a preferred model. If the directors of the corporation represent the interests of the shareholders and if in fact they are the shareholders, then any liability for their negligence is borne principally by them. The market can provide an alternative source of regulation. There are other mechanisms to hold the directors accountable; namely, loss of profits, corporate reputation, the media, investors, etc. The duty of care, however, provides a “legal face” to this problem. It shows that the law cares how directors and officers make their decisions. This adds symbolic value, but does not necessarily have practical effects. To meet their “duty” directors and officers may over-compensate by requiring the production of too much information, that they either cannot process or that takes time to process. This 20 production carries costs. If the net cost to society under this production/valuation rule is greater than the costs incurred for liability for truly negligent decisions, then the policy makes little sense in economic terms. Too much liability also constrains risk-taking behaviour of the directors. Perhaps as an alternative legislation can encourage whistleblowing behaviour. Directors can be removed by election. We don’t want the courts questioning business decisions of the directors; they are not experts in business. Arguments in favour of adding/maintaining the duty of care The duty of care has a symbolic function. It makes directors conscious of their obligations. It also provides another source of deep pockets for shareholders who have lost their investments following a poorly planned decision. A duty of care is fine if it actually provides accountability. A subjective standard does little to hold directors accountable, because they are not held to any meaningful standard. A modified objective standard has the effective of creating a disincentive against talented directors staying on corporate boards when the corporation is in trouble. This encourages directors to consult professionals. It also encourages directors to solicit opinions from the staff. This essentially shift the risks from directors to professionals with liability insurance (instead of the market). A due diligence defence would otherwise be required, so that directors have a sense of their obligations. 21 Fiduciary Duty – Duty to the Company Martel says that the common law can provide a source of reasoning/jurisprudence for the civil law to use. The civil law and common law share underlying concepts of “loyalty”. Whereas in the common law the inspiration for the jurisprudence was the law of trusts, in the civil law it is the mandate. This approach is favourable to using the common law to build civil law concepts or applying common law concepts director in the civil law. What is loyalty? Loyalty forms in relationships of trust, where one person relies on another for care, advice, or support. A disloyal person is someone who takes advantage of an interest when the other party intends to act on that interest. In such cases, full disclosure if important to sanitize the risk of disappointment, hurt, etc. The duty of loyalty is the core duty. Surrounding the core duty are other duties which can help to prove a disloyal act. First, if the fiduciary puts himself in a CONFLICT OF INTEREST, the court presumes disloyalty. Second, if the fiduciary PROFITS from a transaction, there is a further presumption. There are two groups of people who will litigate breaches of loyalty. The first is the shareholders, often the minority shareholders. They want to ensure that the transactions made by directors fairly represent their interests. The second is creditors. Although voluntary creditors can account for the risk of a disloyal action by the directors 22 when loaning money, involuntary creditors rely on the director’s integrity to keep the corporate assets in the corporation. Martel – Duties of Loyalty in Quebec Martel explains that the evolution of a director’s duty of loyalty in Quebec is the product of relatively recent legislative changes. Quebec courts were first confronted with the integration of this duty into civil law in 1975, when Parliament amended the CBCA to include s. 122(1)(a). Common law judges looked to trust law for a model within which to develop corporate director responsibility. Wilson J explained in Frame v. Smith that fiduciary relationships share three things in common: (1) the fiduciary exercises discretionary powers (2) which affect the interests of the beneficiary (3) that is particularly vulnerable. As such fiduciaries must act loyally and honestly toward beneficiaries, they must not profit at the beneficiary’s expense, or act in a manner that furthers their interests at the expense of the beneficiary’s. If the beneficiary proves a conflict of interest or profit, the burden shifts to the fiduciary to show that he acted loyally. The beneficiary need not prove fraud/bad faith or injury to his patrimony. In Quebec, and under the C.C.L.C., the trust institution was quite limited. The civil law had a developed law on mandate, from which Quebec courts drew inspiration. The mandatary also owed a “duty of loyalty” to the beneficiary, although this duty was not as developed or as strict as in common law. Both the mandatary and the common law trustee were under an obligation to account for profits and losses related to the management of their beneficiary’s property. The courts had to bring in officers under a. 2138 C.C.Q. because they were not included in a. 322 C.C.Q. Mandate is the analogous concept that civilian judges have used to build the jurisprudence on director responsibility. Mandate is not enough, which is why a. 322 C.C.Q. enlarges the duty and allows for a growth of the duty of loyalty outside of the scope of mandate. After the court’s decision in Nozetz, Quebec civil law incorporated fiduciary duties based on the notion that directors were mandataries 23 of the corporation. As such the director had to act as a “bon père de famille” and not profit at the company’s expense. After the Ng decision, the courts recognized that this duty of loyalty attached to officers and senior employees of the corporation as well. Martel recognizes the weakness of the mandatary analogy: that mandate is a contractual relationship, but the director-corporation relationship is a product of statute. He says that courts should now look to the statutes for guidance as to how to set out the appropriate duties. The jurisprudence on mandate and even the common law cases are still useful sources of interpretation. Although Martel feels that Quebec courts should harmonize their interpretation of the CBCA with the rest of common law Canada, he fails to recognize that the other provincial courts may have slightly varying interpretations of the provisions. It is all too easy when handling another’s property to use that property for your own interests. The corporation has no voice, and therefore, the shareholders will step in and act on behalf of the corporation. There are three common situations which give rise to fiduciary claims: 1. Interested party transactions 2. Benefiting from the unauthorized use of corporation assets 3. Taking of a corporate opportunity. Each of these will be discussed in the cases below. One should note, however, that these are examples of breaches of the prophylactic duties. Proof of bad faith is not required since there is a presumption of disloyalty. The directors can also be found to have acted disloyally even when they do not profit or are not in conflict (see discussion in Peoples, infra). There are limitless situations in which such breaches can arise. 24 1. Interested Party Transactions To be an interested party, the director has to be a party to the transaction and has to have a material interest in the transaction. Nozetz c. Habitations CJC Inc. (1986) S.C. Facts: Sauvé was the director of Rock. Rock had acquired the rights to purchase some land at a low price and was going to resell the land to Braindvert for a large profit. Instead, Sauvé arranged for CJC to purchase the land and then sell it back to Rock. The result was that CJC would profit substantially at Rock’s expense. Issues: Is Sauvé responsible for accounting for the profits lost? Holding: Yes. Reasoning: Sauvé redirected profit that belonged to Rock for personal gain. He deprived Rock of a business opportunity which he was supposed to secure for that company. There is no such thing as a “fiduciary” duty in civil law (yet) but the analogous situation is one of mandate. A mandatary must act as a “bon père de famille” and a reasonable BPdF would not have acted in the way that Sauvé did. The rule in Canadian Aero, infra, applies in civil law to protect corporate assets from being stolen or misused by directors. 25 Rationale: As a mandatary of the company, a director will have to account for profits denied to the company for breaches of its duty of loyalty. Gray v. New Augarita Porcupine Mines Ltd. (1952) HL Facts: Gray used the company as a personal savings account. He issued shares to himself at a heavily discounted rate and then sold them at full value in the market, keeping the profit for himself. Gray attracted the attention of the Ontario Securities Commission who installed a new board of directors. The new board wanted to regularize the accounts and proposed a settlement to Grey. Gray proposed a settlement to the Board and voted for its approval. Issues: Can the board accept the settlement? Holding: No. Reasoning: Per Lord Radcliffe: a director is not entitled to put himself in a position where he can absolve himself of a conflict of interest. Gray was the only person with the relevant information about how much he stole. The new Board did not arrive at the settlement amount using the full information about how much Gray stole. (Like in Van Gorkom, the amount represented a “guess”) Gray is not allowed to advance a defence which provides that the directors would otherwise have accepted the settlement amount. This is not an ends-related inquiry: how much does the company feel that it is injured because of its director’s actions; it is a means-related inquiry. If there is a breach, the director must account for the value of the breach to the company and disclose the relevant information. This leaves the question open: what is relevant information? Rationale: A director cannot continue to place himself in a position of conflict after he breached the duty of loyalty. In such cases, the director must disclose all relevant information about the breach and cannot vote to approve a settlement afterward. In some situations, the director is the best person to obtain a product or service from. The director may be a party to the corporation’s contract if it (1) provides full disclosure, (2) secures informed consent from the board of directors, (3) does not vote on the transaction, and 26 (4) ensures that the transaction is reasonable and fair when it was approved. If the director fails to meet all 4 conditions, he must account for the profits personally. Points to consider: Under s. 120(7.1) CBCA, the shareholders at a special meeting can forgive the director’s breach and confirm the otherwise voidable contract. This is an open question: why can the shareholders forgive the director if the duty is owed to the corporation? Under a. 326 C.C.Q., the corporation can go to court within 1 year and seek to annul the contract (relative nullity). Does “legal personality” mean more than a debtor-creditor relationship? If so, why should shareholders step in on behalf of the corporation or on behalf of their own interests, as we will see below in Feldman? We cannot necessarily equate the interests of the corporation with the interests of the shareholders. The shareholders may have a plurality of interests. Shareholder ratification by the majority may oppress the minority; it also may be hard to get in widely-held corporations. 2. Benefiting from Corporate Assets If a. 322 C.C.Q. is new law, then officers and senior employees should not be subject o a duty of loyalty. The jurisprudence, however, says otherwise (see Ng, below). Bank of Montreal v. Ng (1989) SCC Facts: Ng was a securities trader with the Bank. He was an employee and not a director or officer. The Bank authorized him to make up to $40M in trades daily. Ng, however, used client funds to make his own trades and earn a profit. He also dealed with some of the Bank’s clients directly and split the profits on trades with them. Although the Bank did not lose money, it did lose opportunity. Issues: Is Ng responsible to account for the profits to the Bank? Holding: Yes. 27 Reasoning: The court explained that when someone uses someone else’s property to make a profit, the user is liable for the gains (per the duty of loyalty). Ng was akin to a “possessor in bad faith” and therefore he was not entitled to keep the profit from the transactions. With respect to the second group of transactions, the court could not locate a direct codal provision in Quebec law which circumscribed the duty of loyalty. The silence of the C.C.Q. is not dispositive. It looked to French law to explain that in some contracts of employment, the employee can owe such a duty. The duty of loyalty varies with the degree of trust and authority vested in the employee. The more authority, the more the authority must be constrained. Ng would not have had access to the clients had it not been through his position with the Bank. Furthermore, a person should not be able to benefit from his own wrongdoing (“ex turpi causa “ rule). Rationale: Employees in senior positions owe a duty of loyalty to the employers and may have to account for profits gained in breach of that duty. This case raises another question not addressed by the court: does an employee owe his or her entire economic potential to the employer? Why should Ng have to account for money that he made – that the employer could not make or that he made off company time? Another troublesome point is that the Bank disgorged the profits and not the clients. It was their money that Ng used. Maybe the Bank would have made the profits from those transactions or maybe the Bank received a mandate from the clients to sue Ng. Perlman v. Feldman (1954) C.A. 2nd Cir. Facts: Feldman was the majority shareholder in Newport, a steel company. The steel company was not a viable concern, however, the government’s demand for steel during the war drove up prices. As a result, the company could inflate its prices. Feldman sold his shares to another company, Wilport. Wilport, therefore, would not have to pay the inflated prices for the steel since it would acquire it directly from Newport (effectively its own subsidiary). The minority shareholders sued Feldman for part of the sale price, arguing that they had to forego part of their profits because the new purchase would not have to pay a premium on steel. 28 Issues: Is Feldman liable to the minority shareholders? Holding: Yes. Reasoning: Per Clarke J: The court said that Feldman as director and shareholder stood in a fiduciary relationship. Although Feldman was entitled to benefit from the sale of his shares, he also had a duty as the director. Because he is also the majority shareholder, his behaviour has to conform to a higher standard of conduct. The sale necessarily amounts to a sacrifice of “corporate good will” and therefore Feldman has to account for the gains that he took from the corporation. Hence, part of the sale proceeds must go to the other shareholders (or back to the corporation). Rationale: A majority shareholder must ensure that if he sells his shares at a premium and it costs the company money, the shareholder may be accountable for part of the proceeds of the sale. Critique: Per Swan J: A majority shareholder is privileged to sell his shares at the best possible price. The shareholder is not under a duty to assist the minority shareholders; he is in business for himself. The minority shareholders should be aware of this risk. Furthermore, there is no proof that Newport suffered any damage from the transaction. This idea is problematic, since the majority shareholder not only has to be fair to the minority shareholders, but actually has to account for their interests when they act. 3. Taking Corporate Opportunities As the duty of loyalty finds its origins in trust law, the courts have relied on trust law rules to frame corporate governance. One such rule is the prohibition against taking an opportunity available to a beneficiary even if the beneficiary cannot benefit from the opportunity itself (see Keech v. Sanford). If this happens, the shareholders must approve the transaction. Shareholder ratification, itself, can be problematic. Although the director would not have been told about the opportunity but for his position, the shareholders can hold the director hostage for a 29 percentage on the deal even though the shareholders could not benefit. There are two reasons for not allowing the taking of corporate opportunities. The first is tradition (see Keech). The second is the evidentiary issue. The courts cannot get required information because the directors have control over the information. This is why when a taking can be prima facie established, the director must disprove a breach of the duty of loyalty. Regal (Hastings) Ltd. v. Gulliver et. Al (1941) HL Facts: The parent corporation owed a theatre. The company sought to acquire the lease of two more theatres, although it didn’t have enough capital to finance the transaction. The directors could have guaranteed the leases; instead, they supplied the subsidiary corporation with the capital. The parent corporation acquired the leases. When the parent corporation was sold, the directors received a profit. The new directors, on behalf of the corporation, sought to recover the profit from the former directors. Issues: Are the former directors liable to account for the profits? Holding: Yes. Reasoning: Directors and officers cannot make use of a corporate opportunity “by reason of and in the course of” their position as directors. Per Lord Sankey, “at all material times, they [the defendants] were the directors and in a fiduciary position, and they used and acted upon their exclusive knowledge acquired as such directors. They framed resolutions by which they made a profit themselves. They sought no authority from the company to do so, and by reason of their position … they are liable to account to the company.” Rationale: “By reason of” is the knowledge element while “in the course of” is the time element of the rule. The directors could manipulate the corporation in order to limit the opportunities that the corporation could avail itself of. As such, the courts have placed a bar against this. However, some economists argue that if the directors cannot take an opportunity, no one might take it. The rule does not account for business reality. There is a perverse incentive for corporations to stand by and wait for 30 directors to assume the risk of the transaction, and should the directors profit, disgorge the directors. Peso Silver Mines v. Cropper (1966) SCC Facts: Cropper was the director of the plaintiff company. He had years of business experience in the mining experience. Cropper was an active director. Dickson, a prospector, approached the company with an offer to acquire a mining claim. The Board considered the offer (in good faith) but rejected it, because the Board only had a certain amount of money to spend on speculative claims. Cropper, as an officer and director of the company, received two to three offers a week. Sometime later, Dickson approached Cropper with the offer. Cropper and Dickson formed a company to manage the claim. When the plaintiff company asked Cropper to disclose and turn over his interests in other mining concerns, Cropper refused. He was fired. The plaintiff company asked Cropper to turn over the shares in the new company. Issues: Is the plaintiff company entitled to the shares? Holding: No. Reasoning: The Court applied the rule in Regal (Hastings). To succeed, the plaintiff must show that the director took a corporate opportunity by reason of and in the course of his employ as director. The plaintiff need not prove bad faith. The Court, however, distinguished Regal on the basis that Cropper did not rely on privileged or confidential information. Dickson approached Cropper in his personal capacity, not in his capacity as a director. Furthermore, enough time had passed between the rejection of the offer by the corporation and Cropper’s acceptance (“forgot all about it”) – which evidenced the fact that that the opportunity was no longer a “corporate opportunity”.4 4 What would have happened if Cropper had been offered the opportunity before the corporation? Cropper is not under a duty to give the opportunity to the corporation. In such a case, there would have been no problem. In this case, however, Cropper found out about the offer by virtue of his office. Dickson went to the company first – and as such the company had the opportunity to act. 31 Rationale: The duty to avoid taking opportunities does not last indefinitely. After the proposition is rejected by the company, a director can act on opportunity. The court in Peso seemed to be doing what the House of Lords in Regal said was an impossible task: that is, the Peso court was trying to inquire into factual situations in which a director can take advantage of a corporate opportunity while still in the employ of the corporation. The conflict between Peso and Regal seems to be: the more involved you are as a director, the less likely it is that you can take advantage of business opportunities in your personal capacity. This seems antithetical to the rule in Regal. What happens if the directors or officers resign? Does the duty of loyalty end? The Court in Canadian Aero held that the duty of loyalty persists. Again, like in Ng, the court takes a functional analysis to define the duty of loyalty. The more control that a person has over the corporation, the greater the need for accountability and constraint. Canadian Aero Services Ltd. v. O’Malley (1973) SCC Facts: O’Malley and his co-defendants held executive and directorial positions in Canadian Aero. The defendant, while controlling Canadian Aero, met with Guyanese officials to secure a mapping contract. The project was funded by the Canadian government – which solicited proposals from other mapping companies. Canadian Aero bid on the deal. O’Malley the others, however, left Canadian Aero to start their own company, Terra, which also bid. The Terra bid was accepted. Issues: Is O’Malley liable to cede the profits to Canadian Aero? Holding: Yes. Reasoning: Per Laskin J: O’Malley and his colleagues stood in a fiduciary relationship with Canadian Aero (functional analysis). The law would be reduced to absurdity if on the simple resignation of the defendants, they could take a corporate opportunity available to their former company. Canadian Aero never abandoned its hope of getting the bid, which distinguished this case from Peso. The acquisition of knowledge about an opportunity while acting as a director is not enough to impose an absolute prohibition. If the director can conform to the contextual factors laid out, then the 32 court can absolve the defendant of liability: The position or office held, The nature of the opportunity, Ripeness/timing, Knowledge possessed, and Status of the fiduciary relationship, among others. Also, what distinguishes this case from Peso is that the defendants used the company’s confidential information – which they gathered in the course of their position. They took advantage of this information to capitalize on the Guyana deal. This was a case of flat out deception. The defendants used the confidential information obtained in the course of their employ to create their own proposal. Rationale: When the directors of a company leave, their fiduciary duty does not expire at that moment. For interested party transactions, the scope of abuse is confined to single directors. The Board, therefore, can constrain behaviour. For taking of corporate opportunities, any director is susceptible to a breach of the duty. Therefore, a non-interested party, like the shareholders should have to approve the transaction either ex post or ex ante. Shareholders may be apathetic to the transaction or may be opportunistic. The reasons that a corporation cannot take an opportunity include: financial inability, legal inability, rejection of the opportunity. If a director takes an opportunity, because the director controls the information needed to show why the corporation could not have taken the opportunity, the burden should be on him to prove loyalty (how they did not manage the company in a way that the company could not take an opportunity). Would it make sense to have a rule as with interested party transactions (Board vote, transition period, etc.) 33 4. Generalized Fiduciary Duty Peoples v. Wise (2004) SCC Facts: Wise and Peoples were clothing retail companies competing in a highly competitive market. Marks and Spencer, which owed Peoples, looked to sell the company. Wise bought it under a leveraged buyout. To protect its interests, Marks and Spencer placed strict conditions on the management of Peoples and took security in the assets of that corporation. As a results, Peoples and Wise were forced to run two separate operations and could not consolidate fully. This caused serious problems for both companies. The directors of Wise (who were also the directors of Peoples) initiated a new arrangement for acquiring and partitioning merchandise. As a result of this arrangement, Peoples would buy the bulk of the merchandise and Wise would owe a credit to peoples. Peoples was put into bankruptcy proceedings and the trustee petitioned the court to include the director’s personal assets as a result of a breach of their fiduciary duty. Issues: Do the directors of a corporation owe creditors a fiduciary duty? Holding: No. Reasoning: Per Major and Deschamps JJ.: The creditors claimed that the inventory policy was detrimental to Peoples, because Peoples had merchandise, while Wise controlled the cash. The fiduciary duty is owed to the corporation and not to the creditors. The decision to allocate the inventory in the particular manner was not a situation where the directors profited or put themselves in conflict of interest. Therefore, any liability would have to arise by virtue of the director’s breach of the generalized duty of loyalty to the company; that is, the directors did not act in the company’s best interests. The directors can take the creditors’ interests into account, but they do not have to (permissive approach to the “entity model”). The court found, to the contrary, that the directors did act in Peoples’ best interests by trying to create a more efficient (less costly) procedure for acquiring, storing, and sharing merchandise between the two companies. The directors had no personal interest in this 34 policy. They implemented the policy in the hopes that it would solve some of the management and accounting difficulties that Peoples (and Wise) faced. The creditors can sue personally under the oppression remedy if the directors acted in a way that affected their interests or expectations. Therefore, there is no need to extend the duty of loyalty to require that the directors account specifically for the creditors’ interests when managing the corporation. The duty of the directors is to make the company a better company not necessarily preferencing one group of stakeholders over another. Rationale: The duty of loyalty does not extend to creditors. So long as the directors act in the best interests of the corporation, even if creditors take a loss, the directors are not personally liable for their decisions. Again, we are forced to confront the question: what is the interest of the corporation? In order to answer that we have to try and figure out how we view the corporation. It is a “moving target”; that is, in situations of insolvency, the interests may centre around the creditors (who want to preserve their assets vs. the shareholders who want to grow them). In takeovers, the shareholders may want to maximize the return on their shares, while the employees may want to keep their jobs. Additional Notes: 35 36 TAKEOVERS A TAKEOVER is a complete change of control of a company. They are regulated primarily by securities regulators, but the jurisprudence does show how the courts are not yet settled on their understanding of the corporation. Although the duty of loyalty is defined clearly in the context of the “prophylactic” duties (strict liability for fiduciary breaches), determining the content of the duty of loyalty in the context of takeovers is more difficult. A company may want to purchase another corporation for several reasons: (1) to break up and sell off the assets of the corporation (Revlon), (2) to eliminate competition, (3) to acquire a supplier (Feldman), or (4) to increase the value of shares. Directors may try to resist takeovers. They might put out an issuer bid, where the corporation buys back its own shares to reduce its capital. They might also effect shareholders’ rights agreements (SRAs) or “poison pills” to raise the cost of acquiring the corporation. Directors might also invoke defensive tactics to preserve their own jobs (see e.g. Pipeline which is why this is a conflict situation). Management may resist a take-over of an inefficient corporation in order to save their jobs. The jurisprudence demonstrates two trends: 1. “Just Say No”/Entity Model – directors and officers have a duty to manage the corporation and if control is threatened by an unsolicited offer, they can take defensive measures to undermine the takeover if they think that the takeover will harm the corporation. Unless it is inevitable that the corporation will be sold off (see e.g. Revlon, infra), the directors can take defensive measures. This model follows the “entity” model or “stakeholder” model. Shareholders are simply investors and there are other constituencies affected during a takeover. 2. Shareholder Choice Model – a takeover is simply an offer for shares to the shareholders. The shareholders can therefore decide whether to accept an offer. Defensive tactics 37 cannot interfere with the outcome, but the directors can use them to encourage competing bids and/or delay the decisionmaking process. Corporate governance is a mechanism to maximize shareholder returns. Labour law will protect employees, while secured transactions law will protect creditors. All that is at stake is the value of the shareholders’ investment. The fundamental problem facing the courts is how to decide what the interest of the corporation is. Another question arises: do we really need these rules? As with the duty of care, the market can regulate corporate governance, because people will sell shares in poorly managed corporations and other shareholders will look to acquire those corporations, replace the management, and try to turn a profit. In Canada, unlike in the United States, securities law carefully regulates hostile takeovers, such that there is less of a need for the directors to take extreme action to thwart a bid. Therefore more discretion can be left to the shareholders to decide amongst the competing bids without the pressure of an unfair tender. From a trans-systemic point-of-view, we have to ask ourselves: (1) Who has the authority to make the decision – the management or the shareholders? If the shareholders decide, then we have to limit the authority of the directors to use poison pills to let the shareholders make the decision. (2) If it lies with management, whose interests are favoured – the company or the shareholders? Remember, corporate law is about balancing authority and accountability. If we leave the decision-making process to the directors, they can entrench themselves. If we leave it to the shareholders, they may not do what is best for the company. How do we balance the two? 38 1. Acting in the Interest of the Corporation (Leave it to the directors) Teck v. Millar (1972) BCSC Facts: Afton mines is a junior mining company. It had acquired a stake in land that was rich in copper. It wanted to develop the land, but lacked the capital, resources, and expertise. Afton’s directors, including Millar, sought out a senior partner to help Afton with the project. Afton and the senior company would conclude “the ultimate deal” where the senior would acquire shares in Afton in exchange for technical assistance and financial capital. Teck had shown an interest in doing the ultimate deal with Afton; however, Millar and the other directors felt that Teck was not a suitable partner. Teck acquired the majority of the shares in Afton so that it could replace Millar and the other directors (by a special meeting of the shareholders) and conclude the ultimate deal. Before the Board was dismissed, Millar concluded the ultimate deal with Canex, thus diluting Teck’s majority interest in Afton. Issues: Were the directors’ defensive tactics disloyal? Holding: No. Reasoning: The directors are not agents of the shareholders. Shareholders do not have powers of management; they have powers to vote at shareholders meetings, to remove directors, to pass amendments to corporate by-laws, etc. The court overrules Hogg v. Cramphorn to state that the directors can consider the interests of the company as a whole, and not just the interests of the majority shareholders. “The corporation has become almost the unit of organization of our economic life. Whether for good or ill, the stubborn fact is that in our present system the corporation carries on the bulk of production and transportation, is the chief employer of both labour and capital, pays a large part of our taxes ,,,, “ Shareholders are not the owners of the corporation. They are passive investors and the directors have to account for the interests of the other stakeholders as well. The directors cannot ignore the interests of shareholders, however. The directors would be acting in good faith even if they considered the interests of the employees. 39 The Court applies a modified objective test to assess the fidelity of Millar’s actions. The court will assess the director’s good faith. However, the directors must perceive a substantial risk of harm to the corporation to justify their actions. In this case, Millar was weary of Teck. He had misgivings about its financial capacity, its technical expertise, managerial strength, and marketing experience. Interests of the Shareholders – the court did say thought that it was in Teck’s interest as a shareholder to have the bid go to Canex (albeit not as a competitor to Canex). Rationale: The directors can use defensive tactics if they reasonably believe that the acquiring company would substantially harm the corporation. What we learn from this case is that the motive of the directors is important. The previous loyalty cases that involve breach of the prophylactic rules required proof of the breach (strict liability). Motive did not factor into the reasoning. This is because the courts will presume improper motive. In the takeover context, the directors’ motives must still be constrained by a reasonableness criterion. They cannot take defensive measures unless the threat to the interests of the company is substantial. The judgment does not shed much light on the “interest of the corporation”. Unocal v. Mesa (1985) Del. S.C. Facts: Mesa, a minority shareholder of Unocal made an offer to acquiring the controlling interest of the company. The offer provided that some of the shares would be acquired at a high rate, but those acquired later on would be at a lower rate, hence the bid was coercive. The Board met to discuss the offer and considered that it was too low. The Board decided to make a self-tender (Issuer Bid) for its own stock by incurring additional debt. Issues: Were the Unocal directors entitled to take defensive measures? Holding: Yes. Reasoning: Directors may deal selectively with shareholders so long 40 as they do not use their powers to entrench themselves. The directors also have the power to repurchase shares from shareholders. Although the court will not substitute its own decisionmaking for the directors, it will examine how the directors made their decision.5 The presumptions afforded by the business judgment rule are not as strong in the take over context, because of the risk of conflict. The directors have a duty to protect the corporation from threats that originate from third parties or even from shareholders themselves. The directors, however, cannot use any “draconian” means available to defeat a perceived threat. The directors must have a reasonable belief that the offer is threatening to the company and take reasonable measures to respond. The directors will look at the following: (1) Inadequacy of the bidding price, (2) The timing of the offer, (3) Impact on the “constituencies” shareholders. other than the The directors would pay out the same value for all of the shares, including Mesa’s. They were not treated any differently than the other shareholders (like in Pipelines, supra). If Mesa is discontent with the decision, they can vote to replace the Board of Directors. Rationale: Where the directors reasonably perceive an offer to be threatening to the company’s interests, they can take proportionate measures to defeat the bid. The directors are often in a position to decide how to maximize shareholder value. They can dissuade coercive bids. They have the responsibility and the wherewithal to analyze the strength of the competing bids. The risk, again, is that management might try to entrench itself. But that risk is alleviated by oppression actions 5 Recall, the business judgment rule applies to exercises of the fiduciary duty in the United States as well. American case law uses the term “fiduciary duty” to apply in the duty of care context but also in cases of loyalty as between the directors and the company and as between the majority and minority shareholders (see e.g. Feldman). The directors are presumed to act in good faith and to have informed themselves. 41 and because the directors bear the burden of proving that their defensive tactics were reasonable. 2. Acting in the Interests of Shareholders 347883 Alberta Ltd. v. Producers Pipelines Inc. (1991) SCA Facts: Pipelines was a closely held corporation. The directors sought to stop a takeover bid by Saskoil, though its wholly-owned subsidiary (347883 Alta. Ltd.). Saskoil applied to the court under the oppression remedy to set aside an SRA that would have made it more difficult for Saskoil to purchase the majority of the Pipeline shares. The Board members circulated an Issuer Bid to repurchase Pipeline’s shares. Saskoil complained that the directors were trying to entrench their position on the Board. Issues: Were the directors’ defensive tactics disloyal? Holding: Yes. Reasoning: Poison pill rules must balance the interest of shareholders without entrenching the position of directors. Applying Teck, directors are charged with making the decision as to who can take over the company. They can assess and evaluate the bids to do what is best for the company. With reference to securities legislation, the securities regulators want to promote an open and even-handed market for trading shares. The responsibility of the directors is to advise the shareholders, rather than to decide the issue for them. The shareholders have the right to dispose of their shares. The directors failed to show that they acted in the interests of the corporation when they proposed the Issuer Bid. The directors were not entitled to deprive shareholders of Saskoil’s offer and to entrench themselves in the Board. Because this is a situation that can involve a conflict of interest (i.e. the directors may want to entrench their position), the onus is on them to show why their defensive tactics were reasonable. *What distinguishes this case from Teck, however, is that there are no competing bids other than the bid manufactured from the directors themselves. They did not use the poison pill to secure an alternative bidder or to maximize the return for shareholders and used the SRA to entrench their own positions on the Board. This demonstrates an improper motive and a poor assessment of the objective 42 unreasonableness of the risk of harm to the corporation. Rationale: Where the directors deploy defensive strategies to entrench themselves, they are acting disloyally. Critique: Saskoil must successfully attack the validity of the SRA to get a remedy. It can attack the “validity” of the SRA (that by its very nature is illegal) or the effect caused by its “operation” (that the effect prejudices shareholders). A cause of action under the “operation” branch requires that Saskoil establish a prejudice, as it cannot attack the validity of the SRA, which the shareholders had consented to. The remedy must rectify the matter complained of. Saskoil profited from the Issuer Bid. It did not, however, gain control over Pipelines. It is difficult to conceive of granting oppression remedy to a person that has not been involved with the company for very long; Saskoil is an outsider. Saskoil’s only prejudice was that it had to wait until the SRA expired to make a bid. The SRA did expire and Saskoil could have made a bid then. It did not and therefore it cannot complain that it lost out because of the poison pill. Saskoil misunderstood and misrepresented the poison pill agreement to its own detriment. The problem with the shareholder-interest hypothesis is that it the courts may favour the shareholders of the company that is being acquired, as opposed to the shareholders of the acquiring company. Revlon v. McAndrews (1986) Del. S.C. Facts: McAndrews Inc. is the controlling shareholder of Pantry Pride Inc. PP put in a bid to acquire Revlon in a public “auction” for the company. The directors took defensive measures to block the sale of the company and McAndrews sued. The defensive measures including the pay out of a large dividend to the shareholders. The directors ultimately proposed the sale of the company to Forstmann, a competing bidder. Issues: Were the directors of Revlon entitled to take defensive measures? Holding: No. Reasoning: The danger in takeover situations is that the directors might be acting to entrench their own interests and that they will not 43 act in the interests of the company or its other stakeholders. As in Unocal the focus is on (1) purpose/motive/good faith and (2) reasonableness of that purpose. The court notes that the Shareholder Rights Plan did cause PP to raise its bid from $42 to $58 per share. This is consistent with the implementation of a defensive measure. Because PP’s offer exceeded what the Board was looking for, it did not need to continue to exclude PP from bidding. Because the company was going to be broken up and sold anyway, the Board had the duty of maximizing returns for the corporation and its stakeholders. This is why the Board held the auction. The Board was not interested in preserving the corporate enterprise. Rationale: Where the company is going to be sold, the Board should not play favourites with the bidders and should use defensive strategies only where the bidders undervalue the shares of the company. 3. Where the Two Interests Converge (The shareholders and directors want the same thing) Maple Leaf Foods v. Schneider (1998) OCA Facts: Maple Leaf Foods is looking to acquire Schneider Corp. Most of the voting shares in Schneider are held by “the Family”. Maple Leaf has claimed that the directors truncated the auction process so that the Smithfield bid would be accepted. Issues: Did the directors act disloyally? Holding: No. Reasoning: Per Weiler JA: The directors must act in the interests of the company. This means that they are not agents of the shareholders and that there may be a conflict between different stakeholders in a corporation. The directors cannot, however, unfairly disregard the interests of a particular stakeholder. One way to avoid conflicts of interest in takeover situation is to set up a “Special Committee” of un-conflicted directors (i.e. outside directors). The Committee can then evaluate the bids. The Committee might be compromised if directors, looking to keep their jobs, influence the Committee’s decision-making process. In this 44 case, the court found that the Committee was not unduly influenced. Citing the Paramount decision, infra, the directors are not under an obligation to hold an auction every time a company is up for sale. They can rely on other methods to ensure the best transaction possible. The directors canvassed the market, and the Maple Leaf bid was not the best one. The directors consulted with the Family and the family said that they would not accept MLF’s bid. The directors did not put the bid to the Family formally (perhaps they should have?). Although the Family stood to gain the most from the higher bid price, they refused the offer because it was not best for the company or its corporate values. “Apart from the financial criteria [which MLF could not match], Maple Leaf did not meet the Family’s expressed concern about the effect of a change of control on the continuity of employment of Schneider’s employees, the welfare of suppliers, and the relationship with its customers, whereas Smithfield did. […t]he real questions are […] whether the process undertaken by the special committee was in the best interest of Schneider and its shareholders in the circumstances. While Paramount, supra, indicates that non-financial considerations have a role to play … here it was conceded that the court should only have regard to financial considerations.”6 Rationale: A selection committee used to procure offers is a defensive tactic that conforms with the exercise of the directors’ duty of loyalty. The distinction between the two theories is not all that clear. In some cases, the employees can be the shareholders looking to take over the corporation. Furthermore, the interests among the different shareholders may diverge, or the shareholders may reject short term profit in lieu of a long term viability for the company (see e.g. Maple Leaf). So what is going on here? Is it the shareholders’ financial considerations that matter or is it their “other” considerations. 6 45 Additional Notes: It is important to realize that takeover situations fall at the periphery of the discussion about the duty of loyalty. Like a bankruptcy situation, the corporation, as it has existed, will “end” with a takeover. The corporation’s vision, its purpose, its mode of operation can be shaped. It is in this context that the connection with the shareholders also ends. The shareholders, who by virtue of their position are being bought out, are left in a vulnerable position. Without anyone to protect their interests, an acquiring company can seize control of a corporation at great cost to its shareholders. This is why corporate law has to preference shareholder interests – that is, maximizing value on their investment – during this situation. It seems to me that the shareholders’ interests are placed in a paramount position when (1) the company is going be sold (Revlon) or (2) when there is no threat to the company (Pipelines). In those circumstances, it makes sense to allow shareholders to exercise their prerogative to sell their shares. Otherwise, when a takeover bid threatens to (1) undermine the long term development of the company (Teck, Paramount) or (2) is coercive to certain shareholders (Unocal), then the directors should intervene, as they would in the context of the every day transactions. The directors also owe a duty of loyalty to the corporation while the takeover occurs. They cannot simply ignore this duty. Is it a looser duty in Canada than in the US, because of the greater pressure to put bids to shareholders? The “hostile takeover” was unheard of until the 1980’s. There was a frenzy of takeovers and corporate law was placed in a crisis. The long-term interest of corporations died. The courts could not longer fudge the shareholder-stakeholder debate. Maybe the stakeholder-shareholder debate only arises when the corporation is coming to an end (takeovers and bankruptcy). It is in these situations where a particular interest is the most vulnerable. 46 SHAREHOLDERS There are different kinds of shares that a person can buy. Although some shares have both a voting and a dividend element, a person can buy Class A voting shares, which gives the shareholder only control or Class B preferred shares, which gives the shareholder preference for the dividends. Some commentators have criticized a dual share structure because the people that contribute the capital, do not necessarily exercise ultimate control over the corporation. The market, however, will package shares to meet public demand. Investors want to trade control for dividends and would pay a premium to do so. The shareholders know what they are buying at the IPO (and from subsequent purchases). When there is the availability of choice in the capital market, the 1 share : 1 vote proposal becomes largely irrelevant. In fact, it may be in the shareholders’ interests in centralized control in order to allow the directors to manage the corporation for the long term. Is the corporation a democracy? Bainbridge explains that when we leave it to the institutional investors or the shareholders to approve decisions, we are simply shifting authority and accountability to the shareholders and away from the directors. Hansmann & Kraakman already told us that when you separate management and benefit, you create “agency costs” (Berle & Means) may not manage the property to maximize the benefits of the beneficiaries. They may try to use the property for their own benefit. But, duplicating decision-making processes can be highly wasteful. Shareholders can participate in the management of corporations. For example, in closely-held corporations, shareholders can dispense with the Board altogether under a USA. In a larger corporation, institutional investors can supervise or monitor the directors. This is not always likely to occur in reality, since institutional investors often lack an incentive to expend resources. They are often “captive funds” like pension plans, where the clients cannot pull out their money. With widely diversified holdings, both institutional investors and shareholders would have to incur too high a cost to supervise boards. There is also a free-rider problem, because competitors (or other 47 shareholders) would benefit from the energy and cost expended to supervise. It is also hard to tell the players apart. The major shareholders of the corporation may be its employees or pensioners. Participation The shareholders have some ability to control the corporation. If we adopt a model that confers shareholders control, then we have to ask ourselves – do we think that the corporation ought to be controlled by the shareholders. From a social entity perspective, perhaps shareholders have too many inputs into the system. 1. Direct participation - voting To exercise voting rights, a shareholder can attend the annual general meeting (AGM). If the shareholder cannot attend, the shareholders can submit a proxy vote, to be conducted by an officer. At the AGM, shareholders must approve by-laws, fundamental changes to the corporation (i.e. amalgamations), and vote in new directors. 48 A nominating committee of the Board will put forward a slate of directors to be voted on at the AGM. The Board will nominate exactly enough directors as there are spots to ensure that there is no competition. So long as the director receives one vote (his own, if he owns a share), the director is eligible to take a seat on the Board. The Board may have an internal policy to ask directors not to take a seat if the director does not receive enough support. Under the CBCA, a shareholder can nominate a director, but the majority can vote for its own candidate. Legislative reforms could make the voting process more meaningful. Although legislation could allow shareholders to nominate their own director, without the proxies (or the votes), the nominee will not get elected to the Board. 2. USAs A USA can dispense with management altogether. This reduces agency costs completely, but it is practical only in closely-held corporations. A USA essentially “converts” the corporation into a limited liability partnership. 3. Indirect Participation – Shareholder Proposals Shareholders can submit PROPOSALS at the AGM. Proposals are non-binding, but they are closely followed by the media. They are a “communication” device more so than a control or monitoring device. Proposals are also a source of dialogue between investors and management. They are a source of contention, though, because the Board of directors cannot be expected to act as a “legislator” not does it want to deal with the suggestions of shareholders. Proposals may provide for changes to: (1) Corporate governance (i.e. salaries of the directors, number of women on the Board, etc.) (2) Political/social/environmental activities The QCA does not have a shareholder proposal provision, but the CBCA does. 49 Proposals provide a way for shareholders to voice dissatisfaction with the management or its policies. It might also encourage management to invite shareholders to discuss the policy-making process. It still has “legal” expression even if not binding. Under some circumstances, management can refuse to put a shareholder proposal to the shareholders. In the US, management can reject proposals that (1) are directed toward business matters because the shareholders should not second guess the business decisions of the management, or that (2) does not involve a policy questions. The Canadian approach takes the opposite focus; the CBCA allows shareholders to make business proposals but excludes public policy proposals. Shareholders in Canadian corporations risk doing damage to their message by framing social issues (such as child labour) into business concerns (such as unfair trade practices). It dilutes the message. According to Dhir, even after legislative reforms in 2002, the Canadian approach does not remove the public policy exception. Management can exclude proposals if they do not involve business matters. It is difficult to understand why executives think that it is a good idea to reject proposals. It just exposes the corporation to greater medial coverage. Paradoxically, proposals are non-binding measures but can have the greatest impact, while voting is a binding measure and it does not. The following two cases are on opposite ends of the corporate law spectrum. The Dodge case highlights the pre-dominance of the shareholder primacy model, while Paramount shows the predominance of the entity model. Dodge v. Ford (1919) Mich. Sup. Ct. Facts: Dodge invested money in Ford. The Board was paying dividends at a rate of 60% per year to the shareholders. Dodge claimed that the dividends were too low. Ford claimed that the shareholders were already getting a huge dividend, that the company needed money for its expansion plans, and that the vision of the company involved employing more Americans at higher wages, to build the economy and to produce less expensive cars. Issues: Was Ford entitled to withhold dividends from the 50 shareholders when the profit margins were so large? Holding: No. Reasoning: Despite the rule that says that discretion lies with the directors to declare dividends, the corporation cannot be run so as to benefit the shareholders incidentally. Rationale: When corporate profits are very high and there is money available to invest in the corporation, the Director will have to exercise its discretion to declare a dividend. Note: In the early 20th century, governments were still distrustful of corporations. Their corporate charters limited the industries they could venture into. They had caps placed on the amount of available capital. Also, as a subtext to this case, the court might have been aware that the Dodge brothers wanted to start their own company. They needed capital to compete with Ford, which might have motivated the court to pay out more dividends to the Dodges. This case also might have been informed by notions of partnership law. Under a partnership, the earnings are split between the partners. Paramount v. Time (1990) Del. Sup. Ct. Facts: Time wanted to grow its business and it was looking for a partner corporation to undertake a merger. It did not want to give up its journalistic integrity and it wanted to merge its cable services with compatible services. The Board met over a period of several months to discuss possible partners. It settled on Warner Brothers. Paramount, however, made a bid to acquire all of the shares of Time in an all cash and shares offer. Time management resisted the takeover and restructured its agreement with WB. Issues: Was the Time Board required to put the takeover bid to the shareholders? Holding: No. Reasoning: Paramount made two claims: a Unocal claim and a Revlon claim. 51 1. Unocal claim Under the test defined in Unocal, the directors are entitled to resist a takeover when there is a reasonable belief that the takeover will harm the corporation. The directors can account for a range of factors, and the shareholders’ interests are not controlling. They must act proportionally to the response. The purpose of the Unocal analysis is not to compare the value of the ultimately proposed offer and the plaintiff’s proposed offer. The Board was entitled to consider the other threats posed by Paramount – including their belief that Paramount could not meet the needs of the company. The Board had already rejected Paramount as possible merger candidate. This case actually identifies what we mean by the interest of the corporation – distinct from the interests of a particular group. The interest of the corporation is the preservation of an independent and credible news service with journalistic integrity. Paramount was seen as a threat. 2. Revlon claim When the sale of the company is inevitable, the duty of the directors is to maximize shareholders’ return (since there is no corporation anymore). Paramount argued, to no avail, that mergers trigger Revlon duties. The break up of the company was not inevitable. “The question of “long-term” versus “short term” values is largely irrelevant because directors, generally, are obliged to chart a course for a corporation which is in its best interests without regard to a fixed horizon. Rationale: The Board has the authority to chart the course of the corporation without thinking constantly about maximizing shareholder value in the short-term. Note: Perhaps that the “interest of the corporation” is an instrumental argument, in which the court is recognizing the interests of the employees who benefit from large news budgets. 52 In the takeover context, we do not have a fixed idea of how we conceptualize the corporation. In a single case, we see both the shareholder and the stakeholder theories. Sometimes, both are reconcilable (as in Teck), when in the long-term, the shareholders are better off when the takeover is resisted to protect (1) creditors, (2) employees, or (3) corporate vision. In Revlon situations, there are no long-term interests, because the death of the corporation is inevitable. According to Stout, it may be in the shareholders’ own interests to keep a take-over bid from them. They might be better off in the longterm by a corporation with a vision and a plan for development. Stout dismisses the shareholder primacy arguments to explain that the shareholders are not the owners of the corporation; they invest some of the capital and only hold shares, or personal rights, in the corporation. The fact that shareholders are residual claimants is a concern of bankruptcy. In such situations, shareholders likely will get nothing anyway. Stout emphasizes the TEAM PRODUCTION MODEL of the corporation. The fortunes of the shareholders, employees, directors, and creditors rise and fall with the success of the corporation. This is a built-in expectation in corporate law. If corporate law was designed to benefit shareholders only, then there would be less of an incentive for the other players to participate in contributing to corporations. If shareholders wanted shareholder models, they would have emphasized this in enabling statutes. There are few examples where the authority is given to the shareholders or where their interests are considered – which should evidence an alternative conception of the corporation. Allen says that the shareholder-stakeholder problem will never be resolved. We can see the language of both in a given cases, and the courts will shift back and forth on which theory they will prefer. Additional Notes: An underlying tension in this area of the law is the one-size-fits-all nature of corporate law. We see this with the duty of care and with legal personality. There may not be a legal difference between a mom-and-pop corporation and a multinational, but the two types of companies are functionally different. The 53 multinational has an identity (Time) and “interests” where with smaller corporations, the interests of the company and the principle shareholder may not be distinct (see insurance cases, infra). Corporations are set up to be self-governing. Within the corporate governance model, however, there are problems that cannot get resolved. This is where the courts should intervene. When the directors do not conform to their obligations, affected parties need a recourse (the “safety” valve). 54 JUDICIAL SUPERVISION Derivative Action The courts will intervene in the affairs of the corporation when the directors or officers are abusing their powers and are in breach of their legal duties. The CBCA spells out in detail the recourses available to interested parties (“derivative action”). The CCP, however, has a single provision (Art. 33, the “oblique action”) which confers authority to the superior court to remedy an abuse of powers. The difference in results, however, is negligible, given the importation of common law case authority into Quebec (see Martel). Interference with corporate affairs has ramifications on legal personality. The corporation may be harmed by its directors by not receiving value for an asset (Daniels), but this harm can affect shareholders because their shares will be devalued, or can affect creditors because the value of the corporate patrimony is reduced. 55 For a long time, however, minority shareholders and creditors could not complain. Although the directors might have abused their rights, only the majority shareholders could step in on behalf of the corporation and sue. However, if the majority shareholders controlled the Board and could confirm the actions of the directors, no one else could intervene, except in cases of fraud (Foss v. Harbottle). Corporate law did not have an equivalent bill of rights. This leads to two concerns: (1) If we are going to take legal personality seriously, why should the majority share holders get to absolve the directors of liability? (2) What do the other interested parties do? Every time the directors move assets out of the corporation, they deprive employees, creditors, and shareholders value. This is ironic because at the time the courts considered shareholder primacy the norm, but if the corporation is harmed, the shareholders only suffer indirect harm. Before you can bring a remedy under the CBCA, you must be a proper plaintiff. By allowing anyone that the court thinks is a “proper person” can still bring a complaint on behalf of the corporation. So far, it has only been used by creditors and prior shareholders. See section 238 CBCA. Daniels v. Daniels (1977) Ch. Div., UK Facts: The plaintiffs, minority shareholders, complained that two of the directors sold land to one of the company’s directors for less than market value. The defendants moved to strike on grounds that the claim does not disclose a reasonable cause of action. Issues: Can the plaintiffs make a derivative claim? Holding: Yes. Reasoning: The persons who hold and control the company will not permit and action to be brought. The court should not let the harm go unaddressed. Fraud is not required to allow a minority shareholder to sue on behalf of the corporation. If directors or officers abuse their authority and they, or the majority shareholders benefit from the breach, the other shareholders can act. 56 Rationale: Minority shareholders can sue the directors on behalf of the corporation if the majority shareholders or the directors benefit from the breach. It is often difficult to distinguish between harm done to the corporation and harm done to the shareholders. This leads us to question: do we really need a derivative action? It may be better to complain about harm to oneself, so that they can get a remedy. Consider Regal Hastings. The new shareholders received the benefit of the suit, even though the old shareholders held the shares in the company when the directors breached their fiduciary duty. As a result, the new shareholders benefited from a discounted share price. There are arguments for derivative claims. The plaintiffs do not need leave from the court and the court can provide remedies for individuals as well as the corporation. Iacobucci and Davis argue that there is no procedural reason why a plaintiff should not be able to bring a derivative action under the oppression remedy. However, the derivative action and the oppression are different causes of action. Derivative actions look at the application of legal rules and powers, whereas the oppression remedy is an “equitable” remedy based on concepts of good faith. 57 Oppression Remedy The court cannot shield plaintiffs from business risk. The oppression remedy is subject to the same problems as contract law, because the court may re-write terms to remedy injustice. It is hard to determine “reasonable expectation”. Consider the following situations: A, a shareholder, receives dividends for sale of a product. The government then makes the sale of the product illegal. What are the reasonable expectations of A? On one hand, the shareholder should have accepted the risk that the government would render the sale of the product illegal; or, the shareholder had an expectation in the share of the profits and should be entitled to dividends based on the sale of other products. A is a bondholder and at the time of issuing the bond the corporation had little debt. The corporation was bought out in 58 a leveraged buy out and the value of the bond dropped significantly. Does A have a remedy based on reasonable expectation? Before the buyout, bondholders never anticipated the buyout. The oppression remedy is akin to the Charter of Rights and Freedoms of corporate law (see Budd v. Gentra, below) 1. No breach of the legal duty required Intervening decisions have altered the risk to the plaintiffs, which puts the plaintiffs in a worse situation. The directors do not need to breach legal duties. By virtue of a decision, often made within lawful authority, can have an effect on the “reasonable expectations” of the parties. The courts are no longer constrained by the powers of directors and officers and majority rule. A director may have met the legal duty, but the interests of a party are harm. The courts had to resolve what happens if the directors have breached a contract in the interests of the corporation, but they have affected the interests of protected parties. Unless the “expectation” is reasonable, then the plaintiff cannot complain. The complaint must meet an unfairness standard. Directors can be prejudicial. Every decision will hurt someone’s interests. The legislature could have created a “duty not to be oppressive” but instead, it drafted the remedy only. This is because the court cannot tell in advance when conduct is oppressive – it just knows when a case comes to court, looking at the facts, that the outcome was oppressive. This sort of ex post analysis requires that directors take more time to assess decisions – increasing transaction costs. 2. Broad Remedial Powers Business flexibility needs to account for an infinite variety of factual circumstances; but there is an introduction of uncertainty which leads to higher transaction costs. The plaintiffs must establish that the actions are “oppressive”, “unfairly prejudicial” or that they “unfairly disregard interests”. 3. Justifying the Oppression Remedy 59 Maybe we should limit oppression remedies to family firms. In those contexts, the parties have not had access to legal advice. There are family conflicts, which translate into corporate problems. In larger publicly-traded companies, the shareholders can sell their shares, which do not always have recourse to sell their shares (capital contribution with shares no one wants to buy). Notice how the creditor is the odd-person out. It is not generally included in the corporate governance triangle, yet creditors are brought into corporate governance because they can sue the corporation or its directors for oppression. 4. Development of Standards Initially, it was thought that the oppression remedy should be limited to vulnerable parties or to small closely-held corporations. However, there is a relational aspect to the oppression remedy. The parties expected things to work a certain way. They didn’t. Now the complaining party wants to put the situation back to meet their reasonable expectations. There are situations in which nonvulnerable parties may need the benefit of a remedy (i.e. a deadlock on the Board) If the law confers authority on the directors to manage the corporation, gives the shareholders the right to vote, then the courts should not interfere unless these mechanisms fail and the directors did not exercise their authority properly. The corporation is not just an investment vehicle for the majority shareholders. As in contract or family law, the courts can intervene when relationships break down and one party acts in an “unconscionable” manner. The law is not concerned that other remedies might be available;7 the remedy is not one of last resort. If the law imposes too much accountability, however, then the courts will begin to second guess the decisions of the directors. This is why the courts will not give remedies based on the wishes, hopes, or aspirations of the parties. However, there may be situations where the directors acted in compliance with their duties but they may not 7 First Edmonton could have filed a claim under the landlord-tenant regime. 60 have met the reasonable expectations of the parties (see e.g. Peoples v. Wise). The good faith of the directors is irrelevant. The oppression remedy protects the interests of the shareholders, creditors, directors, and officers against unintentional as well as intentional harm. 'In determining whether reasonable expectations existed and had been violated a heavy weight was to be given to private ordering by way of the corporate constitution's allocation of rights or by way of contract. The courts should be reluctant to alter this balance by invoking the oppression remedy. To cases which usefully illustrate this approach are the trial decision in 820099 Ontario Inc. v. Harold E. Ballard Ltd. and the appeal decision in Westfair Foods v. Watts.' (Chapman) Naneff v. Con-Crete Holdings Ltd. (1995) O.C.A. Facts: The father was the founder of the family business. He has two children, Alex and Boris, both of whom became involved in the family business. Through an estate freeze, the father made his sons equal owners of the common shares of the company, while retaining control of the business through voting shares. Alex, the plaintiff, began to keep company with a woman whom the parents disapproved. Alex was removed as an officer and excluded from participation in the company. He was cut off financially as well. Issues: Is Alex entitled to a remedy from oppression? Holding: Yes. Reasoning: Per Galligan JA: Section 248(3) of the Ontario Business Corporations Act gives the court broad discretion to fashion a remedy. The remedy does not seek to punish but seeks to correct. In determining whether oppressive conduct has occurred, the court must look at the reasonable expectations of the parties. It is not a “wish list” of the shareholders. Because Alex would not have expected control of the company while his father was alive, he is not entitled to an oppression remedy that would allow him to do so.8 The appropriate remedy would be to 8 Blair J, the trial judge, ordered that the corporation be put up for sale. This could have allowed Alex to secure a loan and buy the firm. 61 require that Boris and the father acquire Alex’s shares. This would compensate Alex for his contributions to the family business. Rationale: A plaintiff seeking an oppression remedy is not entitled, by virtue of said remedy, to be put in a position that would have bettered its reasonable expectations.9 5. Bringing an Oppression Claim to Court As stated above, before you can bring a remedy under the CBCA, you must be a proper plaintiff. By allowing anyone that the court thinks is a “proper person” can still bring a complaint on behalf of the corporation. So far, it has only been used by creditors and prior shareholders. See section 238 CBCA. In addition to being a proper The plaintiff must allege that the exercise of powers has been unfairly prejudicial to the interests of a (1) security holder, (2) creditor, (3) director, or (4) officer. This means that standing to bring the action is broader than the nature of the interests that are affected (section 241 CBCA). This provision gives access to creditors to bring an oppression claim. But, quantifying business risk is the work of creditors. Iacobucci and Davis argue that in cases when the corporation approaches insolvency, the interests of the shareholders and the creditors are diametrically opposed. The shareholders will want to gamble all of the assets – whereas the creditors will want to preserve the assets in order to get paid; creditors, therefore, are more aligned with the interests of the shareholders (see e.g. Peoples v. Wise). Access to the oppression remedy gives stakeholders a stronger role in corporate governance. This remedy is another entry-point for shareholders to have control over corporate affairs. The list of remedies is so long because the legislature wants courts to exercise their authority to undo harmful transactions. Does it make sense to allow creditors to make an oppression claim? To make a successful claim, the creditor must argue (1) that there 9 In larger corporations, it is easy to sell your shares; it is harder to do so in smaller family-owed corporations. 62 was a breach of an underlying expectation or (2) that the directors used the corporation to commit fraud. The creditors can do so by arguing inequities beyond the fact that the debtor did not pay its bill. It needs to allege that there was: An inequality of bargaining power (trade or supply creditor) Could not have protected themselves in advance; the court is not going to re-write a bad contract but to fill in the gaps. Has the corporation done something legal but prejudicial to the creditor? It is really hard to think of circumstances when this is the case. If the reasonable expectations are reasonable and knowable then the director and the creditors will know about them in advance. The oppression remedy is not intended to subsume contract law, securities law, etc. It must be something else. It would have been very hard in the Peoples case to argue that the directors frustrated their expectations in a falling retail market.10 It seems that there has to be a breach of a legal duty that compelled the creditor to change its position. Iacobucci and Davis argue that when the corporation approaches insolvency, the shareholders don’t care about the corporation – only their shares. The role for creditors is narrow and only in situations of insolvency where the risk of malfeasance or gambling with the assets is high. Employees, like creditors, are vulnerable too. As the creditors supply goods and cash, employees supply labour and expertise. Do they have a reasonable expectation in the profits of the company? Probably not. They might however have a reasonable expectation to keep their jobs in good economic times (plant problem). The team production model (Stout) would expect that the employees could benefit from the oppression remedy. Maybe Peoples should not have taken on more debt that it needed – which undermined its reasonable expectations. 10 63 6. Distinguishing Between the Two Remedies Conceptually, there is a difference between the derivate action (on behalf of the corporation) and the oppression remedy. The court made the distinction in the First Edmonton case below. First Edmonton Place v. 315888 Alberta Ltd. (1988) Alta. Q.B. Facts: FEP (landlord) transferred approximately $250, 000 to the numbered company as a leasehold improvement allowance and signing bonus. It also allowed the company to rent the premises for a rent-free period. The company transferred the money to its directors and vacated the premises after the rent-free period was up, in violation of the lease. The landlord is suing the directors personally so that they can recover the bonuses. Issues: Is the landlord, as a creditor, entitled to file a derivative action or an action in oppression? Holding: The landlord was the proper person to make a derivative claim and the court granted leave. The landlord did not have a reasonable expectation that the corporate respondent would retain the signing bonus and therefore it cannot sustain its claim for oppression. Reasoning: The purpose of the remedial provisions is to ensure that the rights of creditors, minority shareholders, and the public are protected within corporate law [stakeholder model]. The view that the management of the company falls exclusively within the hands of the directors is no longer current. The wrongdoers should not be able to prevent others from undoing the effect of the wrongdoing. 1. Derivative Action It is highly unlikely that a “toxic” board will bring an action against itself. The derivative action allows a complainant to bring an action against the directors, on behalf of the corporation, with leave of the court. The complainant must act in good faith and must demonstrate that the case is “prima facie in the interests of the corporation” so as not to “harass” the directors. 2. Oppression Action The provision gives the court the authority to remedy conduct that is 64 considers to be oppressive with remedies that are “just and equitable.” The remedy does not purport to deal with unpopular decisions. It should not supplant the legitimate exercise of the Board’s power. The exercise of the Board’s power must pass a threshold of oppressiveness. The court will gauge the oppressiveness of conduct by looking at the “reasonable expectations” of the injured party. The court will assess the following factors: the closeness of the company and the nature of the proprietary interests. 3. Application to the case In this case, the landlord is not a “creditor” under the act because it dos not hold a debt obligation like a bond. However, the landlords does fall within the generalized category of “complainant” because it is the proper person to make the application for a derivative action, but not the proper person to make an oppression action. 1. There is no evidence that the directors used the corporation as a vehicle for committing a fraud against the creditors (even though they may have perpetuated a fraud against the corporation).11 2. The creditors did not have an underlying expectation that the signing bonus would remain with the corporation. The “good faith” requirement is supposed to prevent private vendettas from being litigated. The landlord is acting in good faith because it wants to ensure that the corporation has assets to fulfill the breach of the lease claim (which the landlord will file/has filed). The court also rejected the landlord’s oppression claim on the grounds that it did not affect the interests of creditors. At the time that the landlord complained of the actions of the directors, it did not owe the creditors a present obligation to pay the rent; the landlord had 11 This shows that the corporation may have an “interest” being protected. 65 only a future right to the rent. Creditor, when given its plain and ordinary meaning, does not apply in this circumstance.12 Rationale: A landlord can file a derivative action on behalf of a corporation when the landlord seeks to recover money used to satisfy rent and when the landlord is doing so in good faith. This was a self-dealing transaction and a breach of the duty of loyalty. In these circumstances, it is easy to see that that the creditor can claim oppression. The actions of the directors have increased the risk to the creditor. Personal Liability of the Directors in an Oppression Claim Budd v. Gentra (1998) O.C.A. Facts: The plaintiff-appellant, Budd, is a former shareholder of Royal Trust Co, and is bringing a class action on behalf of the members of the Litigation Committee of shareholders. The appellant alleged that the company’s funds were mismanaged, that the financial disclosure statements were incomplete and that the sale of assets to Royal Bank took place at the detriment of the shareholders. In 1992, the company reported a sharp decline in profits but projected that its earnings would improve. The next year, the company took a huge loss and sold off substantially all of its assets to Royal Bank. The appellant also alleged that the defendant, Gentra, should have disclosed that another controlling entity was running Royal Trust Co among other claims. Issues: Does the claim frame a reasonable cause of action in oppression? Holding: No. Reasoning: Per Doherty J.A.: Officers of limited liability companies are protected from personal liability unless their actions are themselves tortuous or exhibit a separate identity or interest from the company so as to make the conduct complained of their own (ScotiaMcLeod v. Peoples Jewellers). The court narrows the definition of “creditor” in order to restrict the application of the oppression remedy in this context. 12 66 The plaintiffs failed to ground this allegation in their claim and therefore the claim was rightfully struck. The language of section 241 pertains to “acts or omissions of the corporation” and “the powers of the directors of the corporation.” Actions by directors not attributable to the corporation do not fall under section 241, therefore. The oppression claim is different from the Peoples claim; under the former, a person alleges that the corporation, through the actions of its controlling minds, has acted oppressively. However, if a director is implicated in oppressive conduct and rectification of the conduct is appropriately made by a personal order against the director, the court can issue said order under section 241 [This seems somewhat contradictory]. To make such a claim, the plaintiff must establish: (1) That the acts of a particular director provided the basis for the oppressive actions of the corporation; (2) That the court could rectify the situation by issuing an order against the director personally. The plaintiffs failed to allege either ground in their claim. The case law provides examples of situations when the court should hold the directors liable personally: when the directors benefited personally from the conduct, furthered their own control of the company through their conduct, or the director of a closely held corporation exercises total control. Rationale: There is a difference between personal liability (under Scotia) and making an order against a director. The issue is whether it is appropriate to rectify the oppression by directing an order against a director. It is about making an order to rectify the oppression. The director does not have to be negligent in private law in order to have to be the object of the damages. The impugned activity in Budd involves a breach of the duty of care and loyalty, but the claim was for oppression. 67 In Quebec civil law, there is no legislative basis for an oppression remedy. Like the common law, the courts were reluctant to allow oppression remedies because the courts regarded corporations as internal governance mechanisms. The directors had the authority to manage the affairs of the corporation and they were accountable to the shareholders through the voting system. Gradually, Quebec courts recognized that minorities may be disadvantaged by the actions of the majority. Quebec courts began to apply Art. 33 CCP; however, questions arose as to whether the courts were implementing “judicial legislation”. Had the common law not enacted an oppression remedy – maybe Quebec judges would not have been so concerned. Martel and Paquette ask: what explains the reticence of the commercial courts? The powers under Arts. 6,7 C.C.Q. and 33, 46 CCP are extremely broad. Can Quebec courts go as far as s. 241 CBCA? In Desautels, the sister and the brother-in-law tried to squeeze out the plaintiff. The court could not ignore that Art. 33 CCP is expanding; however, the court was uncertain as to whether this was possible. Arguably, it is must less interventionist than to incur the costs to wind up the company. Winding Up in Quebec: The Corporate Death Penalty All that these plaintiffs wanted was an out. They thought that they would get along, but they didn’t. The corporation is broken up and the shareholders get a pro-rata share. Why not just give the liquidated value back to the plaintiff? By destroying the corporation, the order affects the employees, the contracting parties, trade-creditors. There is a tremendous sense of economic waste. The value of the going concern (and its goodwill) is lost. When these cases were decided there was no oppression remedy in Quebec. It would have been easier to compel the corporation to buy out the shares. Instead, the court has to go through the winding up process and “kill” the corporation. 68 Candiac v. Combest (1993) Qc. C.A. Facts: Unahl is the majority shareholder of Candiac, and Combest is a minority. The property that the corporation holds is going to be rezoned and increase in value. Combest wanted to divest itself, but decided not to, because it realized that the value would increase. Unahl tried to take over the corporation to secure the benefit for itself. Combest argued that given the sustained practice of abuse by Unahl, they want out; they are worried that Unahl will transfer all of Candiac’s value to Unahl. Issues: Is Candiac entitled to a wind up order? Holding: Yes. Reasoning: Per Rousseau-Houle JA: Combest made the following allegations against Candiac: 1. Insider knowledge that the land was going to be rezoned (information was kept secret from Combest) 2. Firm paid management fees to another corporation controlled by FRAM. Given the fact that Candiac is not doing any business, these management fees are not justified. Rousseau-Houle struggled with the proper remedy to order. He looked at the CBCA, which contains an oppression remedy, and found no such equivalent in Quebec civil law. The judge held that he was bound to issue the winding up order in this case and even so, he determined it to be appropriate in light of the abuse by the majority shareholder. Winding up a corporation occurs against the wishes of the corporation. Courts can consider winding up a corporation when it is “just and equitable” to do so (Winding Up Act, s. 24). Candiac argued that it should be available as a remedy of last resort. The court rejected this argument and held that “just and equitable” does not depend upon the existence of other remedies. Courts should be very careful about winding up a corporation that is a going concern, because of the effect on third parties. There has been a pattern of sustained abuse that will continue. It is unfair to keep the minority shareholder in a position where it has to come to court to litigate. 69 Rationale: When there is no expectation that the situation will improve the court can order the winding up of the corporation. Lutfy v. Lutfy (1996) Qc. Sup. Ct. Facts: The applicant and the respondent were brothers. Both shared managerial responsibility for the company. The respondent, however, held all of the voting shares. The brothers found it increasingly difficult to work together. The relationship between the brothers deteriorated to such an extent that they called in a management consultant to explain to them how to work together. The respondent moved increasingly into the sphere of the plaintiff. During the plaintiff’s absence, the business tanked. The brothers were left at a complete impasse and the applicant applied to wind up the corporation. Issues: Is the applicant entitled to the wind up order? Holding: Yes. Reasoning: Winding up is an “equitable remedy” and it need not be reserved for situations of last resort. It may be ordered when there is (1) an impasse or deadlock, (2) loss of confidence in management, (3) the partnership analogy doctrine? or (4) loss of substratum or raison-d’être. Loss of Confidence in Management The court found the applicant’s contention of loss of confidence justifiable. Despite the recommendation of the planning consultant, the respondent continued to involve himself in the planning processes. He denied the applicant access to financial information. During the enforced isolation of the applicant, the company suffered heavy losses. The applicant’s financial position was “locked in” during that period and he could not realize the interest of his investment. The court also must consider the effect of the wind-up order on the interested parties. Although the order would prejudice the current employees, the court found that it could be possible to keep the business going as a going-concern by members of the Lutfy family. 70 Rationale: Where a person holds a substantial portion of the equity in a company, where that person has established grounds showing loss of confidence in management and where the interests of third parties are not unreasonably affected, the court can order the wind up of the corporation. Always draft an exit strategy for the termination of corporations. If we think that the oppression remedy is intrusive, the winding up action is even more so. There are such high transaction costs. Arguably, the oppression remedy provides a really simple solution: buy back the plaintiff’s shares. Additional Notes: Reasonable expectations underlie the relationship between the stakeholders of a corporation. This is a zone of “sub-legal expectancy” which the parties cannot plan for (see Stout article). Maybe detrimental reliance is a better test, but it may be that the courts use detrimental reliance as a limiting tool anyway. Although it is difficult to understand how creditors can have a breach of legitimate expectations when the corporation is solvent, under insolvency, the creditors will expect that the directors do not gamble the assets of the corporation away and preserve those assets for the creditors. Minority shareholders, too, have reasonable expectations. They expect that the majority shareholders will not forego corporation property or opportunities when they sell their shares (Perlman). As for employees, they, like creditors contribute to the corporation. However, the law makes a distinction between contributions of labour and capital. It is hard to find a situation when the corporation would oppress the employees. Employees are protected by other forms of law (employment/labour) and by collective agreements in the case of unionized employees. They are in a position to negotiate directly with management. 71 72 PIERCING THE CORPORATE VEIL At the beginning of the course, we learned how legal personality was a fundamental component of the corporation. A person may ask to lift the corporate veil under two circumstances: (1) A person has been harmed and wants to get at the assets of another corporation or person; (2) A person wants to access the assets of the corporation or plead on its behalf. Art. 317 C.C.Q. provides: In no case may a legal person set up juridical personality against a person in good faith if it is set up to dissemble fraud, abuse of right or contravention of a rule of public order. This provision does not create a new obligation. It only provides a reason to break through legal personality. The provision has two elements: a “deception” element and the circumstances (fraud, etc.). When a shareholder uses the corporation as a “sham” then the justification to protect the corporation’s assets erodes. Recall the Saloman decision. In that case, the business was a going-concern when he incorporated. Saloman did not create the corporation for the purpose of defrauding his creditors. There does seem to be a higher risk that one-person corporations are more likely to be the alter-egos of their shareholders. Single-shareholder corporations should not be a sufficient requirement to pierce the veil. Fraud is intentional deception for personal gain. Public order rules are mandatory, and therefore parties cannot deviate from those rules under contract. Abuse of right is an unreasonable exercise of rights. Abuse of rights plays a role similar to equity in the common law. Does “abuse of rights” belong here? Fraud and contravention of a rule of public order work with the “deception”/ concealing idea. Shareholders can use the corporation to do something that they themselves cannot do. Abuse of rights does not fit well with this, as extra-contractual obligations are imported into this. We saw an example of this problem under the old code, as the courts could pierce the corporation veil for a breach of contract and even in a parent-sub relationship. If there is no underlying principle, then the provision weakens legal personality. 73 Abuse of rights has both a subjective and an objective component. 13 A court, therefore, does not need to find bad faith to find an abuse of rights (see Houle, infra). Because of the objective component, a shareholder/director could act unreasonably and be found liable under this theory. Note, though, that under some circumstances it is necessary for director-shareholders to act unreasonably in order to protect the corporation. Martel (majority view) explains that Art. 317 C.C.Q. applies to shareholders and not to directors or officers. To find directors liable, a person must use Art. 1457 C.C.Q. Director’s personal actions that cause injury falls within the scope of private law; they can be sued separately for their own negligence. A plaintiff, however, could not get at the shareholders qua shareholders without Art. 317 C.C.Q. The courts should disregard legal personality exceptionally and the provision should be narrowly construed. Crete & Rousseau (minority view) explain that there may be evidentiary benefits to allowing directors to be impleaded under Art. 317. The purpose behind the provision is to address concealment and is not concerned with the identity of the actors. If anyone, including the directors, use the corporation for instrumental aims, they should be held liable. It creates another basis for liability. The court is reluctant in the case of contractual breach. It may be economically inefficient to breach the contract. Sophisticated parties are aware that corporations will breach their contracts when it is efficient to do so. 1. Impleading persons behind the corporate veil Transamerica Life v. Canada Life Assurance (1996) OCGD Facts: The plaintiff corporation sued the parent company (parent-co) of its co-contractor, as the subsidiary (sub-co) did not have sufficient assets to pay its obligations. The plaintiff contended that the sub-co – a mortgage broker -- should have done a risk assessment of its 13 7. No right may be exercised with the intent of injuring another or in an excessive and unreasonable manner which is contrary to the requirements of good faith. 74 clients. Issues: Should the court allow the claim against parent-co? Holding: No. Reasoning: The court described the relationship between parent-co and sub-co as follows: sub-co had its own head office, it was managed independently of parent-co, parent-co dealt at arms-length with sub-co. Parent-co had not been involved in any dealings with the plaintiff, nor did the two parties communicate with each other. The plaintiff is a sophisticated party that should have known that it was dealing with a subsidiary corporation that might be underfunded. The plaintiff should not have considered parent-co to be an underwriter for its losses. Applying Saloman, the parent-co and sub-co are distinct persons. Only where there is a compelling reason to break down the corporate veil will the courts do so. The entities must act as a “single business entity”. Otherwise, the risk is that the courts will engage in “palm tree justice”. Common law jurisdictions do not have statutory provisions that provide for the piercing of the corporation veil. Rather under the common law, the corporate veil can be pierced when: (1) Legislation allows it; (2) The corporation is a mere sham used to shield fraudulent or improper conduct [this is problematic]; (3) When the corporation is acting as an agent. Rationale: Without evidence of fraud, the court will not pierce the corporate veil and implead a parent corporation. The concept of “improper conduct” is problematic because the concept can go further than mere abuse of rights. Again, if the principle under which a court can disregard legal personality is incoherent, then it undermines legal personality as a foundational principle of corporate law. What seems problematic for the courts is that there is a tendency to find a human person responsible for the corporation’s misconduct. It is difficult accept that responsibility lies with a 75 corporation when human persons made decisions that led to the harm. Walkovszky v. Carlton (1966) N.Y.C.A. Facts: Walkovsky was hit by a driver employed by Carlton’s company. Carlton structured the company so that the company would be a conglomerate of smaller sibling corporations. Each corporation has two cabs and the minimum amount of liability insurance. Walkovsky sued Carlton as the principal shareholder arguing that the sibling corporation was a sham. Issues: Is Carlton personally liable as a shareholder? Holding: No. Reasoning: The court rejects the plaintiff’s “enterprise theory” of liability. The defendant is entitled to structure the company for tax advantages and to minimize the risk of liability. The court also rejects the plaintiff’s “fraud theory” as the corporation was not set up fraudulently. Had the legislation required that cab companies assume greater insurance, it would have stated so. Walkovsky should not be able to win the accident lottery by having access to deeper pockets. Rationale: The court was unwilling to disregard legal personality because the debtor was undercapitalized. Critique: Per Keating J: In this circumstance, legal personality is being abused. Maybe Carlton is using the right to incorporate as an abuse of rights. Carlton sets up a “flimsy corporation” to minimize liability. The firm was intentionally under-capitalized. Cab driving involves more than an “ordinary” risk. Carlton anticipated the risk which is why it under-capitalized. This shows concealment and fraud. If we apply Art. 317 to Carlton, it may work. 2. Accessing the assets of the corporation National Bank v. Houle (1990) SCC Facts: The Houle Brothers were shareholders in their family company. The company had a credit line with the Bank with whom they had a 60-year relationship, which was supported by a security 76 signed by the shareholders and a trust deed on all the company’s assets. The loan was a demand loan, thus bank had a right to recall the prestation on a moment’s notice (similar to Soussice). Aware of the impending negotiations of sale of the company to new shareholders, the bank informed company of loan recall and took possession of the assets three hours later. The Houles closed sale of company but received $700 000 less than expected and are claiming this amount from the bank. They ask for a lift of the corporate veil. Issue: Did the bank abuse its contractual right? If so, can the respondents as third party shareholders to the contract, ground an action in contractual liability? Held: Recall of loan without a reasonable delay amounted to an abuse of bank’s contractual right to recall loan with no notice. The Houles, however, could only claim on grounds of extra-contractual liability, since they were third parties to the contract. Reasoning: The doctrine of abuse of contractual rights is part of Quebec civil law. The criteria for the abuse of contractual rights is not malice or bad faith. A contractual party has an implicit obligation to undertake the “reasonable exercise” of a contractual right. The support for this is 1053 (the standard for extra-contractual liability is “reasonableness”) and 1024 CCLC (an implicit obligation of contractual parties to exercise rights in accordance with rules of equity and fair play). The abuse of a contractual right gives rise to contractual liability, but third parties to the contract have no right of action in contractual liability. There is no privaty of contract between the Houles and the Bank. This is so to limit risk only to the parties involved. In ECO, the idea of neighbourliness/duty-of-care fulfills a similar function. The Houles effectively multiplied the courses of action by filing an ECO claim. The bank did not abuse its contractual right to recall the loan (it had reasonable explanation for doing so), however it abused its contractual right to realize securities after the demand for payment was not met. The right was exercised unreasonably (without sufficient delay) when the bank knew of the impending sale of the 77 company. What is the standard of industry practice? It could establish a reasonable standard of care. The court ruled that people cannot contract for an abuse of rights: the bank acted in a sudden and impulsive manner. The abuse of rights also falls under extra-contractual obligations (bank committed a delict). The court did not lift the corporate veil to protect the Houles on contractual grounds. The bank’s impulsive and detrimental repossession and sale of the company’s assets after such a short and unreasonable delay, while fully aware of the respondents’ imminent sale of their shares, was a fault entailing its liability for the ensuing direct and immediate damage caused to the shareholders. Rationale: Criteria for abuse of contractual right is not malice or bad faith but “reasonableness”. The court recognized the implied obligation to exercise a contractual right in a reasonable manner (now codified in Article 7 CCQ). This case provides relief to parties who themselves are not in privity of contract. Kosmopoulos is the flip side of Lee’s Air and Saloman. If the corporate veil is lifted for the benefit of the sole shareholders, then there would be no principled reason to refuse to lift it for the creditors. Kosmopoulos v. Constitution Insurance Co. (1987) SCC Facts: Kosmopoulos purchased insurance for the property of his business. Kosmopoulos incorporated his sole proprietorship in the advice of his lawyer. All of the documents, including the insurance papers, referred to Kosmopoulos operating as Spring Leather Goods. After a fire damaged the premises, Kosmopoulos tried to claim the insurance proceeds, but the insurance company refused payment. The company claimed that the company needed to insure the premises. Kosmopoulos forgot the “little details”. This often happens, especially in small family firms; should have sued the lawyer, but didn’t. 78 Issues: Is Kosmopoulos entitled to claim the proceeds? Holding: Yes. The court did not have to pierce the corporate veil to issue the proceeds. Reasoning: Per Wilson J: Citing Saloman, a legal entity is distinct from its shareholders. The court will lift the corporate veil when the company acts as a mere agent or puppet of the controlling shareholder. Those who have chosen the benefits of the corporate form have to assume some of the risk. This is not a corporate law problem – it is an insurance problem. The court held that Macaura did not apply in this circumstance. Kosmopoulos had an insurable interest as the sole shareholder of the company. But for the fire, he was the beneficiary of the assets of the company. He benefited from the existence of the assets and was prejudiced by their destruction. Wagering was not an issue. It might have been had there been more shareholders (say 2, 5, 10, etc.). The insurance company is raising a “technical objection” to deny insurance when everyone knows that the corporation’s assets were meant to be the object of the insurance.14 The oppression remedy is always available if some of the shareholders insure the assets of the corporation and the corporation’s assets are destroyed (when there are multiple shareholders). Secured creditors might be able to access those funds. Rationale: Sole shareholders retain the benefits of the assets of the corporation and can insure those assets. This case problematizes the one-shareholder corporation. It conflates the interests of the sole shareholder with the corporation, even though they are distinct legal entities. Courts are reluctant to engage in piercing the corporate veil for 1person corporation. It is not enough that there is 1 person. The corporation has to be an instrument to further the interests of the individual; a sham. 14 This change to insurance law is a minor problem that will not have wide-spread implications on the industry. 79 Marzell is entirely consistent with Kosmopoulos. Reluctantly, rhe court did not favour Marzell. Marzell v. Greater London Council (1975) Lands Tribunal Facts: The council expropriated Marzell’s shop. Under the legislation, compensation is awarded for the property. A second amount is awarded for the business (disturbing of goodwill). Issues: Is Marzell entitled to both awards? Holding: No. Reasoning: To get the extra payment, the leasehold had to have been transferred to the corporation or the corporation had to have paid rent. Marzell had the interest in the house, and the company received the receipts. Although Marzell could have amended his statement of claim on behalf of the corporation, the corporation did not have an interest in the house. Marzell did not create the corporation as an extension of himself; he created it for legitimate reasons: for tax advantages and to create legitimacy to procure suppliers. Rationale: The court will not pierce the corporate veil simply to create a financial advantage for the sole shareholder, despite the fact that third parties are unaffected. These cases raise a question – should it ever be possible for a person to stand in for the corporation? People have chosen to create legal personalities; they should have to accept the costs and benefits of that choice (Kosmopoulos). Houle and Kosmopoulos show us that it may not be necessary to pierce the corporate veil. For example, there are a lot of companion torts that impose secondary liability (i.e. conspiracy to injure, inducing breach of contract or trust, vicarious liability). For example, the court could have found in Transamerica that parent-co induced the breach of the contract. Additional Notes: 80