Non-Competition Covenant in Employment Contract Not Enforceable

A restrictive covenant in an employment contract imposing a one-year prohibition after cessation of employment against dealing with any business that was a customer of the employer during the period of employment was held to be overly broad and unenforceable. 

The case of Mason v. Chem-Trend Limited Partnership, 106 O.R. (3d) 72 (C.A.), illustrates how a restrictive covenant will be analyzed by a court in determining whether or not it should be enforced against a former employee.    

In the Mason case, a former employee of a Michigan company which manufactured and sold processing chemicals around the world for use in the rubber, polyurethane and other industries had been employed for 17 years by the company as a technical sales representative and had signed an employment agreement containing certain restrictive covenants when he was hired. One of the covenants imposed a one-year prohibition against engaging in any business or activity in competition with the company by providing services or products to, or soliciting business from, any business entity which was a customer of the company during the period of his employment. After he was terminated, he brought an application in the Superior Court for a declaration that the restrictive covenant was unenforceable. When his application was dismissed, he appealed to the Court of Appeal.

In allowing his appeal, the Court of Appeal summarized (at pages 76 and 77) the governing principles that are applicable when considering whether a restrictive covenant in an employment contract is unreasonable and therefore unenforceable. It stated that the covenant must be “reasonable between the parties and with reference to the public interest”, and that the “balance is between the public interest in maintaining open competition and discouraging restraints on trade on the one hand, and on the other hand, the right of an employer to the protection of its trade secrets, confidential information and trade connections’. In making an overall assessment of the clause, the following three factors should be considered:

(1) did the employer have a proprietary interest entitled to protection; (2) are the temporal or spatial limits too broad; and (3) is the covenant overly broad in the activity it prescribes because it prohibits competition generally and not just solicitation of the employer’s customers?

The Court of Appeal found the complete prohibition against competing with the company was an overly broad restriction on the former employee’s activities for a number of reasons. First, there were other clauses in his employment contract that protected the company, including a clause that protected the company’s trade secrets and confidential information. Second, the prohibition on dealing with those who were former customers of the company during his period of employment, which spanned 17 years, covered customer information which could be very stale and which was inconsistent with its application for just one-year after his employment ceased, following which he could compete freely.

The third reason given by the Court of Appeal (at pages 78 and 79) relates to his limited sales territory and the position he held with the company, as follows:

The appellant is prohibited not just from soliciting former customers, but from any dealing with them in competition with the respondent. He was not the president or chief financial officer, where there may be more justification for a broader prohibition on competition after such a highly placed employee leaves the company.

The fourth reason given by the Court of Appeal (at page 79) concerns the breadth of the customers covered in the prohibition, which included all of the company’s customers and not just those he served directly, and the difficulty he would have in determining who they might be, as follows:

The appellant was an employee for 17 years. The company has worldwide operations with customers, many of which also operate in many countries. The restriction is not limited to the appellant’s own customers over that period, but includes all customers of the company during that period. As the application judge found, the appellant neither knows nor has he any access to a list of all of the company’s customers, a list which is very large. Therefore, the appellant has no way to know whether any particular potential contact he may wish to make either is or was, during the last 17 years, a customer of the company. …

Effectively, because the appellant cannot know which potential customers are off-limits to him, he is prohibited for one year from dealing with any business that may have been a customer of the company. The restriction is therefore not only ambiguous in its practical implementation, but effectively prohibits the appellant from competing with the respondent for one year. 

The Mason case should remind employers that the restrictive covenants in their employment contracts should be clearly drafted and go no further than is necessary to protect their trade secrets and connections. A covenant which prohibits competition generally and not just solicitation of the employer’s customers will likely be difficult to enforce.

Compensation but not Shares for Unperformed Agreement to Issue Shares

A director and vice-president relying upon an unperformed oral agreement with other director and sole shareholder of a company that he would receive a 40 ownership interest in the company was held to be a proper complainant under the oppression remedy and awarded compensation though not shares since the relationship between the parties was beyond repair.   

The case of Fedel v. Tan, 101 O.R. (3d) 481 (C.A.), explains how such a remedy is sensible in the context of a small, closely held company.

In the Fedel case, the applicant director and vice-president of a company in the business of importing carrageenan to be blended into various processed food products was to have a 40 per cent interest in the company under an oral agreement made with the other director who was to have 60 per cent. No shares were ever issued to the applicant but the applicant made significant contributions to the company over a period of ten years. When the applicant brought an application under the oppression remedy, the application judge found the applicant had a contractual right to a 40 per cent interest in the company, that he was entitled to remedies as a security holder, and that he should receive damages for wrongful dismissal based upon a one year notice period.

In allowing an appeal in part, the Court of Appeal held that even though the applicant had a claim for breach of contract, he was still entitled to claim under the oppression remedy. It was implicit in the application judge’s holding the business was an “incorporated partnership” that the applicant was a beneficial owner of 40 per cent of the shares of the company, and the Court of Appeal agreed that the applicant was a “proper complainant” as a security holder, although it held that the evidence did not support some of the compensation initially awarded. It did, however, uphold the damages awarded for wrongful dismissal, and further upheld the application judge’s decision to award compensation to the applicant rather than direct the issuance of a share certificate for 40 per cent of the company. It was clear that the relationship between the parties was beyond repair.

In deciding that the applicant was a “security holder” even though such term is not defined in the OBCA, the Court of Appeal stated (at pages 496 and 497) as follows:

However, it is well established that a security holder includes a beneficial owner of shares. … “Beneficial ownership”, defined in s.1 of the OBCA, includes “ownership through a trustee, legal representative, agent or other intermediary”– situations in which a person’s interest in a company is held by another. …

Implicit in this finding is a conclusion that [the respondent] Tan was holding a 40 per cent ownership interest of the shares of [the company] GPI for [the applicant] Fedel. In short, Fedel was a beneficial owner of those shares. The appellants properly acknowledge that a finding of beneficial share ownership by Fedel, as in my view was made by the application judge, permits recourse to s. 248 of the OBCA.

In upholding the application judge’s decision to award damages but not to direct the issuance of company shares, the Court of Appeal held (at pages 501 and 502) as follows: 

Section 248 is remedial legislation that provides a court with considerable latitude in deciding on a fair and just remedy in the circumstances of a particular case. A trial judge’s decision with respect to an appropriate award of compensation under s. 248 of the OBCA is entitled to considerable deference in this court.

In fashioning a remedy based on the relief sought in Fedel’s application, the application judge was required to decide first whether or not he would order Tan and GPI, or both, to deliver to Fedel 40 per cent of the issued shares of GPI. Had he done so, Fedel would have continued as a shareholder. The application judge decided against this approach. In my view, his decision was sensible. It was clear that the relationship between the parties in this small, closely held company was beyond repair. Having reached that conclusion, the application judge was then left with the question of what he should order by way of compensation to Fedel for his interest in GPI. …

Although the application judge did not frame this award as a return of capital, in the context of the relationship as it had developed, this part of the compensation award could be seen at least in part in this fashion. That being the case, the application judge’s compensation order addressed, in some measure, compensation for Fedel’s ownership interest. In addition, the application judge’s compensation order included a requirement that GPI and Tan compensate Fedel for all moneys improperly removed from the company. Again, this part of the compensation award addressed, to some extent, Fedel’s ownership interest. 

The Fedel case illustrates how the court has the discretion to craft the most “sensible” remedy when oppression is claimed.  

Payments to Related Parties Held Oppressive

A director of a corporation which held real estate as “bare trustee” on behalf of a joint venture extracted the equity from the joint venture property and transferred it to companies which were solely owned and controlled by him. The payments to the related companies were held to be oppressive conduct and the director was held personally liable for the amounts wrongfully paid. 

The case of Hurontario Property Development Corp. v. Pinewood Business Interiors Inc., 100 O.R. (3d) 261, provides another example of how payments to related parties may be attacked as oppressive. 

In the Hurontario case, the plaintiff entered into a joint venture with Pinewood for the development of certain real estate in Mississauga which he owned. A Mr. VanDyk who had sole control of Pinewood also had sole control of another corporation which served as a “bare trustee” in holding the joint venture property. The property was sold to the Ministry of Transportation for Ontario without the plaintiff’s knowledge, and Mr. VanDyk extracted the equity from the property and transferred it to companies solely controlled by him.

In allowing the plaintiff’s action for oppression, the Superior Court held that transferring the equity in the joint venture property to companies controlled by Mr. VanDyk constituted oppressive conduct and that in the circumstances, it was appropriate to make an order against Mr. VanDyk personally. The Court found that “absurd” fees were charged to the joint venture trustee corporation, and referred (at page 265) to the attempts “to divert as much money as possible from the proceeds of the sale of the joint venture property to the VanDyk group of companies by means of exaggerated expense claims”.

Despite provisions in the trust agreement which required the approval of the joint venturer beneficiaries of any sale or mortgage of the joint venture property, the plaintiff was not made aware of the sale of the property or the granting of two mortgages on it. The Court found (at page 272) that “Mr. VanDyk increased the mortgages on the joint venture property as a means of taking the equity in that property and misappropriating it to himself”, and (at page 276) that “virtually all of the net proceeds from the sale were appropriated by the VanDyk companies on the same day they were received”.

In finding that the mortgages were not taken out for a valid business purpose and that the plaintiff’s reasonable expectations were evidenced in the joint venture agreement (which included the trust agreement), the Court held (at page 277) as follows:

Self-dealing is a common category of oppression. I am satisfied that the looting of [the trustee] VanDyk-Mary Fix Creek Developments Limited constitutes self-dealing. The conduct was authorized by Mr. VanDyk and resulted in companies that he solely owned acquiring all the money generated by the sale and mortgaging of the joint venture property.

I am further satisfied that the [individual] plaintiff Wandich and the plaintiffs had the reasonable expectation that the defendants, including Mr. VanDyk, would act in a manner that was consistent with the joint venture agreement and the trust agreement attached to it as far as the mortgaging and sale of the joint venture property was concerned. I am satisfied that this expectation was completely frustrated by the way in which Mr. VanDyk caused the proceeds of the sale and the over-mortgaging to be misappropriated.

In short, payments to related parties can be risky business, particularly when they attempt to disguise a director’s self-dealing.

Distributions to Shareholders as Equal Bonuses Rather than Per Share Dividends Held Oppressive

Directors of a closely held family company distributed profits to each shareholder equally by way of bonus rather than by dividends based upon actual shareholdings. A deceased shareholder was held to have been oppressed by the failure to distribute funds according to the shareholding. Corporate record keeping inadequate, not indicating shareholder informed about or consented to the bonus scheme, and not supporting conclusion that shareholder’s expectations to receive only what other shareholders received.

The case of Tanenbaum Estate v. Tanjo Investments Ltd., 99 O.R. (3d) 196, provides some guidance on making distributions to company shareholders.

In the Tanenbaum case, a successful land developer indicated in a letter of wishes before his death that all of the benefits under the family trusts created to hold shares in his investment holding company were to be shared equally between his seven grandchildren rather than divided unequally because of differences in the number of children in each family. Upon his death, the directors of the company put his wishes into effect by arranging for the distribution of company funds as a bonus on a 1/7^th basis to each grandchild. One of the grandchildren would have been entitled to 1/3, not 1/7, if the funds had been distributed on the basis of actual shareholding, and her estate (after her death) brought an application alleging the distribution was oppressive conduct.

In granting the application, the Superior Court held that it was a reasonable expectation of the deceased grandchild that the company affairs would have been conducted in proper form regarding the distributions but that there were no records of directors or shareholders meetings or resolutions approving the distributions by way of bonus, and the actions of the directors thereby unfairly disregarded the interests of the deceased grandchild.

In considering the need for proper corporate records, the court stated (at page 211) that “there may well be a different level of form and accountability that takes place in a closely-held private family company or companies compared to that required for a widely held public corporation”. But in holding that the actions of the directors effectively reduced or eliminated the value of the shares held for the benefit of the deceased grandchild Katherine Tanenbaum without informed advice or consent reflected in appropriate corporate resolutions, the court held (at page  213) as follows:

The authorities cited above and others have clearly recognized that the expectations of a shareholder in a closely held family company or companies must take into account that the formality required of a large public company may not always be present. In this case, there is almost a complete lack of formal evidence of the informed proper corporate steps that would be required to support a conclusion that Katherine Tanenbaum’s reasonable expectation was only to receive in effect what those in charge advanced her. … If, as suggested in submission, Katherine Tanenbaum was content to receive the same as her cousins, how easy would it have been to have the process proceed formally, including the appropriate resolutions…

The Tanenbaum case is another reminder of the need for closely-held companies to keep proper records and obtain proper approvals when dealing with their shareholders.

Failure to Notify Other Shareholders of Share Transfer Invites Oppression Remedy

A director acquiring shares of a company in two previous tranches sold his shares and resigned his directorship before a third tranche and concealed his sale and resignation from the plaintiff shareholders who invested in the third tranche. The company then failed and the shareholders lost their investment. All of the company directors were held liable under the oppression remedy to restore the plaintiffs’ losses because the plaintiffs were entitled under a unanimous shareholder agreement to notice of, and vote upon, the director’s share sale. 

The case of Fiorillo v. Krispy Kreme Doughnuts, Inc., 98 O.R. (3d) 103, illustrates how a failure to comply with a notice and consent provision of a shareholder agreement can result in an oppression remedy.

In the Krispy Kreme case, a director acquired shares in the first two tranches of a company’s capital raising but sold his shares and resigned his directorship prior to a third tranche taking place. The company operated a retail doughnut business through parts of Canada under a franchise granted by a U.S. based franchisor. All three of the plaintiffs had invested in the first tranche, and two had invested in the second tranche. After the director told one of the plaintiffs that he was not participating in the third tranche because he already had enough shares, but did not advise that he had already sold his shares or resigned as a director, all three plaintiffs invested in the third tranche.

A unanimous shareholder agreement required that any transfer of company shares be first approved by the company’s shareholders, but such approval was not sought for the transfer of the former director’s shares. When the company failed and the plaintiffs lost their investment, they claimed against all of the directors under the oppression remedy for failure to give notice of the proposed sale of the former director’s shares, as well as against the former director for fraudulent or negligent misrepresentation, alleging that they would not have invested in the third tranche had they known of the former director’s prior share sale and resignation.

In addition to allowing the claim by one of the plaintiffs against the former director for fraudulent misrepresentation, the Superior Court held that the three plaintiffs could recover the losses on their third tranche investments under the oppression remedy from the company’s directors because of the failure to give notice of, and obtain shareholder consent to, the former director’s share transfer as required under the unanimous shareholder agreement. The court stated (at pages 144 and 145) as follows:

…notice of a proposed resolution approving the transfer was required to be given to the plaintiffs who were to be given the opportunity to sign the written consent in the form of a Special Shareholders Resolution. It was the obligation of the directors who were charged with the responsibility to manage the business and affairs of [the company] Kremeko to see that the proposed steps were taken. What occurred did not correspond to the protection of the plaintiffs’ rights. There was no shareholders’ meeting.

In holding that the plaintiffs had a reasonable expectation pursuant to the unanimous shareholder agreement that they would be entitled to notice of the former director’s share transfer, the court found that such expectations were breached by the board’s conduct which unfairly prejudiced the plaintiffs and unfairly disregarded their interests.

While the court recognized that directors are generally not personally liable for the acts of the corporation, it stated that such liability may follow when the directors act in their own separate interests, as occurred here when the directors acquired either personally or through their respective holding companies the shares of the former director.

By imposing such liability on the directors in this case, the court (at page 148) relied upon the following statement found in Budd v. Gentra Inc., [1998] O.J. No. 3109, 43 B.L.R. 92d) 27 (C.A.), para. 52:

The plaintiff must allege a basis upon which it would be “fit” to order rectification of the oppression by requiring the directors or officers to reach into their own pockets to compensate aggrieved persons. The case law provides examples of various situations in which personal orders are appropriate. These include cases in which it is alleged that the directors or officers personally benefited from the oppressive conduct, or furthered their control over the company through the oppressive conduct. Oppression applications involving closely held corporations where a director or officer has virtually total control over the corporation provide another example of a situation in which a director or officer may be held personally liable to rectify corporate oppression. 

In finding that the directors benefited by keeping confidential the transfer of shares by the former director, the court held (at page 49) as follows:

… the view of the Kremeko board was that they did not want widespread knowledge of the sale and a flood of potential investors wanting to redeem their shares and take their money and move on. All directors had that concern and all were shareholders of Kremeko. This was a closely held corporation and the value of their shareholdings would undoubtedly have been affected had Kremeko had difficulty in raising further capital for its anticipated Western expansion.

The Krispy Kreme case provides a strong warning to those involved with a closely-held company that they should respect the provisions of the company’s shareholder agreement.

Distributions to Shareholders May Be Oppressive Conduct

Builders refused to pay invoices and replenish security deposits as required by agreement with developer, and paid out profits leaving nothing for developer. Directors of builders personally liable as their actions unfairly disregarded the interests of the developer as a creditor.

The case of Tas-Mari Inc. v. DiBattista*Gambin Developments Ltd., 97 O.R. (3d) 579, illustrates how shareholder distributions can amount to oppression.

In the Tas-Mari case, a developer of two subdivisions in Brampton, Ontario entered into agreements of purchase and sale with three builders. The agreements allowed the developer to correct any deficiencies or damage and charge back the relevant amounts, while also requiring the builders to provide security deposits by way of letters of credit. The developer was entitled to deduct the amounts owed from the security deposit and the builders were required to reinstate the security deposit to the original amount. The developer invoiced the builders for various amounts and the builders paid some of the invoices. To recover the unpaid amounts, the developer drew on the letters of credit, but the builders refused to reinstate the security deposit. The builders were closely-held, single purpose corporations which ceased to generate revenues once the subdivisions were completed and which had distributed their profits to their shareholders, leaving no assets to satisfy any judgment.   

In addition to seeking an order for the replenishment of the letters of credit, the developer claimed against the directors of the builders personally under section 248 of the Ontario Business Corporations Act.

The Superior Court allowed the claim against the directors of two of the builders to succeed. In holding that the actions of the builders and their directors had been conducted in a manner that unfairly disregarded the interests of the developer DBG as a creditor, the Court stated (at page 617) as follows:

After those security deposits were drawn upon by DBG, the principals of the corporations made conscious decisions that they would not replenish them. The purpose of those security deposits is to provide funds out of which DBG could make claims for moneys that it claims were owing to it. If the corporations and their principals believed that DBG had improperly drawn upon the security deposits, their remedy was to sue. What they were not entitled to do was to decline to replenish the security deposits, decline to pay outstanding invoices and nevertheless pay out all of the profits of the corporation leaving nothing for DBG if DBG were to succeed in this action, as it did, at least in part.

The principals of the corporations knew, at all relevant times, that these claims were outstanding and would likely end up being litigated, as they were. If properly advised, they were aware that there was a risk that their position would not be sustained and that DBG’s position might prevail. Notwithstanding that knowledge, the principals of the corporations nevertheless paid out all of the profits leaving nothing for DBG.

The Tas-Mari case is a useful reminder that efforts to creditor proof a company may be overturned by way of the oppression remedy. 

Failure to Pay Company Officer Justifies Oppression Remedy

Wrongful dismissal of a company officer does not, standing alone, justify a finding of oppression. However, the company’s payment of amounts owed to two directors along with a substantial premium to them after the company made a large profit while disregarding the officer’s right to receive deferred compensation and payment under two promissory notes does justify a finding of oppression.

The case of Walls et al. v. Lewis et al., 97 O.R. (3d) 16, explains why. 

In the Walls case, the plaintiff was a founding shareholder and vice-president of finance of a company involved in the development and distribution of point-of-sale terminals, debit/credit processing and “corner store” automated teller machines. In joining the company, he agreed to accept a lower salary on the basis that his deferred compensation would be paid to him when the company became profitable. He also loaned money to the company in exchange for promissory notes on the understanding that the notes would be repaid when the company’s cash flow permitted.

When the company made a significant profit on a particular transaction, it paid two of the company’s directors everything they were owed on their loans plus a substantial premium, although the plaintiff received only a portion of what he was owed. When he was terminated by the company, after nine years of service, he received a severance payment equal to 6 years salary. He then sued the company and the two directors for his deferred compensation, payment of the promissory notes, and damages for wrongful dismissal.

The Superior Court held that the company was liable for the entire amount of the claim, including damages equal to an additional six month’s salary to be added to the severance payment he had already received, although the company was “dormant” and unrepresented by counsel at the trial. While the two directors were also found personally liable under the oppression remedy for the deferred compensation and the amounts owing under the promissory notes, they were not found liable for wrongful dismissal damages.

In holding that the two directors could not be held personally liable on the wrongful dismissal claim, the Court stated (at pages 26 and 27) as follows:

Wrongful dismissal, standing alone, does not justify a finding of oppression. It is only where the interests of the employee are closely intertwined with his interests as a shareholder and where the dismissal is part of a pattern of conduct to exclude the complainant from participation in the corporation that the dismissal can be found to be an act of oppression…. None of this happened here.

In holding that the directors Lewis and McKee were personally liable for the deferred compensation and payment of the promissory notes which remained unpaid by the company DSTI, the Court commented (at page 27) as follows:

DTSI decided to pay Lewis and McKee in full, even adding a premium, while paying Walls only a portion of what he was owed. In doing this, to track the language in s. 248(2)(a), the corporation, DSTI, engaged in acts that effected a result that unfairly disregarded the interests of Walls as creditor (i.e., to also be paid in full).

And further, in a footnote on that page, the Court stated:

[The Company after the transaction] could have repaid all of its lenders in full and still had a balance of just over US$3 million. No one is suggesting that the company was required to do this. Indeed, the better business judgment may well have been to pay out only a portion of the [investment sale] proceeds to note-holders and other creditors. Had DTSI … made proportionate payments, fairly and equally, to all of the shareholder- creditors, there would have been no basis for complaint. It is the unfair and unequal distribution to two DTSI directors that provides the basis of this action against Lewis and McKee personally.

In determining whether Walls’s expectations in the circumstances were reasonable and whether they were violated when assessing the claim for oppression, the Court held (at page 28) as follows:

Mr. Walls reasonably expected that he would eventually be paid his deferred compensation once the start-up was in funds. … In my view, Walls’s reasonable expectation as a founding shareholder and company creditor was violated by the disproportionate amounts paid out to directors Lewis and McKee, conduct that unfairly disregarded his interests as a creditor. Likewise with the two promissory notes. 

In fixing personally liability on the two directors, the Court referred (at page 29) to the decision in Budd v. Gentra Inc., [1998] O.J. No. 3109, 43 B.L.R. (2d) 27 (C.A.), as follows:

In Budd v. Gentra Inc., the Court of Appeal held that officers and directors may be personally liable in cases where the officers or directors “personally benefited from the oppressive conduct”. All the more so, I would add, where the corporation is closely held, chooses to operate with no formal shareholder or directors meetings and relies on ad hoc decision-making… 

In short, the Court held (at page 30) that the “only way to correct the fact that Mr. Walls’ (sic) interests as creditor were unfairly disregarded is to require the two beneficiaries of the company’s generous repayment decisions to disgorge such amounts as should have been fairly and properly remitted to Walls – namely the balance owing for deferred compensation and the amounts owing on the two notes”. 

The Walls case, in other words, confirms that an oppression remedy may be able to achieve more than an action for wrongful dismissal.  

Shotgun Clauses Examined

The exercise of a “shotgun” clause in a shareholder agreement does not give rise to a fiduciary duty or duty to act in good faith. A loan agreement secretly entered into by one shareholder to finance the purchase of the other shareholder’s shares upon the exercise of a shotgun did not amount to oppressive conduct.

The case of Aronowicz v. Emtwo Properties Inc. provides some very helpful insight, from both the Superior Court (96 O.R. (3d) 510) and the Court of Appeal (98 O.R. (3d) 641), into the rights and obligations surrounding the use of shotgun clauses. 

In the Aronowicz case, two brothers each held 50 per cent of the shares of a company which owned five commercial properties in Toronto. They were both directors of the company and parties to a unanimous shareholder agreement which contained a shotgun buy/sell provision. The shotgun provided that in the event one shareholder made an offer to the other, the shareholder receiving the offer could accept the offer and sell his shares, or purchase the offeror’s shares, or elect to divide the company’s assets into two packages.

The defendant brother triggered the shotgun by offering to purchase the plaintiff brother’s shares and requesting certain confidential documents and information concerning the company. The defendant brother had entered into a loan agreement with third parties to finance his acquisition of the plaintiff brother’s shares under the shotgun. The loan agreement provided that the loan would be repaid by transferring three of the company’s properties to the lenders. The plaintiff bother was not made aware of the loan agreement when the defendant brother exercised the shotgun. The plaintiff brother’s election to divide the company properties was held on arbitration to be ineffective and he was deemed to have accepted the offer to purchase under the shotgun. Upon eventually learning of the loan agreement, the plaintiff brought an action claiming breach of fiduciary duty and oppression along with other claims.

On the defendant brother’s motion for summary judgment on the basis that there were no genuine issues for trial, the Superior Court dismissed the action, holding that the evidence did not support the allegations made.

In its decision, certain statements made by the Superior Court are helpful in understanding and interpreting shotgun provisions generally. In short, the Court held (at page 546) that “the Shotgun Provision expressly provided a non-consensual, unilateral means of breaking a deadlock by allowing one party to trigger a termination of the [shareholders’] relationship”. 

In holding that there was no basis for a fiduciary duty in the exercise of the shotgun, the Superior Court found that such a provision allows a shareholder to act in his own self interest. Some of the Court’s comments (at page 532) on the shotgun provision and the rights and obligations of the plaintiff brother Abraham and defendant brother Harry under it are as follows: 

The Shotgun Provision specifically enables a shareholder to act in his own interest and contrary to the interest of another party who wishes to maintain the existing ownership structure of the corporation. Moreover, Harry was not in a position to unilaterally exercise any power or discretion so as to affect Abraham’s legal or economic interests apart from triggering the Shotgun Provision. Nor is there any basis for finding that Abraham was at the mercy of Harry in some manner or was otherwise vulnerable to him….There is no room in such circumstances for the operation of a fiduciary duty in the sense of a duty of the exercising shareholder to prefer the interests of the other shareholder(s) to his own or a duty to act only in accordance with interests of the other shareholder in the exercise of the Shotgun Provision.

In holding that there was no basis for a duty to act reasonably and in good faith in the exercise of the shotgun, and in distinguishing it from rights of first refusal, the Superior Court found (at pages 532 and 533) as follows:

The parties bargained for an unqualified right to exercise the Shotgun Provision at any time. However, the plaintiffs argue that, in respect of the exercise of the Shotgun Provision, the court should  infer an obligation analogous to the implied obligation “to act reasonably and in good faith” in respect of rights of first refusal. I do not think there is any basis in law for such an obligation. This result flows from the fact that the rationale underlying the existence of such a duty with respect to rights of first refusal does not extend to buy/sell provisions. The considerations applicable in respect of rights of first refusal differ from the Shotgun Provision in two important respects.

First, as mentioned above, after exercising the Shotgun Provision, Harry had no further rights exercisable under the Provision to which a reasonability standard is applicable. In contrast, rights of first refusal typically involve a regime of mutual rights and obligations among the shareholders in the operation of such provisions after their invocation by the triggering shareholder, including rights to which such a standard is appropriate.

Second, in a right of first refusal, a remaining shareholder is entitled to insist on reasonable compliance by a departing shareholder with a right of first refusal in order to protect itself against being forced into a relationship with a new “partner” to whom it did not consent. In a buy/sell arrangement of the nature of the Shotgun Provision, because the parties are terminating their business relationship, the remaining shareholder does not have a continuing interest to which the departing shareholder must have regard in exercising its rights under the buy/sell arrangement. This conclusion is reinforced in the present circumstances by the fact that Abraham had the right to determine which of the parties was to be the remaining shareholder and which was to be the departing shareholder.

In holding that there was no duty on a party to disclose its financing arrangements for the exercise of a shotgun, the Superior Court stated (at page 536) as follows:

The purpose of the Shotgun Provision is to terminate the relationship between the parties. This is a qualitatively different situation from the ongoing relationship between shareholders of a corporation in which duties of a fiduciary or quasi-fiduciary nature have, in some circumstances, been found to exist.

The Court expanded upon its view that no duty to make such disclosure existed, as follows (at page 539):

In contrast, the Shotgun Provision established a classic negotiation relationship between the parties. In that context, each party is generally entitled to act in his or her own interest. There is no principle of law that requires a party to disclose the basis of its negotiating position. In particular, there is no obligation on the part of the triggering shareholder to disclose the basis on which the shareholder arrived at his offer price.

The Court found (at page 539) that the unanimous shareholder agreement, or USA, for the company Emtwo did not require such disclosure, as follows:

First, as mentioned above, the USA contains an explicit mechanism for achieving fairness between the parties It provides options in favour of the non-triggering shareholder that permit that shareholder to realize the value of Emtwo, as assessed by that shareholder with full access to all Emtwo information and records. Second, there is no need for disclosure to police the use of the Shotgun Provision as there were no other “exit provisions” in the USA that could be circumvented by triggering the Shotgun Provision.     

In a response to the plaintiff brother’s argument that the company’s shareholders owed a duty of honesty and good faith to each other because they were brothers, the Superior Court stated (at page 534) as follows:

I see no additional evidence that would support a finding by a trial judge that each brother also owed such duties to the other in their personal capacities as shareholders. The fact that [the company] is a “family” corporation in the sense that its shares were held by two brothers and its activities conducted by one of them is not, by itself, sufficient. In the absence of express contractual commitments in the USA, which are absent, there must be special circumstances in the relationship between the brothers to justify a finding of such a duty. 

In upholding the motion judge’s dismissal of the motion for summary judgment, the Court of Appeal held that a shotgun buy/sell provision in a unanimous shareholder agreement does not attract the operation of fiduciary obligations. The Court of Appeal, at page 657, held that there was nothing in the relationship between the parties in the context of the shotgun provision that carried the indicia of a fiduciary relationship, as follows:

No duty of loyalty or good faith. No discretionary power or trust. No undertaking by one party to submerge its own interests and to act for the benefit of the other. No dependency or vulnerability. As noted above, the relationship between the parties to a shotgun buy/sell agreement is the very antithesis of these attributes.

At page 658, it confirmed that “courts are appropriately reluctant to impose fiduciary duties where the parties’ relationship is governed by commercial contract”.    

And at page 659, the Court of Appeal held that “the disclosure of confidential information did not constitute a breach of fiduciary obligation or oppressive conduct because there was no evidence of any harm or detriment to Emtwo or to Abraham, or of any benefit or profit to Harry, as a result of Harry’s disclosure of the confidential information to [the lender] Mr. Grinshpan”.

Therefore, in light of both decisions, shareholders should be able to exercise a shotgun contained in a shareholder agreement while regarding only their own best interests.

Wrongful Dismissal of Company Officer Leads to Oppression Remedy

The wrongful dismissal of a company officer in contravention of a shareholder agreement constituted oppressive conduct by the company’s majority shareholders. Causing company customers (which they controlled) to stop paying accounts to the company also constituted oppressive conduct by the majority shareholders.

The case of 2082825 Ontario Inc. v. Platinum Wood Finishing Inc., 96 O.R. (3d) 467, illustrates how these actions lead to an oppression remedy.   

In the Platinum Wood case, the applicant shareholder held though his holding company 30 per cent of the outstanding shares of the corporation which carried on the business of finishing hardwood flooring. Instead of acquiring a 50 per cent interest, he paid a premium for his shares on the condition that he was to be the president of the corporation at an annual salary of $100,000. The terms were set out in a unanimous shareholder agreement. The other shareholder of the corporation was a holding company owned by three brothers who were not involved in the management of the corporation’s business yet ran a separate business which was a major client of the corporation. The three brothers though their holding company caused the corporation to stop paying the applicant’s salary when he was in the hospital suffering from leukemia, and when he returned to work, they voted him out as a president, terminated his employment, and removed him as a director. They also caused the major client which they controlled to stop paying the accounts to the corporation.

The application judge found that the brothers acted in an oppressive manner by wrongfully dismissing the applicant and allowing the receivables to build up to the detriment of the corporation, and held them jointly and severally liable for damages for wrongful dismissal and for a buy-out of the applicant’s shares.

The Superior Court (Divisional Court) upheld that decision on appeal. Although the brothers argued that their actions should be supported by the business judgment rule, the court held that the business judgment rule has no application when the shareholders have agreed to the applicable terms in a unanimous shareholder agreement. The applicant took the position of president and settled for only a minority shareholding in reliance upon the terms of the unanimous shareholder agreement. The applicant’s claim for wrongful dismissal was appropriately dealt with as part of the oppression application because there was an intimate connection between the applicants’ contract of employment with the shareholder agreement.  

In holding that the business judgment rule had no application where the shareholders have put their minds to a particular business issue and have agreed upon the terms, the court held (at page 474) as follows:

It is apparent from the course of negotiations that those terms were central to [the applicant shareholder] Barbieri agreeing to take a minority, and therefore vulnerable, shareholder position. If the business judgment rule were held to override the express terms of a unanimous shareholder agreement, such agreements would be of negligible value to a minority shareholder who becomes an equity owner in reliance on the protection contained in terms of a unanimous shareholder agreement. Instead of providing protection, such agreements could easily become the instruments of a “bait and switch” if controlling shareholders were permitted to shelter under the business judgment rule when violating the terms of a unanimous shareholder agreement to the prejudice of a minority. 

In holding that the actions of the brothers were contrary to the reasonable expectations of the applicant and were oppressive, the court found (at page 476) that the dismissal of the applicant was unauthorized and unjustified as follows:

Indeed, the parties had expressly addressed the contingency of Barbieri becoming disabled and had agreed as to the point in time when his remuneration was to stop. On a fair reading of those provisions, the parties having agreed to cessation of pay after one year of disability, the logical and reasonable inference is that the parties agreed that sickness or disability for less than a year would not result in cessation of pay.

In finding that the build up of receivables owed by the appellants’ company to the corporation was detrimental to the corporation and constituted oppressive conduct, the court held (at pages 476 and 477) as follows:

The evidence clearly supports [application judge] Newbould J.’s finding that the individual appellants chose to let the receivables of [their company] Herwynen Sawmill Ltd. build significantly, requiring [the corporation] Platinum, in turn, to borrow funds to support Platinum’s day-to-day operations. The actions of the appellants, in essence, made Platinum the interest-free banker of Herwynen Sawmill Ltd., benefiting the appellants to the detriment of the respondents.

In finding that the case at its heart was an oppression claim with a wrongful dismissal component, the court held (at page 478) as follows:

Barbieri’s position as president and manager, on the other hand, was inextricable from his agreement to acquire a minority interest as opposed to a 50 per cent interest. He did so on terms that he have management of the company and a secure remuneration of $100,000. The vulnerability of Barbieri’s Company minority shareholding would be balanced by Barbieri’s role in management and his secure salary.

In short, when an individual’s rights as an employee are connected to his rights under a shareholder agreement, an oppression remedy may be available to enforce those rights.

Unauthorized and Imprudent Loans a Breach of Director’s Fiduciary Duty

A company director may be in breach of his fiduciary duty to the company if he causes the company to make unauthorized and imprudent loans to other companies related to him.   

The case of Paragon Development Corp. v. Sonka Properties Inc., 96 O.R. (3d) 574, provides a good example.

In the Paragon case, a director of the applicant corporation caused the corporation to make unsecured loans to other companies which the director owned or controlled for the purpose of investing in real estate projects. The corporation’s principal assets were four residential apartment buildings in Toronto. The corporation claimed damages by way of the oppression remedy equal to the amounts remaining unpaid on the loans.   

The Superior Court held that the director breached his fiduciary obligations to the corporation. He ignored certain limits on his authority to make the loans, and he was not acting in good faith or in the best interests of the corporation. The loans were highly risky and no reasonably prudent director would have made such loans on an unsecured and unguaranteed basis. The only reasonable explanation for the loans was the director’s preferment of his own interests over those of the corporation. The court also held that claims for breach of fiduciary duty are not subject to a limitation period (although other oppression claims may be). The court further held that a guarantee subsequently given by the director was a “specialty” debt and subject to a 20 year limitation period.

As the director was believed to be insolvent and unable to pay the loan amounts outstanding, the applicant corporation sought a declaration that the holding company of the applicant be entitled to set off the amount of the judgment against any distribution following the liquidation of the applicant which may be payable to a company beneficially owned by the director which was a shareholder of the holding company. The court held that the principle in Cherry v. Boultbee (1839), 2 Kee 319 4 My. & Cr. 442, 41 E.R. 171 (which provides that a person who is entitled to share in a specific fund but who is also under a liability to contribute to that fund cannot recover the share from the fund until the liability to contribute has been determined and accounted for) can apply to liquidating distributions to shareholders.

Because the shareholder was wholly owned by the director, the court disregarded the existence of the corporate shareholder, and allowed for the set-off on the basis that the broad powers the court has under the oppression remedy allow it to fashion relief that is similar in effect to the application of the principle in Cherry v. Boultbee. In other words, the holding company was entitled to deduct from any liquidating dividend to be paid to the corporate shareholder the amount of the loan amounts owed to the applicant corporation.   

In finding the director did not act in the best interests of the applicant corporation, the court held (at page 610) as follows:

The risk inherent in such loans was not addressed by the provision of security or a personal guarantee of Kaiser [the director]. It was not even secured by the underlying investment of the Kaiser-related entity. There is also no evidence that the loans were expected to pay interest at a rate that was commensurate with this equity risk. The economic reality of the loans is that Paragon [the applicant corporation] bore the down-side risk and Kaiser realized all of the up-side benefit. 

Furthermore, the court held that the director was required to ensure that the loans were administered in a manner that ensured that prompt demand for payment was made by Paragon in the event of any indication of financial difficulty on the part of the borrower, but the director failed to do so. The court stated (at page 611):

The obvious inference is that he did not do so because such action would have required that the borrowers liquidate the underlying equity investments to Kaiser’s personal detriment.  

The Paragon case serves as a useful reminder to the directors of a company that they should not prefer their own interests over the interests of the company.

 

An appeal of the Superior Court’s decision was dismissed by the Court of Appeal on different grounds (103 O.R. (3d) 481).