COVID-19 Financial Services update: conflicts – related party loans

April 27, 2020 | Stefan Mirkovic, Kenneth R. Rosenstein

In light of the current economic environment surrounding the COVID-19 pandemic, companies are in need of additional liquidity and working capital. Recently, our group has seen an increase in lending transactions where shareholders are providing secured subordinated loans to their invested companies. Often times these shareholders appoint nominee directors to the company’s board. In such a situation, the director finds themselves conflicted, which in turn gives rise to an obligation for the director to disclose the details of the nature and extent of their conflict to the board.

If a director has an interest in a material contract or transaction or proposed material contract or transaction with the corporation, such director is under an obligation to disclose the nature and extent of such interest and to abstain from voting on the matter. The obligation arises from (i) the relevant provincial business corporations act for provincially incorporated corporations or companies, or (ii) the Canada Business Corporations Act, the federal statute that applies to federally incorporated corporations (the “CBCA”). This analysis is based on the obligations set out in the CBCA however the provincial acts have similar provisions and a similar analysis should be undertaken if this situation arises with a provincially incorporated entity. The determination of what constitutes a material contract or transaction is a factual one that varies on a case by case basis, depending on the nature of the corporation, the director and the business being transacted. A director can be considered to have an interest in a material contract or transaction if they are a director or officer, or an individual acting in a similar capacity, of the person party to the contract or transaction (as would be the case of a nominee director on a corporation’s board of directors appointed by the corporation’s subordinated lender). A director can also be considered to have an interest in a material contract or transaction if they have a material interest in any person who is a party to the contract or transaction. Although the CBCA does not define “material interest”, it can be generally interpreted to mean an interest which could result in a benefit to the director beyond some de minimis threshold.

We recommend that directors disclose the nature and extent of their interest in as much detail as possible to avoid any scrutiny, and in any event to ensure that there is sufficient information to allow the other directors to ascertain what the interest is related to and to what extent the director in question is interested. In order to comply with the time frame prescribed by the CBCA, we strongly advise that the interest is brought to the board’s attention as early as possible when negotiations for the material contract begin and in any event before or during the discussions regarding the board resolution for the material contract or transaction. We have advised our clients to include the disclosure of the director’s interest in the written resolutions of the board of directors adopted to approve a financing. A simple recital indicating the director’s position with the subordinated lender was sufficient in our view to describe the nature of their interest.

The failure of a director to disclose their interest may carry consequences. If the contract was not reasonable and fair to the corporation at the time it was approved by the board  and the interested director voted to approve the resolution without disclosing their interest in accordance with the CBCA, impacted parties may apply to the court to have the director account to the corporation or its shareholders for any profit realized from the contract, or the contract can be set aside entirely. In order to prevent this from happening, we recommend (i) disclosing the interest in as much detail and as early as possible; and (ii) that interested directors do not participate in the voting or consideration of the material contract and, (iii) out of an abundance of caution, removing themselves from voting or consideration of any matters where the director’s objectivity could be fettered by their conflicted interest. We have advised our clients to exclude the interested directors from signing and approving the written resolutions of the board of directors adopted to approve a financing, and to also add a recital to the resolutions to the effect that the remaining directors of the corporation have determined that the material contract or transaction is reasonable and fair to the corporation.

Given that subordinated lenders can often appoint nominee directors, especially during uncertain economic times such as the current one we find ourselves in, we recommend that our corporate and lending clients alike look out for this possible issue and ensure that sufficient disclosure is provided to avoid the possibility of having their financing come under the court’s scrutiny.

 

Miller Thomson is closely monitoring the COVID-19 situation to ensure that we provide our clients with appropriate support in this rapidly changing environment. For articles, information updates and firm developments, please visit our COVID-19 Resources page.

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