Shareholders Agreements and Insolvent Shareholders:

No Discounts Allowed

By Alexander J Friedl

When a shareholder in a corporation becomes bankrupt or insolvent, their interest in the corporation’s shares may pass to or vest in a trustee in order to maximize the recovery effort for their creditors. The trustee would then be responsible for valuing and selling the shares for the benefit of the insolvent shareholder’s creditors. If this happens, the shares could then be sold to an unknown third-party.

The prospect of such a sale to a third-party can be concerning for private businesses, especially smaller or family run businesses. The introduction of an unknown third-party to a business can bring with it significant uncertainty and concern, not only to ongoing business operations but also to employee morale, customer relationships, and the company's strategic direction. The remaining solvent shareholder(s) are placed in the undesirable position of needing to either come up with financing to buy-out of the interest in the insolvent shareholder’s shares, sometimes on short notice, or accept the sale of the insolvent shareholder’s shares to the third-party.

Navigating Shareholder Insolvency with a Shareholders Agreement

The best way to control the sale of an insolvent shareholder’s shares is by entering into a Shareholders Agreement. Generally, a Shareholders Agreement is an agreement between a corporation’s shareholders, or class of shareholders, that provides a structure on how the shareholders will deal with situations that may arise throughout the life of the business. If you are interested in other advantages of having a Shareholders Agreement, you can refer to an article written by my colleague, Mark Hazlett, titled “Four Benefits of a Shareholders’ Agreement”, for further information.

A Shareholders Agreement can set out the rights, obligations, and conditions that will govern the sale of shares upon a shareholder being petitioned into bankruptcy, insolvency, receivership, or making an assignment in bankruptcy (an “Insolvency Event”).

While Shareholders Agreements will vary based on the individual interests of the shareholders and the corporation, typically a Shareholders Agreement will provide for the following rights upon a shareholder triggering an Insolvency Event:

1. the corporation can buy back an insolvent shareholder’s shares; and,
2. a right of first refusal which allows the solvent shareholder(s) the opportunity to purchase the insolvent shareholder’s shares before they can be sold to a third-party.

Ensuring Validity of Insolvency Provisions: Shareholders Agreements and the Anti-Deprivation Rule

If the insolvency provisions in a Shareholders Agreement are not drafted carefully, there is a risk they may violate the anti-deprivation rule, which can result in the provisions being rendered void and unenforceable. This may also have the unintended consequence of affecting the enforceability or application of other provisions.

The anti-deprivation rule originates from the common law and “renders void contractual provisions that, upon insolvency, remove value that would otherwise have been available to an insolvent person’s creditors from their reach.”[1] For the purposes of this definition, “person” includes corporations and partnerships.

The anti-deprivation rule protects third-party creditors from being unable to recover the maximum amount of what they are owed due to an insolvent shareholder entering into a contract which directly reduces the “size of the pie” from which the creditors can recover their losses.

To determine if a contractual provision will be void for violating the anti-deprivation rule, an “effects-based test” will be applied to the impugned provision.[2] An “effects-based test” requires that the following two elements be satisfied for the provision to be rendered void:

1) is the clause triggered by an event of insolvency or bankruptcy; and

2) is the effect of the clause to remove value from the insolvent’s estate. [3]

Application of the Anti-deprivation Rule to Shareholders Agreements

There are two provisions in Shareholders Agreements that are sometimes used that can unintentionally violate the anti-deprivation rule and, as such, may be unenforceable.

The first provision is one that sets out a pre-determined discount on the fair market value of an insolvent shareholder’s shares. In the event a shareholder is subject to an Insolvency Event, this provision is triggered and the corporation or solvent shareholder(s) can buy-back the insolvent shareholder’s shares at the discounted price.

However, these “discount” buy-back provisions in Shareholders Agreements will violate the anti-deprivation rule and are thus void. The provision is triggered by the occurrence of an Insolvency Event and the effect is that value is removed from the insolvent shareholder’s estate that would otherwise be available to creditors.

A Court of King’s Bench of Alberta decision provides an example of such a provision violating the anti-deprivation rule. In this case, a shareholder of a corporation went into receivership. In accordance with the Shareholders Agreement, the remaining shareholders had the right to purchase an insolvent shareholder’s shares for a 25% discount paid over 36 months without interest upon the insolvent shareholder triggering an Insolvency Event.[4] Referring to this provision, the Court found that “insolvency triggers the removal of value from the insolvent person’s estate” and the provision was void for violating the anti-deprivation rule.[5]

To help highlight the deprivation that occurred in this situation, if the solvent shareholders purchased the insolvent shareholder’s shares for 75% of their fair market value, the effect would be to deprive the insolvent shareholder’s creditors 25% of the value of the shares which would have otherwise flowed to them.

The Anti-deprivation Rule and Genuine Pre-estimates of Damage

The second provision in a Shareholders Agreement which may violate the anti-deprivation rule is one where the provision is triggered by an Insolvency Event and reduces the purchase price of the insolvent shareholder’s shares as a genuine pre-estimate of damages for the costs associated with the sale of the insolvent shareholder’s shares. This type of language is typically included in contractual provisions to avoid violating the penalty clause rule.

For example, a Shareholders Agreement may contain provisions where the corporation can buy-back a shareholder’s shares at a price which is equal to 90% of their fair market value following an Insolvency Event. To avoid violating the penalty clause rule, a complimentary provision would be included stating that the 10% reduction in price is a genuine pre-estimate of damages caused by the costs incurred by the corporation’s buy-back of the insolvent shareholder’s shares and is not intended as a penalty.

Notably, the Supreme Court of Canada addressed in Chandos Construction Ltd. v. Deloitte Restructuring Inc., 2020, whether the validity of a penalty clause would impact the application of the anti-deprivation rule, finding that “if a provision is invalid for one reason (the anti-deprivation rule in bankruptcy law), it does not matter whether it is or is not invalid for another (the penalty rule in contract law).”[6]

As such, an enforceable penalty clause may still be rendered void for violating the anti-deprivation rule. When applying the “effects-based test” to these provisions, they satisfy both prongs of the anti-deprivation rule and would likely be void. The corporation’s buy-back of the shares is triggered by an Insolvency Event and the effect of the clause is to remove value from the insolvent shareholder’s estate (the 10%) which would otherwise be accessible to their creditors.

Conclusion

Preparing or amending a Shareholders Agreement is often complex, requiring careful attention to the legal implications of its provisions, including the anti-deprivation rule. A well-drafted Shareholders Agreement can offer certainty and control if a shareholder faces an Insolvency Event, provided it complies with the anti-deprivation rule and other applicable laws.

If you have any questions related to Shareholders Agreement and Insolvent Shareholders, please contact Alexander Friedl (afriedl@sorbaralaw.com).