©2003 A. Paul Mahaffy. All rights reserved.

Introduction

Most prudent owners of a business recognize the need to reduce risk and safeguard their business assets from possible claims brought by other parties. While they may not specifically describe what they need as a creditor proofing plan, they know they need to protect the assets of their business as well as their own assets. If they are operating their business as a sole proprietorship, or as a partnership with someone else, incorporating the business becomes an essential component of their protection plan.

A business owner attempting to escape personal liability for the debts of his sole proprietorship or partnership usually transfers the proprietorship or partnership business assets to a new corporation. The corporation then gradually pays off those earlier debts for which the owner was personally liable while incurring new debts with lenders and suppliers. These new debts are the corporation's obligations, not the owner's.

If the owner does decide to operate the business through a corporation, the use of a single corporation is often as far as his business protection plan goes, supplemented only by property and general liability insurance, perhaps with business interruption insurance as well.

This paper will attempt look at some of the additional actions that an owner of a business can take when implementing a more comprehensive creditor proofing plan. Since it will be addressing structures which are ordinarily used within Ontario jurisdiction, offshore asset protective trusts will not be discussed.

Creditor proofing should be undertaken at a time when the business is able to meet its debts generally as they become due. If any asset transfers are made to related corporations with the intent to hinder or defeat existing creditors, such transfers may be overturned. However, there is nothing wrong with structuring the business operations to minimize liability before any concerns over possible insolvency arise. In other words, effective creditor proofing is designed to isolate the business and its assets from the future claims of future creditors, not from the current claims of current creditors.

Many of the statutory restrictions outlined below apply when a transferor is insolvent, and many of the exemptions from such restrictions apply only when a transfer is made in the ordinary course of business. It is usually difficult to argue that transfers carried out when implementing a creditor proofing plan are part of the ordinary course of business. These statutory restrictions are in place to deter debtors from taking unusual and extraordinary steps to prevent an orderly distribution of their property to their creditors when they anticipate a bankruptcy on their horizon. These steps include transferring property in an attempt to place it beyond the reach of creditors, preferring one creditor over others, or declaring dividends prior to a bankruptcy in order to keep money away from creditors. This paper will provide a brief overview of such statutory restrictions.

It's helpful to keep in mind who might attempt to attack a creditor proofing plan when attempting to set the plan up. While planners normally think of secured creditors, preferred creditors like landlords and taxing authorities, and ordinary trade creditors as being the most likely to attack such plans, potential attacks from employees and shareholders, and even from Crown prosecutors, shouldn't be disregarded. The possible application of the Criminal Code, as hereinafter discussed, can certainly cause the planners to think carefully before proceeding.

Components of a Creditor Proofing Plan

Use of multiple corporations

As with an owner's own investment portfolio, the owner of more than one business shouldn't put all of his "eggs in one basket". He should diversify his risk, and use more than one corporation to carry on his separate businesses. Separately incorporating each business owned can make sense, so that if one business should fail, the others will not be endangered. A business which is a potential loser should be isolated from those businesses which are current winners by simply compartmentalizing the owner's overall business arrangements into separate corporations.

Operating many businesses through one entity may offer some tax or operational benefits, but these factors alone should not determine the structure. Asset protection may be far more important, particularly when a business is at an early stage and most vulnerable. Only when the businesses become more mature and more stable should tax, financing, creditor relations and operational factors be equal to liability protection as a planning objective.

However, it still should be kept in mind that transferring assets from one corporation to another can have negative tax consequences, although proper structuring can reduce or avoid such consequences.

Multiple corporations can be held through one holding company, so that each operating company becomes a subsidiary. Parent company guarantees can then be substituted for the personal guarantees of the owner. Profits of each operating company can be distributed to the holding company as tax-free inter-corporate dividends and protected from possible claims against the operating company. If any of the operating companies require working capital, the holding company can loan the funds back on a secured basis.

New or separate business divisions or projects can be set up in separate companies in order to insulate the other companies in the related group from risk. If one of the companies becomes financially troubled, it can be liquidated, sold off, or rehabilitated without jeopardizing the other healthy businesses. For example, real estate developers generally put each new project into a separate corporation, so that the failure of the new project won't put the developer's other properties and projects at risk.

Separating Ownership of Valuable Assets from the Operating Business

Valuable assets used by an operating business should be owned by another company and simply leased or licensed back to the operating company. Limit the access of business creditors to the fewest and least valuable assets possible. In most cases, an operating company should not own any more assets than are necessary to carry on the company's business activities. The operating company's assets should usually be restricted to its contracts, accounts receivable and inventory.

If the operating company runs into difficulty, such assets will not be available to satisfy the claims of the operating company's creditors. The leases or licenses can simply terminate. Real estate is one asset that should be held outside of the operating company. Equipment, vehicles, furniture, fixtures, trademarks, trade names, copyrights and patents are also assets that should be held by entities separate from the operating company.

Investing in the Operating Business by Secured Loan

If investment in the operating company is made by way of secured loans instead of by way of straight equity, those making the secured loans, whether they be the owner, or friends or family of the owner, will have priority over the various unsecured creditors of the operating company. Whether or not those lending funds on a secured basis are also shareholders of the operating company, they will control what happens to the operating company. If they are friendly to the owner, they might realize on their security after a default and sell the business back to the owner. A related company might invest in the operating company, again by way of a secured loan.

Even if most of the business assets already stand as security for existing indebtedness, perhaps as general security to a bank or other financial institution regarded as the "senior lender" of the business, the other investors who are secured creditors can still be next in line after the bank has been satisfied should the business fail. These investors often evidence their investment by way of a non-interest bearing note, secured by a registered general security agreement. If these investors don't take security, they will end up within the ranks of the unsecured creditors to the business who may get nothing upon an insolvency. A financial institution which is not currently a lender to the operating company will usually require those creditors who are secured to postpone and subordinate their security in favour of the financial institution before it advances any funds to the operating company.

Providing Services to the Operating Business through Another Company

An affiliated company may provide consulting, information processing, administrative or other services to the company operating the business, and the amounts which the affiliated company is owed for such services can be secured by the assets of the operating company.

Holding Valuable Lease Separate from Operating Business

If the operating business is carried on out of leased premises with a valuable location, it may be disadvantageous for the operating business to hold the lease. If the operating company holds the lease and then becomes bankrupt, the lease may end up being assigned or terminated. It may be safer having another company lease the valuable location, and that company in turn sublet the premises to the operating company, possibly on a month-to-month basis. The other company therefore controls the lease, and can evict the failing operating company on default and re-sublet to a different, more solvent tenant, including a new business established to succeed the failing operating company at the same location under a new sublease.

Conversely, a separate or "shell" company with few assets might be used to execute a lease on behalf of an operating company. If the tenant company fails, the landlord has recourse only to the "shell" and not against the operating company. Alternatively, if the lease is held by the operating company, a related company may enter into an option with the landlord to lease the valuable premises should the operating company tenant become insolvent.

Keep Deposits and Loans Separate

Given that the financial institution where the operating company keeps its funds on deposit might try to offset such funds against any outstanding loans which the operating company may have with such institution, it's advisable for the operating company to borrow where it doesn't maintain a deposit account.

Stripping Equity

An operating company may engage in an ongoing effort to reduce the amount of its assets which might be vulnerable to potential creditor claims by simply converting them to cash and distributing the cash to its shareholders, which may be one of the related companies discussed above. Selling or factoring accounts receivable, reducing inventory to the lowest level possible without jeopardizing sales, selling and then leasing back equipment, or selling intellectual property and licensing it back, are all techniques that can be used to generate cash to be dividended out and to thereby reduce the assets subject to possible attack from creditors in the future.

Dividing Ownership amongst Family Members

Creditors may be deterred from attempting to go after shares in any of the related companies if such shares don't represent a controlling interest. By selling additional shares to other family members, or other family controlled corporations, or family trusts or limited partnerships, ownership may become diluted enough to avoid creditor efforts to seize the shares. Spreading ownership of a corporation amongst family members so that no one family member owns more than 49 percent may achieve the desired result.

However, just as with any transfers of personal assets by a business owner to members of his immediate family, transferring shares to family members still requires an owner to consider the stability of his marriage and his relationship with his children prior to the transfer. While transferring assets to family members may provide creditor protection, the owner may lose control of the assets as a result. Use of a family trust to hold the assets may be a preferred alternative.

Furthermore, while mentioned in more detail below, bankruptcy and insolvency, fraudulent conveyance, and assignment and preference legislation makes transfers to family members particularly suspect. While putting assets in a spouse's or adult child's name may be a popular form of creditor proofing, such transfers may be void if the transferor becomes insolvent within one year of the transfer, and creditors may be able to reach back five years after the transfer and have it unwound with proper grounds. Also, transfers to children may have adverse tax consequences for the owner, given the capital gains and income attribution rules which may apply.

Commonly Used Structures

Creditor proofing often involves the transfer of assets between related corporations using one of three methods in an effort to reduce or defer the amount of taxes which would otherwise be payable upon such transfers. Transfers may be effected by an operating company to a new parent company, or to a new subsidiary, or to a new sibling company. Such transfers are ordinarily accomplished by way of tax-free rollovers under section 85 of the Income Tax Act (Canada). The consent of the bank or other financial services company currently providing credit to the operating company, whether on a secured or unsecured basis, will most likely be required in order to carry out any of these three methods.

Transfer of Assets to a Holding Company

The shareholders of the operating company transfer their shares in the operating company to a newly incorporated holding company and make an election under section 85 of the Income Tax Act (Canada). The operating company then declares and pays a dividend in favour of the holding company, and any of the dividend proceeds received by the holding company which are needed by the operating company are then loaned back to the operating company. Such a loan is secured by way of a general security agreement covering the operating company's personal property and possibly a mortgage covering its real property, although such security is usually subordinated and postponed to any security held by the operating company's principal banker.

This process can be repeated over time as additional profits earned by the operating company are paid out to the holding company as dividends and then lent back to the operating company when needed. However, while this method may serve to creditor proof the profits of the operating company, it doesn't creditor proof the real estate, equipment, intellectual property or other valuable assets which remain with the operating company.

Transfer of Assets to a Subsidiary

The operating company incorporates a new subsidiary and transfers its inventory, accounts receivable and minor operating assets to the subsidiary, while retaining its real estate, intellectual property, major equipment and other valuable assets. Which assets stay and which assets are to be transferred may depend upon the position of the operating company's principal banker, including whether some of the existing bank debt will be transferred to the new subsidiary and whether guaranties and other security will be given by both companies. Which contracts are to be transferred, particularly those with suppliers, customers and equipment lessors, may depend upon whether consents to such transfers are required and can be obtained. The overall transfer may be made pursuant to section 85 of the Income Tax Act (Canada) although a separate election may be possible under section 22 in respect of the accounts receivable. The overall transfer can ordinarily avoid GST and retails sales tax.

The new subsidiary then acquires from the original operating company, at fair market rates, leases for the real estate and major equipment and licenses for the intellectual property which it needs in order to carry on its business. Funds needed by the new subsidiary for working capital are then loaned by the original operating company from time to time, with such loans being secured by a general security agreement covering the assets of the new subsidiary.

Transfer of Assets to a Sibling Company

The shareholders of the operating company transfer some of their shares in the operating company to a newly incorporated sibling company in exchange for common shares of the sibling company. The operating company then transfers its real estate, intellectual property, major equipment and other valuable assets to the sibling company in exchange for preference shares of the sibling company which are redeemable for the amount of the fair market value of the assets being transferred to the sibling company. The transfers of the operating company shares and assets to the sibling company are both made pursuant to section 85 of the Income Tax Act (Canada). However, the transfer of the operating company's real estate to the sibling company may trigger the imposition of land transfer tax.

The operating company then purchases for cancellation its shares held by the sibling company at a price equal to the redemption amount of the sibling company's preference shares held by the operating company, and the sibling company then redeems its preference shares held by the operating company. As with an asset transfer to a subsidiary, being able to complete these steps, in what is often referred to as a "butterfly" reorganization, may depend upon the position of the operating company's principal banker. Since it now holds the valuable assets, the sibling company will likely be required to guarantee the credit facilities extended to the operating company.

Legislative Restrictions

One of the main objectives of bankruptcy and insolvency legislation is that all ordinary unsecured creditors are to be treated equally. The general concept of equality among the ordinary unsecured creditors has been backed up by legislative provisions in the Bankruptcy and Insolvency Act, such as section 91 (settlements), section 95 (fraudulent preferences), section 100 (reviewable transactions) and section 101 (improper dividends) and by provincial legislation such as the Fraudulent Conveyances Act, Assignments and Preferences Act, and Bulk Sales Act. These statutes provide a trustee in bankruptcy or the creditors of the debtor with various ways to challenge improper transactions and recover property which has been improperly disposed of by the debtor.

While the debtor is solvent and operating in the ordinary course of business, preferring one creditor over another is both common and acceptable because, at common law, a debtor is entitled to pay its creditors in whatever order it pleases. It is generally assumed that if a debtor is continuing in business, each of its creditors will be paid eventually over time, some just sooner than others. But when the debtor is insolvent, it is assumed that the debtor will not be able to continue in business and, over time, pay all of its creditors. In such circumstances, the legislation imposes a concept of equality to correct creditor preferences by providing the means to recover property which is transferred to one creditor in preference over another creditor.

Bankruptcy and Insolvency Act, R.S.C. 1985, c. B-3

Section 91 - Settlements

Any transfer of property made gratuitously or for merely nominal consideration, called a "settlement", is void against the trustee in bankruptcy if it is made within one year of bankruptcy. The debtor must intend that the settled property be retained for the benefit of the transferee either in specie or in traceable form. If a settlement is made within five years of bankruptcy at a time when the debtor was unable to pay its debts without the use of the settled property, the settlement will be void. However, settlements to a purchaser or lender acting in good faith and for valuable consideration are permitted.

Section 95 and 96 - Fraudulent Preferences

In the event of a bankruptcy, particular transactions between the bankrupt and its creditors can be declared void as against the trustee in bankruptcy if it is determined that the transactions constitute a fraudulent preference. A broad range of transactions can be challenged under this section: a conveyance or transfer of property, the creation of a charge on property, every payment made, every obligation incurred, and any judicial proceeding taken or suffered, by the debtor.

In order for a transaction to be a fraudulent preference, the following requirements must be met: the debtor was insolvent at the time of the transaction; the debtor intended to give the creditor a preference; the debtor intended to defeat, hinder or delay other creditors; and the transaction took place within three months of the debtor's bankruptcy. If the transaction is with a party related to the debtor, such as a parent company or subsidiary, the three month period extends to twelve months. Even though these tests are met, the transaction is only presumed to be a fraudulent preference. It will not be declared void, for example, if it can be proven that it was done in the ordinary course of business, or done to enable the debtor to remain in business.

Section 100 - Reviewable Transactions

Any transaction, called a "reviewable transaction", which is made by the debtor with a person who is not at "arm's length" with the debtor within one year of bankruptcy can be reviewed by the Court to determine if the debtor gave or received fair market value as consideration for the transaction. If the consideration is found to "conspicuously" differ from fair market value, the Court can award judgment to the trustee in bankruptcy against the other party to the transaction for the difference. A non-arm's length party can include a parent or subsidiary company of the debtor. There is no requirement that the debtor be insolvent, or had any fraudulent intent or any intent to defeat or prefer creditors, at the time of the transaction. Good faith of the parties in carrying out the transaction is irrelevant.

Section 101 (1) - Improper Dividends, Share Redemption or Share Purchase

Any payment of dividends, or any redemption or purchase of its shares, made by an insolvent corporation within one year of bankruptcy can be attacked by the trustee in bankruptcy. The Court can award judgment against any director for the amount of the dividend, redemption price or purchase price that hasn't been repaid to the corporation unless the director protested against the corporation taking such actions at the time. A shareholder receiving funds resulting from such actions can be similarly liable. There is no requirement for the trustee to prove any fraudulent intent.

Fraudulent Conveyances Act, R.S.O.1990, c.F.29

Conveyances made by a debtor with the intent to defeat, hinder, delay or defraud creditors can be challenged under this Act and need not fall within the same strict time limitations as under the Bankruptcy and Insolvency Act. Although proof of the debtor's intent to defeat creditors is required, proof that the debtor was insolvent at the time the property was conveyed is not required, nor is proof that creditors were actually defeated by the conveyance. Conveyances to parties for good consideration who take bona fide without notice or knowledge of an intent to defeat creditors are however exempt.

Assignments and Preferences Act, R.S.O. 1990, c.A.33

Conveyances made by a debtor with the intent to defeat, hinder, delay or prejudice creditors at the time the debtor was insolvent can be challenged under this Act. Unlike the Fraudulent Conveyances Act, proof that the debtor was insolvent at the time the property was conveyed is required. If a conveyance which gives a creditor a preference over other creditors is attacked within 60 days after being made, or if the debtor makes an assignment for the benefit of its creditors within 60 days after such a conveyance, the debtor's intention to defeat creditors will be presumed. If these time limits are not met, the presumptions will not arise and the party attacking the conveyance will have to prove that the debtor intended to create an unjust preference. Conveyances made in good faith for fair value in the ordinary course of business are however exempt, including paying money to existing creditors or granting security for a present advance.

Bulk Sales Act, R.S.O. 1990, c.B.14

A sale in bulk may be set aside and the buyer may be held to account to the creditors of the seller for the value of the assets sold unless the buyer complies with this Act. Compliance can be achieved if the seller delivers to the buyer a statement of the seller's creditors and the buyer then elects to pay the sale proceeds to the seller if the seller has also sworn that all of the creditors have been paid in full or if the seller has made provision for payment of all of the creditors immediately after the sale, except for those creditors waiving their rights to immediate payment. Alternatively, if 60% of the unsecured trade creditors consent and they have received the seller's statement, the buyer may elect to pay the sale proceeds to a trustee appointed by the seller for further disbursement to all of the creditors in accordance with the priorities established under the Bankruptcy and Insolvency Act.

Business Corporations Act (Ontario), R.S.O.1990, c.B.16

A corporation under this Act is prohibited from purchasing its shares under section 30, from redeeming its shares under section 32, and from declaring a dividend under section 38, where there are reasonable grounds for believing that (a) the corporation is unable to pay its liabilities as they become due, or would be unable to do so after the payment is made, or (b) the realizable value of the corporation's assets after the payment would be less than the aggregate amount of its liabilities and stated capital for all classes of shares (or for those classes ranking ahead of or equal to the class being redeemed, in the case of share redemption). Directors who authorize an improper dividend or improper share purchase or redemption are liable under subsection 130 (2) to restore to the corporation any amount so distributed, so long as any action against them is commenced within two years of the date when the dividend, purchase or redemption was authorized by the board.

A creditor of a corporation may be able to apply to the Court for an "oppression remedy" under section 248 of this Act as a "complainant" where an act or omission of the corporation effects a result, or where the business of the corporation or powers of the directors are being carried out in a manner, that unfairly disregards the interests of the creditor, and the Court may make an order to rectify the matters complained of.

Corporations governed by the Canada Business Corporations Act, R.S.C. 1985, c. C-44 are subject to comparable restrictions. A corporation under this Act is prohibited from purchasing its shares under section 34, from redeeming its shares under section 36, and from declaring a dividend under section 42, when the corporation cannot meet comparable solvency tests, and a creditor may seek an oppression remedy under section 241.

Criminal Code, R.S.C. 1985, c. C-46

Certain actions taken when implementing a creditor proofing plan can run afoul of the Criminal Code whether or not taken during, or on the eve of, insolvency. Section 392 provides that anyone who conveys property or conceals property with intent to defraud his creditors commits an indictable offence and is liable to imprisonment for two years. It also provides that anyone who receives property from someone with intent to defraud his creditors also commits an indictable offence and is liable to imprisonment for two years. Sections 366 to 368 relate to forgeries and the making of false documents, and provide that anyone who commits forgery or who knowingly uses a forged document as if it were genuine is guilty of either an indictable offence or an offence punishable on summary conviction.

More importantly for those who advise clients in the implementation of creditor proofing plans is section 21. That section provides that anyone is party to an offence who actually commits it, or aids or abets any person in its commission. Section 21 also provides that where two or more persons form an intention in common to carry out an unlawful purpose and to assist each other to that end, and one of them commits an offence, then each of them can be a party to that offence.

Things to Avoid

In the past, many attacks on creditor proofing plans in non-bankruptcy situations have been made under the Fraudulent Conveyances Act and have often relied upon the traditional "badges of fraud" to create a presumption of intent on the part of a grantor of property to defraud. These badges of fraud have been expanded over time and include certain actions which should be considered and hopefully avoided by those setting up a creditor proofing plan for an operating company, especially if the company's financial position is taking a bad turn. While these badges of fraud are of assistance in determining whether an intent to defraud exists, they are not conclusive evidence of fraud. More importantly, if none of the badges is present, a conveyance is unlikely to be successfully attacked.

Set out in much greater detail in Houlden and Morawetz, Bankruptcy and Insolvency Law of Canada, (3rd edition - revised), the badges of fraud include a transferor of property continuing to show ownership of, or retaining some interest in, the property after its purported transfer. They also include the absence of any change in possession of the property, or the existence of a trust over the property, after its purported transfer. The inadequacy of the consideration paid, the payment of the consideration by way of cash instead of cheque, and the absence of any documentation relating to the transfer, have also been regarded as badges of fraud.

In practice, avoiding these badges of fraud when setting up a creditor proofing plan often means creating evidence that each corporation in the plan is engaged in business as a legitimate legal entity, separate and apart from each of the other corporations and their owners, and that each transfer of property amongst them is documented as if it were an arm's length transfer. Creditors may try to claim that the corporation receiving the property or the property transfer itself is nothing more than a sham. The onus is on the creditors to prove this, but they may have a tougher time in proving this if the related corporations avoid the following pitfalls:

Commingling of Assets

Each corporation should be operated as a distinct entity, and the cash and other assets of one corporation should be clearly segregated from those of each other. A failing business must appear to the creditors as a separate entity, unconnected to other healthy businesses. Sharing of bank accounts, or commingling of cash, inventory or other assets, or utilizing one payroll account, may result in creditors attempting to pierce the corporate veil.

Failing to Identify the Business as a Separate Corporation

While there are advantages from a marketing perspective to represent a number of related corporations through the use of a common trade name, all dealings with third parties should clearly identify which corporation in involved. All signage, letterhead, marketing materials, invoices, checks, e-mail and all other means of communicating with third parties should use the correct corporate name and not simply a trade name. All contracts should set out the corporate name and clearly be signed by an officer of that corporation in his corporate capacity. All required business licenses should be issued in the correct corporate name. A separate telephone number or telephone listing, and separate business and e-mail address, help to distance one related corporation from another.

Interlocking Boards and Management

Multiple corporations should be managed autonomously, each with separate and not identical or interlocking boards of directors. If convenience requires that board meetings of each related corporation be held at the same place and on the same day, they should be held consecutively, not concurrently. Officers of related corporations should occupy different positions.

Failing to Maintain Separate Records and Record Inter-corporate Transfers

All transfers of assets, particularly inventory, between corporations should be recorded, and each corporation should maintain not just separate accounting records, but also corporate minute books which record separately the directors and shareholders meetings of each corporation.

Transferring Assets for only Nominal Consideration

All transfers of assets between corporations should be for good consideration which is preferably set at the aggregate fair market value of the assets being transferred. Obtaining current appraisals of the assets from reliable, independent third parties, or a least referring to commercially available valuation databases, in an effort to establish a reasonable range of fair market values can be helpful in defending against an attack on the transfers.

Example of a Creditor Proofing Structure

In Downtown Eatery (1993) v. Ontario (2001) 54 O.R. (3d) 161 (C.A), the Court of Appeal took a look at one creditor proofing structure in attempting to determine the extent to which an unsatisfied judgment for damages for wrongful dismissal rendered against one company could be collected from other related companies. In short, the Court of Appeal recognized that a business does not have to operate through a single company and that there is nothing unlawful or suspicious about choosing a complex structure, provided that the complexity doesn't defeat the rights of wrongfully dismissed employees.

The structure chosen by the two individual defendants in the case who controlled the various defendant companies was indeed complex. In order to carry on a nightclub business in downtown Toronto, one company was used to own the nightclub's premises, which were leased to another company which owned the nightclub's trademark and held the necessary liquor and entertainment licenses. A further company owned the nightclub's chattels and equipment and was a licensee of the trademark. And still a further company, Best Beaver Management Inc., paid the nightclub's employees. All of these companies were owned by two holding companies, which were in turn owned by Grad and Grosman, the two individual defendants.

Joseph Alouche, a former manager of the nightclub, obtained a judgment for damages for wrongful dismissal against Best Beaver Management Inc. which had previously been paying him, but that company failed to satisfy the judgment. In fact, that company had ceased to carry on business and its assets were distributed to other companies related to the nightclub before the judgment was even rendered. When a small amount of cash, allegedly belonging to the company which owned the nightclub's chattels and equipment, was seized by sheriffs executing on the Alouche judgment, that company claimed against Alouche. Alouche then counterclaimed against all of the related companies, along with Grad and Grosman, to recover his unsatisfied judgment.

At trial, Alouche argued the common employer doctrine and oppression, as well as fraudulent conveyance, but lost on all three grounds. On appeal, he argued and won on the first two. The Court of Appeal held that the asset distribution to related companies was oppressive conduct on the part of Grad and Grosman, and that the related companies were collectively Alouche's employer, accountable for his wrongful dismissal.

The appeal decision is useful as another reminder of the types of conduct that can give rise to an oppression remedy, as well as being noteworthy in its discussion of the common employer doctrine and the liability to employees which companies within a related group may face.

In dealing with the common employer doctrine, the Court of Appeal cites the following passage from Sinclair v. Dover Engineering Services Ltd. (1987), 11 B.C.L.R (2d) 176 (S.C.), aff'd (1988) 49 D.L.R. (4th) 297 (B.C.C.A.) as being particularly persuasive:

The old-fashioned notion that no man can serve two masters fails to recognize the realities of modern-day business, accounting and tax considerations. There is nothing sinister or irregular about the apparently complex intercorporate relationship existing between Cyril and Dover. It is, in fact, a perfectly normal arrangement frequently encountered in the business world in one form or another. Similar arrangements may result from corporate take-overs, from tax planning considerations, or, from other legitimate business motives too numerous to catalogue. As long as there exists a sufficient degree of relationship between the different legal entities who apparently compete for the role of employer, there is no reason in law or in equity why they ought not all to be regarded as one for the purpose of determining liability for obligations toward those employees who, in effect, have served all without regard for any precise notion of to whom they were bound in contract.

The Court of Appeal adds this caution to directors and shareholders planning such a perfectly normal and frequently encountered arrangement:

However, although an employer is entitled to establish complex corporate structures and relationships, the law should be vigilant to ensure that permissible complexity in corporate arrangements does not work an injustice in the realm of employment law. At the end of the day, Alouche's situation is a simple, common and important one - he is a man who had a job, with a salary, benefits and duties. He was fired - wrongfully. His employer must meet its legal responsibility to compensate him for its unlawful conduct. The definition of 'employer' in this simple and common scenario should be one that recognizes the complexity of modern corporate structures, but does not permit that complexity to defeat the legitimate entitlements of wrongfully dismissed employees.

In dealing with the oppression remedy, the Court of Appeal adds this further caution to directors and shareholders:

It was the reasonable expectation of Alouche that Grad and Grosman, in terminating the operations of Best Beaver and leaving it without assets to respond to a possible judgment, should have retained a reserve to meet the very contingency that resulted. In failing to do so, the benefit to Grad and Grosman, as the shareholders and sole controlling owners of this small, closely held company, is clear. By diverting the accumulated profits of Best Beaver to other companies that they owned, they were able to insulate these funds from being available to satisfy Alouche's judgment. For the foregoing reasons, it is our opinion that Alouche has demonstrated his entitlement to an oppression remedy against Grad and Grosman.

Conclusion

While the Downtown Eatery decision may confirm that there is nothing inherently sinister or irregular about carrying on a business through a number of related companies, the legislative restrictions outlined above certainly require those attempting to set up a creditor proofing plan to act long before the business is insolvent or on the eve of insolvency. Ensuring that each of the companies participating in the plan is established for valid business purposes, and that each of the asset transfers between them is made at fair market value, will help to defend against an attack.

Implementing a plan when the business is in financial difficulty, or undertaking a transfer which defeats, hinders or delay creditors, or carrying out a bulk sale without provision being made for any of the creditors of the business, can encourage a successful attack being made. Oppressive conduct on the part of the directors of any of the participating companies in the plan can further encourage successful attacks. Yet even in the absence of such circumstances, cases like Downtown Eatery make it difficult for business lawyers acting on the transfer of assets between related companies to assure clients that their plan is 100% creditor proof.

©2003 A. Paul Mahaffy. All rights reserved. A. Paul Mahaffy practises business law with Bennett Best Burn LLP of Toronto, with particular emphasis on purchase and sale agreements, technology transfers, Internet commerce, joint ventures, and financing. He can be reached by e-mail at pmahaffy@bbburn.com and his recent publications can be viewed online at http://paulmahaffy.com