It's a standard tactic of creditor proofing. Instead of investing in a business, principals make loans to the company. Then, if the business fails, they're secured creditors, standing first in line when the receiver sells company assets to pay creditor claims.
It should be noted, however, that this only works if the stratagem is properly executed, as the recent case of Tudor Sales Ltd. demonstrates. In Tudor, the Supreme Court of BC found that loans from the sole officer and director to the company were, in reality, capital contributions that were thus subordinated to all creditor claims.
Unsecured claims rejected
Tudor was a steel distributor in BC and Tavi Eggertson was its sole officer and director. In 2005-06 Eggertson advanced a total of $1.37 million to Tudor, later secured under terms of a General Security Agreement (GSA). When Tudor assigned itself into bankruptcy in 2013 the trustee in bankruptcy reported there would be no funds to satisfy claims of unsecured creditors after meeting Eggertson's claim.
The trustee's report was challenged by an unsecured creditor, who sought a court order expunging the Eggertson claim. Eggertson counterclaimed that all funds held by the trustee should be released to him in recognition of his secured claim.
Beyond expressed intentions
The court said it must look beyond the expressed intentions of the loan transaction to determine its true substance. Reviewing company records, court found that the loans were originally unsecured, non-interest-bearing and without fixed terms of repayment. Company documents did not refer to the loans as "secured" until 2011 and no interest rate was fixed until 2012.
"Payments ... were discretionary, based on the advice of the accountants, and varying with Tudor's profitability." Such a scheme "is the hallmark of ownership," the court said. The advances were therefore equity, not debt, and no security could attach to them under section 140.1 of the Bankruptcy and Insolvency Act.
This case makes clear that creditor proofing should only be undertaken with the advice of expert counsel and with precise documentation.