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Ontario Court provides guidance on non-arm's length transactions

A trustee in bankruptcy has special powers to investigate the affairs of a bankrupt estate, and among the greatest of those powers is the ability to review and potentially unwind transactions prior to bankruptcy under section 95 and 96 of the Bankruptcy and Insolvency Act ("BIA").

In 1085372 Ontario Limited v Kulawick, 2019 ONSC 2344, the Ontario Superior Court of Justice had to consider whether a transfer of shares between shareholders was a transfer at undervalue, and whether the parties were not dealing at arm's length. Under the BIA, a transfer that is not at arm's-length in the year prior to bankruptcy is automatically voidable.

In this case, the bankrupt was a substantial shareholder and primary investor in an entertainment company. Facing financial difficulties, the bankrupt sought some sort of return on his $1,000,000 investment in the company. The company advanced $100,000 to the bankrupt as a return of capital, and a further $177,000 under a loan evidenced by a promissory note. The bankrupt defaulted on the loan and the company foreclosed on the bankrupt's shares, effectively getting for $277,000 what had been purchased for $1,000,000 several years earlier.

In reviewing the transaction, the court determined that the parties, despite their long relationship, entered into a transaction at arm's length. The court provided useful analysis of the issue, noting that the special rules against non-arm's length transactions were intended to prohibit artificial transactions that were actually designed to confer benefits on one of the parties instead of both parties trying to maximize their own economic self-interest. The question is not simply whether the relationship is arm's length, but whether the transaction at issue is being dealt with in an arm's length way. The court ultimately determined in this case that the parties were dealing at arm's length, and so the transaction was not unwound.

When a party is facing financial difficulties, they may end up in desperate situations in which short term cash is accepted to the detriment of longer-term interests. Parties involved in such transactions (or their creditors) would be wise to get the advice of experienced insolvency counsel.

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