Canada: Trapdoors In Newfoundland And Labrador Transactions: Prohibited Financial Assistance

Any corporate or commercial transaction involving a Newfoundland and Labrador corporation must include a consideration of the prohibited financial assistance provisions in the Corporations Act (Newfoundland and Labrador) and how to address any issues that arise. Failure to do so could result in the enforceability of a loan or guarantee, personal liability for corporate directors and professional negligence claims. This newsletter outlines the concept of prohibited financial assistance under NL corporate law and the most common ways the prohibition is overcome or mitigated.

What is Prohibited Financial Assistance?

Certain provisions of the Corporations Act restrict the ability of a corporation to provide financial assistance to related persons when the assistance would jeopardize the solvency of the corporation. The provisions were originally intended to prevent the use of the assets of a corporation from being used to benefit another person in situations that would be seen as unfair to the creditors of the corporation. While originally widespread in Canadian corporate law, today prohibited financial assistance provisions have been repealed or rendered relatively toothless in Canada with the exception of Newfoundland and Labrador.

Section 78 of the Corporations Act prohibits a corporation from giving financial assistance, which may be a loan, a guarantee or some other structure, to certain blacklisted persons when "circumstances prejudicial to the corporation exist". The blacklist includes shareholders, directors, officers or employees of the corporation and associates of those persons. It is a wide net that catches most entities in the same corporate organization. Expectedly, the provisions are usually encountered in financing transactions where corporate guarantees are required or in intercompany loan situations.

There are exceptions set out in the statute. The most commonly relied upon exceptions are the giving of assistance by a wholly-owned subsidiary to its parent corporation or by a corporation to a subsidiary. However, when these exceptions are not available, a full analysis is required to determine if the provisions are applicable and what course of action is most appropriate to ensure that the assistance can be provided.

Circumstances Prejudicial to the Corporation: the Solvency Tests

Once it is determined that the NL corporation is being asked to provide financial assistance to a blacklisted person and no statutory exception exists, the question turns to whether circumstances prejudicial to the corporation exist within the meaning of the Act. This involves a two-part solvency test. Both parts of the test must be satisfied.

The solvency test calls for an examination of whether there are reasonable grounds for believing that (1) the corporation is or would be unable to pay its liabilities as they become due after giving the financial assistance, or (2) the realizable value of the corporation's assets (excluding the amount of any loan given or assets secured for a guarantee) would be less than the corporation's liabilities and stated capital of all share classes after giving the financial assistance. The inquiry is both a factual and legal one, and should be undertaken as a joint effort between management and legal counsel. If there are reasonable grounds for believing either, then circumstances prejudicial to the corporation are deemed to exist and the giving of the financial assistance will be prohibited.

Managing the Prohibition

Various methods have been developed to overcome the prohibition, but their respective utility will depend on the factual circumstances of each transaction, including the state of the corporation's finances, tax considerations, transaction structure and timelines for closing. The most common techniques are:

• Solvency Certificates. If a corporation satisfies the solvency test then the financial assistance is not prohibited. After an appropriate corporate officer conducts a proper inquiry and consults with legal counsel, a solvency certificate can be completed certifying to the appropriate persons that no reasonable grounds exist for believing that prejudicial circumstances exist.
• Qualify for a Statutory Exemption. Sometimes it may be possible to effect a share restructuring of the problem corporation so that one of the statutory exceptions now applies. The usefulness of this method is questionable in most cases however, given the potential transaction and tax costs associated with shuffling the equity for such a limited purpose.
• Co-Borrower Structure. When the financial assistance required is a guarantee, many lenders, borrowers and lawyers will simply add the problem corporation as a primary borrower of the loan, and conclude that the issue has been resolved. However, this approach still requires a consideration of whether the corporation is actually receiving the benefit of the loan for which it has become liable – there is a persuasive view that if the purpose of the corporation signing as a co-borrower is in substance to procure the benefit of the loan for the true borrower, this would constitute prohibited financial assistance.
• Exporting to a Different Jurisdiction. Every other Canadian corporate statute has either repealed their financial assistance provisions, made them optional or only requires notice of the assistance to be given. By continuing a Newfoundland corporation under the corporate laws of another jurisdiction, the barrier to providing the financial assistance is removed. It is quite common to see Newfoundland corporations exported to the Canada Business Corporations Act to take advantage of that statute's lack of prohibited financial assistance provisions.
• Auto-reduction Clause in Guarantee. A contractual attempt to address prohibited financial assistance, an auto-reduction clause serves to decrease the amount guaranteed by a corporation to an amount that would not offend the prohibited financial assistance provisions, without setting a pre-defined amount. While this approach is commonly used in non-Canadian jurisdictions with similar restrictions, it has not been judicially considered in Newfoundland so remains untested.

Lenders, borrowers, directors and their advisors all need to have an understanding of the unique restrictions applicable to Newfoundland and Labrador corporations. Identifying any potential issue early in the deal planning stages is essential to finding a solution that will protect all of the interested parties while ensuring the successful closing of the transaction.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.