Canada: Stakeholder Claims For Unfair Corporate Conduct: Courts Affirm D&O And Affiliate Liability And Confirm High Leave Hurdle For Derivative Actions

The Securities Litigation Group is pleased to report on two recent successes before the courts.

Success Story One: Injunction and Derivative Action Commenced by Disgruntled Shareholder and Former Director Defeated

Cassels Brock litigators successfully defeated a motion for leave to commence a derivative action and for various heads of injunctive relief commenced by a disgruntled shareholder and former director. The motions were dismissed and the defendants were awarded costs in the amount of $50,000.

The decision highlights the "high onus" on parties seeking leave to commence a derivative action under s.246 OBCA and their obligation to satisfy the requirements of good faith and the best interests of the company. The onus does not lie on the directors and officers defending the derivative action to prove bad faith.

The decision also demonstrates the Court's willingness to give effect to commercial realities: the Court refused to compel unwilling parties to work together and refused to grant extraordinary injunctive and equitable relief to a disgruntled shareholder who did not come to court with clean hands. Instead, the Court encouraged a corporate divorce.

The Litigation

Cassels Brock acted on behalf of Vacuum Metallizing Limited (VML) and the two officers and directors of Powder Coating Solutions Inc. (PCS). The plaintiff is a former director of PCS and also a lawyer by trade who, at one time or another, acted on behalf of VML, PCS and its shareholders.  The plaintiff and the two defendant directors of PCS are the only shareholders of PCS.

The plaintiff commenced an action seeking relief under the oppression remedy and damages for breach of contract and breach of fiduciary duty against VML and the two officers and directors of PCS. In particular, the plaintiff alleged that the defendants misappropriated PCS' corporate opportunities through VML and that VML was competing with PCS in breach of a non-compete (that the plaintiff had drafted). The plaintiff then moved for leave to commence a derivative action on behalf of PCS and for various injunctive relief.

In Justice Penny's decision, his Honour denied the plaintiff's relief across the board and found in favour of the defendants.

Derivative Action

In denying the plaintiff's motion for leave to commence a derivative action, the Court agreed that a derivative action was an extraordinary remedy and that the plaintiff failed to meet the high onus required under s.246 of the OBCA.

Significantly, in finding that the good faith requirement had not been satisfied, the Court pointed to the plaintiff's "clear potential conflict" as a personal shareholder of PCS and as counsel for the defendants. The Court also found that a derivative action was not in PCS' best interests on the basis that a "shareholder divorce" was required and encouraged the parties to work to achieve this end.

Injunctions

The Court also denied the four injunctions sought against the defendants. The Court's analysis offers guidance to officers and directors who may be faced with any one of these injunctions and demonstrates that the Courts are willing to come down hard on disgruntled shareholders, despite the severity of the accusations alleged:

i.     Injunction to preclude the defendants from competing with PCS: While the Court held that VML was not competing with PCS, the Court further found that the non-compete drafted by the plaintiff was unreasonably broad in scope and geography such that it was void. 

ii.     Injunction to compel the defendants to pay money into court: The Court ruled that a requirement for monies to be paid into Court is akin to a Mareva injunction and requires proof of a real risk that assets will be removed from the jurisdiction or that the defendant will dissipate assets so as to render a future tracing of assets remote, if not impossible. The mere fact that the funds may have been used by the defendants to foster VML was insufficient to grant the injunction.

iii.     Injunction to compel the defendants to protect PCS' intellectual property: The Court accepted the defendants' argument that PCS had no intellectual property such that they were not required to take active steps to protect it.

iv.     Injunction to preclude the defendants from distributing funds from PCS and to compel the plaintiff's participation in PCS: The Court gave effect to the commercial realities of PCS and refused to grant the injunction when it was clear that the parties could not work together.

Lorne Silver and Carly Cohen of Cassels Brock's Securities Litigation Group acted on behalf of the defendants. Read the full handwritten decision here.

Success Story Two: Director and Affiliate Liability for Oppressive Corporate Conduct and Breach of Trust Upheld on Appeal

In a ruling released on April 19, 2016, in the case of T. Films S.A. v. Cinemavault Releasing International Inc.et al, 2016 ONSC 404, the Ontario Divisional Court upheld a decision of a lower court in which the lower court found that the director (Nicolas Stiliadis) of a judgment debtor, Cinemavault Releasing International (CRI), as well as affiliated companies of that judgment debtor (Cinemavault.com Inc. and Cinemavault International Inc.) were each liable for an arbitral award previously obtained by creditors against CRI, even though there was no privity of contract between the director of CRI or its affiliated companies with any of the creditors. The underpinning of the Divisional Court's ruling was both the affirmation of the rights of corporate creditors to engage the oppression remedy to address unfair conduct and the application of long-standing legal principles pertaining to breach of trust.

Creditor Oppression

In the facts of the case, the creditors sought to enforce, as against the director of CRI and affiliated companies, an arbitral award issued solely against CRI of approximately US$500,000 arising from CRI's failure to properly account for film distribution revenues received pursuant to and in breach of a sales agency agreement. Ultimately, the lower court found that it was established "beyond peradventure" that the film distribution business of CRI was wound down and that there was a "virtual tsunami of documentary evidence that CRI's assets and business were transferred to other Cinemavault companies owned or controlled by Mr. Stiliadis." Consequently, the lower court found that the director of CRI and CRI's affiliated companies were each liable due to their collaborated and oppressive conduct, which had the effect of impairing the ability of the creditors to collect on the arbitral award. The Divisional Court upheld these findings on appeal; in doing so, the Divisional Court affirmed that corporate creditors may use the oppression remedy against directors and affiliated corporations in cases of improper corporate conduct which has the effect of impairing the collection efforts of corporate creditors.

Breach of Trust

Additionally, the lower court had to decide whether unpaid distribution revenues collected by CRI (and not paid to the creditors) were impressed with a trust, despite the fact that the sales agency agreement did not expressly refer to those distribution revenues as "trust funds" or expressly provide for the establishment of a trust account by CRI. The lower court found that there was abundant evidence to support a finding that the distribution revenues were impressed with a trust, which evidence included a covenant in the sales agency agreement that prohibited CRI from the "cross-collateralization" of distribution revenues and expenses relating to different films. The lower court then found that Stiliadis and CRI's affiliated companies were each liable for knowingly participating in a breach of trust and for knowingly receiving trust funds belonging to the creditors. Once again, the Divisional Court upheld these findings on appeal; in so doing, the Divisional Court affirmed that trust obligations may be created, even in the absence of express contractual language referencing the creation of a trust.

The T. Films S.A. v. Cinemavault case is also noteworthy in that the Divisional Court refused to allow the appellants (CRI, Stiliadis and CRI's affiliated companies) to adduce fresh evidence on the appeal by which they sought to provide an innocent explanation (through accounting evidence) for the transfer of CRI's assets to other Cinemavault companies, and to suggest that the transfer of CRI's assets did not materially impair the ability of the creditors to collect on the arbitral award. In dismissing the motion to adduce such fresh evidence, the Appellate Court found that the appellants could have adduced this evidence in advance of the initial hearing (but likely chose to withhold this evidence for tactical reasons); therefore, the appellants did not meet the legal requirement to show that the fresh evidence could not have been tendered earlier through the exercise of reasonable diligence. Further, the Divisional Court also dismissed the appellants' motion because the fresh accounting evidence had a number of inconsistencies, making it unreliable, and had no bearing on a central issue raised in the litigation, namely whether the distribution revenues collected by CRI for the film were impressed with a trust.

Robert B. Cohen of Cassels Brock & Blackwell LLP acted for the successful creditors in T. Films S.A. v. Cinemavault. Read the full decision here.

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.

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