Court-Appointed Inspectors in Shareholder Disputes: Disappearing Profits

OBCA Inspection Orders Can Verify “Skimming”

Section 248 of the Ontario Business Corporations Act R.S.O. 1990. c. B.16 (OBCA) sets out the courts’ overarching power to make an order rectifying a situation where a corporation has acted or failed to act in a manner that is oppressive, unfairly prejudicial, or unfairly disregards the interests of a security holder. This is commonly known as the “oppression remedy”.

In this context, courts have the added power to make an order directing an investigation in stipulated circumstances, in response to an application by a shareholder or certain other parties. One of those scenarios, as set out in section 161(2)(a) of the OBCA, is where “the business of the corporation or any of its affiliates is or has been carried on with intent to defraud any person.”

Practically speaking, this can cover a situation where a director or shareholder of a closely-held corporation has skimmed or siphoned money from the corporation directly into his or her pocket.

Intent to Defraud and Inspector Appointments

This was the exact scenario in a case called Noble v. Noble 2003 CarswellOnt 6742. Early in their marriage, the husband and wife had formed a partnership to develop health-related products. They later incorporated a company to manufacture massage products, which became very successful over the span of a decade.

When the husband asked for a divorce, it triggered a lengthy court battle between the former spouses. They did not agree on many business-related matters, including the extent of the shares allocated to the wife, and whether she had a right to share in corporate revenues. At that time the husband was the corporation’s chief officer and its sole remaining director.

In this context, the wife accused the husband of having skimmed funds from the corporation, and asked the court to appoint an inspector under section 161(2)(a) of the OBCA.

Proof of the husband’s corporate misconduct was readily-available: He admitted to the court that the Canada Revenue Agency had forced him to amend his tax returns over a half-decade period, to report substantial amounts of money that he had siphoned directly into his own pocket, rather than having the money go back into the corporation as it should have. He was also found to have engaged in what the court called a “tax dodge”, involving an improper transfer of corporate profits into a foreign entity. Finally, when the wife had questioned him on his claim that the corporation had no more money – despite its decade-long profitability and the husband’s $2 million in annual remuneration – the husband simply asked her to “trust him.”

The husband had subsequently offered what the court called the “baldest of assertions” that he had made monetary adjustments in the corporation’s favour, to account for these skimmed amounts in the past. However, his record-keeping was shoddy, and he failed to provide requested documents or other evidence to confirm his claims. The court noted that the husband’s efforts to document and rectify some of the problems consisted mainly of making phone calls to some customers and asking them for information.

The court concluded that the husband’s overall approach and methodology for curing the results of his admitted skimming “did not lend itself to objective verification”, and that the circumstances “cry out for an investigation”. It granted the wife the relief she requested, and ordered the appointment of an inspector.

However, the court cautioned that the inspector was not being authorized to go on a “wild goose chase”. Rather, the scope of the investigation was confined to specific issues including the tax dodge, and was limited to the post-1997 period, which the husband admitted was the point when he started siphoning corporate money. The costs of the investigation were to be borne by both the corporation and the husband personally, with some of the funding to be provided in advance.

Even Small Businesses Can Benefit

As a means for addressing skimming allegations, the provisions of section 161 of the OBCA are not limited to larger corporate entities; the courts can consider making these kinds of orders even in connection with more modestly-sized corporations. However, when doing so courts will remain mindful that the cost of an investigation may be prohibitive, in terms of the benefit to the corporation and its shareholders.

In a case called Evans v. Facey 2000 CarswellOnt 2102, [2000] O.J. No. 2276, the court considered a dispute between two men who operated a floundering restaurant business called “The Fish Palace”. The restaurant was a very small one, with only six tables, in an area of less than 1,000 square feet. Originally, it had been poorly run and mismanaged by Facey alone, and he invited Evans to join him in the business to help turn matters around.

The business partnership did not work out, and Evans ultimately applied under the OBCA for various oppression remedies, including a request to have an investigator appointed under section 161(2)(a). He had become suspicious that Facey was not accounting for all the cash that was collected from restaurant customers. After Facey denied the accusation and avoided all related discussions, Evans set a “trap”: He showed up unexpectedly at the end of a business day, just as Facey was counting the days’ cash receipts against the cash register tapes. Evans uncovered a $500 difference that Facey seemingly did not intend to remit and enter into the corporation’s records. Evans testified that this caused him to lose confidence in Facey’s honesty as a partner.

In these circumstances, the court declined to make an order under section 161 of the OBCA, but only because the cost was prohibitive especially given the poor corporate record-keeping. As the court explained:

[113] The problem with regard to many of the remedies claimed on behalf of [Evans] is that they are predictably very expensive having regard to the value of the business in question. … The expenses might put an end to the business or at least leave little value to be shared between Facey and Evans. I trust that I may be forgiven for briefly describing two images that came to mind when I was considering the appropriateness, in the circumstances, of some of the wide ranging remedies that I was asked to apply. The first image was that I was being asked to put a saddle on a cat! The second was that the wood was so shot that it would not hold the screws!

In the end, the court found the cost of an investigation would be prohibitive in this case, as compared to the net benefit to this small business. However, it went on to order certain other remedies for oppression, which were tailored to fit the circumstances.

The Bottom Line

Whether large or small, and especially if it is a closely-held entity, a corporation can be the victim of profit-skimming by directors or shareholders – who are also the best-positioned to conceal their misconduct.

The provisions of section 161(2)(a) of the OBCA can therefore be an important tool for having an investigator appointed, and for allowing needed information about the skimming and siphoning of corporate funds to be revealed and properly addressed.

Disclaimer: The content in this article is provided for general information purposes only. It does not constitute legal advice. All rights are reserved.