Can Related Party Claims be Secured Under a General Security Agreement?

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In a recent case out of the Ontario Superior Court of Justice, Skymark Finance Corporation v Mahal Venture Capital Inc. et al. 2023 ONSC 2354, the Court ordered that approximately $1.9M of the nearly $2.2M of debt owing by a company subject to receivership was not secured and awarded $95,000 of court costs to the court-appointed receiver and other opposing party.

In Skymark, the sole shareholder, officer and director of Golden Miles Food Corporation (“Golden Miles”), Santokh Mahal (“Mr. Mahal”), had been given a general security agreement (the “GSA”) by Golden Miles to secure past, present and future advances made by Mr. Mahal to Golden Miles. After the court appointment of the receiver, Mr. Mahal sought a declaration from the court that the GSA was valid, enforceable, ranked in priority to other security interests given by Golden Miles that were registered under Ontario’s Personal Property Security Act and secured repayment of nearly $2.2M. The unusual aspect of the application was that three of the entities who had made the advances to Golden Mile were not parties to the GSA but were companies wholly owned by Mr. Mahal. He argued, based upon U.S. Steel Canada Inc. (Re), 2016 ONSC 569, 34 C.B.R. (6th) 226, at para. 217, that the underlying substantive reality of the transactions was that of a wholly-owned subsidiary relationship. Mr. Mahal argued that the GSA secured both direct and indirect indebtedness and therefore the advances made by the other three entities wholly owned by him were secured.

The Receiver and another party opposed Mr. Mahal’s application and the Court agreed with them. The court held that it did not agree that the GSA secured indirect indebtedness nor that the advances made by the related companies were even an indirect debt to start with. For the court to accept such a claim would cause considerable mischief. Other creditors would be unable to properly understand a company’s secured debt obligations as debts to related parties would be not searchable and whether they were outstanding would be ambiguous. The court held that a debt owing by Golden Miles to one of Mr. Mahal’s other companies is not an indirect debt owed to Mr. Mahal. A shareholder’s interest in the accounts receivable of a corporation is not a debt claim as the shareholders are simply entitled to the residual equity value of the corporation after all creditors have been paid. Further, the Court distinguished the US Steel case from the present facts as US Steel was a wholly-owned parent subsidiary relationship between two companies whereas in the present case, the affected companies were not in a parent subsidiary relationship but rather they were all simply owned by Mr. Mahal. Accordingly, the parent’s ability to control its subsidiary’s actions as a sole shareholder was not a factor in the present facts and analysis of the court.

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