Saving The Value of Your Investment Is Not Oppression

December 30, 2022

By Brian Babcock

We have written a series of articles about the oppression remedy as a solution to shareholder disputes in closely held private corporations, particularly where there is deadlock, fraud, or other causes of relationship breakdown making the continued relationship between the shareholders impossible.

As we have written before, not every situation involving a shareholder dispute is suitable for the oppression remedy. The case that we commented on previously, Leis v Lee was one example of that concept – a mutual falling out is not necessarily oppression. Something more is required.

THE CASE

Justice Morgan of the Superior Court of Justice for Ontario has given us a further example in Darvish-Kazem v. Pazkaz Enterprises Inc. Justice Morgan is never reluctant to find novel approaches to resolving problems. He also does not suffer fools, so an unreasonable party had better hope they get a different judge. Though he is polite, he is not shy to express his opinions. In the oppression arena, he is quite willing to enforce reasonable expectations, but knows if a party is being unreasonable – in which case, they get no sympathy in his court.

Darvish-Kazem was a 40% shareholder in Pazkaz, a holding company that owned approximately 40% of the shares of a start-up software company, Rave.

The alleged oppressive conduct was the issuance of additional shares to the other shareholder of Pazkaz, named Pazaratz, plus other investors. Darvish-Kazem complained that this diluted his own shares and as a result was unfair and oppressive.

Pazaratz owned the remainder of the Pazkaz shares, while several employees, together with Pazaratz, and Pazaratz’s mother owned the balance of the shares in Rave. That resulted in Pazaratz and friends controlling Rave and owning directly or indirectly about 67 percent of Rave. Darvish-Kazem, instead of 40 percent, was left with about 33 percent.

Pazaratz worked full time in the business, without salary. When the company struggled, Darvish-Kazem returned to practicing as a doctor.

The business had yet to make a profit, although the shareholders were hopeful. Darvish-Kazem and Pazaratz founded the business with a long-term goal of securing outside investment. Initially they were 50% shareholders each. Subsequently, Pazaratz made additional financial contributions and the shareholdings of Pazkaz shifted to 60% Pazaratz, 40% Darvish-Kazem.

There was no shareholders agreement to restrict the issuance of shares or require both investors to maintain equal ownership. Darvish-Kazem was unwilling or unable to invest further. Pazaratz’s action kept Rave afloat.

The resolution authorizing the restructuring of Pazkaz, in addition to setting out the amounts of the investment (as shareholder loans) also provided that there would be no further shares of Pazkaz issued until the shareholder loans were repaid in full. The resolution made no mention of additional shares in Rave. Pazaratz’s  investment in Rave was never converted to a shareholders loan. Darvish-Kazem approved the resolution.

About a year after the change in the share structure, the parties started to have a series of disagreements and by February of the following year Rave was on the brink of bankruptcy. Pazaratz advanced further money to Pazak to fundraise ongoing operations.

Darvish-Kazim refused to contribute a proportionate amount of funds but took the position that Pazaratz’s further contribution to Rave was “improper” because it had not been approved by the board of Pazkaz.

This dispute led to Darvish-Kazem giving up any active participation in the business and Pazaratz voted to remove Darvish-Kazem as an officer and director of both corporations.

When Rave needed further cash injections to stay in business, Darvish- Kazim declined an opportunity to buy shares at the same price as the new shareholders. The valuation at which the new shareholders purchased was advantageous financially to Darvish-Kazim, as on paper at least he had a higher net worth. In reality, if not for those investors his entire investment would likely be worthless.

THE RESULT

Justice Morgan did not agree that the history of dealings with the shares resulted in an improper dilution of Darvish- Kazem’s interest. Both companies issued shares commensurate with the respective shareholder investments. This did not constitute oppression. Darvish-Kazem retains exactly the same number of shares as he had before, and the dilution of his proportionate shareholding was necessary to protect that investment.

Therefore, rather than being “unfairly prejudicial to” or “unfairly disregarding” Darvish-Kazem’s reasonable expectations, the dilution was in Darvish-Kazem’s own interest. There was no preferential benefit to Pazaratz or the new investors.

Not every failure to meet a stakeholder’s expectations is necessarily oppression. The statute requires unfair disregard or unfair prejudice for a finding of oppression.  The leading Supreme Court of Canada decision on the test for oppression further says that oppression carries a sense of coercion, abusive conduct or bad faith. However, the failure to provide required audited financial statements is unfairly prejudicial to a shareholder’s interest, so justice Morgan ordered that they be prepared and produced to Darvish-Kazem. Otherwise the application was dismissed.

Unlike in some situations, this was not a case where the judge ordered a different sort of corporate remedy to break a deadlock.

TAKEAWAYS

This case is more than simply a reminder that oppression remedies are not automatically available in all corporate disputes.

This case:

  • emphasizes the importance of unfair disregard or unfair prejudice in a finding of oppression;
  • refines our understanding of those terms by applying the Supreme Court test requiring misconduct by the responding parties, such as coercion, abusive behavior, or bad faith to facts in which the applicant’s expectations were just not reasonable;
  • points out that an applicant can be successful in obtaining a technical order for particular relief even if they are generally successful on an oppression application;
  • highlights the possibility that if the applicant only recovers nominal or technical relief, they are not likely to receive any contribution towards their costs, and they may be required to reimburse part of the respondents costs;
  • illustrates the importance of having a unanimous shareholders agreement to regulate issues such as dilution of shareholdings or the issuance of new shares; and
  • shows the need for good corporate drafting lawyers who will have a variety of clauses that they can tailor to fit any situation. A failure to agree on an appropriate wording may be an indication of problems with the incorporation of the business even before it gets up and running.

HOW WEILERS LLP CAN HELP YOU

The corporate commercial lawyers at Weilers LLP have extensive experience in drafting corporate documents including unanimous shareholder agreements. We take the time to collaborate with our clients to understand their needs and expectations, and in negotiating an agreement we assist them in achieving as close to those expectations as possible.

If, despite best efforts, you find yourself involved in a dispute, the litigation team at Weilers LLP has a solid record of negotiating favourable outcomes as well as obtaining remedies through alternative dispute resolution or litigation. We understand the different corporate remedies that are available and carefully structure your pleadings or attack the opposition’s pleadings accordingly to seek the right relief for the facts.

If you need corporate law advice of any type, give us a call. Weilers LLP may be the right lawyers for you.