Creditor Proofing and Corporate Structuring Risks: Implications of the Botham v. Braydon Case
Operating a business through a corporation is a long-standing and acceptable form of protecting individuals from claims of creditors of the business. Likewise, holding high-value investment assets (such as real estate or a stock portfolio) in a separate holding is a legitimate way to protect the value of those investments from future creditors of an operating company. But, as was demonstrated by the British Columbia Court of Appeal in Botham Holdings Ltd. (Trustee of) v. Braydon Investments Ltd., the manner in which such corporate structures are initially set up is critical and, if done incorrectly, can have disastrous consequences.
An application to appeal the British Columbia Court of Appeal’s decision in Botham v. Braydon has been filed with the Supreme Court of Canada. Unless that appeal is heard and results in a different outcome, Botham v. Braydon will be the governing law in British Columbia.
In Botham v. Braydon, Mr. Botham undertook a restructuring of his company Botham Holdings Ltd., which had recently realized a profit of approximately $20 million from the sale of its real estate (which triggered capital gains tax). Botham Holdings was wholly owned by Mr. Botham and his family trust.
Around the time of the sale, Mr. Botham was contemplating investing in a risky partnership. Mr. Botham could have incorporated a new company to be the general partner in the new business. However, there would be some tax benefits that would offset some of the capital gains tax Botham Holdings had just paid on the sale if he used Botham Holdings as the general partner.
Mr. Botham did not want to risk all of his and his family’s accumulated wealth in Botham Holdings on this risky new business venture. Botham Holdings was therefore restructured using a butterfly style spin-off of its assets to a new holding company, Braydon Investments Ltd. Although the restructuring was done in a tax-deferred manner using section 85 of the Income Tax Act, fair market value consideration was exchanged with preferred shares being issued from Braydon Investments to Botham Holdings that were equal in value to the assets transferred from Botham Holdings to Braydon Investments. Following a series of cross-redemptions and offset of promissory notes, the majority of Botham Holdings’ assets had been transferred to Braydon Investments.
The purpose of this restructuring was two-fold: to protect the accumulated wealth of Botham Holdings from future creditors of the risky new business venture and to take advantage of certain tax benefits. These two purposes were identified in a letter from one of Mr. Botham’s advisors.
The new business was a spectacular failure. After only seven months it had operating losses of more than $5 million and, one year later, had creditors’ claims that exceeded $20 million.
An action was commenced in the British Columbia Supreme Court to allow the creditors of Botham Holdings to recover amounts from Braydon Investments in respect of the assets transferred from Botham Holdings to Braydon Investments during the restructuring.
The British Columbia Supreme Court held that the transfer of the assets to Braydon Investments was a fraudulent conveyance within the meaning of the Fraudulent Conveyance Act and therefore that the creditors of Botham Holdings were entitled to recover amounts owed to them from those assets. This decision was upheld by the British Columbia Court of Appeal.
The Fraudulent Conveyance Act provides that a disposition of property, if made to delay, hinder or defraud creditors and others of their just and lawful remedies is void and of no effect against a person whose rights and obligations by collusion, guile, malice or fraud are or might be disturbed, hindered, delayed or defrauded.
At first glance, the threshold to meet before a transfer will be a fraudulent conveyance appears to be high: the wording of the legislation indicates that there must be “collusion, guile, malice or fraud.”
Counsel for the creditors agreed that Mr. Botham was not accused of lying or deceit. Counsel for Braydon Investments argued that there was no fraudulent intent, or mala fides, as there were no outstanding creditor claims against Botham Holdings at the time of the transfer, no creditors had relied on the asset holdings of Botham Holdings and Botham Holdings received fair market value consideration for the transferred assets in the form of preferred shares in Braydon Investments.
Both the British Columbia Supreme Court and the Court of Appeal held that there need not be “collusion, guile, malice or fraud.” Rather, a transfer will be a fraudulent conveyance simply where there is the intent “put one’s assets out of the reach of one’s creditors.”
Because protecting the wealth of Mr. Botham and his family (that had accumulated in Botham Holdings) from the creditors of the new risky business venture was one of the two purposes of the transfer, this requisite intent was present and therefore the transfer was a fraudulent conveyance. Note that both Courts had no difficulty in establishing this intent as creditor protection was stated as one of the purposes of the restructuring in the letter from Mr. Botham’s advisors.
Also, both Courts were clear in their interpretation that there need not be any current creditors for a finding of a fraudulent conveyance. It is sufficient that there be the intent to hinder future creditors.
There is an exception to the application of the Fraudulent Conveyance Act where the transfer is made (1) for good consideration, (2) in good faith and (3) to a person who, at the time of the transfer, has no notice or knowledge of collusion or fraud. All these criteria must be present in order to avoid the application of the Act.
The British Columbia Supreme Court held, and the Court of Appeal agreed, that in this case the exception did not apply. The Courts found that, even though Botham Holdings received preferred shares equal to the value of the transferred assets, at the end of the restructuring (after the redemptions of the preferred shares and the set-off of the promissory notes), Botham Holdings was essentially left without any assets. Accordingly, the Courts held that there was no good consideration which passed from Braydon Investments to Botham Holdings. Further, the Courts held that the transaction was not made in good faith because one of its purposes was to move the assets out of reach of Botham Holdings’ creditors. Finally, the Court held that Mr. Botham was the directing mind of both companies and therefore had notice and knowledge of the fraud.
Both Courts stressed that Botham Holdings could have legitimately limited its liability had Mr. Botham incorporated a new company to be the general partner of the new venture instead of restructuring Botham Holdings. Unfortunately for Mr. Botham and his family, the use of Botham Holdings to obtain a tax advantage has cost them approximately $20 million.
To summarize, where a transfer is a fraudulent conveyance, the transfer is void as against creditors and the creditors can recover their claims against the recipient of the transferred assets. In the context of a corporate restructuring, Botham v. Braydon illustrates the following points:
- A transfer can be a fraudulent conveyance where there is any intent to protect the assets from present or future creditors. This is the case even where there are other additional legitimate business purposes for the transfer.
- The issuance of preferred shares with a redemption value equal to the value of the transferred assets may not constitute “valuable consideration” so as to avoid the application of the Fraudulent Conveyance Act.
Based on the above, the Fraudulent Conveyance Act can potentially catch many of the most routine corporate restructurings, with serious consequences. Any proposed restructuring should be carefully considered. It would be wise to consult with your advisors before completing any corporate restructuring and/or transfers and to obtain a legal opinion as to whether the Fraudulent Conveyance Act may apply to such restructuring or transfer.