Shareholder Loans – a health warning

Introduction

A recent High Court decision (D4 Cash Investors Limited v Advanced Creative Technologies Limited [2017] NZNC 3280 [21 December 2017]) that made headlines more, I suspect, because the names of some of the investors than the underlying fundamentals provides another lesson for those considering some form of shareholder loan with which to prop up an SME.

The case involved Advanced Creative Technologies Ltd (“Creative Technologies”), a company which had been promoted as the owner of computer software known as the ‘Matariki Codex’ – with a numbering of eye-watering claims (none of which had eventuated). In 2005, a number of investors ploughed in approx. $300,000 through a vehicle called D4 Cash Investors Ltd (“D4”). D4 claimed that the initial investment was later converted to a loan – and that it was owed $3.2m (which included penalty interest at 30%).

The background to the repayment claim was detailed. In simple terms, High Court was told Creative Technologies was struggling for further financing in 2005 and decided to spin off potential commercial benefits from a data compression capability derived from its primary software development. The funds were initially raised on the basis that the investors would receive a minority shareholding in Creative Technologies. With investors complaining about a lack of commercial progress, this equity investment was later re-structured as a debt investment with the loan backdated. No repayments were ever made.

The reason for the restructuring and its effect were disputed. Creative Technologies said it was a joint venture – and nothing was payable until revenues were received.

The use to which the funds were applied was also in dispute – with claims that the money was used for research that was wider than what was agreed – and was therefore unauthorised spending.

Was the Loan Agreement a sham?

In seeking to defend a demand for repayment plus interest, Creative Technologies argued the Loan Agreement was a sham because no funds were advanced after the parties signed it – and there was never any intention to do so. However, the judge:

• Accepted that, at the time the Loan Agreement was signed, the directors of both lender and borrowed realised additional funding was required for the project – and that the Loan Agreement provided an avenue for doing so. The wording of the Loan Agreement expressly provided for an extension of the amount of the loan and the time for repayment.

• Found that, at the time the Loan Agreement was signed, there was a genuine common intention that funds would be advanced under the Loan Agreement. And the fact that there were no advances following the date of signing cannot serve to extinguish this intention.

• Noted that the sham argument also pointed to a lack of intention to repay. But this was inconsistent with the language of the Loan Agreement. And the directors of both lender and borrower said they were acting in the best interests of those companies.

• Noted that the Loan Agreement was said to fix the irregularity affecting the use of the funds – which also strongly suggested that there was a genuine intention on the part of Creative Technologies to repay those funds.
Accounting treatment

The accounting treatment of the Loan Agreement both by borrower and lender was at odds with the assertion the loan was never intended to be repaid. This is countered by the point that it is hard to see why it would feature as an asset in D4’s balance sheet and a liability for Creative Technologies.

Adequate consideration?

Backdating the Loan Agreement created a legal issue. No funds were advanced after signing, and the advances made beforehand could not constitute consideration. Some other consideration is required if the loan is to be enforceable.

Here, the judge was satisfied that, if D4’s funds were used in an unauthorised way that benefitted Creative Technologies and was of no benefit to D4, then D4 would have legal remedies against Creative Technologies. Remedying this situation by converting the funds that were irregularly applied into a loan from D4 would put any such argument at an end. Removal of potential risk while such argument remained alive could constitute (valuable) consideration. In return for D4’s disavowal of interest in Creative Technologies’ intellectual property in the Matariki Codex, Creative Technologies promised to pay the sum stipulated in the Loan Agreement.

The judge found this explanation consistent with the evidence – and rejected Creative Technologies’ argument that the consideration on which D4 relied (to enforce the Loan Agreement) was illusory.

The judge was also satisfied that those benefits were present at the time the Loan Agreement was executed – and, therefore, they provide sufficient consideration to support the Loan Agreement.

Collateral contract/estoppel argument

It was not clear who drafted the Loan Agreement although the judge noted that the terms of the Agreement were something the directors of Creative Technologies and D4 seemingly reached agreement upon amongst themselves. However, the judge:

• Rejected a claim by Creative Technologies that there were additional conditions that were not recorded in the Loan Agreement.

• Rejected a similar claim that the parties concluded a collateral oral contract that the Loan Agreement would not take effect until Creative Technologies had the funds to repay the loan – because there was nothing or no-one to obstruct the inclusion of such a term. And because such a provision would be the mainstay of the Agreement – its absence cannot be explained as a mere oversight.

General observations on status of Loan Agreement

At the time the Loan Agreement was executed, Creative Technologies directors were also directors of D4. The judge noted that those directors were hardly likely to call up a loan if there were no funds to pay the loan. They may also have believed that once the “monetising event” occurred the loan could readily be repaid. Nonetheless, the judge accepted that each company simply assumed no demand for repayment would be made until Creative Technologies could make it – so that the inclusion of a clause deferring payment obligations until a “monetising event” was unnecessary.

However, she added that such assumption and conduct cannot constitute an enforceable oral collateral contract capable of obstructing the demand for payment. Nor can it amount to an enforceable representation by way of estoppel.

The judge also noted that, at no time in the communications between D4 and Creative Technologies in the years between 2006 and 2012 did Creative Technologies act in a way that suggested it disputed the loan was legally valid. Indeed, in 2010 Creative Technologies wrote to D4 proposing that the loan, which it recognised to be comprised of the original money investment in D4, be capitalised in return for shares in Creative Technologies. This conduct was not consistent with how Creative Technologies sought to portray the Loan Agreement.

This decision provides another example of a situation where arrangements between what were often closely-related entities, including conduit lenders, were:

• not adequately documented; and/or

• did not adequately address the possibility that any departures from arm’s-length terms that were not adequately signposted – could later be “back-filled” (particularly where the parties later ceased to be closely-related).

Specifically, even if it might seem obvious that a conduit lender would be unlikely to call up a loan if there were no funds to repay it (or would not call for repayment until there was a “monetising event”) these conditions should be adequately documented.

Further information

If you would like more information about any of the matters discussed in this note, please contact me.