How to Start a Distillery in Ontario

Here’s an article that’s been a long time coming. On top of my law practice, I’m also a founder of Last Straw Distillery, an award-winning micro-distillery near Toronto, Ontario. I started out as the company’s lawyer, and as with any small business, that role has slowly expanded to a litany of other tasks…. But the lawyer role remains central. I’ve also helped several other alcohol producers through the business startup and licensing process, so the contents of this article are hard-won knowledge. It’s a long read, but it’s a no bullshit assessment of the challenges you’ll face in getting your distillery off the ground.

The first thing you need to know about distilling is that it’s heavily regulated. The laws on spirits are even more dense and difficult to navigate than the regulations on beer or wine. This is, of course, because in the inestimable wisdom of successive governments since the end of prohibition, spirits are evil. For some strange reason (probably at the behest of the beer lobby), some Scottish Presbyterian politician in Ontario decided that the ethyl alcohol in hard liquor should be treated differently than the ethyl alcohol in wine and beer.

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Much like we’re seeing right now with the legalization of marijuana in Ontario, the laws are written by and for established, well-connected, well-funded big businesses. The time, expense, and expensive advice involved in navigating the system are designed to limit competition. For spirits, the government at the end of prohibition wrote the rules in a way that would make it difficult and expensive to start and run a distillery, and impossible to start on a small scale. As a result, Ontario had only a handful of big distilleries for nearly 80 years. It’s only recently that a few dedicated masochists set out to buck the trend. Through their dedicated efforts, some of the barriers to entry were lowered (slightly), and the Ontario distilling renaissance began.

I’m writing this article as an overview of the major steps involved in starting a distillery in Ontario, Canada. I imagine that most of the steps are mirrored in many other jurisdictions, but the nuances of the regulations will differ. As with any business, you certainly don’t need a lawyer to help you get it started, but a good lawyer will reduce the time from startup to sale, and deal with a lot of the headaches that can come from dealing with five or six different government departments at once.

Let’s get started.

Division of Powers

Booze has the unfortunate distinction of being one of the few market sectors that is regulated by Federal, Provincial, and municipal governments. Technically, municipal governments are a subset of the Province, but practically speaking, it’s another layer you’ll have to deal with.

The Federal government’s primary concern with alcohol regulation is tax. As a luxury item, spirits are subject to Federal tax under the Excise Act. This tax accrues from the moment a drop of alcohol is manufactured, but only becomes payable when the alcohol is sold. More on this later. The Federal government also regulates the production, and labeling of spirits through the Food and Drugs Act and its Regulations, Consumer Packaging and Labelling Act, Consumer Packaging and Labelling Regulations, and the Spirit Drinks Trade Act. Oh, and if you’re thinking about selling your products internationally, the Federal government also regulates and licenses cross-border trade, where a different set of taxes and fees apply, on top of those imposed by the jurisdiction you’re exporting to.

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If that bundle of joy isn’t enough for you, the control of liquor is the responsibility of the Province. The Ontario government has created the Alcohol and Gaming Commission of Ontario (AGCO) to control the production and sale of spirits in Ontario. The AGCO then created the Liquor Control Board of Ontario (LCBO), which has an absolute monopoly on spirits sales in Ontario. The AGCO implements government policy on spirits through the Alcohol and Gaming Regulation and Public Protection Act, the Liquor Control Act, and the Liquor License Act. As a manufacturing business, you’re also subject to the rules of the Electrical Safety Authority under the Electricity Act, as well as Ontario’s Building Code and Fire Code.

Lastly, as with any business, spirits producers are subject to the planning and zoning regulations of the municipality you’re in. In some municipalities, there’s a double layer of government – at the regional and town level.

Perhaps the worst part of working through the byzantine maze of regulations are the odd ways in which they interact. As I mentioned, the system was not developed with ease of navigation in mind, and there’s no clear, direct path through them. It’s common for applications to be caught in a Catch-22 of two levels of government refusing to process your application any further without the approval of the other coming first. In my experience, different offices of the same government branch interpret the exact same rules differently (and sometimes incorrectly), and impose different requirements. It takes time and patience to work through these things. Budget at least six months, or more realistically one year to work your way through this stuff. When I say budget, I mean both time and money – as you’ll be spending money on rent for a space you’re not allowed to use while your applications are in progress.

Now that you’re scared, let’s walk you through what it takes to get from idea to open for business.

Form of business

Distilleries can be any form of business, but if you don’t incorporate it, you’re a dumbass. When setting up your corporate structure, two factors will be relevant to the government:

  • Who controls the corporation; and
  • Who are directors, officers, or holders of at least 10% of any class of shares

Control comes into play in two ways. First, the government wants to know if the applicant is controlled by a company that is already licensed to produce spirits. Each distillery with a Provincial license is allowed one bottle shop at its distillery. An existing manufacturer can invest in starting another distillery, but special permission is required to open a bottle shop at the second distillery. Once you have that special permission, you can sell some products from the first distillery at the second one, but not the other way around. Weird, right?

Secondly, and most importantly, the government wants to know who are directors and officers of the business, and who owns 10% or more of any class of shares of the corporation. Because spirits are evil, the government wants to make sure that the people who own and operate distilleries are at least 19 years old, financially responsible, and of good character. If you own your shares through a holding company, you have to disclose the ownership and management of that holding company, and so on.

In my experience, simplicity in the way you structure the business helps a great deal. The folks reviewing your applications at the CRA and AGCO are not lawyers, and don’t understand the finer points of business ownership. If they see something they don’t understand, they’ll flag it, and get legal advice before proceeding. This, of course, takes time. The more complicated your ownership structure, the longer your application will take.

Zoning & Planning

This is probably the biggest, and most unexpected pain in the ass of the whole process, and where your lawyer will earn their keep. It is absolutely essential that you choose a location that will allow your business model to operate. Because distilleries are still relatively rare when compared to breweries and wineries, most municipalities don’t know how to deal with you. When in doubt, town planners and town councils will err on the side of what will get the municipality the most revenue in development fees. If you ask the municipality whether or not a distillery is allowed, you’ll probably end up paying to play. The only thing you actually need the municipality to do is to sign off on your bottle shop. Some municipalities may require a business license before you can set up shop, but most don’t.

Once you know where you want to start your distillery, and before you start searching for properties, get your lawyer to review that municipality’s planning and zoning bylaws, and provide an opinion. The lawyer’s opinion should tell you what zoning in that municipality allows a distillery to operate. The lawyer will also tell you if a variance or zoning change is required in order to operate. Also, believe it or not, some municipalities still have “dry” (no alcohol allowed) or “damp” (retail sales allowed, but not by the glass) neighbourhoods. The status of the neighbourhood may not prevent you from manufacturing, but it can prevent you from selling through a bottle shop, or an on-site bar. Both the CRA and AGCO will consider whether you’re contravening municipal bylaws, and whether your premises comply with the CRA and AGCO’s regulations. The lawyer’s opinion is super valuable in demonstrating that you’ve ticked all of the boxes.

Lastly, before you sign your lease or buy the property, take a good long look at what’s in the area. If any schools, churches, parks or playgrounds, community centres, or libraries are within a one kilometre radius, you may not be allowed to open a bottle shop or on-site bar.

Building/Fire Code

Once you have a location, you have to build it out. Obviously, all of your construction work must be done in accordance with the Ontario Building Code. Make sure that whoever is doing the work knows and complies with that code. Generally, Building and Fire Codes are dictated by the Province, but enforced by the municipality. Fire inspectors can enter anywhere, at any time, and can shut you down on the spot if you’re not in compliance, so don’t cut corners here.

Distilleries in Ontario are considered “High Hazard Industrial Occupancy” under the Fire Code. That means the building can’t also be used for public assemblies, residences, care facilities like hospitals or clinics, or for detention. If the occupancy load of the building is to be more than 25 people, the building requires emergency planning under the Fire Code. The Fire Code rating (F1) triggers specific requirements in the Building Code for fire-resistant barriers and insulation, emergency exits, and the like. It also triggers requirements in the Electrical Act, requiring the sign-off of an Electrical Safety Authority (ESA) inspector.

ESA sign-off is another odd bird. For all the distilleries I’ve helped through the process, I’ve never seen the same standard applied twice. Each inspector seems to interpret the requirements differently. The inspector’s requirements will play into your build-out – ventilation, type of wiring and electrical fixtures, signs, fire suppression systems, and even separating equipment in different fire-resistant rooms, for example. Find an inspector, and get their direction before you start building. Pass that direction on to the person doing the build out work, and make sure they build to that standard.

Lastly, if you’re looking to open an on-site bar, you’ll need the sign off of the Fire Department. Exits, fire suppression, and signage are all things they’ll look at.

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Federal Licensing

Once you’ve got an appropriate space locked down, you can then apply for your Federal licenses. The licenses are tied to the location. You have to occupy/possess the premises before your application will be processed. This means you’re paying rent on a space you can’t use while your applications are being processed – as long as 18 months in some cases.

The Canada Revenue Agency administers the licensing of distilleries under the Excise Tax Act. The licenses are issued for a two year period, and must be renewed. At the time of writing, there are no fees for the federal licenses. There are three key licenses – all of which can be applied for on the same form – which will cover off most things distilleries want to do.

Spirits License

The spirits license is the main one. It’s what permits you to produce or package spirits (beverage alcohol that isn’t wine, and is over 11.9% alcohol – otherwise it’s beer) in Canada, and to possess a still. If you’ve applied for a spirits license, you can possess a still, but can’t operate it. Home distilling is illegal. Without this one, you’re a bootlegger, not a distiller – and you won’t be able to secure any Provincial licenses either.

Excise Warehouse License

If you’re going to be storing spirits – whether in bulk, aging in barrels, or sitting in bottles waiting to be sold – you’ll also need an Excise Warehouse License. This delays the payment of Excise Tax on the spirits until they’re removed from the warehouse.

You will need to post security for the Excise Tax. The amount of security depends primarily on how many litres of absolute alcohol you plan to store in your warehouse. The CRA wants to make sure that even if you go bankrupt, you can still pay your Excise Tax. The minimum is said to be $5,000.00, however the lowest requirement I’ve seen is $10,000.00, and that’s for small distilleries dealing in white spirits – meaning they’re not aging large quantities. If you’re making whisky, rum, brandy, and other aged spirits, plan on posting way more. Security is typically posted by bond (insurance), though you can post negotiable instruments (cash, Canada Savings Bonds, etc) as security as well.

User’s License

The user’s license allows you to transfer bulk alcohol between booze producers of a different type. If you’re planning on buying in bulk alcohol to distill, age, modify, or repackage, you’ll probably need this. I say probably, because different CRA personnel apply the policy differently. You definitely need a user’s license to transfer bulk beer or wine from licensees. You might need a user’s license to buy bulk spirits – such as a neutral grain, or aged whisky for blending. Regardless of what your CRA agent says, some producers won’t transfer bulk spirits to you without seeing your user’s license, so it’s usually a good idea to get this license just in case.

Application

The application process takes anywhere from 3-18 months, depending on your agent, how prepared you are, if there are any issues with the application or the people involved in your business, and how busy the agents are. There are a few parts to the application:

  • L63E license application form
    • This includes details on directors and officers of the business, and will result in a background check on both criminal and financial sides
  • Business plan including:
    • Business industry overview;
    • Operating plan;
    • Human resources plan;
    • Financial plan or sources of funds;
    • Sale and marketing plan;

Your business plan must include 3 year projections of the litres of absolute alcohol you expect to produce, and the amount of what you produce that will be stored in bulk for aging, compared to what you expect to sell. This is what the CRA will use to calculate your security requirements.

You’ll also need to figure out how you’ll post security for the excise. Most distilleries will buy a bond, rather than posting the cash themselves. It’s a monthly expense, but your capital will be more useful elsewhere. The CRA will require the sealed original bond.

Once you’ve submitted the application, the CRA will get in touch with you pretty quickly to start the process. They’ll schedule a site visit, so they can inspect your facility to ensure it’s suitable (they’re primarily concerned with physical security – if someone steals your spirits, they’re stealing tax dollars too!). You don’t have to be fully built out by this point, but you must at least have the premises and a floor plan.

They’ll also confirm that you’ve ordered your still and instruments for measuring alcohol content. Your instruments must be inspected/calibrated by the CRA to ensure they’re accurate, which involves a fee. They may conduct a second site inspection before granting the license.

Once the license is approved, you’re finally able to produce spirits! Crank that still up, and get to work!

Provincial Licensing

Bet you thought the hard part was over. Well, it’s not. While the CRA licenses will allow you to produce and store alcohol, if you want to sell it in Ontario, you’ll need another set of licenses and authorizations from the Provincial government, which are administered by the AGCO.

The Provincial Manufacturer’s License is what allows you to sell spirits in Ontario. It takes about 1-3 months to process, if all goes smoothly, and costs $2,540.00 for 2 years, or $5,040 for 4 years at the time of writing. The application requires:

  • Completed application form
  • Business plan – generally the same one that you used for your CRA license will do, plus:
    • Floor plans for your facility
    • Details on planned sales channels
    • If you’ll be buying in mash, low wines, or bulk spirits from other producers
  • Municipal authorization form
  • Copy of CRA Spirits License
  • Lab test results on at least one product
  • Copy of business name registration
  • Application fee (non-refundable)

The AGCO will schedule a site inspection of your facility. As with the CRA, different agents will focus on different things, and sometimes the agent will waive the site inspection altogether.

Bottle Shop

If you want to operate a retail store on site, then you’ll need a retail store authorization from the AGCO. The AGCO delegates the administration of this to the LCBO. There’s no fee for the application, but you must include:

  • Municipal Information for a Retail Store Authorization form
  • Site plan detailing the production site and the proposed retail store location
  • Floor plan of the proposed retail store including square footage
  • If ownership and control of the production site is shared with any other licensed manufacturer – supplementary documentation demonstrating substantial ownership and control of the production site
  • A copy of each notification letter (if applicable) sent to any place of religious assembly, schools, public parks and playgrounds, community centers or libraries within 1 km of your proposed store location and copies of any responses/objections

If your bottle shop is approved, then you’ll need to sign a non-negotiable contract with the LCBO about how the bottle shop will be operated, and how you’ll pay the Spirits Tax. One of the most time-consuming parts of this contract is waiting for the LCBO to sign it – as only the President of the LCBO signs them, and does so about once a month. Schedule your grand opening accordingly!

Direct Delivery

If you want to deliver directly to bars & restaurants or to duty free shops, you’ll need separate direct delivery authorizations for each. The process is much the same as for a bottle shop, and results in another contract.

There are also separate licenses to sell spirits by the glass, and to operate an on-site bar or restaurant of your own, but we’ll save those for a future article.

Summary

As you can tell, it’s an awfully long and tedious process to get a distillery from the idea stage into operations. The typical timeline is 6-18 months, based largely on factors outside of your control. In my experience, each agent of a regulator that gets its hands on your application views the requirements differently, so there’s often a fair bit of back and forth involved.

TL;DR? Here’s Mikes’ 9 “Simple” Steps to Starting a Distillery in Ontario

  1. Incorporate
  2. Lawyer’s opinion on zoning/planning
  3. Sign lease
  4. Submit CRA license application
  5. Hire ESA inspector, get requirements for buildout
  6. Build
  7. Get CRA licenses, get municipal authorization
  8. Apply for AGCO licenses & authorizations
  9. Profit

Of course, having someone to turn to who’s been through the process before can help to grease the wheels. I’ve helped several distilleries through the startup process, and I’d be happy to help yours too. Drop me an email, and let’s talk!

 

Mike Hook
Intrepid Lawyer
http://intrepidlaw.ca

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Legal Aspects of Business Continuation Planning

This article is the second in my series on what’s involved in planning for the worst. In the last one I gave an overview on who and what is involved in the process. This time I’ll lay out some of the legal work that may need to be done in order to put your plan into effect. The goal here is for your business to continue relatively smoothly if you die or are incapacitated. The most obvious benefit is that you or your beneficiaries will have a chance to receive the value of the business – which could be lost if you’re not there to run the business.

There are a bunch of great resources out there, largely from insurance companies and banks, about business continuation planning. Though it may seem like a lot to wrap your head around, the legal side is fairly simple. The first step is to identify what the essential parts of your business are. What’s the bare minimum that must be done in order to keep the doors open? Who’s capable of doing those things? What’s to become of your control of the business, and your share of the profits? Once you’ve figured that out, your business advisers can help you to get the paperwork done. That paperwork typically includes:

Continuation Plan

While not necessarily a legal document itself, it becomes enforceable when the directors or officers of the corporation resolve to adopt it. The continuation plan should include who is to assume what responsibilities, who is to oversee the transition, what is to happen with loans that are personally guaranteed, key contacts at customers, suppliers, service providers, advisers, and creditors, insurance policy information, where business records are kept, and any other information that someone taking over your role will need to know about the business.

The continuation plan should be kept in the company’s minute book.

Shareholders’ Agreement

A shareholders’ agreement is a contract between the owners of a company as to how they’ll run the corporation. It can also force those who become shareholders in the future – perhaps resulting from your death or incapacity – to do certain things in running the business. I’ve talked about why you should have one for your business in an earlier article. I’ll write another one soon about what should go in to one… but the continuation plan for the death or incapacity of key people should be part of the shareholders’ agreement. If you have one in place already, work with your lawyer to make sure it jives with the continuation plan. If you don’t have one in place, it’s a good idea to make one.

Insurance

Though it’s not a purely legal issue, insurance is an enabler for most continuation plans. It’s common for the company or your co-owners to take out insurance on you, and the other main players in the business. There are a number of different types of insurance, each with strengths and limitations. The goal is to ensure that there’s cash available to tide the business over and find someone to fill in for the person that’s been lost. Each business will be different, and a good insurance agent can give you the full slate of options, and help you to choose one that works for your company.

It’s important that your insurance agent and lawyer get in touch to discuss the policy you’ve selected so that the legal documents mesh with the policy. Your lawyer can also help you to understand what’s covered, and what’s not under the policy. Once you understand where the gaps are, you can come up with ways to minimize the risks that remain.

Corporate Documents

Picking someone to step into your shoes is one thing. Giving them the lawful authority to make decisions in your place can be another one altogether. You should consider appointing the chosen one as an officer of the corporation, and giving them conditional authority to speak and sign to bind the company in legal documents. They should know where the corporate records are kept, and be put in touch with key advisers including the corporation’s lawyer, accountant, and insurance agent.

When the continuation plan is made, you should ensure that your business books and records are up to date and complete, including the minute book, government filings, and accounting records. Your successor will have enough to deal with already, without having to deal with figuring out what state the company is in first. The corporate minute book should also include a resolution approving the contingency plan, which will prove useful in dealing with outside institutions – banks in particular.

Wills & Domestic Contracts

Not only should you have a will in place that deals with your interest in the company, but it should be in harmony with the continuation plan. If the corporation has decided that your control of the business should pass to one person, but your will passes all of your property to your spouse, there’s a huge potential for conflict. Many people use separate wills for their personal and business assets. Domestic contracts – while painful to negotiate – can be used to protect control of the corporation as something that’s not included in the marital assets in the event of separation or divorce.

Powers of Attorney

A Power of Attorney for property is a legal document that authorizes someone to act for you in making decisions in the event that you’re incapacitated. Banks and other creditors will want to see this, possibly along with the resolutions authorizing the contingency plan and granting signing authority before they’ll deal with someone they don’t know. These are usually made or updated at the same time as your will.

Employment Contracts

Many owner-operators work without a written contract of employment in place with their company. It’s generally understood that as an owner-operator, your responsibilities and risks are almost indefinite. It is a good idea to put an employment contract in place with yourself – a description of duties, salary, and benefits at a minimum. This will help to set expectations for what’s expected of and given to your replacement.

A current employee who steps up into your role will be taking on a great deal more responsibility, and assuming more personal risk in the form of director or officer liability than they had before. This type of change to the employer-employee relationship is something that should be down on paper to protect both of you. Salary, responsibilities, and expectations may all change in the new contract. It’s also good practice to give some form of protection, called indemnity, to those who run the company.

If there’s nobody in your company who could step up to run it, a manager may need to be hired from the outside. If you want to have any say over their role, and any limits on their authority, you’ll have to set those out in advance. Again, the starting point could be your employment contract.

Again, insurance can be used to cover some or all of the expense of hiring, training, and paying a new employee.

Practicalities

Training your possible successor is the most important piece of the puzzle. They may show the potential to run the business by having the right skill set, but will probably need time to be brought up to speed on how the business works. It’s never too early to start. The up-sides of having someone who’s capable of running the business are many – you may even be able to take a holiday for once!

It’s also important to be mindful of avoiding trying to run the business from beyond the grave. A properly trained and equipped successor will still have their own ideas, and should have the flexibility to see them to fruition.

Conclusion

When a thorough continuation plan is made, it’s a major step towards peace of mind for you and your dependents. If you’re laid up with an injury or illness and the business founders without you, you may not be able to pay for your own care. If you pass away, and the business you’ve worked so hard to build follows closely behind, your dependents may be left high and dry. If the business goes under, your employees and others who rely on it for their livelihood, could be in dire straits. While it’s an uncomfortable thing to talk about and plan for, it’s the responsible thing to do.

I’m happy to help you start the process, and I’ve got a good team of specialists who can guide you through the finer points of tax, employees, insurance, and financial planning should you want the help. The next article, on how to plan for your retirement, will be on its way soon!

Now, to counter all those gloomy thoughts I’ve put in your head, here are some very cute animals trying to look tough.

See you soon…

 

 

Mike Hook
Intrepid Lawyer
http://intrepidlaw.ca
@MikeHookLaw

Unanimous Shareholder Agreements

This can be a confusing topic. There’s a whole lot of stuff written about it, utilizing an abundance of excessively Brobdingnagian verbiage, but it’s usually a lot of talk about what a unanimous shareholder agreement (or “USA”) is, rather than why you might want one for your corporation. Here I’ll give you the basics of what it is, why you might want one, and what’s in it.

What is it?

A USA is a contract between all the shareholders of a corporation that limits the power of the directors to supervise or manage the business of the company. It could even take all management powers away from the directors. Without one in place, the directors can exercise all of the powers they’re given by the corporate laws, at the director’s discretion. Back in the day, if directors started running the company in a way that the shareholders didn’t like, there wasn’t much that the shareholders could do about it until it was time to vote for the directors again. Nowadays, the USA gives shareholders an out.

The rights, powers, and responsibilities that are taken away from the directors are then assumed by the shareholders. The shareholders will also take on the liabilities that go along with the powers – such as liability for unpaid employee wages, tax remissions, pension, environmental protection, etc. Some liabilities can’t be opted out of, such as the ones in the Occupational Health and Safety Act. Make sure you know the risks before signing on the dotted line!

A USA is a “constating document” of the corporation – like its articles and by-laws – that deals with the inner workings of the company. It is important to make sure that it doesn’t conflict with the articles or by-laws.

Once a USA is in effect, any new shareholders are deemed to be a party to it, and they should be given notice that it’s in place.

Why would I want one?

USA’s are most common in companies with a few shareholders, who own roughly even percentages of the company. They’re typically used to modify or supplement the rules in the Business Corporations Act:

  • Set out a Succession Plan: I’ll blog about succession plans soon, but a USA can be used to hand off the ownership and management of your corporation so that the business can continue after you retire, or if something bad happens to you.
  • Change Default Corporate Law Rules: such as the % of directors required to vote in favour of certain material decisions, such as paying dividends, buying or disposing of major assets, entering into joint ventures, non-arms-length transactions, mortgaging or liening property, or changing the business of the Corporation.
  • Protect Investor Interests:  venture capitalists, angel investors, or banks may want a USA in place to ensure that they can control things that directly affect their investment – such as amending the articles or by-laws, mergers, issuing new shares, or the sale of substantial company assets.

USA’s can also be used to do a few tricky things, which aren’t guaranteed to work out the way the shareholders intended.

  • Foreign-owned Corporations: the law requires at least 25% of directors to be resident Canadians. A USA can take all the powers away from the directors, and let the foreign shareholders do the decision-making. This may work for some purposes, but courts will ignore this sleight of hand in certain situations, particularly to do with tax liabilities.
  • Protecting Directors: where the shareholders own their shares through a holding company. Those holding companies assume the directors’ liabilities, and in theory, the people who own those holding companies are protected. It’s likely that a court would look right through this technicality though, if there wasn’t enough to pay out the creditors.

What’s in it?

Like any contract, the contents are up to the people making it. Typically, a USA may cover many of the following topics:

  • Decision making process
  • Quorum for meetings
  • Restrictions on share transfers, and how to deal with involuntary share transfers on death, bankruptcy, or court order
  • Special rights of minority shareholders, or special restrictions on majority shareholders
  • Process to amend the USA
  • Funding considerations – from existing or new shareholders, or
  • If the directors aren’t stripped of all of their powers – representation on the board, or a right to appoint someone to observe board meetings
  • Dispute resolution
  • Right to dissolve the corporation

There are plenty of templates out there that can get you started, including this useful one from the Law Society – but as I said above, it’s incredibly important to understand the risks before fiddling with the way your corporation is run…. like using a game of Operation to prepare for open-heart surgery.

If you need a lawyer, I happen to know a guy

Mike Hook
Intrepid Lawyer
Email: mike@intrepidlaw.ca
Twitter: @MikeHookLaw

Duties and Liabilities of Directors and Officers of a Corporation

So, you’re the proud owner/director/president/chief-bottlewasher of a shiny new small business corporation. “President” looks sharp on your business cards. You’re primed to flex your management muscle, and power the company into the marketplace. With that power comes responsibility and risk, however. The laws of Ontario and Canada impose a lot of it on the directors and officers of a corporation. What follows are some of the basic “must-know” duties and liabilities of the people who run companies.

The legal responsibilities of directors and officers of a for-profit corporation come mainly from two laws – the Canada Business Corporations Act (CBCA) and the Business Corporations Act, Ontario (OBCA). They’re similar in most respects, so unless I mention otherwise, you can assume that the same duties and liabilities would apply for a federal or Ontario corporation. These laws have been interpreted and applied by the courts in order to determine what’s expected of those trusted with the operation and direction of a business corporation.

Limited Liability

One of the biggest advantages of a corporation is that it is a separate legal person, which assumes its own liability. If the corporation goes bankrupt, gets sued, or has some sort of accident, the directors and officers of a corporation are generally protected by the “corporate veil.” This means that the corporation is the person that may be held liable, not the people who run it. In exchange for this protection, the law expects directors and officers to fulfill certain duties. In general, more is expected of a director than of an officer. If you don’t live up to those duties, you may lose the protection of the corporate form, and face personal liability.

So What Are these Duties?

1. Management

First things first – directors and officers play different roles in the management of the company. In a startup or small corporation they may be the same people, but as the company grows you’ll need to divide up the responsibilities a little more. Many companies will bring in outside directors with business or other expertise to raise the company’s profile or influence, and guide the business.

The basic role of the board of directors is to manage or to supervise the management of the corporation. Directors are elected by the owners of the corporation – the shareholders – to protect the owners’ interests. Directors’ duties include providing oversight, questioning the reports and recommendations of the officers or committees, and retaining ultimate control and direction over the business of the corporation. Other managerial tasks the directors may do themselves, or delegate them to the officers of the corporation. Delegating duties to officers does not relieve directors of their oversight responsibilities, but absent grounds for suspicion, the directors may trust the officers to perform their duties honestly. Directors should take care not to micromanage the officers by questioning every decision.

Officers – such as the CEO, President, Vice-President, Secretary or Treasurer – are appointed by the board of directors, and are responsible to manage the day-to-day operations of the corporation honestly and in good faith. Officers are usually the “directing minds” of the corporation’s daily business.

2. Fiduciary Duty

Directors and officers are “fiduciaries” of the corporation. Fiduciary is a legal term that means that they owe the utmost loyalty and good faith to the corporation, and must act only in its best interests. They may not put themselves in an actual or potential conflict of interest with the corporation. The courts are very strict in enforcing this duty, and will continue to be so.

The fiduciary duty is designed to protect a corporation against the people who control it using the corporation for their own benefit. The most common breaches of this duty include self-dealing, self-interested actions, and bad faith actions by directors or officers. The duty doesn’t mean that a corporation can’t deal with its directors or officers. Directors and officers must simply take extra steps to ensure that the conflict is disclosed, and the transaction is reasonable and fair to the corporation. The proper procedure to follow in the event of a potential conflict of interest in dealing with a party that director or officer has an interest in will be discussed later.

A director’s fiduciary duty is owed to the corporation, not to the shareholders who nominated them as a director. The limited liability of a corporation will not protect a director who acts in the best interests of their nominator over those of the corporation.

A director can be found personally liable if they use confidential information they received in their capacity as a director or officer to steal business opportunities from the corporation. It is a breach of fiduciary duty, whether it is for their personal gain, or the gain of another entity they have an interest in.

3. Care, Diligence and Skill

Directors and officers must carry out their duties with the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances. What is “reasonable” is subjective, and depends on a number of factors, including the:

  • director or officer’s qualifications
  • significance of the action to the director or officer when making the decision
  • time available to make the decision
  • alternatives available to the corporation

Directors and officers are not expected to predict the future, or to make perfect decisions – only to exercise reasonable business judgement. Courts will not intervene in honest, prudent business decisions made in good faith, even if it turns out not to be the best decision after the fact. Directors and officers must be diligent in gathering information, and make business decisions in an impartial and informed manner. This is often a matter of following the proper procedure or process, so long as that process makes sense.

Since the directors have ultimate control over the affairs of the corporation, the board of directors must be able to show that it took an active role in the decision-making process, and document its process and reasons for decisions in minutes of its meetings.

4. Complying with the Law

Directors and officers must comply with their duties under every applicable law, as well as the articles of incorporation and by-laws of the corporation, and must ensure that the corporation does too. Some of the laws that hold directors or officers liable for certain failures to comply are the:

  • Occupational Health and Safety Act (Ontario)
  • Environmental Protection Act (Canada & Ontario)
  • Consumer Packaging and Labeling Act (Canada)
  • Securities Act (Ontario)
  • Criminal Code (Canada)
  • Bankruptcy and Insolvency Act (Canada)
  • Income Tax Act (Canada)
  • Canada Pension Plan Act, Employment Insurance Act, Excise Tax Act (Canada)
  • Ontario Retail Sales Tax Act
  • Consumer Protection Act (Ontario)

5. Conflicts of Interest

As mentioned above, the CBCA and OBCA set out a specific process when a conflict of interest or potential conflict of interest arises for a director or officer.

First, you must disclose the nature and extent of any interest that you have in a material contract or transaction with the corporation, whether it’s already made or simply proposed. An interest in a transaction could be if you’re a director or officer of, or have a material interest in another party to the transaction. Notice is given to the corporation either in a registered letter, or is entered in the minutes of directors’ meetings or meetings of committees of directors.

If you’re required to make such a disclosure, you may not vote on any resolution to approve the contract or transaction, unless it relates to your remuneration, is for indemnity or insurance, or the transaction is with another company that is an affiliate of the corporation.

 So What’s the Risk?

The major liabilities of directors and officers result from failure to fulfill the duties and responsibilities discussed above. Liabilities include:

1. Misuse of Corporate Finances

Directors can be held personally liable to make up the difference if they consent to the issue of shares for consideration other than money (think goods, services, or land) if the corporation doesn’t get a fair value in return. Directors may also be personally liable for unrecovered amounts if they consent to a resolution authorizing:

  • a purchase, redemption or other acquisition of shares
  • a commission
  • payment of a dividend or an indemnity, or
  • payment to a shareholder

…in a manner that’s prohibited by corporate law, the articles of the corporation, or its bylaws.

2. Wages and Employee Payments

This is probably the biggest financial risk of taking on a directorship. In some situations, such as if a corporation is being dissolved, is bankrupt, or lost a wrongful dismissal lawsuit but doesn’t have the money to pay, its directors may be on the hook to make up the shortfall. Directors, who ought to have knowledge of the financial health of the company, can be held personally responsible for up to six months of unpaid employee wages and up to twelve months of vacation pay. This is to protect employees, by deterring directors from putting people to work when the directors know the corporation won’t be able to pay them.

Directors are also personally liable for source deductions such as income tax, EI, and CPP premiums should the corporation fail to remit them.

3. Environmental Contamination

Government officials may issue orders to corporations as well as individually to directors to rectify environmental contamination on the corporation’s land – whether it was caused by the company or not. Failure to comply may result in liability for both the company and its directors.

4. Securities Legislation

For companies that are traded publically on the stock exchange, any person or company that makes a misrepresentation in a filed securities document, commits fraud or insider trading, or manipulates the market may face substantial fines or imprisonment. Any director or officer that knew, or ought reasonably to have known of the illegal act may be personally liable.

5. Civil Liability

Directors and officers may be personally liable in civil court for actions they take that are outside of the scope of their duties – known in law as an “independent, actionable wrong.” So, if someone is suing the corporation, and a director of the company also did something to that person personally, the director may be liable for damages as well. This is common in disputes over firing of employees, oppression of minority shareholders, and sometimes in negligence. When a director is “out to get” somebody, they can’t hide behind the corporation.

A corporation may indemnify its directors and officers – as in, pay the costs of defending them – so long as they acted within their authority, honestly and in good faith, and the lawsuit isn’t the result of their gross negligence or intentionally wrongful act. The corporation may pay the indemnity itself, or take out insurance to cover it. You should speak with the corporation’s insurer, and consider having a clause in officers’ employment contracts stating what is and is not indemnified by the corporation.

 Sounds Like A Lot….

If all of this seems scary, don’t fret. Here are a few simple things that you can do to keep yourself out of hot water:

  • Stay informed about the business of the corporation by:
    • attending all directors’ meetings, or reviewing the minutes if you’re unable to attend;
    • keep your own notes, and review them before attending meetings;
    • reading the terms of the articles of incorporation and the bylaws, and know them to the point where you can verify that the corporation is doing business as it should;
    • knowing what powers have been delegated to officers by the board of directors;
    • reviewing the opinions of professional consultants – including lawyers and accountants;
    • knowing what laws regulate the business or industry, and what liabilities those laws may impose on you;
    • keeping informed about the industry and any environmental or other risks that are associated with it
    • keeping informed of the business activities of the corporation by reading reports from management;
  • If you disagree with the actions of a majority of the board of directors, ensure that:
    • your dissent is recorded in the minutes, or;
    • if you’re not at the meeting but see a resolution in the minutes that you disagree with, ensure your dissent is recorded in a registered letter to the board;
  • Avoid any conflict of interest, particularly in any share transactions that result from inside knowledge of the corporation.
  • If you hold shares of the company, do so as a long-term investment, and minimize trading in order to avoid the appearance of insider trading
  • Ensure that you’re indemnified, and that you know what is covered.

Bear in mind that what’s considered to be “reasonable” in a given situation is highly subjective. When in doubt, call a lawyer. The cost of a legal opinion up-front to clear up a grey area before making a decision is way cheaper than the potential cost of a lawsuit or government fine. I happen to know a guy…

Mike Hook
Intrepid Lawyer
Email: mike@intrepidlaw.ca
Twitter: @MikeHookLaw