What’s a cooperative?

There are a lot of different models available to people to set up their businesses, but one of the most underused is the cooperative model. Frankly, I find it odd that so few startups consider using a co-op, given the shift towards people-centric companies, corporate social responsibility, social enterprise, crowdfunding, and the sharing economy. In many ways, co-ops are ideal for these types of ventures, since the primary aim of a cooperative is to benefit its members. It’s up to the members to decide what “benefit” means, so co-ops are often about more than just maximizing profits.

Perhaps unfamiliarity breeds avoidance. The co-operative corporation is an odd beast, and far less common than corporations, partnerships, and proprietorships. A lot of folks don’t even know the co-op exists as an option. Hell, a lot of business lawyers I know have never touched the things, and just gloss it over in the “other” category when talking about business structures. Its weirdness makes it difficult to understand. Co-ops are a mash-up of business and not-for-profit corporations, with partnership-esque decision-making, which are sort of public companies, and report to a separate branch of government than every other business in Ontario.

the-people-dont-know-their-true-power-tc-cartoon-sad-hill-newsIt’s high time we blew the dust off the ol’ girl, and maybe you won’t think co-ops are so weird and scary after all. You might even start to think that your business would do well as a co-op, in which case, we should talk.

There are a LOT of possible variations in co-ops, so I’ll stick to the basics in this article. The goal is to give you an idea of the broad strokes, and I’ll leave the details for later articles. I’m going to talk about:

  • What a co-op is
  • Advantages and disadvantages
  • Types of ownership
  • Types of co-op
  • The basics of financing a co-op, and
  • The basics of decision making

So what is a Co-op Anyway?

Co-operatives are democratically-run businesses governed by those who use their services – their members. Co-ops generally rely on member participation to make the wheels turn. Members pool their money, goods, or services, have a say in decision making, and share in the profits or losses of the co-op’s business. Members can be human people, corporations, and not-for-profits.

cooperative-movementAs we’ll see below, a co-op can be set up with shares, like a business corporation; or without, like a not-for-profit. Co-ops with shares can sell them to members and the general public to raise capital. Co-ops without shares may operate as not-for-profits, and apply for charitable status.

Decision making is one-member, one-vote, so each member has an equal say. Members can be broken down to stakeholder groups, where each group’s votes may be weighted differently, kind of like in a partnership.

Once they reach 35 shareholders or lenders, co-ops become somewhat like a public company, and have to distribute information about the business and its finances to potential investors. The annual financial statements of a co-op must be audited, to ensure that the co-ops accountants are preparing the statements by accounting norms. Ontario co-ops are regulated by the Financial Services Commission of Ontario, rather than the Companies Branch

Advantages

  • Egalitarian – while corporations can allow their stakeholders to participate in ownership through stock option plans and the like, such plans are often carefully controlled to prevent those stakeholders from controlling the company.
  • Democratic – each member has an equal say.
  • Cheaper to set up and run than stock option plans or large partnerships – though the rules governing co-ops can be a bit tedious, many of the rights and responsibilities are written in the law, rather than being custom creations
  • Shared resources – members can get access to more and better equipment or facilities, increased negotiating power when buying/selling, shared marketing costs, etc.
  • Networking and education – members have access to people who face similar challenges, and make contacts up and down the supply chain.
  • Limited liability – a co-op is a “person” in the eyes of the law, which takes on its own liability. Members and shareholders personal assets are protected, and they only stand to lose what they invested.
  • Flexibility – co-ops have a huge array of options on goals, structure, financing, decision-making, and services.
  • Double or triple bottom line – benefits to the members aren’t limited to a share of the profits.

Disadvantages

  • Startup costs – are typically higher than for simple incorporations or partnerships. It takes more legal and accounting work to get ’em off the ground.
  • Offering statements are required to raise money – which takes time and money to prepare, and there are ongoing disclosure requirements.
  • Annual financial statements must be audited – which adds an extra annual operating expense.
  • Decision making can be slow and difficult – especially when there are a lot of members, or stakeholder groups with different interests. Think of how much of a pain in the ass the membership meetings of a condominium can be…
  • Unfamiliarity – because there are relatively few co-ops, compared to other business forms, government and foreign entities may have a hard time wrapping their heads around how to deal with you.

Membership Shares, or Members?

You have two options when incorporating a co-op – ownership through shares, similar to a regular ol’ corporation – or control by members, similar to a not-for-profit corporation. Choosing between the two usually comes down to two things:

  • Whether the co-op’s purpose is to operate like a business and turn a profit, or to provide a service on a break-even or non-profit basis; and
  • How much capital is needed to get started and run the co-op. The greater the need for capital, the more likely it is you’ll lean towards shares.

Consult with your lawyer and accountant before choosing which way you’ll go.

Shares

Shares are just a bunch of rights in the co-op. Most of these rights centre on control (voting), profits (dividends), and ownership (right to a share of the net profit if the business is sold or wound up). Every co-op with share capital must issue at least one type of “membership shares”. Each membership shareholder gets one vote at members’ meetings to do things like electing the directors, setting the rules (bylaws) of the co-op, choosing an auditor, approving annual financial statements, and major business decisions like selling or dissolving the co-op. Different types or membership shares may have slightly different rights.

You also have the option of creating and selling different types of “preference shares” to raise money. Like a regular business corporation, you can get pretty creative with the rights that the preference shareholders have, like priority on dividends, to be bought out or redeemed, to be paid part of the proceeds of liquidation, to receive information, and to receive a portion of the net profits of the co-op each year as a patronage return.

Members

For co-ops without share capital, there are only members, who fill much the same role as membership shareholders, above. The biggest consequence of this type of co-op is that its only financing options are membership fees, loans from members to the co-op, and loans or other debt from outside sources.

Multi-Stakeholder Co-ops

In these bad boys, members are organized into stakeholder groups, depending on what they contribute to the co-op. Each stakeholder group has certain rights as a group, such as appointing directors to the board, or to receive a lower or higher share of the co-op’s profits.

Types

There are four basic types of co-op in Ontario

  • Worker-owned

    Exactly what it sounds like. Only workers can be members of the co-op, and at least 75% of employees of the co-op must be members. An example would be Toronto’s Co-op Cabs, where each taxi license holder is a member of the co-op, and gets a share of the net profits of the company rather than revenues from their specific cab.

  • Consumer

    Businesses, often in retail, which are owned by their customers for their mutual benefit. Resources are pooled to buy in bulk, then the savings are passed on to the members. The most common are credit unions, green energy, insurance, and grocery stores. I’ll lump housing co-ops in here too.

  • Producer

    Producers of a certain product, or a certain category of goods band together to share common expenses like warehousing, equipment, shipping, and marketing. Most people have seen farmers’ co-ops, which often have warehousing and large equipment, as well as buying farm supplies in bulk. Producer co-ops could work for any business from lumber, to crafts, to booze.

  • Multi-stakeholder

    Here, many different groups of interests recognize that they’re all in the same boat, and band together for common gain. These groups could include workers, producers, service providers, consumers, and supporters of a certain cause. Health care and social services are common areas for this form. There’s a big push towards sustainable food co-ops right now, bringing together farmers, land owners, seed banks, grocers, and restauranteurs.

Dolla Dolla Bills Y’all

A co-op model can allow a business to take a fundamentally different path than a regular corporation. The directors of corporations are voted in by shareholders to maximize the value of the shares. Co-ops exist for the benefit of their members, which can far broader than simple monetary gain. That’s not to say that a co-op can’t turn a profit. It’s just up to the members as to how far up the priority list profit falls. The rules on how money comes into and flows out of a co-op are different than regular corporations too.

Money In

Besides profits from the sale of goods, the most common fundraising method is membership fees – an annual fee that members must pay to stay members. In most cases, this isn’t a large sum. Co-ops can also charge fees for use to members or the public – like an hourly rate for use of equipment and facilities, or for sales leads they generate for their members.

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Debt Financing

As with any business, a co-op can borrow money, known as debt financing, from a variety of sources. Co-ops can, and often do, require their members to loan money to the co-op, which is common in agricultural co-ops where production is cyclical. They need the cash up front to float the year’s operations, and the loans are paid back when the harvest comes in. They can force members to re-invest profits earned from the previous year as member loans as well.

Co-ops can borrow from banks, government, and other private lenders, same as any other business. They can also apply for government grant funding.

Equity Financing

Co-ops with share capital can raise money by selling preference shares. The magic number is 35, meaning that if there will be 35 or more people who own securities (shares and debt) when the sale is done, the co-op has to file an “offering statement” with the Financial Services Commission. This is similar to, but less demanding than, what a corporation must do before “going public”. The goal of the offering statement is to ensure that the investors know what they’re investing in. The exact requirements vary depending on the co-op, but the result must be a full, true, and plain disclosure which answers any reasonable question an investor may have. There are a few exceptions which mean you don’t have to file one for small numbers of investors, and small amounts raised.

Money Out

Aside from paying operating costs, wages, tax, and debt, there are rules about how the profits of the co-op are paid out. What’s left after operating expenses are paid, but before tax, is called the “surplus”.

A co-op can set aside some or all of its surplus to create a “reserve fund” of retained earnings for its future expenses, and it can pay out the surplus through dividends and patronage returns.

Dividends

Dividends are paid out of a co-op’s after tax income. The member or shareholder is taxed on the dividend (not as regular income), meaning some tax credits are available to them.

The maximum dividend allowed on membership shares is the prime lending rate +2% per year. There’s no cap on dividends to preference shareholders, so the rate of dividend is what’s set out in the Articles of the co-op.

Dividends may be paid in more shares of the co-op as well, which allows the business to reinvest the profits, and increase the equity holdings of the shareholders.

Patronage Return

This posh sounding term is the profit share a member is entitled to based on how much business they’ve done with the co-op. This is the main way in which members receive their profits. Patronage returns are paid out of the pre-tax income of the co-op, and are taxed as income for the member.

Different rules apply to different types of co-op, but the way patronage returns are calculated is set out in the bylaws. Worker co-ops, for example, pay patronage returns based on hours worked, or total compensation paid each year. Producer co-ops may account for the relative profits earned from different products contributed to the co-op (a ton of strawberries may turn a higher profit margin than a ton of potatoes. No offence to potatoes.)

Non-members may also be paid a patronage return, so long as the return for non-members is the same or less than what’s paid to members.

Decision Making

As with a corporation, co-ops have three levels of decision-making – members, directors, and officers.

Members

Each member, or membership shareholder, has one vote at meetings of the members. Members have to attend a meeting in order to vote – they can’t send a proxy to vote in their place.

Most votes are decided by a simple majority of votes, after a resolution has been discussed. The key decision members are called upon to make is to elect the board of directors, or removing them if need be. They also approve audited financial statements, and vote on resolutions proposed by members.

Members have a say in other major decisions, which require a 2/3 majority to pass. These include changing the articles of the co-op, adopting new bylaws, and approving the sale or merger of the co-op.

5% of members can call a meeting, or propose member resolutions. 10% of members can force a directors’ meeting to pass a new bylaw or resolution.

Directors

Elected by the members, the directors have a fiduciary duty to run the co-op in the best interests of the members. All directors must be members of the co-op, and there must be at least three directors on the board. The board is responsible to set the strategic direction of the co-op, and appoint the officers to manage its day-to-day affairs. They vote on things like approving new members, budgets, major contracts, and expansion plans.

Officers

Appointed by the directors, officers oversee operations, and supervise the lower-levels of leadership. Officers are employees of the co-op, and except for the President and chair of the board, they don’t have to be members. The duties of the different offices are listed in the Cooperative Corporations Act. Most co-ops will delegate a certain amount of decision-making power to officers, such as the ability to sign contracts up to a certain amount, to hire and fire employees, and to do the co-op’s banking.

Conclusion

So, there you have it, co-ops in a nutshell. This is by no means a complete guide to co-ops in Ontario, but I hope it proves to be a useful starting point. If you’re looking at starting a business or non-profit, take a good, give co-ops due consideration.

There are a ton of good resources out there for information gathering, including a whole series of guides from the FSCO, and the Ontario Co-operative Association that can help you to get started.

As always, I’m happy to help you birth your cooperative business baby. Reach out.

 

Mike Hook
Intrepid Lawyer
mike@intrepidlaw.ca
@MikeHookLaw

What is a Joint Venture?

Many folks in business bandy about the words “partnership” and “joint venture”, or even a “JVP” (short for joint venture partnership – a made up term like “Leafs playoff tickets” or “government transparency”), without understanding that partnerships and joint ventures are different legal animals. Though the two have much in common, there are a few important differences that, if not understood from the outset, could affect your work together in strange and not-at-all-wonderful ways. If it walks, talks and acts like a partnership it will likely be treated as one, even if the intention was to create a joint venture. Ergo, it’s important to be clear and precise when creating a co-owned business, in order to avoid unexpected complications with tax, ownership of property, or liability.

What’s the diff?

Partnerships and joint ventures are both agreements to do business together between two or more individuals or corporations, with the goal of making a profit. Both are formed and governed by contract between the parties.

Joint ventures usually are usually used for one-off projects. They’re limited in time and scope – you’re not working together on everything, and they’ll often have an expiry date, which allows parties to renew or eject. They’re particularly useful when you’ll all be putting in different skills and assets, in different quantities. Joint ventures don’t create a separate business entity, and generally are not registered with the government. You work together to the extent that’s agreed to in the contract, and that’s it.

Partnerships, which I talked about in this other article, create an ongoing business relationship through a partnership agreement. Partnerships must be registered as a business entity with the government, and are governed by the rules in the Ontario Partnership Act.

Key terms in the contract

Terms common to both joint ventures and partnerships include:

  • Length of the agreement and conditions for renewal
  • What the business will and will not do
  • What money, assets or skills each party is contributing
  • Share of profits and losses, salaries, and expenses
  • Calculation of profits
  • Duties and responsibilities of each venturer
  • Management structure
  • Indemnity between the venturers
  • Dispute resolution

Terms of a joint venture agreement – or JVA – include:

  • Limits on time or scope of work
  • Termination, including how to divide up assets
  • Ownership of co-created assets and intellectual property
  • Assigning liability for actions of the other venturers
  • Accounting between the venturers, record keeping,
  • Bank accounts, and insurance
  • Division of expenses and revenues

Ownership of property

Ownership of property contributed to a joint venture remains the property of each joint venturer. The party who owns the asset may use it for other purposes without the consent of the joint venture unless it’s otherwise agreed.

Assets contributed to a partnership are considered the property of the partnership and not of the individual partners.

Tax consequences

 Your accountant will care a great deal about this stuff, and the tax consequences of the business structure you choose could be substantial. Make sure to ask before you choose one or the other…

Income Tax

The distribution of profits in both is governed by the agreement. Joint venturers assess their taxes based on their own expenses and share of the revenues from the joint venture. Partners in a partnership are taxed based on the net profits of the partnership. The net profits are distributed to the partners according to their share of the partnership, and taxed at the partners’ normal income tax rate.

The choice between partnership or JV makes a big difference if one party is spending more than the others. In a partnership, a party with higher expenditures would not be able to claim that amount individually.

Capital Cost Allowance

Capital cost allowance is a tax deduction that allows a business to account for the depreciation of capital property. Joint venturers may each claim the capital cost allowance individually to maximize their own tax benefits for the depreciation of the assets they put in to the joint venture. In a partnership, the capital cost allowance claimed must be the same for each partner because only the net profit of the partnership is distributed.

Fiscal Year

Joint venturers report their share of income and losses based on each venturer’s tax year. A partnership will have its own fiscal year end.

Corporate partners in a partnership are required to claim income (but not losses) for the period between the end of the partnership’s tax year and the corporation’s tax year.

Liability

Joint venturers are liable for their own debts and obligations, and can limit their liability based on the joint venture agreement. That way a creditor can’t go after one joint venturer for the debts of the other. The venturers can agree to share responsibility for liabilities taken on in the course of the project, or can split them up however they see fit.

Partners in a partnership, on the other hand, are “jointly and severally liable” for the debts, obligations and misconduct of the partnership and the other partners. “Joint and several liability” is a legal term meaning a creditor can go after the other partners to settle one partner’s debt. The liability can be limited by creating a “Limited Partnership” where a “general partner” takes the excess of any liability that the other partners can’t cover. Each other partner is only on the hook for their own debts or misconduct up to a fixed amount. I’ll get into Limited Partnerships in a different article later.

Both joint ventures and partnerships can agree to assume only their own liability, but there is more risk involved in a partnership if the at-fault partner cannot cover the loss.

Summary

Where two or more parties want to join forces together for a one-off project rather than becoming co-owners of a business, a joint venture is typically the way to go. Whichever business structure is chosen, the choice should be clearly set out in the agreement between all parties involved. Though joint ventures and partnerships may have many characteristics in common, the legal differences between the two warrant taking the time to talk to a lawyer and figure out which structure is right for the business at hand.

I’m indebted to my awesome law student intern, Claudia Dzierbicki, for her work in putting together the guts of this article.

 

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

How do I structure my business?

One of the most common questions I get from entrepreneurs at networking events is how to structure their business. Actually, the conversation usually starts with a question about whether or not I “do incorporations” (the answer is yes, btw). It seems most people have an idea that there are advantages to incorporating, even if they don’t understand what the advantages may be.

The short answer is yes, there are some advantages to incorporating, but there are many ways to skin the business structure cat. Before you make up your mind that the corporate form is right for you, you should know what your other options are, and what some of the advantages and disadvantages are.

So, without further ado, here are three of the most common business structures in Ontario:

The Corporation

When you incorporate, you’re birthing a separate “legal person” that has many of the same rights and responsibilities as an actual person. It can enter into contracts, borrow money, sue and be sued, pay taxes, and even has some rights under the Charter of Rights and Freedoms. It is owned by its shareholders, and run by its directors and officers.

The biggest advantage of incorporation is “limited liability” – meaning that if someone has a legal dispute with a corporation that you own, your personal exposure isn’t more than the assets you’ve invested in the company. (This isn’t true 100% of the time – see this article on director & officer liability). Another advantage is that the corporate tax rate is much lower than the individual tax rate. A good accountant can work with your lawyer to set the business up in a way that minimizes your business and personal tax costs.

Other advantages:

  • It continues to exist even if the shareholders, officers or directors move on or pass away.
  • Ownership can be sold or transferred in whole or in part.
  • Easy to raise money (capital) by selling shares or options for shares.
  • There are clear rules on the roles of the people who control and operate the company.
  • Corporations can be shareholders (owners) of other corporations, which can further protect the people who ultimately own the companies from liability.

Disadvantages:

  • Extensive record keeping and annual reporting requirements to the government.
  • More involved process to take money out of the corporation to pay yourself.
  • Possible disputes between shareholders and management.
  • Higher startup costs than other business structures.

Well Suited For:

Industries with more risk of being sued, that are more likely to need outside money to grow, and where hiring employees or contractors to run parts of the business is likely, such as:

  • Manufacturing
  • Retail, bars & restaurants
  • Construction & landscaping
  • Resources
  • Transportation, tourism & adventure
  • Tech services and support

A corporation is a very flexible business structure that, if set up correctly in the first place, can grow and change with your business as it evolves. If you’re considering setting up shop as a corporation, give me a call, and we can make sure we get it done right.

The Sole Proprietor

This isn’t much more than you registering a business name, and starting to do business. You and the business are the same person for legal and tax purposes, so anyone who is owed a debt by the business could claim against your house, car, or personal savings to get it paid back.

Advantages:

  • Simplicity
  • Very little startup cost
  • Little government regulation
  • You have direct control of decision making
  • Business losses can be deducted from your personal income

Disadvantages:

  • Your personal assets may be at risk.
  • Higher tax rate on business income means there’s less to reinvest in the business.
  • Banks and other lenders may be less willing to make loans.

Well suited for:

Low-risk industries, remote/virtual workers, consultants, and services for individuals rather than businesses, such as:

  • Social media
  • Personal training
  • Bookkeeping
  • Professional services and other consultants
  • RMTs
  • Web design

A sole proprietorship is a cheap and easy way to get your business off the ground. It’s not particularly flexible, or well suited for long-term growth, but it’s not difficult to incorporate a business later once you’re ready to grow, hire, rent space, and enter into contracts with suppliers and customers.

The Partnerships

A partnership is an agreement, typically in writing, between two or more people (or corporations) to carry on business together for mutual gain. You pool your resources, and share in the profits or losses according to your agreement. No separate legal person is created – so creditors can still look to the partners’ personal assets to satisfy debts owed by the partnership. Partnership income is paid out to the partners, and you’re each taxed at your individual rate.

Limited Liability Partnerships are ones in which the other partners aren’t liable for the debts or claims against one of the partners. Law firms and accounting practices commonly use this form.

Limited Partnerships ones where all partners own the assets of the business, but certain partners limit their liability to the value of their contribution to the partnership. At least one of the partners must be a general partner, with no limited liability.

Advantages

  • Simple to start up.
  • Very flexible, and can allow each partner to keep control of their portion of the business
  • Few ongoing formalities such as annual meetings
  • Business losses can be deducted from your personal income.
  • Costs and profits are shared between the partners

Disadvantages

  • Your personal assets may be at risk
  • You are legally and financially responsible for business decisions made by your partner – such as entering in to bad contracts, or breaking them
  • Income is taxed at your personal rate
  • Possibility of conflict between partners
  • Higher start-up cost, as all partners should have independent legal advice in negotiating and drafting the partnership agreement.

Well Suited For:

Diverse groups of professionals working towards a common goal (pooling resources), people cooperating on short-term projects, and projects in exploratory or preliminary phases in:

  • Professional services – accounting, architecture, real estate, medicine, incubators/accelerators
  • Industrial or real estate development
  • Mining projects
  • Arts, theatrical and film ventures
  • Medical, scientific and technology research

Since a partnership is a private agreement between the partners, it can be adapted to suit just about any relationship. If you’re considering entering in to a partnership, you should have legal advice to make sure that you know what you’re agreeing to, and that your interests are protected. More information on partnership agreements is coming soon.

Hopefully this article helps you to understand what your options are, and gives you an idea of how to get your business off the ground. I’m happy to discuss these options with you, and help you get your business set up for long-term success.

 

Mike Hook
Intrepid Lawyer
mike@intrepidlaw.ca
@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