In-House Counsel As a Service

Contract Drafting: Letting the Precedent Think for You

Posted: January 17, 2022

Authors: Warren Ragoonanan and Katherine Lorriman

During World War II, the U.S Air Force had a problem. They were losing too many planes in the theatre of war. Sometimes they were shot down by Nazis, other times it was friendly fire. They knew that to curb their losses, they needed to add armour to the planes, but how much? Too much, and they would be too heavy to fly. Too little, and the armour would be useless.

For help, the Air Force brass turned to the Statistical Research Group (SRG), a classified program that brought together top U.S mathematicians and statisticians. Chief among the SRG team was Columbia University statistics professor Abraham Wald. Like any good statistician, to work his mathematical magic Professor Wald needed data. Th

e military provided him with damage reports on the planes that returned from Europe. They broke the figures down by the number of bullet holes per square foot over the: engine, fuselage, fuel system, and the rest of the plane. The data showed the highest number of bullet holes in the fuselage and the lowest in the engine.

The Air Force looked at the data and thought the answer was simple – put the armour over the fuselage. Professor Wald looked at the data and came to the opposite conclusion – put the armour over the engine. Professor Wald saw something that the Air Force officers did not. The data provided only covered planes that survived the attacks; what was missing was data on the planes that the enemy shot down. There were no reports on those, meaning that the data set from the military was skewed towards the planes that survived. In a representative sample, you would find bullet holes evenly distributed all over the plane, including the engine. If planes were coming back with fewer bullet holes in the engine, then, Professor Wald reasoned, the engine must be a major vulnerability. The fuselage, fuel system and other parts could take damage without taking the whole plane down. The engine could not (for the full story on Professor Wald check out the book How Not To Be Wrong by Jordan Ellenber).

The Air Force leadership assumed that they were working with a full set of data, and that nothing was missing. They were exhibiting what we know today as survivorship bias. This is a cognitive bias where a human being focuses on information that has survived a selection process and overlooks what was weeded out. Indeed, survivorship bias is one of many types of cognitive biases that act on our brains. These biases leave us with blind spots. The legal profession is no exception. As lawyers, we are sensitive to bias and any perception of bias. Hence the need for conflict-of-interest rules and confidentiality built into the system of legal ethics. However, lawyers rarely talk about cognitive bias even though it impacts what we do every day.

Look at the task of contract drafting. In the profession, we often hear the old maxim that, when it comes to drafting, we should not “mindlessly follow precedents”. Except that, thanks to our cognitive biases, it is easy to end up doing just that without even realizing it. When drafting a contract, lawyers rarely start from nothing – working from a precedent is the norm. And when they do, survivorship bias can creep into how lawyers choose that precedent. Contract drafting is a broad area. It can encompass consulting service agreements, employment contracts, real estate agreements of purchase and sale, share/asset purchase agreements, and other types. Moreover, there are different contracts tailored to different industries, and rarely is there a standard form (if there is a standard form, clients often draft the contract themselves and bypass lawyers completely). So where do lawyers find their precedents? They can reach out to colleagues within or outside their firms. They can go to a precedent encyclopedia like the O’Brien’s Encyclopedia of Forms. They can also do a random Google search and hope that yields some results. These are common precedent-hunting approaches, but not one of them will guarantee a representative sample connected to the client’s needs. It is very likely that the lawyer’s “data set” of precedents will be skewed in one form or another. Lawyers will be looking at the catalogue of precedents that they happen to have and selecting one as the starting point. This is survivorship bias in action.

You may be thinking to yourself, ‘Surely lawyers read the precedent before they start drafting right? How much of an impact can survivorship bias really have?’ It is obviously necessary to read the precedent and if it turns out to be completely irrelevant to the mandate, you can set it aside and use something different. But what happens where the precedent is 50% relevant, or maybe 60% to 70% relevant, and you cannot find another one quite as good? The usual practice is to work with the document you have and try to revise it as best you can to suit the client’s needs; after all, that is usually a better option than burning more time trying to find the “perfect” precedent. It is at this point that another cognitive bias can show up, known as anchoring bias. Anchoring bias is a tendency for us to let a reference point subconsciously influence our decisions. The reference point is usually the first thing you see. If you are negotiating a business deal, that anchor may be the first price you see, which in turn influences how you negotiate and what price you actually pay. When it comes to you as a lawyer drafting a contract, the reference point is the precedent you are using. The same one in which only 50% to 70% of the clauses are relevant to your client’s deal. As the lawyer, utilizing professional judgement, you must make decisions on how to rework or remove those irrelevant clauses. Those decisions are going to be anchored to the language that is already in the document.

Thanks to both survivorship bias and anchoring bias, it can be difficult for us to spot issues that make it necessary to draft additional clauses that the precedent in front of us excludes. These biases also make it difficult to see which contract terms are only tangentially relevant and should be deleted. Hence you have the phenomenon where the drafter keeps in clauses that they do not completely understand just in case taking them out could hurt the client in an unknown future scenario. It is easy to end up with a contract that is both overly complicated, and only passingly relevant to the business transaction the client is trying to complete.

Here is our challenge:

How do business lawyers overcome cognitive biases when drafting and negotiating contracts?

This is a big question. In the productive thinking approach to problem solving (outlined in the book Think Better: An Innovator’s Guide to Productive Thinking), we call this a Catalytic Question – a question specifically crafted to help us think. As we draft, let’s keep this Catalytic Question in mind. There may be one answer, or there may be several. Regardless, keeping our Catalytic Question in mind as we draft is the first step to stopping contract precedents from thinking for us.

Whadaya Mean My Corporation Isn’t Organized?

Posted: October 7, 2021

Author: Warren Ragoonanan

At WRD, we create a lot of corporations. And, we write about it a lot as well – case in point: The 7 Key Steps for Incorporation, Incorporation Documents, Minute Book, Unanimous Shareholder Agreements, and End of the Road: Dissolving Federal Corporations.

We have noticed a bit of a trend. Routinely, entrepreneurs come to us having incorporated, but not having organized, their corporations. We talk about the organizing process quite a bit in some of other WRD of Mouth entries (in particular, see The 7 Key Steps for Incorporation and Incorporation Documents). Without repeating too much of what has already been said, some of the particularly important parts of organizing include enacting by-laws, issuing shares, electing your first Board of Directors, appointing officers, and setting your fiscal year end. It also includes enacting a shareholder agreement if you have two or more shareholders. These are all the parts that make up the corporation’s Minute Book.

It is a given that for most new businesses, money is tight. Founders tend to do a lot of work themselves, and that includes their own legal work. The temptation is strong, Especially because the Corporations Canada Online Filing Centre is so easy to use. Frequently, we see founders skipping organization entirely. Even if they are aware of the requirements, founders may ignore them until they become necessary. Or even worse, founders may look for boilerplate documents on the internet and try to be their own lawyer.

As an alternative, I have seen several do-it-yourself incorporation websites pop up. They are popular because they appeal to the scrappy DIY spirit of the average business founder. These sites promise incorporation and organization at a low price. Some of WRD’s clients take advantage of these before coming to us. You know what we haven’t seen? A proper set of organizing documents from these sites. We have always found mistakes. Today, as I write in October of 2021, you still need a human lawyer to advise on and draft organizing documents. It is just not possible using today’s technology to program a site that can capture the nuance and judgement used by a lawyer during this process. I have no doubt that artificial intelligence technology will advance to the point where a site can do a corporate organization quickly and cheaply, without human intervention. But we aren’t there yet.

A missing, or incorrect organization is a major problem. What compounds that problem is that there are rarely any immediate consequences for not organizing. Years, and even decades, can go by without anything happening. And then one day, you are trying to do a major transaction and, surprise, you step on this legal landmine. Take the following scenarios:

Selling Your Business: A common way to sell your business is to sell the shares. Sellers of a business may prefer a share sale because they can simply hand over the reins on an “as-is” basis rather than parceling out assets and dealing with any remaining loose ends themselves. Also, with proper planning, selling shares can allow sellers to take advantage of a certain exemptions to capital gains tax in the Income Tax Act (Canada). However, if shares were never issued in the first place, there is a big problem. Buyers cannot evaluate what they are buying, and sellers do not know what they are selling. You can’t sell what doesn’t exist.

Bringing in a Partner: We have encountered many business owners who run the business themselves, but then want to provide an equity stake to a new shareholder. It could be a key employee, or it could be a son or daughter they are hoping will take over after they retire. Some of our clients even want to set up formal employee share ownership plans to retain key talent, and foster growth. These are all great ways to expand your business. But if shares were never issued, those transactions run into a problem. Again, you can’t sell shares that don’t exist.

Managing a Tax Audit: Canada Revenue Agency normally wants to see your tax receipts and financial records during an audit. However, we have seen cases where they want to look at minute books. They want to make sure that corporations have properly declared dividends and prepared the necessary minutes or resolutions. If no shares exist, then explaining those dividends to CRA will be challenging.

Defending a Lawsuit: When you incorporate, owners are supposed to enjoy limited liability. The idea is that the corporation is sued in its own right, and only the assets belonging to the corporation have liability exposure. However, limited liability only applies to shareholders (see section 25(1) of the Canada Business Corporations Act, and section 92(1) of the Business Corporations Act (Ontario)). If a business owner was never issued shares, there is an argument that there are no shareholders, and no one involved in the business should have limited liability. That would make the owner personally liable for the obligations of the business, as if they were a sole proprietor. This concept is known as “piercing the corporate veil”. The cases that involve veil-piercing are complicated, and well beyond the scope of this piece. The key takeaway is that this is a non-issue if the corporation is properly organized.

When problems like the ones canvassed above come up, the owner is forced to get their corporation organized and updated in a rush. We see this problem a lot. When we encounter it, we need to review the filings and tax returns, and then rebuild the corporate records from scratch. It is a time-consuming and expensive undertaking. It can be frustrating, especially when the failure to organize holds up some other transaction by months or weeks.

What do I mean you aren’t organized? I mean that you have missed a major step in setting up your corporation. It is a step that you cannot skip. Get it done when you incorporate. It may cost a little more now, but that is likely much less than what you would pay us to fix it later.

End of The Road: Dissolving Federal Corporations

Posted: January 4, 2021

By Heath Campbell

A time may come in the life cycle of the business where a corporation needs to end – legally known as a “corporate dissolution”. We have seen many of these in our practice, both at the Ontario and federal level.

Because at WRD we tend to favour federal corporations, we thought it would be useful to write down a few comments about the federal dissolution process. In this entry, we are going to focus on voluntary dissolutions.

What is Voluntary Dissolution?

Under corporate law, a corporation is a separate and distinct legal person and survives the death of its owners (i.e. the shareholders). However, there are times when the shareholders decide the corporation is no longer serving a useful purpose and opt to terminate its existence. This is considered a “voluntary dissolution” as opposed to other situations where:

a government entity prematurely revokes or cancels a corporation’s legal existence (for instance, when the corporation has failed to make its mandatory company filing.); or
the creditors of the corporation or a court demand that the corporation wind-up or liquidate its operations.

Once dissolved, the corporation is classified as inactive, no longer has status as a separate “person”. It is, for all intents and purposes, dead.

Why Would I Voluntarily Dissolve a Corporation?

The common reason is because a tax advisor (i.e., an accountant or tax lawyer) advises you to dissolve. Dissolutions are a common practice as part of a tax-driven corporate restructuring.

Another common scenario is where the corporation is part of an estate. If the estate trustee cannot sell the business, then it may need to distribute its assets and dissolve the corporation to wrap up the estate’s affairs.

Finally, the shareholders of a corporation may decide to dissolve it simply because they have no further need to keep it alive. This can occur for any number of reasons but a common one is that the owner(s) is (are) retiring and cannot find a buyer for the business. Occasionally, a corporation may be formed but remain dormant, leading to unnecessary costs, obligations, and confusion.

How Do I Voluntarily Dissolve a Corporation?

Dissolving a corporation is a legal process that requires careful execution. Below is a basic summary of the process.

Shareholders’ Consent

Dissolving a federal corporation requires the approval of shareholders holding two-thirds of shares in the corporation. If the corporation has different “classes” of shares, all shareholders of all classes, regardless of their voting rights for other matters, are permitted to vote as a class on the question of dissolution, and each class must approve the dissolution by a two-thirds majority.

Settling Debts

A corporation must settle its debts and obligations or obtain creditors’ permission to leave the debt unpaid before it may dissolve. Furthermore, debts must be settled before any of the corporation’s assets are distributed to the corporation’s shareholders. The corporation must also give notice to each creditor of the corporation that it intends to dissolve, give notice in each province where the corporation carried on business, and cease to carry on any further business, except as is necessary to settle its debts and obligations.

The corporation must file a final tax return for the year in which the corporation is dissolving, as well as any outstanding tax returns from prior years, even if the corporation has no taxable income for the year of dissolution. It can also be useful to obtain a clearance certificate from the Canada Revenue Agency (CRA) before proceeding with the dissolution. However, because clearance certificates are not necessary, we, as corporate counsel, tend to defer to the expertise of the corporation’s accountants or tax professionals on whether a certificate is useful in a given situation.

If a corporation distributes its assets to shareholders while it still owes money to a creditor (including the CRA), those creditors can sue the corporation after it has been dissolved and may also collect this unsettled debt from the shareholders who received payment.

Splitting the (Remaining) Pie

Once the corporation’s debts and obligations, including taxes, have been accounted for, it is time to distribute the remaining assets to shareholders. Determining the process of distribution, including any priorities that one share class may hold over another, involves reviewing the corporation’s governing documents and share-related records located in its Minute Book.

At this stage, the corporation should sell and properly transfer title to any remaining property it owns and divide the cash value of the proceeds of sale to its shareholders and creditors.

Vesting in Crown

It is crucial that every item of property (including money) be distributed prior to articles of dissolution being filed.

If not, then section 228 of the Canada Business Corporations Act applies, making that undistributed property vest in Her Majesty in right of Canada. That means that once the articles are filed, ownership in any property still in the corporation is automatically transferred to the Canadian federal government. The chances of ever getting that property back are slim. We note that the Business Corporations Act (Ontario) has a similar provision vis-à-vis provincial corporations and the provincial government (see section 244).

This is not well known and can take the average business owner by surprise.

Articles of Dissolution

Once the remaining assets have been distributed, the corporation will submit articles of dissolution to Corporations Canada declaring that the steps in the dissolution process have been completed and conform to the law. Corporations Canada will then confirm its approval of the articles of dissolution by issuing a certificate of dissolution, the receipt of which marks the completion of the dissolution process for the corporation.

Guiding Your Journey

Shutting down (and ultimately dissolving) an active federal corporation is not necessarily complicated. However, it still requires some planning. There are the approvals, payouts and transfers mentioned above. Plus, you may need to incur some “closing” costs to terminate staff and end third party contracts (like leases or franchise agreements). Finally, there is the added need to move or dispose of any hard assets like furniture or computers.

The bottom line is that if you are looking to dissolve your federal corporation, do not try to rush the process. Instead, step back and take a breath. Then prepare a plan, come up with a budget and go step-by-step. It may take a little longer, but is a small delay really such an inconvenience when what you get in return is peace-of-mind!

What kind of shares should I issue?

Posted: March 2, 2020

What kinds of shares should I issue?

A “share” is a percentage of ownership in a corporation that entitles its owner to certain rights in that corporation. These rights can generally be categorized as “control rights” and “income rights”. Control rights refer to the shareholder’s ability to influence decisions of the corporation, whereas income rights refer to the shareholder’s ability to share in the corporation’s profit or loss. Many of our clients have found it helpful to consider the balancing of these rights prior to determining the specific classes of shares to issue.

Control Rights

Voting – The ability to influence decision-making such as electing directors of the corporation, approving by-laws and passing resolutions is the primary control feature of voting shares. Each corporation is required to have at least one class of shares with voting rights. Once this class is established, the corporation is free to issue shares that have limited or no voting rights. Despite this flexibility, there are certain circumstances in which even non-voting shareholders are entitled to a statutory right to vote

Conversion – Conversion rights provide a shareholder with the opportunity to convert their existing shares to shares of another class, which may be desired for efficient tax planning purposes or to increase in their control of the corporation.

Income Rights

Dividends – Dividends are the primary method of distributing income from a corporation to shareholders. The types of dividends available by holding a class of shares will likely determine the type of investors they will attract. Shares offering fixed dividends that are paid in priority to other dividends are appropriate for investors seeking a predictable return from the corporation, whereas shares eligible to share in the profits of the corporation are appropriate for investors willing to tie their potential financial returns to the corporation’s underlying performance.

Dissolution Rights – Upon a corporation’s dissolution there are different potential rights available to shareholders. Some classes of shares are only eligible to participate to fixed amounts, whereas others may be entitled to a larger return of capital. The corporation must also consider in what priority different classes of shares will be eligible to participate in the return of capital upon dissolution.

Redemption, Retraction & Conversion – A corporation may redeem (repurchase) certain classes of shares for a stated amount. Exercising this option provides shareholders with a fixed return on their investment, but may preclude them from future earnings. Similarly, certain classes of shares may include retraction rights, which provide shareholders with the right to demand that the corporation repurchase their shares for a fixed price. Having this option available provides flexibility to investors to realize their return on investment on demand. Conversion rights may also provide shareholders with the opportunity to alter their income rights in the corporation.

After considering their desired allocations of control and income rights, we often focus our discussion on the following classes of shares with our clients:

Common Shares – Common shares are the most typical type of shares issued by a corporation. They often come with voting rights, a dividend structure tied to the profits of the corporation and the opportunity to participate upon dissolution after higher-ranking stakeholders (e.g. creditors, preferred shareholders). Common shareholders are likely to value pre-emptive rights and may also benefit from the right of conversion. Common shares are most commonly issued to founders, employees and advisors.

Preferred Shares – Preferred shares are typically issued to investors seeking predictable returns from the corporation. They are often non-voting and provide fixed dividends and priority participation upon dissolution. Preferred shareholders are likely to value conversion and retraction rights, while resisting redemption rights. Preferred shares are most commonly issued to investors.

Special Shares – Special shares often include elements of both common and preferred shares. These “hybrid” shares offer the corporation the opportunity to issue shares with a unique mix of rights that are desirable in specific fundraising circumstances. Special shares are also often utilized as part of an effective tax-planning strategy to take advantage of tax-saving opportunities such as income splitting, capital gains exemptions and estate freezes.

Determining which class of shares to issue, and which rights to attribute to those shares, is an ongoing and fundamental consideration in the life of a corporation. We are always happy to work with our clients and their accounting advisors to determine the optimal mix of shares that meet their operational, fundraising and tax-planning needs.

Note: Special thanks to our LPP Candidate Donald P. Brown for his contributions to this post.

[1] CBCA: s. 163(3), s. 176, s. 183 (3), s. 188(4), s. 189(6), s. 210(2), s. 211 (3).

OBCA: s. 148, s. 170, s. 176 (3), s. 182(4), s. 184(6).

Unanimous Shareholder Agreements

Posted: March 2, 2020

What is a Unanimous Shareholder Agreement?

Corporate statutes in Canada[1] provide that a corporation’s default position is to be managed entirely by its directors and officers. This situation can be reversed through the use of a unanimous shareholder agreement (“USA”), which restricts the power of the directors to manage the corporation and instead transfers additional authority to the shareholders. All of the shareholders must agree that they desire to enter into a USA.

Why is a USA useful?

A USA is particularly useful for a closely held start-up company to establish the rules for governing and managing the corporation. The USA will provide mechanisms for resolving deadlocks and govern any transfer of shares. Clarifying expectations between shareholders at the initial stages of organizing the company can be the best way for the corporation to avoid drawn out and expensive disputes in the future.

What are the drawbacks?

Shareholders may become subject to the liabilities normally assigned to directors and officers to the extent that the USA removes powers and responsibilities from the directors and gives it to the shareholders. Protection from liability for shareholders is an important factor in deciding to incorporate a business in the first place. Consequently, any loss of that protection should be carefully weighed.

Typical USA Contents

USAs typically address a number of key measures that are designed to ensure a fair outcome for all parties involved during the course of the corporation’s existence:

Dispute Resolution: Consideration can be given as to how deadlocks amongst shareholders can be resolved. The dispute resolution process may be limited to mediation or binding arbitration, which can be a less expensive alternative than seeking restitution through the courts. Shareholders may also wish to consider whether one of them should have a tie breaking vote or a veto over certain actions.
Unanimous Shareholder Approval: In the case where one shareholder owns the majority of shares, it is important to consider whether any issues exist that should not be decided by a simple majority vote. A USA can set out a class of material decisions which require supra-majority and/or unanimous shareholder approval to ensure that the majority stakeholder is not able to make unilateral decisions without first obtaining the consent of the other stakeholders involved.
Share Transfer: A USA typically contains a primary rule that no shares can be transferred without the receiver of the shares becoming a party to the USA. This primary rule can be supplemented with a number of additional mechanisms to promote liquidity of the shares:
1. Right of First Refusal: A shareholder who receives a bona fide offer from a third party to purchase his or her shares must first allow the existing shareholders the right to match such offer prior to selling to any third party. This mechanism allows the existing shareholders the option to prevent a third party purchaser from becoming a shareholder and exercising control over the corporation in the future.
2. Buy/Sell or “Shot Gun” Provision: This provision allows one shareholder to offer the other shareholders a price and establish the terms under which he or she is prepared to either purchase the other shareholder’s interests or sell his or her interest to the other shareholders. It is then up to the other shareholders to decide whether they wish to either buy the offered shares or sell their own shares on the same terms and conditions presented. This provision can be very useful in the event of a shareholder dispute where the relationship between the shareholders has broken down and one party wishes to exit.
3. “Piggyback” or “Tag-along” Provision. If a shareholder is able to sell shares to a third-party, a piggyback or tag-along allows the non-selling shareholders to include their shares in the agreement with the third-party buyer. In other words, a shareholder could tag along with the seller and exit the corporation.
4. “Drag-along” Provision. If a majority shareholder decides to sell its shares it can require the minority shareholders to sell their shares to the buyer as well. This allows a majority shareholder to exit the corporation without a minority shareholder blocking the sale.
Funding Considerations: A corporation requires access to capital both upon incorporation and during operation. A USA can prescribe how such capital can be obtained and ensure that each shareholder contributes the requisite amount in conjunction with his or her interest in the corporation or face a penalty for failure to do so. In the case of debt financing, a USA can prescribe how guarantees are to be signed and provide for the sharing of liability among shareholders.

There are several other matters that a USA can address depending on the needs of an organization. We are always happy to discuss how a USA may be of value to your corporation, and answer any question you may have.

Additional Reading:

Canada Business Corporations Act: Unanimous Shareholder Agreements

Chapter 8 – Organizing Your Corporation: The Shareholders

[1] In particular, the Business Corporations Act (Ontario) and the Canada Business Corporations Act