McCoy v. The Queen

McCoy v. The Queen
Court (s) Database
Tax Court of Canada Judgments
Date
2003-05-15
Neutral citation
2003 TCC 332
File numbers
1999-4555(IT)G
Judges and Taxing Officers
Donald G.H. Bowman
Subjects
Income Tax Act
Decision Content
Citation: 2003TCC332
Date: 20030515
Docket: 1999-4555(IT)G
BETWEEN:
ALAN McCOY,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Bowman, A.C.J.
[1] This appeal is from an assessment for the appellant's 1995 taxation year. At issue is the appellant's right to deduct $73,850 as his share of a loss which he claims was incurred by a limited partnership of which he was a member.
[2] Although the trial lasted about 15 days the essence of the transactions giving rise to the litigation can be summarized briefly.
[3] In 1994 Edward Furtak, who was then living in Bermuda, developed through his Bermuda corporation, Trafalgar Research (Bermuda) Ltd. ("Trafalgar Research"), a software package consisting of 34 programs to be used in trading currency and financial futures contracts. The software package was called MarketVision and it was owned by a subsidiary of Trafalgar Research, Trafalgar Capital Ltd. ("Trafalgar Capital"), another Bermuda corporation. I shall refer to them collectively as Trafalgar.
[4] A number of limited partnerships were formed among which was Trafalgar II Limited Partnership ("Trafalgar II" or "the partnership"). In February 1995 it acquired an 18.18% interest in MarketVision for a stated consideration of $10,000,000. Subsequently, on December 31, 1995 this was raised to a 22.07% interest for a stated consideration of $12,140,000. This figure was 22.07% of $55,000,000 which was said to be the value of 100% of MarketVision. A valuation had been received from a firm, emc partners, indicating a value in the range between $55,500,000 and $59,980,000.
[5] The consideration of $12,140,000 for the software was to be satisfied by a promissory note in the amount of $8,619,400 maturing December 1, 2005 and the balance of $3,520,600 in cash.
[6] The appellant bought 150 units in Trafalgar II for $150,000. This amount was payable as follows:
On closing (Dec. 31, 1995)
$19,500
Cash on March 15, 1996
$ 7,500 plus interest of $150
Cash on June 15, 1996
$16,500 plus interest of $750
Promissory note due Oct. 30, 2005 bearing interest at 9% per annum
$106,500
[7] In other words 29% or $43,500 cash at or shortly after closing and 71% by way of promissory note due about ten years after closing. This ratio was the same as that between cash and promissory note on the acquisition of the software by Trafalgar II.
[8] The relationship between Trafalgar Research, its subsidiary Trafalgar Capital, and the partnership was governed by a somewhat complex agreement under which Trafalgar was required to trade commodities and futures contracts in a certain volume and to share the profits with Trafalgar II. It was to use a portion of the proceeds received on the sale of the software for its trading purposes.
[9] In 1995 the partnership reported a loss based substantially on capital cost allowance ("CCA") on the software and the appellant claimed his pro rata share of that loss.
[10] The Minister of National Revenue disallowed this loss and many grounds are advanced.
(a) Trafalgar and Trafalgar II were not dealing at arm's length and under section 69 of the Income Tax Act the software was deemed to have been acquired at its fair market value which the respondent says is a small fraction of the $55,000,000 price.
(b) The note given by the partnership was contingent and cannot enter into the computation of the consideration.
(c) The claim for CCA is unreasonable under section 67 of the Income Tax Act.
(d) The partnership had no reasonable expectation of profit.
(f) The promissory note was a limited recourse amount within the meaning of section 143.2 of the Income Tax Act.
(g) The software was not acquired for the purpose of gaining or producing income and was therefore not depreciable property by reason of paragraph 1102(1)(c) of the Income Tax Regulations.
(h) The appellant's share of the loss claimed exceeds his "at-risk amount" (subsection 96(2.2)).
(i) The software was leasing property and accordingly the partnership claim is limited to the income otherwise determined before CCA from the property.
[11] The facts summarized above require elaboration but I do not propose to do so in the sort of detail in which the evidence was presented. I believe that the resolution of this case depends upon a determination of three or four relatively simple and straightforward issues. It is important to emphasize at the outset that the Minister allowed the partnership no deduction for CCA and therefore denied the appellant's claim for a loss from the partnership. This is consistent with the assumption that the software was not acquired for the purpose of gaining or producing income and was therefore not depreciable property. It is also consistent with the REOP assumption, an argument which counsel for the respondent did not exactly abandon in so many words. He alluded to it and moved on to something else, in light of the Supreme Court of Canada's decision in Brian J. Stewart v. The Queen, 2002 DTC 6969. The other assumptions (fair market value, reasonableness, contingency, at risk, limited recourse) all would generally allow the appellant something (although I should recognize that the respondent contends that by combining subsection 143.2(8) and subsections 96(2.1) and (2.2) one achieves an at-risk amount of minus $201,178 (subject to section 257 discussed below) and therefore no deduction). The appellant does not allege that the Minister did not act on all 79 of the assumptions pleaded and so I must accept that he did. However it seems hard to believe that the Minister would have had the mental agility to base an assessment upon such a potpourri of contradictory and inconsistent assumptions.
A. The acquisition of the partnership interest
[12] The appellant was an investment broker with the stock broking firm Midland Walwyn during the relevant time. In December 1995 he bought 150 units of an Ontario limited partnership (Trafalgar II). The general partner of Trafalgar II was an Ontario company TSLP Management Inc., all of the shares of which were owned by Capital Vision Inc., an Ontario corporation registered as a limited market dealer in Ontario. All of the shares of Capital Vision Inc. were owned by a Toronto lawyer, Greg Coleman, who was also the sole director and president of TSLP Management Inc.
[13] The limited partners were the investors, including the appellant.
[14] The price for the partnership interest was $150,000, payable as follows:
- on closing (December 31, 1995): cash $19,500;
- a promissory note for $130,500, of which $7,500 was payable on March 15, 1996, $16,500 by June 15, 1996 and the balance of $106,500 by October 30, 2005. On the first two instalments of the note interest was payable in the amount of $150 and $750.
[15] The result was that by June 15, 1996 the appellant had paid $43,500 in cash and the remainder was covered by the promissory note which matured on October 30, 2005.
[16] The promissory note given by the appellant to the partnership contained the following terms.
PROMISSORY NOTE
December 31, 1995
Toronto Ontario
MATURITY DATE: October 30, 2005
FOR VALUE RECEIVED, the undersigned (the "Maker") acknowledges itself, himself or herself, as the case may be, indebted to and promises to pay to Trafalgar II Limited Partnership (the "Holder"), on the dates specified below at 225 Richmond Street West, Suite 400, Toronto, Ontario, M5V 1W2 (or at such other place as the Holder may from time to time designate in writing to the Maker), the principal sum of $870 in lawful money of Canada (the "Principal Sum") for each unit of limited partnership interest (a "Unit") of Trafalgar II Limited Partnership (the "Partnership") subscribed for by the Maker and accepted by the Holder pursuant to the Partnership's Offering Memorandum dated September 1, 1995, being 150 Units together with interest thereon as set forth herein.
The Principal Sum together with interest shall be due and payable by the Maker the Holder as follows:
(a) $50 per Unit plus $1 interest payable on March 15, 1996;
(c) $110 per Unit plus $5 interest payable on June 15, 1996; and
(e) $710 per Unit plus interest on October 30, 2005.
The principal sum from time to time outstanding shall bear interest from and after the date hereof at the rate of nine percent (9%) per annum, compounded annually both before and after demand, default, maturity and judgment with interest on overdue principal and interests at the same rate until the date of payment in full. The Maker shall pay all accrued and unpaid interest on the principal amount outstanding from time to time, annually, in arrears, on or before January 30 of each year, commencing on January 30, 1996.
...
The Maker hereby consents to the assignment of this promissory note to Trafalgar Capital Ltd. ("Trafalgar Capital") as security for an amount owing from the Holder to Trafalgar Capital under an acquisition note dated December 30, 1994 in the amount of $10,000,000 and hereby directs the Holder to remit to Trafalgar Capital one hundred percent (100%) of the Maker's share of Distributable Cash (as such term is defined under the offering memorandum of the Holder dated September 1, 1995) until all interest then owed by the Maker under this promissory note has been paid, and thereafter to remit to Trafalgar Capital 45% of the Maker's Distributable Cash until all principal then owed by the Maker under this promissory note has been paid.
B. The software
[17] MarketVision is a suite of software programs for trading currency and financial futures markets. It was developed by Edward Furtak, a Canadian who resided in Bermuda, through his company Trafalgar Research. He graduated in 1989 from McMaster University in Hamilton and has developed something of an expertise in technical analysis of financial and securities markets as well as considerable proficiency with computers. On the witness stand he came across as an articulate person with clear abilities as a salesman.
[18] MarketVision was a suite of application software programs which instructs money managers when to buy and sell currency and financial futures contracts. It was designed to analyse statistical data on currency and financial futures markets and to generate trading decisions on the basis of that analysis.
[19] Futures trading involves the purchase of futures contracts which are essentially agreements to buy a commodity for delivery in the future at a specific price determined at the time the agreement is entered into.
[20] The type of analysis used by MarketVision is called technical analysis and is to be distinguished from fundamental analysis. The report of Mr. Jim Horvath, a professional business valuator with Deloitte & Touche, contains not only a useful definition of these terms but also a clear description of just what futures trading is. It is relatively short and I reproduce in full the portion of his report that deals with futures trading, but without the footnotes.
3.2 Futures Trading
The following summarizes the relevant background relating to futures trading and futures trading software. This information has been obtained from various sources including articles, published interviews, discussions with industry participants and regulators, and various websites, as outlined in the scope of review.
A futures contract is defined by the Commodities Futures Trading Commission ("CFTC") as "an agreement to purchase or sell a commodity for delivery in the future: (1) at a price that is determined at initiation of the contract; (2) which obligates each party to the contract to fulfil the contract at the specified price; (3) which is used to assume or shift price risk; and (4) which may be satisfied by delivery or offset." Futures trading include non-financial commodities such as grains, meats and metals, and financial commodities such as interest rates (US Treasury Bonds), currency, and stock indices.
Futures contracts are bought on margin. Margin is defined by the National Futures Association ("NFA") as: "An amount of money or deposited by both the buyers and sellers of futures contracts to ensure performance of the terms of the contract (the making or taking delivery of the commodity or the cancellation of the position by a subsequent offsetting trade). Margin in commodities is not a down payment, as in securities, but rather a performance bond."
Leverage is the term that is used to describe "the ability to control large dollar amounts of a commodity with a comparatively small amount of capital." As discussed below (section 3.4), leverage in a managed futures investing context has a further meaning.
The NFA provides the following example of the arithmetic of futures trading and leverage in its publication, A Guide to Understanding Opportunities and Risks in Futures Trading, page 14:
"For example, assume that in anticipation of rising stock prices you buy one June S & P stock index futures contract at a time when the June index is trading at 1200.
Also assume that your initial margin requirement is $15,000. Since the value of the futures contract is $250 times the index, each one-point change in the index represents a $250 gain or loss.
An increase of five per cent in the index, from 1200 to 1260, would produce a $15,000 profit (60 x $250). Conversely, a 60-point decline would produce a $15,000 loss. In either case, an increase or decrease of only five per cent in the index would, in this example, result in a gain or loss equal to 100 per cent of the $15,000 initial margin deposit."
The reduction in account equity from the peak to the low point resulting from a trade or series of trades is also referred to as a drawdown.
Analysis of futures markets by futures investors (and related trading approaches) can be generally classified as either
• Technical Analysis; or
• Fundamental Analysis.
Technical Analysis is defined by the NFA as "an approach to analysis of futures markets which examines patterns of price change, rates of change, and changes in volume of trading, open interest and other statistical indicators." Technical analysts do not consider underlying fundamental factors such as economic conditions, but instead analyze the patterns or trends such as those described above, usually in the form of a chart. A trading approach or style based on technical analysis is sometimes referred to as mechanical trading, or systematic trading. Indications to buy, sell or hold, based on technical analysis or indicators, are often referred to as signals. The individual variables within a system are referred to as parameters.
Fundamental Analysis is defined by the CFTC as the "study of basic, underlying factors which will affect the supply and demand of the commodity being traded in futures contracts." A trading approach or style based on fundamental analysis is often referred to as discretionary trading.
Many futures investors elect to place their funds in a managed futures funds account, where the authority for trading is exercised and is under the management of a broker, or trader. In the US, such advisors/fund managers are regulated, and are required to be registered with the CFTC. The term Commodity Trading Advisor ("CTA") is used to describe such an advisor/manager. The term CTA is defined by the CFTC as "individuals or firms that, for pay, issue analyses or reports concerning commodities, including the advisability of trading in commodity futures or options."
CTAs, managed futures funds accounts, and the concept of leverage in a managed futures funds context are discussed in more detail below (subsection 3.4).
C. The acquisition of the software by Trafalgar II
[21] Trafalgar Capital, Trafalgar Research (sometimes collectively called "Trafalgar") and the partnership Trafalgar II entered into an agreement made as of 24 February 1995 called the Software Acquisition and Pledged Trading Capital Agreement (the "Software Acquisition Agreement").
[22] In view of the importance of this agreement in governing the relations between the partnership and the Bermuda companies I am reproducing below what appear to be some of the more salient provisions.
WHEREAS Trafalgar Research has developed and Trafalgar Capital is the exclusive owner of an undivided 73.82% interest in and to the Computer Programs;
AND WHEREAS the Partnership wishes to purchase and Trafalgar Capital wishes to sell an undivided 18.18% interest in and to the Computer Programs;
AND WHEREAS in partial payment of the purchase price for the Computer Programs, the Partnership intends to execute and deliver to Trafalgar Capital the Acquisition Note;
AND WHEREAS Trafalgar and the Partnership have agreed to form a joint venture for the purposes of exploiting the Computer Programs;
AND WHEREAS in furtherance thereof, the Partnership and Trafalgar Capital have agreed to make the Computer Programs available to generate trading instructions for financial futures contracts, and Trafalgar Research has agreed to allow the Pledged Trading Capital to be traded pursuant to the instructions generated by the Computer Programs;
AND WHEREAS Trafalgar and the Partnership have agreed to actively solicit third party capital to be traded using the Computer Programs;
NOW THEREFORE in consideration of the sum of one dollar ($1.00), and other good consideration, now paid by each of the parties hereto to the other (the receipt and sufficiency or which is hereby acknowledged), the parties hereto hereby covenant and agree as follows:
1. DEFINITIONS
1.01 For the purpose of this Agreement, the following terms shall be deemed to have the following meanings:
(a) "Acquisition Note" means the promissory note given by the Partnership to Trafalgar Capital pursuant to section 2.02 of this agreement, in the form attached as Appendix "A" hereto;
...
(i) "Capital Additions" means the additional trading capital pledged by Trafalgar pursuant to section 5 of this agreement;
...
(k) "Computer Programs" means MarketVision, a suite of application software programs, developed by Trafalgar Research, which instruct money managers when to buy and sell currency and financial futures contracts, as more particularly described in Appendix "B" hereto, together with all Enhancements, Derivative Works and Maintenance Modifications;
...
(q) "Losses" means any and all loss, damage, claim, demand, deficiency, cost and expense, including interest, compound interest and legal fees on a solicitor and his or her own client basis;
...
(u) "Pledge Agreement" means the agreement dated as of the date hereof amongst the Partnership, Trafalgar Capital and each Limited Partnership, pursuant to which each Limited Partner has pledged his or her Units as security for the performance of the Partnership's obligations under the Acquisition Note;
(v) "Pledged Trading Capital" means the capital to be pledged by Trafalgar Research for a period of 15 years pursuant to section 4 of this agreement and the Capital Additions;
(w) "Purchase Price" means the purchase price paid by the Partnership to Trafalgar Capital for the Computer Programs, as determined in accordance with section 2.02 of this agreement;
...
(z) "Third Party Capital" means all capital which is not Pledged Trading Capital and which is traded using the Computer Programs;
(aa) "Third Party Trading Profits" means all revenues generated and retained by Trafalgar Capital through the use of the Computer Programs and any Third Party Capital, including Third Party Management Fees, less Third Party Brokerage Fees;
(ab) "Trading Profits" means all revenues generated by Trafalgar Capital by the use of the Computer Programs and the Pledged Trading Capital, less Trading Report Fees, Trafalgar Management Fees and Brokerage Fees;
(ac) "Trading Report" means each futures contract trading instruction (a buy instruction and sell instruction together constituting one trading instruction) generated by the Computer Programs in respect of the Pledged Trading Capital;
(ad) "Trading Report Fee" means the US$20.00 payable by Trafalgar to the Partnership for each Trading Report acquired from the Partnership by Trafalgar Capital, payable in Canadian dollars at an exchange rate equal to the greater of (i) CDN$1.40 or US$1.00, and (ii) the prevailing exchange rate at the time such payment is made;
...
2. AGREEMENTS OF PURCHASE AND SALE
2.01 In consideration of the payment of the Purchase Price, and of the fulfilment of the other obligations of the Partnership hereunder, Trafalgar Capital hereby sells, assigns and transfers to the Partnership a 18.18% undivided interest, in perpetuity, in and to the Computer Programs.
2.02 The Purchase Price for the Computer Programs shall be $10,000,000, payable by the Partnership to Trafalgar Capital as follows:
(a) as to $◘by delivery of cheque or bank draft upon the execution of this agreement; and
(b) as to the balance of the Purchase Price, by delivery of:
(i) the executed Acquisition Note;
(ii) Promissory Notes in the aggregate amount of $◘; and
(iii) the irrevocable direction of each Limited Partner to the Partnership and Trafalgar Capital authorizing the Partnership to pay 45% of net partnership income to Trafalgar Capital in payment of the principal on the Promissory Notes and the Acquisition Note.
2.03 Upon execution of this agreement, Trafalgar Capital shall deliver to the Partnership four complete copies of the source code of the Computer Programs, of which:
(a) two shall be in machine readable form on a machine readable storage medium suitable for long-term storage and compatible with either MacIntosh or IBM PC computer systems; and
(b) two shall be in human readable form with annotations in the English language on bond paper suitable for long-term archival storage.
3. FORMATION OF JOINT VENTURE
3.01 The parties hereto agree to form a joint venture, the purposes of which shall be to engage in the trading of financial futures contracts using the Pledged Trading Capital and the Computer Programs and to actively solicit third Party Capital to be traded using the Computer Programs, all in accordance with the terms and conditions of this agreement.
3.02 The term of the joint venture shall commence upon the Closing and continue until November 30, 2009.
3.03 Upon written notice by either the Partnership or Trafalgar, given not less than 60 days prior to the expiry of the term of this agreement and the joint venture and any extensions thereto, the term of this agreement and the joint venture shall be extended for an additional ten (10) years.
4. CONTRIBUTION OF PLEDGED TRADING CAPITAL
4.01 Upon Closing, Trafalgar shall direct that the Pledged Trading Capital be deposited in an interest bearing account (the "Account") at the Bank.
4.02 The Account shall be in the name of Trafalgar Research and shall require two signatures, one of which shall be that of the General Partner of the Partnership, and the other of which shall be designated by Trafalgar, in order to withdraw or transfer funds from the Account.
4.03 Trafalgar Research hereby grants to the Partnership a security interest in and to the Pledged Trading Capital, which interest shall ensure that Trafalgar fulfils its obligations under this agreement. The foregoing security interest shall terminate upon the withdrawal of the Pledged Trading Capital in accordance with section 4.06 of this agreement.
4.04 The Pledged Trading Capital deposited in the Account by Trafalgar shall be equal to 95% of the net proceeds of the Offering to Trafalgar (being the gross proceeds of the offering less the actual out-of-pocket expenses (to a maximum of $100,000) incurred by Trafalgar for the purpose of the Offering and the sale of the Computer Programs to the Partnership), payable by Trafalgar as follows:
(a) as to 24.14% on Closing;
(b) as to 20.69% on or before June 15, 1995;
(c) as to 17.24% on or before September 15, 1995;
(d) as to 20.69% on or before March 15, 1996; and
(e) as to 17.24% on or before June 15, 1996.
4.05 Subject to section 5 of this agreement, all interest paid by the Bank on the Pledged Trading Capital shall be paid to Trafalgar Research.
4.06 On or after February 1, 2009, and notwithstanding any extensions to the term of this agreement pursuant to section 3.03 of this agreement, Trafalgar Research shall be entitled to withdraw all of the Pledged Trading Capital.
4.07 The Partnership and Trafalgar Capital acknowledge that notwithstanding the terms of this agreement, Trafalgar Research shall remain the legal owner of the Pledged Trading Capital.
5. CAPITAL ADDITIONS
5.01 Until such time as Trafalgar delivers to the Partnership written confirmation that all principal and interest owing under the Acquisition Note has been paid in full, 30% of the interest paid to Trafalgar Research pursuant to section 4.05 of this agreement shall be deemed to be Capital Additions and shall be added to the Pledged Trading Capital.
5.02 Subject to section 7.09 of this agreement, fifty percent (50%) of all amounts paid by the Partnership to Trafalgar Capital in 1995 as interest on the Acquisition Note shall be deemed to be Capital Additions and shall be added to the Pledged Trading Capital.
5.03 Until such time as Trafalgar delivers to the Partnership written confirmation that all principal and interest owing under the Acquisition Note has been paid in full, 30% of the Trading Profits paid to Trafalgar Research pursuant to section 7.05 of this agreement shall be deemed to be Capital Additions and shall be added to the Pledged Trading Capital.
5.04 All amounts paid to Trafalgar Capital by the Partnership pursuant to the Software Agreement in respect of principal on the Acquisition Note shall be deemed to be Capital Additions, and shall be added to the Pledged Trading Capital.
5.05 All Capital Additions added to the Pledged Trading Capital shall be subject to the terms and conditions set out in this agreement in respect of the Pledged Trading Capital.
6. THIRD PARTY CAPITAL
6.01 Throughout the term of this agreement, Trafalgar and the Partnership shall actively solicit Third Party Capital to be traded using the Computer Programs.
6.02 The Partnership and Trafalgar shall negotiate in good faith a standard form of agreement (a "Third Party Agreement") to be executed by third parties in respect of management fees and allocation of revenues generated from Third Party Capital, and Trafalgar shall not enter into any other agreement in respect of Third Party Capital and the Computer Programs without the prior written consent of the Partnership, which consent may not be unreasonably withheld.
6.03 Subject to the terms of any Third Party Agreement, all Third Party Capital shall be deposited in one or more accounts (the "Third Party Accounts") at the Bank, and in no case shall any Third Party Capital be commingled with Pledged Trading Capital.
7. TRADING
7.01 Trafalgar Capital shall manage the affairs of the joint venture and, in furtherance of that obligation, shall buy and sell financial futures contracts:
(a) using the Pledged Trading Capital in strict accordance with the Trading Reports; and
(b) subject to the terms of any Third Party Agreement, using Third Party Capital in accordance with the Trading Reports.
7.02 In conducting trades using the Pledged Trading Capital, Trafalgar Capital shall not leverage the Pledged Trading Capital at a ratio higher than four to one (4:1) based upon the initial Pledged Trading Capital plus annual net Capital Additions.
7.03 For each futures contract bought and sold using the Computer Programs and the Pledged Trading Capital, Trafalgar shall pay the Partnership a Trading Report Fee, and Trafalgar Capital shall be entitled to a Trafalgar Management Fee.
7.04 Until such time as Trafalgar delivers to the Partnership written confirmation that all principal and interest owing under the Acquisition Note has been paid in full, Trafalgar Capital shall buy no less than 2,850 Trading Reports per year for each $1,000,000 in leveraged Pledged Trading Capital.
7.05 Until such time as Trafalgar delivers to the Partnership written confirmation that all principal and interest owing under the Acquisition Note has been paid in full, the Partnership shall receive 80% of all Trading Profits, and the balance of Trading Profits shall be paid to Trafalgar Research.
7.06 After Trafalgar delivers to the Partnership written confirmation that all principal and interest owing under the Acquisition Note has been paid in full, the Partnership shall receive 20% of all Trading Profits, and the balance of Trading Profits shall be paid to Trafalgar Research.
7.07 Trafalgar Research acknowledges that in the event that Trading Profits are less than the aggregate of Trading Report Fees, Trafalgar Management Fees and Brokerage Fees, Trafalgar Capital shall be obligated to pay from the Pledged Trading Capital all Trading Report Fees to the Partnership and all Brokerage Fees to the Broker.
7.08 In the event that Trafalgar Capital is obligated to deposit a portion of the Pledged Trading Capital with the Broker, the Broker shall be notified in writing by Trafalgar Capital that all payments and transfers from the account established by the Broker which are not made directly to the Account shall require at least two signatures, one of which shall be that of the General Partner.
7.09 Notwithstanding any other term of this agreement, in the event that the Pledged Trading Capital is reduced to less than 9.5% of the outstanding principal on the Acquisition Note:
(a) Trafalgar Capital shall immediately cease all trading using the Pledged Trading Capital, notify the Partnership in writing forthwith and not recommence trading without the explicit written consent of the Partnership, which consent may be unreasonably withheld; and
(b) until such time as the Pledged Trading Capital is greater than 9.5% of the outstanding principal on the Acquisition Note, one hundred percent (100%) of all amounts paid by the Partnership to Trafalgar Capital in 1995 as interest on the Acquisition Note shall be deemed to be Capital Additions and shall be added to the Pledged Trading Capital.
7.10 Until such time as Trafalgar delivers to the Partnership written confirmation that all principal and interest owing under the Acquisition Note has been paid in full, the Partnership shall receive 18.18% of Third Party Trading Profits, and the balance of Third Party Profits shall be paid to Trafalgar Capital.
7.11 After Trafalgar delivers to the Partnership written confirmation that all principal and interest owing under the Acquisition Note has been paid in full, the Partnership shall receive 3.64% of all Third Party Trading Profits, and the balance of Trading Profits shall be paid to Trafalgar Capital.
...
10. REPRESENTATIONS AND WARRANTIES
10.01 Each of Trafalgar Capital and Trafalgar Research hereby represent and warrant to the Purchaser that the following representations and warranties are true and correct as of the date hereof, and each acknowledges that the Partnership is relying on such representations and warranties in connection with the performance of its obligations under this agreement:
...
(n) Until all principal and interest owing under the Acquisition Note have been paid in full, the Computer Programs will generate at least 2,850 Trading Reports per year per $1,000,000 in leverage Pledged Trading Capital and, between the date hereof and November 30, 2004, will generate an average annual return of no less than 18% on leveraged Pledged Trading Capital.
10.02 The representations and warranties set out in section 10.01 above shall survive and continue in full force and effect for the benefit of the Partnership until five years after the expiry or termination of this agreement, including all amendments, extensions and renewals thereof.
...
11. INDEMNIFICATION
...
11.02 Each of Trafalgar Capital and Trafalgar Research shall indemnify and save harmless the Partnership for and from and against any Losses suffered by it as a result or any inaccuracy in or breach or any representation or warranty by Trafalgar Capital or Trafalgar Research, or the failure of Trafalgar Capital or Trafalgar Research to fulfil any condition or perform any covenant as provided herein.
...
11.05 In the event that Trafalgar breaches the terms of section 7.03 of this agreement, or in the event that the Computer Programs do not achieve an average annual return of at least 16% on leveraged Pledged Trading Capital in the period between January 1, 1995 and December 31, 2004, the Partnership shall have the right, but not the obligation, to replace a majority of the board of directors of Trafalgar Capital with nominees of the Partnership.
[23] The original Software Acquisition Agreement contemplated an acquisition by the partnership of an 18.18% interest in MarketVision and defined "unit" to mean one of the 10,000 units of limited partnership interests in Trafalgar II and a purchase price of $10,000,000. An amending agreement made as of 31 December 1995 amended the definition of unit to mean one of 12,140 units of limited partnership interests and raised the percentage interest to be acquired by Trafalgar II to 22.07% and raised the purchase price to $12,140,000.
[24] The Acquisition Note referred to in the agreement reads as follows:
ACQUISITION NOTE
December 31, 1995
Toronto, Ontario
MATURITY DATE: December 1, 2005
FOR VALUE RECEIVED, the undersigned (the "Maker") acknowledges itself indebted to and promises to pay to Trafalgar Capital Ltd. (the "Holder") on the dates specified below at 225 Richmond Street West, Suite 400, Toronto, Ontario, M5V 1W2 (or at such other place as the Holder may from time to time designate in writing to the Maker), the principal sum of $8,619,400 (the "Principal Sum") in lawful money of Canada, together with interest thereon as set forth herein.
The Principal Sum plus all accrued and unpaid interest thereon shall be due and payable by the Maker to the Holder in full on December 1, 2005. Notwithstanding the foregoing, in the event that the Maker is capitalized pursuant to the offering made pursuant to the offering memorandum (the "Offering Memorandum") of the Holder dated January 10, 1995, and any amendments thereto, the payment terms of this note shall be amended to reflect the terms of the capitalization made pursuant to the Offering.
The principal sum from time to time outstanding shall bear interest from and after the date hereof at the rate of nine percent (9%) per annum, compounded annually both before and after demand, default, maturity and judgment with interest on overdue principal and interests at the same rate until the date of payment in full. The Maker shall pay all accrued and unpaid interest on the principal amount outstanding from time to time, annually, in arrears, on or before January 30 of each year, commencing as of the date hereof.
In the event that the Maker defaults in payment of any sum due hereunder, and fails to correct that default within 30 days of receiving written notice from the Holder, the Principal Sum then outstanding together with accrued but unpaid interest may, at the Holder's option, be accelerated and immediately become due and payable in full, with interest thereon from such date at the rate as specified herein.
So long as the Maker is not in default in the making of any payment due hereunder, it shall have the right to prepay at any time and from time to time all or any part of the Principal Sum then outstanding, and any interest thereon, without notice, bonus or penalty, provided that the right of the Maker to make any such prepayments shall be conditional upon payment by the Maker to the Holder of all accrued and unpaid interest owing in respect of the Principal Sum to the date of any such prepayment.
The provisions of this promissory note shall enure to the benefit of the Holder (who may not transfer, assign, pledge or otherwise encumber this promissory note without the express written consent of the Maker, which consent may be unreasonably withheld) and shall be binding upon the Maker and its successors and assigns. The Maker hereby waives presentment, protest, demand, notice of protest and notice of dishonour of this promissory note and expressly agrees that this promissory note and any payment due hereunder may be extended from time to time by the Holder without in any way affecting the liability of the Maker.
This promissory note is issued by the Maker and accepted by the Holder as partial payment of the consideration due under a software agreement dated January 30, 1995 amongst the Maker, the Holder and Trafalgar Research (Bermuda) Ltd., and this promissory note is subject to the terms and conditions of that agreement.
This promissory note shall be governed by and construed in accordance with the laws of the Province of Ontario and the laws of Canada applicable therein.
Executed at Toronto, Ontario this 31st day of December, 1995.
TRAFALGAR II LIMITED
PARTNERHSIP, by its General
Partner, TSLP MANAGEMENT INC.
Per:
__________(signed)_____________
Greg Coleman - President
[25] By a document made as of December 31, 1995 called "Assignment of Promissory Notes" Trafalgar II assigned to Trafalgar Capital the promissory notes given to it by the limited partners. This document is in my view an important link in the chain of transactions with which this case is concerned and therefore it is reproduced in full.
ASSIGNMENT OF PROMISSORY NOTES
THIS AGREEMENT made as of the 31st day of December, 1995
AMONGST:
TRAFALGAR II LIMITED PARTNERSHIP, a limited partnership formed pursuant to the laws of the Province of Ontario (hereinafter referred to as the "Partnership")
OF THE FIRST PART
-AND-
TRAFALGAR CAPITAL LTD., a company formed under the laws of Bermuda (hereinafter referred to as the "Vendor")
OF THE SECOND PART
-AND-
EACH PARTY who has been or from time to time may be accepted as a limited partner in the Partnership, or who is a successor to any such party (hereinafter individually referred to as a "Limited Partner" and collectively referred to as "the Limited Partners")
OF THE THIRD PART
WHEREAS the Partnership has acquired from the Vendor an undivided interest in MarketVision, a suite of application software programs (the "Computer Programs"), pursuant to the terms of a software acquisition and pledged trading capital agreement (the "Software Acquisition Agreement") dated as of February 24, 1995, and amended by agreement dated as of December 31, 1995;
AND WHEREAS pursuant to the terms of the Software Acquisition Agreement, the Partnership has executed and delivered to the Vendor an acquisition note (the "Acquisition Note") in the principal amount of $9,300,000.00;
AND WHEREAS the Partnership has accepted subscriptions from Limited Partners for 12,140 limited partnership units in the Partnership, and, in partial fulfilment of the subscription price for such units, each Limited Partner has executed and delivered to the Partnership a promissory note in the principal amount of $900 per unit (collectively, the "Promissory Notes");
AND WHEREAS in full satisfaction of the purchase price for the Computer Programs, the Partnership wishes to assign to the Vendor all of the right, title and interest of the Partnership in and to the Promissory Notes;
NOW THEREFORE in consideration of the payment of the sum of One Dollar ($1.00), and other good and valuable consideration, the receipt of which is hereby acknowledged, and of the premises and mutual covenants contained herein, the parties hereto agree as follows:
1. The Partnership hereby assigns and transfers to the Vendor all of the right, title and interest of the Partnership in and to the Promissory Notes.
2. Each of the Limited Partners shall pay to the Vendor, at 225 Richmond Street West, Suite 400, Toronto, Ontario, M5V 1W2, or at such other address as the Vendor may designate from time to time, all amounts, including all principal and interest, payable by each Limited Partner to the Partnership pursuant to the terms of the Promissory Note.
3. In consideration of the assignment of the Promissory Notes from the Partnership to the Vendor, the Vendor hereby releases and discharges the Partnership from all liability under the Acquisition Note.
4. Each Limited Partner hereby irrevocably directs the Partnership to pay to the Vendor 100% of such Limited Partner's share of Distributable Cash (as defined in the partnership agreement of the Partnership), on a quarterly basis, until all of the interest owing under the Limited Partner's Promissory Note is paid in full, and thereafter to pay to the Vendor 45% of such Distributable Cash, again on a quarterly basis, until all principal owing under such Promissory Note has been paid in full.
5. The Vendor may not further assign, transfer, pledge, hypothecate, grant a security interest in or otherwise encomber the Promissory Notes without the express written consent of the Partnership and each of the Limited Partners, which consent may be unreasonably withheld.
6. In the Event that a Limited Partner sells, transfers or assigns his or her units in the Partnership, such Limited Partner shall also be entitled to assign or transfer his or her Promissory Note, provided that:
(a) such transfer is made in accordance with the terms of the Partnership Agreement; and
(b) the transferee assumes all of the obligations under the Promissory Note.
7. Nothing contained herein shall be construed as making any Limited Partner liable to the Vendor for any amount greater than that owed under such Limited Partner's Promissory Note, nor as releasing or limiting the liability of the Partnership from any other liabilities to the Vendor under the Software Acquisition Agreement.
8. This agreement shall enure to the benefit of and be binding upon the parties hereto and their respective heirs, executors, administrators and other legal representatives, successors and assigns.
9. This agreement shall be governed by and construed in accordance with the laws of the Province of Ontario and the laws of Canada applicable therein, and the parties hereto attorn to the jurisdiction of the courts of the Province of Ontario.
10. This agreement may be executed in two or more counterparts, with the same effect as if all parties hereto had signed the same document. This agreement may also be adopted in any subscription forms, transfer and assignment form or similar instruments signed by a Limited Partner or his attorney, with the same effect as if such Limited Partner had executed a counterpart of this agreement. All counterparts and adopting instruments shall be construed together and shall constitute one and the same agreement.
IN WITNESS WHEREOF this agreement has been executed as of the date and year first above written.
TRAFALGAR II LIMITED
PARTNERSHIP, by its General Partner
TSLP MANAGEMENT INC.
Per:
___________(signed)________________
Greg Coleman - President
TRAFALGAR CAPITAL LTD.
Per:
___________(signed)________________
Edward Furtak - President
LIMITED PARTNERS, by their agent
and attorney,
TSLP MANAGEMENT INC.
Per:
___________(signed)________________
Greg Coleman - President
[26] I shall refer later to this document but at this point there are several observations that ought to be made.
(a) One of the recitals speaks of a principal amount of $9,300,000 under the Acquisition Note. The Acquisition Note uses the figure $8,619,400.
(b) Another recital speaks of the limited partners giving promissory notes to the partnership for $900 per unit. The principal amount under the promissory notes was $870.
(c) In the promissory notes the limited partners consent to their assignment to Trafalgar Capital "as security" for the amount owing from the holder [Trafalgar II] under an Acquisition Note dated December 30, 1994 in the amount of $10,000,000. Leaving aside the fact that the Acquisition Note was dated December 31, 1995 and not December 30, 1994 and the amount of $10,000,000 is wrong it is clear in clauses 1 and 3 of the Assignment of Promissory Notes document that the assignment is absolute and not by way of security. Indeed under clause 3 the assignment has the result of releasing and discharging the partnership from all liability under the Acquisition Note. I have reproduced above a number of clauses of the Software Acquisition Agreement. Clauses 5.01, 5.03, 7.04, 7.05, 7.10 and paragraph 10.01(n) all specify serious and fundamental changes in the commercial relations between Trafalgar Capital and Trafalgar II when principal and interest under the Acquisition Note are paid off. Yet that is precisely what clause 3 of the Assignment of Promissory Notes says happened on December 31, 1995.
(d) Clause 6 of the Assignment of Promissory Notes provides that if a limited partner sells, transfers or assigns his or her units in Trafalgar II such limited partner is entitled to assign or transfer his promissory note provided the transfer is made in accordance with the terms of the partnership agreement and the transferee assumes all obligations under the note.
To speak of assigning or transferring the promissory note by the limited partner (the obligor under the note) is not really appropriate. What clause 6 does is to permit a limited partner to have his or her obligation under the promissory note assumed by someone else and Trafalgar Capital is consenting in advance to what is in essence a novation. It seems clear to me that the effect of clause 6 is that if a limited partner "transfers" the promissory note to a third party the original limited partner is released from his or her obligation under the note. Counsel for the appellant referred to National Trust Co. v. Mead, [1990] 2 S.C.R. 410, and Paramount Life Insurance Co. v. Torgerson Development Corp., 51 Alta. L.R.(2d) 59, in support of the view that notwithstanding the "assignment or transfer" of the promissory note to a third party the original debtor remains liable under it. In National Trust Co. v. Mead the Supreme Court of Canada stated at page 427:
A novation is a trilateral agreement by which an existing contract is extinguished and a new contract brought into being in its place. Indeed, for an agreement to effect a valid novation the appropriate consideration is the discharge of the original debt in return for a promise to perform some obligation. The assent of the beneficiary (the creditor or mortgagee) of those obligations to the discharge and substitution is crucial. This is because the effect of novation is that the creditor may no longer look to the original party if the obligations under the substituted contract are not subsequently met as promised.
Because assent is the crux of novation it is obvious that novation may not be forced upon an unwilling creditor and, in the absence of express agreement, the court should be loath to find novation unless the circumstances are really compelling. Thus, while the court may look at the surrounding circumstances, including the conduct of the parties, in order to determine whether a novation has occurred, the burden of establishing novation is not easily met. The courts have established a three-part test for determining if novation has occurred. It is set out in Polson v. Wulffsohn (1890), 2 B.C.R. 39 as follows:
1. The new debtor must assume the complete liability;
2. The creditor must accept the new debtor as principal debtor and not merely as an agent or guarantor; and
3. The creditor must accept the new contract in full satisfaction and substitution for the old contract.
I do not see how any effect can be given to clause 6 if it does not mean that an assumption by a third party of the obligations under the note results in the release of the original limited partner. I am aware that the burden of establishing a novation and the consequent release of the original debtor is a heavy one. Nonetheless it is clear in my view that the intent in clause 6 is that the original debtor be released in the event of an assignment of the promissory note.
D. The offering memorandum
[27] The offering memorandum summarizes what was being offered to the limited partners. It carefully cautions the potential investors that the units are speculative, that they have no market and probably cannot be resold, that the investors might lose their entire investment and that there is no assurance that the business will be operated successfully. It advises the investors to consider the merits of the investment in addition to the expected income tax benefits.
[28] A few passages from the offering memorandum will suffice.
Investment
Investors will become limited partners in Trafalgar II Limited Partnership, an Ontario limited partnership. The Partnership has acquired up to an 18.18% undivided interest in MarketVision, a suite of application software programs which instructs money managers when to buy and sell currency and financial futures contracts. The Computer Programs will be used by the Partnership and Trafalgar Capital to conduct trades over a 15 year period with the Pledged Trading Capital. (See "Structure of the Offering")
Software
MarketVision is designed to analyze statistical data on currency and financial futures markets and to generate trading decisions on the basis of that analysis. In historical simulations from 1989-1994, MarketVision generated average annual returns in excess of 32%. During the same period, the average return for 97 International Fund Managers was 30%. (See "Business Plan of the Partnership"). MarketVision is currently being used to trade more than $6 million in leveraged trading funds in Bermuda.
...
Joint Venture
The Partnership and Trafalgar Capital, the owners of the computer Programs, will form a joint venture to engage in the trading of financial futures contracts using the Computer Programs.
Trading Fund
Under the terms of the Pledged Tradin