NORTH OF THE BORDER UPDATE
This article has been contributed to the blog by Andrea Lockhart, Steven Golick and Benjamin Leith. Steven Golick is a partner in the insolvency and restructuring group of Osler, Hoskin & Harcourt, LLP, and Andrea Lockhart is an associate in the group. Benjamin Leith is an associate in the banking and financial services group of Osler, Hoskin & Harcourt LLP.
The Supreme Court of Canada recently considered which of two innocent creditors, i Trade Finance Inc. (“i Trade”), in its capacity as lender to a company, or Bank of Montreal (“BMO”), in its capacity as lender to the principal of a company, should suffer a loss. A company borrowed funds from i Trade based on false representations, flowed the funds to its principal, who purchased shares with those funds and pledged those shares to BMO to secure a personal MasterCard account. The purchase of the shares was traceable to fraudulently obtained funds.
In the case of i Trade Finance Inc. v. Bank of Montreal, 2011 SCC 26, the Court held in favour of BMO on the basis that the fraud had not yet been uncovered at the time BMO provided credit. This holding was based on the principle of contract law that fraud does not render a contract void automatically, but rather a contract tainted by fraud is voidable at the election of the party defrauded.
Between 2002 and 2003, the principal (the “Principal”) of Webworx Inc. (the “Company”) induced i Trade to lend a substantial sum of money to the Company on the basis of false representations that the Company had substantial contracts for computer services with a large U.S. corporation. The Company used the proceeds of such advances to fund, among other things, paycheques and corporate loans to the Principal. In turn, the Principal purchased shares credited to an investment account with BMO Nesbitt Burns, which account was held jointly with his spouse (the “Investment Account”).
The Principal and his spouse were also joint cardholders of a MasterCard account with BMO, and requested that the bank provide them with a credit limit increase from $10,000 to $75,000. In connection therewith, BMO required the Principal and his spouse to pledge the shares held in the Investment Account to BMO pursuant to a pledge agreement and a notice and direction (collectively, the “Pledge Agreement”). BMO had no knowledge of the Principal’s fraudulent misrepresentation to i Trade.
After the fraud was discovered, i Trade obtained an order that the shares in the Investment Account be sold and that the proceeds be held in trust pending further order of the Court. Subsequently, i Trade commenced civil proceedings and on September 5, 2006 the Court: (i) ordered that the Company and the Principal pay damages to i Trade for conspiracy, deceit, fraudulent misrepresentation and for knowing assistance in breach of trust; (ii) ordered that Company and the Principal held any assets purchased with the funds provided by i Trade to the Company as constructive trustee for the benefit of i Trade; and (iii) granted a tracing order to i Trade, which excluded assets in the hands of bona fide purchasers for value without notice (“BFPVs”).
The essence of the dispute before the Court was whether i Trade or BMO was entitled to the proceeds of the sale of the shares; i Trade, as the beneficiary of the constructive trust and the tracing order, or BMO as pledgee of the shares securing the credit card account.
The Court held that the source of i Trade’s claim for the proceeds of sale was the tracing order, and that such claim arose in equity on the basis of either a constructive trust or an equitable lien. Accordingly, the provisions of the Personal Property Security Act (Ontario) (“PPSA”) did not apply in this case, given that the court order was not a “transaction” that in substance created a security interest.
In the case of BMO, the Court looked to the Pledge Agreement as the source of BMO’s claim and held that it in substance was intended to create a security interest to secure the payment or performance of an obligation in relation to the increased credit limit on the MasterCard account. Accordingly, the Bank could only enforce its security interest as of the moment of “attachment” under the PPSA, upon which such security interest would be enforceable against third parties.
Section 11 of the PPSA provides that a security interest attaches when: (a) the secured party obtains possession of the collateral or when the debtor signs a security agreement that contains a description of the collateral sufficient to enable it to be identified; (b) value is given; and (c) the debtor has rights in the collateral. In this case, it was clear that the Principal and his spouse had signed a security agreement, and that BMO gave value to such parties by increasing the MasterCard account credit limit.
With respect to the last requirement for attachment, the Court held that the fraud made the agreement between i Trade and the Company voidable at the option of i Trade. In this case, i Trade passed title in the funds to the Company and the Company was entitled to use such funds subject to i Trade revoking its consent to the agreement. Until such time, the agreement would be effective by its terms.
The Court held that before i Trade had discovered the fraud and initiated civil proceedings, the Company had i Trade’s consent to use the funds to, among other things, issue paycheques and corporate loans to the Principal. Accordingly, the Principal had sufficient rights in the collateral held in the Investment Account to pledge such collateral to BMO. Given that the Pledge Agreement was executed before the tracing order, BMO’s interest in the pledged collateral could “attach” within the meaning of the PPSA. Further, BMO, as pledgee of the shares, fit within the definition of a “purchaser” under the PPSA and in equity. Accordingly, BMO constituted a BFPV within the exception of the tracing order and was entitled to the disputed funds.
The decision should provide lenders with a degree of comfort where it is later uncovered that the assets subject to their security interest were purchased with funds obtained through fraud. However, lenders should remain diligent. The reasoning may not extend where the fraud is uncovered before the lender’s security interest attaches to the fraudulently obtained collateral, or where the fraudster does not have any rights in the assets, as the fraudster must have rights in the collateral for a security interest to attach.