Fraud victims may not enjoy priority standing in bankruptcy proceedings

In a recent decision, The Court of Appeal for Ontario clarified the circumstances under which a constructive trust remedy will be granted in favour of victims of fraud once a fraudster enters bankruptcy proceedings.

In Credifinance Securities Limited v. DSLC Capital Corp,^[1] DSLC made a $400,000 loan to Credifinance. Some time later, Credifinance defaulted on the repayment of the loan. DSLC came to suspect that the loan was obtained by way of fraudulent misrepresentations. DSLC commenced legal proceedings against Credifinance to recoup the $400,000 loan. As part of those proceedings, DSLC obtained an Order directing that $310,500 be paid into Court by Credifinance from its bank account at National Bank pending the resolution of the litigation. The motions judge held that $310,500 was the amount that remained of the original loan. The principal of Credifinance then assigned Credifinance into bankruptcy and did not pay $310,500 into court.

The only creditors of Credifinance in the bankruptcy were DSLC, the principal of Credifinance and other companies under the principal’s control (these parties alleged they were secured creditors of Credifiance and were owed $127,032.07), and Credifinance’s lawyers who claimed to be owed $128,546.25 as an unsecured creditor.

DSLC made a claim in the bankruptcy for the amount of the outstanding loan, and further claimed that they had a proprietary interest in the $310,500 that remained on deposit at National Bank. DSLC claimed that these were trust funds that belonged to DSLC. 

If DSLC’s trust fund argument prevailed, the $310,500 would be excluded from the bankrupt estate and would be paid directly to DSLC. If the trust fund argument failed, then DSLC would have an unsecured claim for $400,000, and it would share in the bankrupt estate on a pro-rated basis in proportion with the other unsecured creditor in the bankruptcy (the law firm), after the secured creditors (the principal of the bankrupt company and his other controlled companies) received the full amount of their claims.

At the first instance, the trustee in bankruptcy disallowed the trust claim. DSLC appealed the trustee’s decision to a judge of the Superior Court of Justice. The appeal judge granted DSLC a constructive trust over the $310,500. The trustee appealed the appeal judge’s decision to the Court of Appeal.

The Court of Appeal upheld the decision of the appeal judge.

In its judgment, the Court of Appeal pointed out that the remedy of constructive trust is available in a bankruptcy proceeding, although the test for proving the existence of a constructive trust is high. The Court stated that a constructive trust may be granted to prevent an injustice, such as where to do otherwise would allow a bankrupt and its creditors to benefit from misconduct by the bankrupt which was the basis upon which the property at issue was obtained.

In upholding the constructive trust finding, the Court of Appeal relied heavily on the fact that, in the absence of a constructive trust, the principal of Credifinance would obtain a benefit from his fraudulent conduct:

Thus, as the appeal judge found, DSLC was the victim of fraud perpetrated by Credifinance and [its principal]. Importantly, the only creditors of Credifinance impacted by the appeal judge’s order are [the principal] and his lawyers. Enriching [the principal], therefore, with a windfall and depriving DSLC of its interest in the $310,500 would be fundamentally unjust.^[2]

However, later on in the decision, The Court of Appeal made it clear that being the victim of a fraud is not in and of itself sufficient to ground a finding of a constructive trust in a bankruptcy proceeding:

Before leaving this issue, I believe it is important to make a final observation. The appeal judge’s reasons should not be interpreted to suggest that once a civil fraud by the bankrupt on the claimant, whose claim was disallowed by the trustee, is proven, and that is coupled with a loss and an ability to trace the consequences of the fraud, then a constructive trust will always be imposed. That, in my view, is too broad.

Constructive trust is a discretionary remedy. In a bankruptcy there are other interests to consider besides those of the defrauder and the defraudee: there are other creditors. Thus, the exercise of remedial discretion must be informed by additional considerations than in a civil fraud trial. The appeal judge in our case clearly understood this, considered the claims of the creditors, found them to be tainted by [the principal’s] misconduct, and concluded that a rigid formulaic approach, relying strictly on the letter of the BIA would produce an unjust result.^[3]

It will be interesting to see how the foregoing statement of law is interpreted in subsequent bankruptcy proceedings where there has been fraud by the bankrupt, and in particular the consideration that is given to the rights of other creditors in such bankruptcies.   

In a situation where multiple individuals have been defrauded, but only some of them are able to “trace the consequences of the fraud” to the fraudster’s assets at the time of bankruptcy (e.g., perhaps some of the fraud victims’ money has already been spent), then there would be a strong case to be made that all victims of fraud should be able to share in the defrauded assets on a pro-rated basis, since they have all been victimized by the same fraudulent conduct. 

However, in a bankruptcy where a bankrupt has a fraud victim creditor, some unpaid commercial lending creditors, and some unpaid supply creditors, then surely a constructive trust remedy would be appropriate for the fraud victim. If the bankrupt had not been a fraudster, the defrauded assets would not have been part of the bankrupt’s estate. Under such circumstances it would not be unfair to exclude the defrauded assets from the bankrupt’s estate, since those assets should never have been in the bankrupt’s possession in the first place. It would not be unfair to exclude the other creditors from sharing in these defrauded assets.