Canada: i Trade Finance Inc. v. Bank of Montreal

When a fraud is perpetrated in a lending transaction, the result is often that there are too few assets remaining to satisfy creditors, and those assets are subject to competing claims. Even more importantly, one of two innocent people will probably have to bear the loss caused by the fraud. If those competing claims are between creditors with security interests registered under the Personal Property Security Act (Ontario) (the "PPSA"), the decision as to who has priority is generally straightforward, absent extraneous or unusual facts. However, when the claim of a secured creditor is pitted against a party with an equitable claim or proprietary right, the lines become much more blurred, and a secured creditor runs the risk of finding its claim subordinated to that of an unsecured creditor.

Not surprisingly, fraudulent transactions are especially susceptible to the competing claims of creditors with a legal right to assets and third parties with a security interest in those same assets. With fraud, assets are often transferred between debtors without a creditor's knowledge. Such was the case in the recent decision by the Supreme Court of Canada in i Trade Finance Inc. v. Bank of Montreal.¹ The trial judge found in favour of the claim in equity; the Court of Appeal found in favour of the claim under the PPSA; and the Supreme Court of Canada sided with the Court of Appeal, albeit for somewhat different reasons.

While the i Trade decision touches on several separate but related issues, including tracing, claims for unjust enrichment, mistake of fact and the nature of equitable interests, this article will focus primarily on the outcome as it relates to the rules that apply when attempting to resolve a claim between a creditor with a security interest under the PPSA and a creditor with an equitable proprietary interest.

The Facts in i Trade Finance Inc. v. Bank of Montreal

Between 2002 and 2003, i Trade Finance Inc. advanced money to Webworx Inc. on the strength of substantial contracts for computer services which did not actually exist. Certain of these funds were then advanced to the President of Webworx, Rohit Ablacksingh, through his salary and by way of corporate loans from Webworx. These ill-gotten gains were then used by Ablacksingh to purchase shares held in an investment account held jointly with his spouse, Cindy Ramsackal, at BMO Nesbitt Burns.

Ablacksingh and Ramsackal were also joint cardholders of a MasterCard account with Bank of Montreal ("BMO"), which initially had a credit limit of $10,000. Relying on a pledge of the shares in its favour, BMO significantly increased the credit limit of the MasterCard account.

When Webworx's fraudulent practices were discovered, it was ordered, with the consent of all parties, that the shares be liquidated and the proceeds held in trust pending further order of the court.

i Trade sued Webworx and Ablacksingh. On September 5, 2006, Webworx and Ablacksingh were ordered to pay damages. Belobaba J. declared that all assets purchased with the funds advanced by i Trade were held by each of the defendants in the civil proceedings as constructive trustee for the benefit of i Trade. Belobaba J. also declared that the proceeds of the shares were subject to a constructive trust and granted i Trade a tracing order, enabling it to follow the proceeds and seek a personal remedy against any party who might be liable. The Tracing Order, however, specifically excluded assets in the hands of any bona fide purchaser for value without notice.

The primary question at issue in the i Trade Decision was whether BMO, who claimed a security interest under the PPSA, was a bona fide purchaser for value without notice of the shares and could therefore defeat the equitable claim of i Trade to the money. If so, BMO would be paid and could use the money to discharge the indebtedness owing under the MasterCard account. If not, i Trade would be able to trace the Disputed Funds into the hands of BMO and recover the proceeds.

While, as the Supreme Court noted, the issue appeared simple enough, it required consideration of a number of interrelated matters to determine what rules would apply to resolve the competing claims under the PPSA and in equity, including the nature of i Trade's interest in the money, the nature of BMO's interest in the money, whether Ablacksingh had rights in the shares sufficient to support BMO's claim to a security interest and the nature of these competing claims under the PPSA.²

The Decisions of the Lower Courts

In the initial proceedings before the Superior Court, Kiteley J. found in favour of i Trade. In her opinion, Ablacksingh did not have a right in the Shares that could be pledged to BMO to create a security interest because attachment under Subsection 11(2) of the PPSA had not occurred³: Ablacksingh "could not acquire an interest in the collateral that he knew was obtained through his fraud."⁴ Without the requisite rights in the collateral, BMO's security interest could never have attached and, accordingly, BMO's interest in the Shares was not enforceable against a third party such as i Trade, pursuant to the provisions of the PPSA. Kiteley J. also concluded that unjust enrichment had occurred and, in her view, i Trade's ability to assert a constructive trust over the money and trace it were remedies that flowed from that cause of action. Kiteley J. held that BMO was a bona fide purchaser for value without notice, but, nevertheless, further held that BMO's claim failed because BMO had been given the security interest in the Shares by Ablacksingh and Ramsackal, rather than by Webworx, the actual borrower under the lending arrangement with i Trade.⁵

The Court of Appeal unanimously allowed the appeal, finding in favour of BMO.⁶ Blair J.A., writing for the court, held that BMO was a bona fide purchaser for value without notice and was therefore entitled to the money. In Blair J.A.'s opinion, BMO was a bona fide purchaser for value without notice, irrespective of whether it had a security interest under the PPSA, because it had obtained an enforceable interest through the pledge. When i Trade loaned funds to Webworx, it did so with the intention of transferring its ownership interest in those funds. It was this intent that created a voidable interest (discussed in more detail below) in favour of Webworx in the funds, which, citing previous Court of Appeal decisions, Blair J.A. saw as capable of forming the basis for a security interest.⁷ To him, it was immaterial that i Trade had lent the funds to Webworx and not to Ablacksingh personally, because i Trade had advanced the funds with an intention to pass title. Once Webworx had title to the funds, it was free to transfer them to Ablacksingh. As a result, Blair J. held that BMO had a better claim to these funds as a bona fide purchaser for value without notice.

The Decision of the Supreme Court of Canada

Deschamps J. wrote the unanimous judgment for the Supreme Court and agreed with the ultimate conclusion of the Court of Appeal, but focused on the application of the PPSA. She first noted that, in Ontario, when a party claims an interest in personal property as payment for an obligation (as both i Trade and BMO were doing), a court must determine whether the PPSA applies to the interests claimed.

Contrary to the Court of Appeal, the Supreme Court noted that the analysis of the issue required regard to Section 2 of the PPSA, which states that the statute applies to every transaction that in substance creates a security interest. A security interest is broadly defined as "an interest in personal property that secures payment or performance of an obligation." In this case, i Trade's claim to the money arose solely under the tracing order, on the basis that it was subject to a constructive trust or was subject to an equitable lien. Because i Trade's interest in the money arose only by order of a court and was not a "transaction," it did not satisfy the requirements of Section 2 and was not subject to the PPSA.⁸ With no interest under the PPSA, i Trade's interest could only arise as an "equitable proprietary interest."⁹

In contrast, BMO's interest in the money arose by virtue of the pledge agreement that pledged the shares held with Nesbitt Burns. The Supreme Court analyzed the circumstances of the pledge to BMO and found that the transaction was, in substance, intended to create a security interest in the shares to secure payment of the increased credit limit under the MasterCard account.¹⁰ By operation of Section 2, the PPSA applied to BMO's security interest in the money. Pursuant to Section 11 of the PPSA, that interest could only be enforced against a third party such as i Trade if it had properly attached in accordance with Subsection 11(2) of the PPSA.

Similar to the decisions in the lower courts, the Supreme Court analyzed the steps necessary for attachment and found that the first two requirements (that the collateral secured be identified and that value be given) were easily met. The pledge agreement granted to BMO clearly identified the shares and the investment account and that BMO had given value in the form of an increased credit limit under the MasterCard account.

Whether the third requirement for attachment was met, however, required greater scrutiny, because Ablacksingh had acquired the Shares with funds that had been fraudulently obtained from i Trade. Given this, the Supreme Court had to examine whether, at the time the security interest was granted, Ablacksingh possessed sufficient rights in funds used to purchase the Shares to grant a security interest in favour of BMO.

In reaching its conclusion, the Supreme Court noted that fraud makes an agreement voidable, but not void. The difference may seem subtle, but, as noted in the numerous authorities cited by the Supreme Court, an agreement that is only voidable is not invalidated until it has been rescinded by the party on whom the fraud has been perpetrated.¹¹ The innocent party may in fact elect to waive the fraud and enforce the contract. Citing the Court of Appeal decision in R. v. Canadian Imperial Bank of Commerce,¹² the Supreme Court affirmed the proposition that when an innocent party consensually advances funds to another under an agreement, the innocent party has conveyed the right to use those funds until the innocent party revokes its consent.¹³

As a result, when i Trade advanced funds to Webworx during 2002 and 2003, Webworx had i Trade's consent to use the funds. That consent remained until i Trade initiated legal proceedings against Webworx. However, prior to the commencement of legal proceedings, Webworx had advanced certain funds to Ablacksingh by way of paycheques and corporate loans. Given this, the Supreme Court found that Ablacksingh was able to acquire the same interest as Webworx in the funds, which were then used to purchase the Shares. Accordingly, Ablacksingh had rights in the Shares sufficient to support a security interest, and all of the requirements for the attachment of BMO's security interest under Subsection 11(2) of the PPSA had been met.

With a valid security interest, BMO had a legal interest in the Disputed Funds (as proceeds of the Shares). This was important because, as the Supreme Court stated, the tracing order did not extend to the interest of a "bona fide purchaser of a legal interest for value without notice of a pre-existing equitable interest."¹⁴ BMO was a "purchaser," which is defined under the PPSA to include a "pledge," and its security interest in the Disputed Funds was obtained pursuant to the PPSA. i Trade's equitable interest was therefore defeated by BMO's legal interest, regardless of the fact that i Trade's right arose prior to BMO's. BMO was held to be a bona fide purchaser for value without notice and was awarded the money.

Conclusion and Implications

The i Trade Decision is primarily focused on risk management. The underlying policy rationale, cited by the Supreme Court, is that i Trade, as the initial lender, could more readily determine the fraudulent activities of Webworx, and should accordingly bear the risk. As stated in Angela Swan's Canadian Contract Law: "[i]f the contract is held to be voidable only, the risk of loss remains with the [initial] owner, for the contract with the rogue will not be rescinded in this situation and, as a result, title will have passed through the rogue and any subsequent bona fide purchaser will not be liable in conversion to the [initial] owner. It is far preferable that the loss remain with the [initial] owner, for that person had the better (and far cheaper) opportunity to avoid the risk entirely by requiring cash or some other secure form of payment."¹⁵

This case demonstrates the value of thorough initial and ongoing due diligence as an essential part of risk management and loss avoidance strategy. Where fraud has occurred in a lending transaction and funds or assets have been transferred to a third party, the potential for loss as against remains with the initial lender. It is therefore incumbent on a lender to ensure it discovers fraud as early as possible and takes all appropriate steps to curb losses.

That being said, it is also important for any lender to note the applicable period in the i Trade decision. BMO was only protected because it took a pledge prior to i Trade revoking its consent to continuing the transaction with Webworx. Had BMO advanced at a time after that consent was revoked, or when it was aware of the fraudulent activity undertaken by Webworx, it is not clear that BMO would have been a bona fide purchaser for value without notice. Again, a thorough due diligence process will help minimize the risk of loss.

* Brett Kenworthy is a summer student at Aird & Berlis LLP

Footnotes

1. i Trade Finance Inc. v Bank of Montreal, 2011 SCC 26 ["i Trade"].

2. i Trade at para. 20.

3. Pursuant to Subsection 11(2) of the PPSA, attachment requires a description of the collateral sufficient to enable it to be identified, value to be given and the debtor having acquired rights in the collateral.

4. i Trade at para 9.

5. i Trade at para 11.

6. The Court of Appeal decision is found at i Trade Finance Inc. v Bank of Montreal, 2009 ONCA 615 ["i Trade Court of Appeal Decision"].

7. i Trade Court of Appeal decision at paras 24-25.

8. The Supreme Court also noted that the right created in favour of i Trade was not consensually granted, which also weighed in favour of a finding that the PPSA did not apply. See i Trade at para 30.

9. i Trade at para 31.

10. i Trade at para 41.

11. i Trade at para 45.

12. R. v. Canadian Imperial Bank of Commerce (2000), 51 O.R. (3d) 257.

13. i Trade at para 49.

14. i Trade at para 60.

15. Angela Swan with the assistance of Jakub Adamski. Canadian Contract Law, 2nd ed (Markham, Ont: LexisNexis Canada, 2009) at 656.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.