Canada: Secured Creditors May Assert Priority Over Proceeds Of A Fraudulent Preference Action

In the decision of Justice Morawetz of the Ontario Superior Court of Justice (Commercial List) (the "Court") in In the Matter of Aero Inventory (UK) Limited and Aero Inventory PLC, the Court held that proceeds of a fraudulent preference action recovered by a trustee in bankruptcy under section 95 of the Bankruptcy and Insolvency Act ("BIA") may be subject to the rights of secured creditors, to the extent secured creditors had rights in the collateral in question at the time of the impugned transaction. Hence, in some cases the benefit of a preference action may accrue primarily to a secured creditor. There may be significant value available to secured creditors if they do not have to share with unsecured creditors.


Aero Inventory (UK) Limited and Aero Inventory PLC (collectively, "Aero") were companies based in the United Kingdom and Canada and a supplier of parts to the airline industry. Air Canada was one of its customers. On November 1, 2009, administration proceedings were commenced in respect of Aero in the High Court of Justice of England and Wales (Chancery Division, Companies Court), and individuals from KPMG LLP were appointed as joint administrators of Aero (the "Administrators"). On the same day, the Court recognized the appointment of the Administrations as foreign representativeness of Aero under Part IV of the CCAA (the "Foreign Representatives").

In January 2010, a motion was brought by the Foreign Representatives to assign Aero into bankruptcy for the purpose of pursuing a fraudulent preference action under section 95 of the BIA. The relief sought by the Administrations was with respect to a series of transactions between Aero and Air Canada that occurred prior to the commencement of the insolvency proceedings (the "Transactions").

On January 22, 2010, the Court authorized the Administrators to assign Aero into bankruptcy, and KPMG Inc. was appointed as trustee in bankruptcy (the "Trustee"). The Trustee reported in February 2010 that Aero's secured creditors would suffer a significant shortfall and there would be no funds available for distribution to unsecured creditors with the exception of certain UK statutory claims.

The Trustee brought a motion seeking a declaration that the Transactions constituted a preference within the meaning of section 95 of the BIA and should be held void as against the Trustee. The Trustee also sought the return of value in the amount of U.S. $75 million from Air Canada (the "Proceeds"). The Trustee took the position that the Proceeds, once recovered, would be subject to the rights of Aero's secured creditors, as the Trustee had obtained opinions from independent counsel on the validity and enforceability of the security held by a syndicate of lenders. The motion was opposed by Air Canada. Air Canada took the position that any Proceeds should only benefit Aero's unsecured creditors.


The key issue before the Court was whether secured creditors are entitled to assert priority over the proceeds of a preference action.

Air Canada took the position that a trustee cannot pursue a preference action where the proceeds would accrue to the sole benefit of a secured creditor, on the basis that to do so would be: (a) inconsistent with the purpose of a preference action (which is to allow for equal distribution of the debtors' assets among the general body of creditors); (b) incompatible with the fact that the right to pursue a preference action is a statutory right provided solely to the trustee and a secured creditor cannot take advantage of a trustee's statutory right; and (c) inconsistent with the trustee's role as an impartial officer of the court (as to do so the trustee would be realizing a benefit solely for a secured creditor).

The Trustee took the position that the structure of the BIA favoured giving the proceeds of a preference action to the secured creditor, as a successful preference action would render a transaction void as against the trustee under section 95 of the BIA, with the resulting property vesting in the trustee, subject to the rights of secured creditors, under sections 67 and 71 of the BIA. The Trustee also argued that the policy underlying the BIA favoured giving the Proceeds to the secured creditors, as this interpretation avoided altering priorities and nullifying a secured creditor's claim to collateral simply because a debtor dealt with its assets in a preferential manner (i.e. otherwise a debtor could defeat a secured creditor's rights by granting a preference immediately prior to bankruptcy, with the resulting proceeds flowing to the benefit of unsecured creditors).

Following a detailed review of a variety of Commonwealth jurisprudence relating to fraudulent preference actions, Justice Morawetz determined that the focus of the analysis was on whether the secured creditor had rights in the collateral at the time of the suspect transaction. Justice Morawetz held that if the collateral was subject to the claims of a secured creditor, the secured creditor may retain the ability to enforce its rights as against the collateral or any proceeds arising from the collateral. With respect to a fraudulent preference action under section 95 of the BIA, Justice Morawetz was of the view that, while it is the trustee that has the cause of action to declare a preference to be void, the issue of who possesses the right to bring a preference action does not necessarily determine entitlement to the proceeds. Justice Morawetz confirmed his view that the objective of a preference action is to void preferential transactions for the benefit of creditors, while recognizing legitimate security interests.

Justice Morawetz noted that distributions of the bankrupt's estate are subject to the rights of secured creditors, and:

The ability of a trustee to recover monies for the estate for the benefit of creditors is, in its entirety, subject to the rights of secured creditors. If a secured creditor still has rights in the collateral, there is nothing in the fraudulent preference remedy regime that would appear to preclude the secured creditor from exercising its rights. To the extent that the secured party has rights in the collateral and has a remedy against the collateral in the hands of the third party, such remedy and resulting priority is not, in my view, altered because a trustee embarks on a preference action.

Justice Morawetz concluded that:

  1. a trustee in bankruptcy (or a section 38 BIA assignee) is the only party that can bring a preference action in bankruptcy proceedings;
  2. the proceeds recovered by the trustee are brought into the estate;
  3. distribution under the BIA is subject to the rights of recovery of secured creditors; and
  4. the bringing of a preference action and the recovery of proceeds does not preclude secured creditors from pursuing whatever remedies they may have under the provisions of the security agreement and relevant statutes.

The decision also suggests that it may be appropriate for a secured creditor (who may have priority over the trustee) and a trustee (who has the statutory right to take preference proceedings under section 95 of the BIA) to agree about the sharing of costs and the fruits of success of a preference action to the potential benefit of both parties.

Justice Morawetz's decision is an important one for secured creditors, as it confirms that the proceeds of a fraudulent preference action may be subject to their security. In considering enforcement options, secured creditors should now gather information regarding any suspect transactions that the debtor may have entered into, and in the event any such transactions took place and impacted collateral subject to their security, they should consider the options available to them in bankruptcy proceedings. Additionally, the decision is an important one for trustees in bankruptcy, as the possibility that the proceeds of a fraudulent preference action may be to the sole benefit of a secured creditor may impact whether it is in the best interests of the bankruptcy estate for the trustee in bankruptcy to commence such a proceeding.

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