Canada: Constructive Trust 1 vs. Secured Creditor 0

Last Updated: December 29 2014
Article by John Birch

Many secured creditors see their position in absolute terms. They rely on their general security and aggressively assert their priority over unsecured creditors, such as trade creditors. However, a recent decision of the Ontario Court of Appeal(306440 Ontario Ltd. v. 782127 Ontario Ltd. (Alrange Container Services), 2014 ONCA 548) demonstrates that creative arguments by trade creditors may allow them to take priority over even secured creditors in certain circumstances, by using trust principles to remove assets from the estate.

In this case, a lender held general security over a borrower for advances made on an operating loan. The borrower carried on business storing, repairing and selling shipping containers for its customers, including a major international container lessor. Pursuant to a depot agreement (the "Depot Agreement") with this customer, the borrower stored and repaired the customer's containers. From time to time, the borrower also refurbished and sold the customer's containers to third parties. The customer then invoiced the borrower for the containers that had been sold. Nothing in the Depot Agreement gave the customer any security over the sale proceeds collected by the borrower or required such proceeds to be held in trust.

By early 2013, the borrower was insolvent and the lender applied for and obtained an order pursuant to section 243 of the Bankruptcy and Insolvency Act (Canada) and section 101 of the Courts of Justice Act (Ontario) appointing a receiver over all of the property, assets and undertaking of the borrower (the "Receiver"). Cassels Brock acted as counsel to the Receiver but took no position regarding priority.

By that point, all of the customer's containers had been sold, although not all sale proceeds had been received. After the Receiver liquidated the remaining assets of the borrower, the customer claimed a priority to a portion of the total proceeds. The customer claimed that the borrower had breached the Depot Agreement by selling many containers without the consent of the customer. Although such claim would normally have been advanced as an unsecured claim for damages for conversion of the containers or for breach of the Depot Agreement, the customer instead asserted a constructive trust over the proceeds in the Receiver's hands.

The customer's claim for priority over the lender based on constructive trust was unsuccessful at first instance. The Ontario Superior Court of Justice concluded that any proceeds from container sales had been comingled with other monies in the borrower's bank account and, in any event, the bank balance had fallen to zero prior to the appointment of the Receiver. The Court also concluded that it would be unjust to impose a constructive trust in light of the pre-existing general security held by the lender.

The customer appealed the decision to the Ontario Court of Appeal and the appeal was partially allowed. The Court of Appeal provided a clear explanation of constructive trusts and their potential use in insolvency situations. A constructive trust is a proprietary remedy. As such, it carries certain significant benefits, such as the removal of property from the estate of the insolvent party, effectively trumping the usual priority scheme under insolvency legislation. However, the Court noted that the nature of constructive trust as a proprietary remedy requires that there be "a close link between the property over which the constructive trust is sought and the improper benefit bestowed" on the other party. The Court found that the requirement of having such close connection should be even more stringent in commercial cases like this.

In respect of those proceeds of container sales that had been received and spent prior to the appointment of the Receiver, the Court concluded that a constructive trust remedy was not appropriate because there was no longer any clear and direct connection between those dissipated proceeds and the funds then in the hands of the Receiver. However, the Court did grant a constructive trust over the part of the proceeds that the Receiver collected after its appointment. The Court concluded that, even though the corresponding containers had been sold before the appointment of the Receiver, the proceeds were directly linked to those sales and thus the required close connection existed. The Court also concluded that, because the borrower had sold those containers without the requisite prior approval of the customer and in breach of the Depot Agreement, there was no "juristic reason" for the borrower to receive and retain those proceeds. The borrower had been unjustly enriched at the expense of the customer. As such, the Court of Appeal imposed a constructive trust over those proceeds, including the portion of the proceeds that represented the borrower's profit on the sale.

This case is therefore both good news and bad news for secured creditors. The Court made it clear that there is a high hurdle to overcome to establish a constructive trust, especially in commercial cases. However, the Court appears to have opened the door for trade and unsecured creditors to seek a constructive trust over proceeds realized from the sale of those creditors' goods as long as they can establish the required connection. General security may not be as infallible as lenders have previously thought.

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.

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John Birch
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