Canada: The Constructive Trust And The Court Of Appeal: A Cautionary Reminder That Even Perfected Security Interests Are Imperfect

The recent decision by the Court of Appeal for Ontario (the "Court") in 306440 Ontario Ltd. v. 782127 Ontario Ltd.1 serves as a cautionary reminder to secured creditors that their position may not always be at the top of the insolvency food chain, even when they have taken all the proper steps to perfect their security interests. A valid trust claim over property held by an insolvent debtor, including a so-called "constructive trust" that is impressed over the property by a court after the underlying insolvency event has occurred, will place such trust property out of reach of secured creditors, even when the latter hold perfected security interests. This is because the debtor, despite having day-to-day possession or control of the property as trustee, is not the property's true beneficial owner.

While serving as an unwelcome reminder to many, the Court's decision merely reflects a long-line of existing case law, the most uncontroversial aspects of which have long since been codified in statute. For example, the Bankruptcy and Insolvency Act recognizes the supreme nature of the trust, providing expressly that "[t]he property of a bankrupt ... shall not comprise ... property held by the bankrupt in trust for any other person."2 Similarly, a courtappointed receiver, which also takes its mandate from statute,3 is limited to deal only with the assets, properties and undertakings of the debtor, and therefore also falls short of reaching property held in trust for another.

Despite providing a grim reminder to secured creditors that they are vulnerable to trust claims, the Court also reminds potential constructive trust claimants of the high hurdle that they must surpass in order to establish their claim.

Background

Alrange Container Services ("Alrange") was a storer, servicer, and refurbisher of shipping containers. In some instances, Alrange would resell containers to third parties. By January 2013, Alrange's business was in dire financial straits, such that it was only near the end of that month when Alrange's bank account reflected a positive cash balance. On February 15, a secured creditor holding general security over Alrange for advances made on an operating loan successfully applied for the appointment of a receiver (the "Receiver"). Alrange later made an assignment in bankruptcy, at which time it owed the secured creditor approximately $750,000.00. There did not appear to have been any issues with the secured creditor's perfection of its security interest in Alrange's property.

In parallel with the above, one of Alrange's major international customers (a lessor for which Alrange stored, serviced, refurbished and resold containers pursuant to a written agreement), learned of Alrange's financial distress and started taking steps to inventory and recover its containers stored at Alrange's facility. The customer quickly realized that 127 containers were missing, that Alrange had sold these missing containers and that some of the sales were in violation of the written agreement between Alrange and the customer.

Instead of advancing an unsecured claim for damages for conversion or for breach of the written agreement, the customer asserted that Alrange had been unjustly enriched by receipt of proceeds from the sale of the customer's containers, such that the proper remedy was the imposition of a constructive trust over these proceeds.

The Decision

At first instance, the customer's claim was rejected. The motions judge concluded that there was no connection between the funds held by the Receiver and the proceeds from the sale of the customer's containers, both because the sale proceeds had been commingled with other funds in Alrange's account, and because the account balance remained below zero until near the end of the collection process. Moreover, the motions judge held that it would be unjust to impose a constructive trust in the circumstances due to the intervening interests of the secured creditor.

The customer appealed, and the appeal was allowed in part. Within the bankruptcy and insolvency context, the Court undertook a review of: (i) unjust enrichment as a cause of action; and (ii) the constructive trust as a remedy for unjust enrichment. In regards to unjust enrichment, the Court applied the existing and well-known tripartite test of enrichment of the defendant, a corresponding deprivation of the plaintiff and an absence of juristic reason for the enrichment. The Court then examined the constructive trust as a remedy for unjust enrichment, and repeated the well-known (albeit sometimes difficult to apply) law that the "constructive trust remedy only makes sense where the property that becomes the subject of the trust is closely connected to the loss suffered by the plaintiff and/or the benefit gained by the defendant." The Court then emphasized that the need for a sufficient causal connection is even stronger in the purely commercial context, given the reasonable expectations of the parties. Only if this high threshold is met will a constructive trust be imposed, causing "removal of trust property from the estate of a bankrupt, effectively trumping the priority scheme under Canadian bankruptcy legislation."

In regards to the appeal before it, the Court concluded that a constructive trust remedy was inappropriate with respect to the proceeds of the container sales that were received prior to Alrange's bank account accumulating a positive balance. The customer could not trace any of the funds held by the Receiver to the proceeds of those sales, and thus the connection between the sale proceeds and the funds was "far too remote and indirect to justify imposing a constructive trust."

However, the Court did grant a constructive trust over the sale proceeds that were received after Alrange's bank account accumulated a positive balance and that related to the sale of five of the 127 containers. Not only was there unjust enrichment, in that the sale of these five containers was in violation of the written agreement between the customer and Alrange (thereby precluding any juristic reason for Alrange to have received and retained the proceeds from these sales), but these specific proceeds remained in Alrange's account and "could be directly connected by the Receiver to the sale of five" of the containers. The Court was therefore prepared to impose a constructive trust over this narrow band of sale proceeds, including the portion that represented Alrange's profits on these specific sales.

Key Takeaways

This decision serves as a reminder from Ontario's highest court to secured creditors that the size of the estate against which they are claiming may be affected by trust claims, and that these trust claims may not always take the standard form of the classical trust. It is therefore advisable for secured creditors to consider this when negotiating security for their loans. That is, for certain debtors, it may be appropriate to negotiate multiple options for enforcing security so as to provide better protection (i.e. by seeking guarantees, charges on real property, cross-collateralizations, etc.).

Furthermore, this decision may be worrisome for secured creditors because the theoretical concept of the constructive trust is prone to expansion. For example, while now trite law in Canada, the constructive trust as a remedy for unjust enrichment was a bold idea only a few decades ago, and was an expansion from the traditional English law of awarding a constructive trust to remedy certain forms of wrongful behaviour. Moving forward, at least one leading Canadian academic on trust law has now suggested that a constructive trust should be awarded in a third category of cases: to perfect stated intention and protect detrimental reliance.4 While this proposed third category has yet to be addressed by Canadian courts, there is the potential for the constructive trust to continue to grow and evolve, thereby potentially further eroding the position of secured creditors.

The good news for secured creditors is that the Court maintained a narrow range of circumstances in which a court should find the requisite "direct connection" for a constructive trust between property and a claim in the commercial context. The Court was also clear in stating that the legitimate interests of a secured creditor is further justification for the "requirement of a clear and direct connection between the money held" and a specific claim "as a condition precedent to the imposition of a constructive trust" to remedy unjust enrichment. Thus, while the Court's decision serves a necessary cautionary reminder to secured creditors, the latter need not panic – at least not yet, and at least not in most cases.

Footnotes

1 2014 ONCA 548.

2 Bankruptcy and Insolvency Act, R.S.C. 1985, c. B-3, as amended, s. 67(1) (a) [BIA].

3 BIA, supra note 2, s. 243(1); see also Courts of Justice Act, R.S.O. 1990, c. C-43 and associated jurisprudence.

4 Albert Oosterhoff, Robert Chambers & Mitchell McInnes, Oosterhoff on Trusts, 8th ed. (Toronto: Carswell, 2014) at 849.

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