We have discussed s. 178(1) of the Bankruptcy and Insolvency Act on a number of occasions, most recently in February 2022. Section 178(1) lists exceptions to the general rule that a bankruptcy wipes out all debts. The two exceptions on which we rely the most in our practice are found in subsections (d) and (e). Bankruptcy does not discharge a debt or liability arising (d) out of fraud while acting in a fiduciary capacity or (e) when property or services are obtained by false pretences or fraudulent misrepresentation.
Assume that a creditor obtains a consent or default judgment against a debtor for a debt that arose due to fraud, but that the judgment mentions nothing about the fraud; it is just a judgment for the debt. The debtor then assigns into bankruptcy. Can the judgment creditor rely on the judgment and other evidence to allege that the judgment should survive the bankruptcy? As almost always, it depends.
We know this rule well because we fought this case (Lawyers’ Professional Indemnity Company v. Rodriguez) before the Ontario Court of Appeal. The creditor had obtained a default judgment against the debtor, but the judgment itself was completely ordinary. Worse yet, the pleadings in the action giving rise to the judgment did not allege that the debtor had carried on his activity in a manner that would bring it within the ambit of s. 178(1)(d) or (e). The evidence was available, but it was not used for purposes of the action. We were not plaintiff’s counsel for the action itself.
The Court held that the creditor could not adduce additional evidence, referenced as extrinsic evidence, in its application to have its debt survive bankruptcy. Rather, the creditor was bound to rely only on the terms of the judgment and, if the judgment were silent, the allegations pleaded in support of the action and the evidence presented to secure the default judgment.
The extrinsic evidence in Rodriguez demonstrated that fraud that had been involved, but, because it had never been mentioned before the bankruptcy application, the court refused to allow it to be admitted. This was unfortunate because the limitation period had long expired by the time of the bankruptcy and the creditor was unable to bring another action or motion based on the extrinsic evidence. The creditor received nothing.
The moral of the story of the Rodriguez Rule is that elements of fraud should always be pleaded, even if the judgment itself does not mention them. For example, if the creditor relies on a fraudulent mortgage, the creditor should plead the fraud and not just rely on the mortgage breach to obtain judgment.
As an aside, as demonstrated in MOS Mortgage Solutions Ltd. v. Heidary (2022 Ont CA), the important task is to review the pleadings to determine the nature and substance of the debt; the task is not concerned so much with the cause of action, but whether the pleading as a whole suggests fraudulent or unacceptable conduct.
Like almost every rule, the Rodriguez Rule has an exception, which was demonstrated in Yanic Dufresne Excavation Inc. v. Saint Joseph Developments Ltd., a 2022 decision of the Ontario Court of Appeal.
In this case, the creditor had obtained a default judgment against the debtor for breach of trust pursuant to the deemed trust provisions of the Construction Act. The debtor assigned into bankruptcy very quickly after that. The creditor then informed the debtor that it would seek to have the debt survive bankruptcy. That obviously scared the debtor because, consequently, he moved to set aside the default judgment. He filed an affidavit in support of his motion and was cross-examined on that affidavit. The creditor relied on this evidence to allege that the breaches of trust constituted fraud while acting in a fiduciary capacity as set out in s. 178(1)(d).
For whatever reason, the creditor did not move immediately for an order under s. 178(1). It allowed the debtor and the trustee in bankruptcy to be discharged from bankruptcy. Its rights to an order under s. 178(1)(d) would have been defeated without the ability to rely on the new evidence and nothing in the statement of claim or the default judgment suggested that the breaches of the Construction Act trust provisions were based on fraud.
The creditor therefore moved to amend the default judgment to include a declaration that the judgment could be enforced regardless of the bankruptcy. It brought the motion relying on Rule 59.06(2), which allows a party to seek to set aside an order on grounds of fraud or facts arising or discovered after it was made. The creditor alleged that it had no means of knowing the evidence that arose from the debtor’s affidavit and cross-examination until the debtor brought forth that evidence. The motion judge agreed with that allegation.
The motion judge admitted the new evidence and made the requested declaration. The debtor appealed to the Court of Appeal.
The Rodriguez Rule is clear; the creditor had no right to use the new evidence in a separate motion to obtain a survival order; the allegations of fraud were not made in the statement of claim or in the materials filed to obtain default judgment. However, the Court sidestepped the Rodriguez Rule because the creditor did not bring the normal motion under the BIA for a declaration that its judgment survived the bankruptcy; it brought its motion to amend the judgment under Rule 59.06(2). All it needed to do was to show that the required evidence on which it relied was not available to it at the time of the judgment. It succeeded in doing so.
The debtor argued that Rule 59.06 could not be used to change an order to allow for relief that had not originally been pleaded (i.e., the creditor can submit extrinsic evidence, but this still does not allow the creditor to claim in the order what it had not requested in the statement of claim). The Court agreed with this rule, but the motion judge had already found as a fact that the creditor had sufficiently particularised the breach of trust in the statement of claim so that debtor most certainly knew that the issue was front and centre in the action.
It is enough for purposes of s. 178(1) if, in substance, the pleadings as a whole suggest the fraudulent conduct.
The creditor was initially able to obtain judgment against the debtor because of the deemed trust provisions under the Construction Act. However, the courts have been clear that the breach of a statutory deemed trust does not necessarily result in the applicability of s. 178(1). A breach can arise from negligence or incompetence, and not necessarily fraud. Accordingly, a creditor must also demonstrate through its allegations that the actions giving rise to the breach also arose from some element of wrongdoing that would be unacceptable to society because of moral turpitude or dishonesty.
The debtor argued that the pleadings did not demonstrate this. However, once the extrinsic evidence was allowed into evidence, the debtor had to lose on the moral turpitude issue.
The motion judge awarded costs of the motion of $50,000. The debtor argued that the costs order should not survive bankruptcy because it arose after the bankruptcy. The judge held that if a judgment survives bankruptcy, it would be inequitable if the costs order did not. Costs are an intrinsic aspect of an action or motion and a consequence of the judgment or order. The debtor seemed to have accepted, and not appealed, this decision because the Court of Appeal made no mention of the costs decision in its reasons for decision.
Image courtesy of mohamed_hassan.
Written by Jonathan Speigel, the founding partner of Speigel Nichols Fox LLP, leads the litigation and construction practices.