Legal Blog

Busted

As we have previously discussed (see June 2009 newsletter), the existence of a legitimate trust is a defence to a fraudulent conveyance action. For example, a debtor, who transferred property to a non-arm’s length person, states that it was not done to defeat his creditors; rather, it was a transfer in which the debtor was merely transferring his interest in the property as trustee to the beneficiary of the trust. The defence, in essence, states that the property was never the debtor’s property at all. The creditor then has to either give up its action or demonstrate that the trust was a sham. This cat and mouse game was played out in Re McGoey, a 2019 decision of the Ontario Superior Court of Justice.

Debt

This was not a case of a fraudulent transfer, but the principles of the case apply equally well to one. In this case, the debtor, a defrocked executive of a telecommunications corporation, knew by 2010 that he was facing possible litigation relating to the return of a large severance payment he received from his former employer. The litigation materialised in 2011 and, in 2017, the employer was awarded a judgment of $5.6 million against the debtor.

Almost immediately, the debtor made a proposal to his creditors under the Bankruptcy and Insolvency Act. The creditors defeated that proposal 6 months later, automatically putting the debtor into bankruptcy.

Dispute

The debtor’s trustee in bankruptcy sought to convert the debtor’s assets into money. These assets included a 50% interest that the debtor held in two properties with his wife. Both the debtor and wife took the position that, although it looked as if they were the full owners of the property, really they were not. They actually held ownership in the properties in trust for their children.

Documents

The debtor produced two documents. The first was dated January 4, 1995 in which the couple acknowledged to each other that their 1^st property, purchased sometime in 1994, was being held in trust by them for their three children – although the couple had the right of use and were obliged to pay all operating costs. The second was dated March 4, 2004 in which the couple acknowledged to each other that their 2^nd property, purchased in May 2003, was being held in trust by them for their five children (they had been active over the ensuing years) on the same basis as the 1^st property.

The debtor testified that he created these two documents on his own without the benefit of accounting or legal advice and that he and wife signed the trust documents on the dates set out in the documents.

Sham Tests

The common law has created a group of red flags (also known as badges of fraud) that a party asserting a trust has to explain. The badges of fraud include:

• listing a trust property for sale without disclosing the trust’s existence;
• failing to notify a bank or mortgagee of the trust’s existence and effect on title;
• operating in a manner that disregards the proper operation of the trust;
• treating the property as one’s own and only invoking the alleged trust when convenient
• using the property to secure financing (particularly if the trust is not disclosed);
• paying the property expenses, while the alleged beneficiaries contribute nothing;
• retaining personal control of an asset for one’s own use;
• encumbering an asset by using it as security for personal finances;
• not registering a trust agreement on title; and
• a general lack of documentation.

The judge also noted, in fraudulent conveyance situations, that transactions at less than market value, made in the face of a hazardous undertaking or clear financial jeopardy, cry out for explanation.

Expert

The first reaction of every creditor or trustee faced with a homemade document, and sometimes even with a document that a lawyer drafted, is one of disbelief. The trustee in this case was no exception. However, what the trustee, or more likely its lawyer, did to support its disbelief was exceptional.

The trustee retained a graphic arts expert, specialising in design and typography, who testified that the typeface used in the 1995 document had not yet been created as of the document date; the typeface design had only commenced beginning in 2002 and did not reach the general public until 2007. Accordingly, the 1995 document used a typeface that did not exist and the 2004 document used a typeface to which only a Microsoft employee would have had access.

The judge noted that debtor and wife were unable to explain how the debtor used a non-existent font to create his purported trust documents. The debtor’s lawyer suggested that they may have been mistaken as to the dates, but debtor and wife themselves stood by their position that they signed the documents on the dates set out in them.

Once the expert had been qualified to give evidence as an expert and gave this evidence, the conclusion became obvious. The trust documents could not have been signed until at least 2007.

Shams

As far as we are concerned, that would normally have ended the exercise; the debtor and his wife were liars and the trusts never existed.

The judge was more charitable. He stated that it was possible that the trusts came into existence in 2007-2010, before the debtor’s 2010 financial problems. In effect, he stated that, if they did, it was akin to a transfer that might have been effected for non-fraudulent purposes and could therefore still be valid.

Accordingly, he reviewed the badges of fraud to determine whether to give effect to the documents and noted, regarding the first property, a cottage, the following:

• The debtor’s previous cottage (which he also claimed to have held in trust for his children) was sold without mention of any trust.
• No registration of the purported trust on title.
• No reference to or disclosure of a trust for the charges registered on title.
• The couple had free reign to use the cottage as they wished and used it to secure financing flowing into their personal account.
• No mention the existence of the trust to anybody (other than one son) until many years after it was allegedly created.
• The couple paid all operating expenses.
• The couple commingled their mortgage monies with their personal funds in an account containing the debtor’s prior employment income.
• The only document establishing the trust’s existence was a single page created without any input from lawyers or accountants – even though the debtor had regularly used legal and financial professionals for work that included the creation of other trusts.
• The trust indenture was backdated and the couple lied about the creation date.
• The only accounting or tax related documents were prepared in 2017.
• A general dearth of documentation relating to the purported trust.
• By early 2010, the debtor knew he was in serious financial jeopardy and thus had the motive and incentive to attempt to put his assets beyond the reach of creditors.

Virtually all of the same factors were equally applicable to the 2nd property, but, even worse, wife admitted that one of the reasons for this trust was to protect the asset from potential creditors.

Result

The moment that debtor and wife were caught in the lie about the documents’ creation, the die was cast. The judge held that the trusts were sham trusts and that the debtor’s 50% interest in the two properties comprised part of his bankrupt estate for the benefit of his creditors.

 

Image courtesy of Duboix.

Written by Jonathan Speigel, the founding partner of Speigel Nichols Fox LLP, leads the litigation and construction practices.