Legal Blog

Due Diligence

The Fraudulent Conveyances Act allows “creditors or others” to attack improper mortgages. We have occasionally attacked mortgages as being fraudulent under the Act, usually when we determine that the mortgages are really a sham. Can mortgages be attacked under the Act when the mortgages are real and secure money actually advanced under the mortgages? As usual, the answer depends on the circumstances. One set of these circumstances formed the factual basis for the decision in Chen v. Huang, a 2025 decision of the Ontario Court of Appeal.

Overview

The applicants were majority shareholders of a corporation that owned a multi‑unit residential property. The minority shareholder was the corporation’s sole director and officer. Acting alone, the officer executed a $6M second mortgage (1 year at 13% per year) and a $1.7M third mortgage (6 months at 15% per year) against the property. The mortgagees were arm’s‑length private lenders.

The shareholders complained that they knew nothing about the mortgages and that the officer had no authority to grant them. They brought a shareholder oppression application as to the fraud that the officer had allegedly been perpetrating and a motion to set aside both mortgages under the Act as fraudulent conveyances.

Before the motion was heard, the second mortgagee had already exercised its power of sale. The property sold for $16 million. After discharging the first mortgage and fees, approximately $6 million was held in trust pending a ruling on whether the second and third mortgages were valid. If valid, the mortgagees would be paid from the holdback; if invalid, the funds would be released to the corporation. It was likely that, even if successful, the third mortgagee would recover little of its mortgage principal.

Parties’ Positions

The shareholders alleged that the officer had defrauded them and that the mortgagees were reckless or wilfully blind in advancing the mortgage funds. In that regard, they argued that the mortgagees ignored obvious warning signs (i.e. badges of fraud), such as:

• A proper review of rent rolls and financial statements would have revealed that the property’s income was insufficient to service the debt.
• The mortgages were inherently suspicious because the debt obligations rendered the corporation effectively insolvent.
• A reasonable lender would have realized that the defendant was using falsified rental information.

The mortgagees argued that:

• They were bona fide mortgagees for value, unrelated to the officer.
• They relied on legal counsel to ensure title validity and proper registration.
• In private mortgage lending, lenders often look to equity value, not rental income.
• They received an appraisal that valued the property at approximately $18.8 million, resulting in sufficient equity for security.
• High-interest private mortgages compensate for financial risk, and taking business risks does not equate to facilitating fraud.
• The officer had both apparent and actual authority as the corporation’s sole director and officer.

Fraudulent Conveyances Act

The Act is very short. It includes the following provisions:

2. Every conveyance of real property or personal property … made with intent to defeat, hinder, delay or defraud creditors or others of their just and lawful actions, suits, debts, accounts, damages, … are void as against such persons.

3. Section 2 does not apply to an estate or interest in real property or personal property conveyed upon good consideration and in good faith to a person not having at the time of the conveyance to the person notice or knowledge of the intent set forth in that section.

4. Section 2 applies to every conveyance executed with the intent set forth in that section despite the fact that it was executed upon a valuable consideration and with the intention, as between the parties to it, of actually transferring to and for the benefit of the transferee the interest expressed to be thereby transferred, unless it is protected under section 3 by reason of good faith and want of notice or knowledge on the part of the purchaser.

Summary: if a debtor makes a transfer without consideration in order to defeat creditors, the transfer is void as against the defeated creditors. If the transferee gives good consideration in good faith and without knowing of the debtor’s malicious intent, the transfer is not void,

Decision

Not only did the officer have apparent (i.e. ostensible) authority to bind the corporation, as the sole director and officer he had actual authority to do so. Accordingly, the shareholders could not set aside the mortgages based solely on the officer’s lack of authority.

The motion judge accepted that private lenders frequently base decisions on a property’s equity, not financial statements or rent rolls, and that elevated interest rates compensate for financial risk.

There may have been badges of fraud relating to financial unsustainability, but they related to credit risk, not fraud risk. Suspicion about a borrower’s creditworthiness is not suspicion of fraud. A lender who suspects only credit risk is not obliged to conduct financial due diligence. Only suspicion about title validity or ownership irregularities puts a lender on notice of potential fraud. The mortgagees had no basis to suspect title problems or fraudulent intent.

Indeed, everything looked legitimate to the mortgagees. The mortgages were being used to discharge existing second and third mortgages (although we do not know their amounts).

Accordingly, the judge held that the mortgagees were arm’s‑length lenders giving valuable consideration for the mortgages, with no notice of any internal shareholder dispute. The mortgagees had no knowledge of, nor participated in, any fraud. The Court of Appeal agreed with the reasons of the motion judge.

Costs

The motion judge had awarded the mortgagees their costs of the motion on a full indemnity basis – based on provisions of the mortgages that allowed for them.

The Court of Appeal reversed on the costs issue. It noted that while a mortgage contract may bind an unsuccessful mortgagor, a court is not bound to award those full indemnity costs; it still has discretion over costs. More importantly, in this case the mortgagor corporation was not a litigant. The unsuccessful litigants were the shareholders of the mortgagor corporation and were not bound by the terms of the mortgages in their quest to set them aside.

Accordingly, instead of awarding full indemnity costs of the motion, the Court awarded the usual partial indemnity costs (about 60% of full indemnity costs).

 

Image courtesy of BrianPenny.

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