Legal Blog

Fraud Attribution

Assume that shareholders concoct a scheme by which they defraud their corporation and take out money that otherwise would have belonged to it. If the corporation subsequently becomes bankrupt, can its trustee in bankruptcy collect the proceeds of the fraud from the fraudulent shareholders? This issue was decided in Ernest & Young Inc. v. Aquino, a 2022 decision of the Ontario Court of Appeal.

Fraud

The corporation is Bondfield Construction Company Limited (and its affiliate, Forma-Con Construction). We will refer to each under the banner of Bondfield. The fraudster shareholder was John Aquino.

Aquino, who was the directing mind of Bondfield, arranged for a false invoicing scheme by which various suppliers rendered invoices to, and were paid by, Bondfield, but provided no actual services. In doing so, Aquino siphoned off tens of millions of dollars from Bondfield.

The monitor under the CCAA proceedings and the trustee under the bankruptcy proceedings applied, under section 96(1) of the Bankruptcy and Insolvency Act (“BIA“), for a judgment against Aquino and his accomplices for money they fraudulently took from Bondfield.

Interestingly, Aquino and most of his accomplices fully admitted that they had defrauded Bondfield. They denied, however, that they intended to defraud Bondfield’s creditors.

BIA

Section 96(1) of the BIA states that for any period beginning five years before the date of the initial bankruptcy event, a court may order that an undervalue transfer is void against a trustee and order that a party to the transfer pay the amount of the undervalue to the bankrupt estate. The conditions for this  order are:

• The party to the transfer did not deal at arm’s length with the debtor; and
  • the debtor was insolvent at the time of the transaction or was rendered insolvent by it or
  • the debtor intended to defraud, defeat, or delay a creditor.

The court explained the reasoning for s. 96 as follows: “persons must be just before they are generous and … debts must be paid before gifts can be made.”

Aquino defended the application. The key to the application was the 2^nd condition. Aquino argued that the fraudulent acts were not carried out at a time when Bondfield was financially precarious and therefore he did not intend to defeat creditors. He also argued that the 2^nd condition required that the debtor (Bondfield), not the fraudster (Aquino), had to intend to defraud a creditor and that Bondfield had no such intention; rather, Bondfield was an innocent party and the actual victim of the fraud.

Insolvent at time

Aquino looked to the relevant financial statements at the time of the impugned transfers and, in essence, argued as follows: “Bondfield had lots of money during that period and was financially robust even after we had defrauded Bondfield of tens of millions of dollars.”

The problem with this argument was that the premise on which it was based was incorrect. The application judge found, and the Court of Appeal concurred, that

• Bondfield, at the time of the transfers, had significant potential liabilities and was about to enter upon risky undertakings.
• Bondfield had long-term and off-balance sheet liabilities, including contingent obligations in the tens of millions of dollars.
• Bondfield was embarking on a significant expansion of its construction activities when its lender was not prepared to increase its lending.
• Aquino was temporarily transferring significant funds to Bondfield for the sole purpose of misleading Bondfield’s lender into believing that Bondfield was in a stronger financial position than it was.
• Bondfield’s accounts payable were understated and its accounts receivable were overstated.
• Bondfield’s financial records were prepared under Aquino’s supervision.
• Bondfield’s surety under various construction bonds had already suffered losses over $300,000,000 in paying subtrades and completing Bondfield projects, losses that arose from projects started years before the bankruptcy.
• The mere fact that Bondfield satisfied its current liabilities during the transfers did not mean that Aquino did not intend to defeat then-current creditors.

The court concluded: “I see no reason why John Aquino’s recklessness as to the consequences of the fraudulent transfers with respect to the interests of the companies’ creditors would not be similarly sufficient for establishing the requisite intent under s. 96 of the BIA.”

Attribution

Although the court had confirmed Aquino’s fraudulent intent, it also had to deal with the second defence: should Aquino’s fraudulent intent be attributed to Bondfield so that it could be stated that Bondfield had attempted to defraud its creditors?

This was a simple question with an answer that was not obvious. Prior jurisprudence from the Supreme Court of Canada had already dealt with the attribution of fraudulent acts in the criminal and civil law contexts. The test was stated as follows:

“To attribute the fraudulent acts of an employee to its corporate employer, two conditions must be met: (1) the wrongdoer must be the directing mind of the corporation; and (2) the wrongful applications of the directing mind must have been done within the scope of his or her authority; that is, his or her applications must be performed within the sector of corporate operation assigned to him. For the purposes of this analysis, an individual will cease to be a directing mind unless the application (1) was not totally in fraud of the corporation; and (2) was by design or result partly for the benefit of the corporation.”

This test makes a lot of sense in the criminal and civil contexts. A corporation should be liable for the fraudulent acts of its directing minds only if it benefited from those acts. However, if it received no benefit and, indeed, it was defrauded by those very acts, why should it be criminally or civilly liable?

However, there is a third context. Does the corporate attribution doctrine apply in a bankruptcy and insolvency context? The court stated that the policies for the third category are quite different from the civil and criminal contexts. In that regard, the court stated:

“attributing the intent of a company’s directing mind to the company itself can hardly be said to unjustly prejudice the company in the bankruptcy context, when the company is no longer anything more than a bundle of assets to be liquidated with the proceeds distributed to creditors. An approach that would favour the interests of fraudsters over those of creditors seems counterintuitive and should not be quickly adopted.”

Accordingly, the court held that the underlying question here is who bears responsibility for Aquino’s fraudulent acts, which were done within the scope of his authority: Aquino or Bondfield’s creditors?

Result

The court held that allowing Aquino to keep the benefits of his fraud at the expense of Bondfield’s creditors would be perverse and that the way to avoid this perverse outcome would be to attach Aquino’s fraudulent intentions to Bondfield. This would achieve the social purpose of providing proper redress to creditors, which the court stated was the core aim of s. 96 of the BIA.

The court dismissed the appeal with costs of $75,000. Aquino and his associates were required to pay the trustee, on behalf of Bondfield, approximately $21,800,000.

 

Image courtesy of Engin_Akyurt.

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