Legal Blog

Liability Forever

In prior newsletters (July 2000 and November 2000), we have discussed the possibility that directors and officers who are potentially liable for breaches of trust could be liable without benefit of a limitation period and could remain liable regardless of their subsequent bankruptcy.

Given the decided cases to date, construction lawyers have been drafting judgments to state that individuals who have been held liable for a corporate breach of trust are also liable for their own breaches of trust. With that judgment, a creditor can argue at a bankruptcy hearing that the bankruptcy, which does not release the bankrupt from any debt or liability arising out of fraud, embezzlement, misappropriation or defalcation while acting in a fiduciary capacity, does not affect the judgment debt arising from the breach of trust.

The question then arises: are directors and officers, who have been found personally liable for a corporate breach of trust under section 13 of the Construction Lien Act, also liable for their own individual breaches of trust? This question was answered in Baltimore Aircoil of Canada v. ESD Industries Inc., a 2002 decision of the Ontario Superior Court of Justice.

Liability under Act 

Section 13(1) of the Act states that in addition to the persons (e.g. the corporation) actually breaching the trust, other persons are also liable for the breach. These persons include directors, officers, and anyone who has effective control of the corporation or its relevant activities. To be liable, the persons must “assent to, or acquiesce in, conduct that he or she knows or reasonably ought to know amounts to breach of trust by the corporation.”

Common Law Liability 

Assume that we are not dealing with a construction project; rather, there has been a breach of trust by a corporation and the beneficiaries of the trust who have been hurt are trying to fix liability on directors and officers of the corporation for the corporate breach. Can this be done? It depends on whether a director or officer can be saddled with the breach of a constructive trust. That depends on the tests set out in the common law (i.e. judge-made law).

The judge in the Baltimore case reviewed the decisions in other non-construction cases, the most important of which was Air Canada v. M & L Travel Ltd., a 1993 decision of the Supreme Court of Canada. He noted that, under certain circumstances, directors could be found liable for breaches of trust in respect of a relationship to which they would otherwise be strangers.

However, the judge held that the factual basis to support personal liability under the common law principles was much more stringent than for finding liability under section 13 of the Act.

Decision 

We assume that the trust beneficiary in the Baltimore case put forward no facts on which to demonstrate the liability of the director, other than that he was a director. Accordingly, although the judge held that the director was personally liable under the Act, he refused to make a declaration that the director himself was in breach of trust. 

The judge knew that this would allow the director to declare bankruptcy and rid himself of the judgment debt. However, he noted that “in order for the scheme under which liabilities are imposed for breaches of trust under the Act to properly operate, the concept of ultimate enforceability of the judgment is not relevant … The Act deals not with the issues relating to the collectability of the judgments or the effect of the” Bankruptcy and Insolvency Act.

Second Guess

Did the judge properly apply the principles set out in the Air Canada case? In that case, a corporate travel agent collected fares in trust that it was supposed to submit to its beneficiary, Air Canada. The corporation went under and was unable to pay the beneficiary. There was no doubt that the corporation was liable for a breach of trust. The question was whether its two directors were liable.

The Court noted that the directors, who were strangers to the corporate trust, could be liable as constructive trustees if they were knowingly in receipt of the trust property or “if they assisted with knowledge in a dishonest and fraudulent design on the part of the trustees.”

The first prong of the test was inapplicable because the money went to the corporation, not the directors.

The real issue related to the second prong. The court had to deal with two parts of the analysis.

Knowledge 

What knowledge is sufficient to satisfy the test? “The knowledge requirement for this type of liability is actual knowledge; recklessness or wilful blindness will also suffice.” Further: “Whether the trust is created by statute or by contract may have an impact on the question of the stranger’s knowledge of the trust. If the trust was imposed by statute, then he or she will be deemed to have known of it.”  In the Air Canada case, the trust was set up by way of contract.

The court noted that the stranger to the trust needed both actual knowledge of the trust’s existence and actual knowledge that what was being done was in breach of that trust. However, in both situations “a person wilfully shutting his eyes to the obvious is in no different position than if he had kept them open.”  

The court also noted that “the knowledge requirement will not generally be a difficult hurdle to overcome in cases involving directors of closely held corporations. Such directors, if active, usually have knowledge of all of the actions of the corporate trustee.” 

In this case, both directors knew about the trust.

Dishonest Design 

Does the corporation need to have an actual design to dishonestly breach the trust or is a lesser standard applicable? The court opted for the lesser standard. It stated: “I would therefore take as a relevant description of fraud the taking of a risk to the prejudice of another’s rights, which risk is known to be one which there is no right to take … In that respect, the taking of a knowingly wrongful risk resulting in prejudice to the beneficiary is sufficient to ground personal liability.”

In the case, the court held that the corporation knew that, by not placing the trust monies in a separate trust account, it was taking a risk to the prejudice of the rights of Air Canada. Accordingly, the court held that the corporation had a dishonest design.

The court therefore concluded that the directors knowingly assisted the corporation in a fraudulent design and were each liable for breach of a constructive trust.

Difference 

Is there a difference in the facts in the Air Canada case and the Baltimore case that should indicate a different result? We think not.

In the Baltimore case, there was deemed knowledge on the part of the director because there was a statutory trust. The individual was the sole director and officer of the corporate defendant. If he did not have knowledge, who could? There was also a dishonest design on behalf of the corporate trustee because the corporate trustee took an improper risk by not holding the trust funds in a separate trust account. All aspects set out in the Air Canada case to demonstrate a breach of constructive trust were present in the Baltimore case.

Accordingly, we feel that the Baltimore case should have been decided differently.