As a general rule, an unsecured debt does not survive bankruptcy. However, like all general rules, it has exceptions. Exceptions arise out of s. 178(1) of the Bankruptcy and Insolvency Act. The two that pop up the most in our practice are 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. Many applicable legal concepts apply equally to ss. (d) and (e). These concepts are set out in Shaver-Kudell Manufacturing Inc. v. Knight Manufacturing Inc. a 2020 decision of the Ontario Superior Court of Justice subsequently appealed to the Ontario Court of Appeal.
Findings on Merits
A trial judge held that the defendant misappropriated the plaintiff’s trade secrets and breached his duty of confidence. Costs of $300,000 were awarded and a hearing was to take place to determine the plaintiff’s damages and other relief. That hearing and the collection of the costs were stayed when the defendant made an assignment into bankruptcy.
The plaintiff relied on s. 178(1)(e) and sought (i) a declaration that the judgment survived the subsequent bankruptcy and (ii) an order lifting the automatic stay of proceedings upon bankruptcy. The defence revolved around the determination of whether the bankrupt’s actions fell within the ambit of “obtaining property or services by false pretences.”
The motion judge set out a complete synopsis of the legal principles involved in ss. (e) set out below.
- “The exceptions set out in s. 178 are types of claims which outweigh any possible benefit to society in the bankrupt being released from those obligations. The exceptions contained in ss. (e) are morality concepts that look at conduct. These types of conduct are not acceptable to society and a bankrupt should not be rewarded with a release of liability.
- One of the important purposes of bankruptcy is to encourage the rehabilitation of an honest but unfortunate debtor and to permit their re-integration into society.
- In reaching a conclusion on the scope of s. 178, the Court is to consider the pleadings and the evidentiary proceedings at trial.
- The onus is on the creditor who seeks to have the debt or liability survive the discharge to bring it within one of the provisions of s. 178(1).
- (e) uses the expressions ‘false pretences’ and ‘fraudulent misrepresentation’ disjunctively (ed – a creditor may rely on either).
- ‘False pretences’ and ‘fraudulent misrepresentation’ are similar concepts but not identical. Only one basis of liability must be proven to engage this subsection.
- The core content of the phrases ‘false pretences’ and ‘fraudulent misrepresentation’ is deceitful statements.
- The essential test for both ‘false pretences’ and ‘fraudulent misrepresentation’ under ss. (e) has been described as determining whether the bankrupt was ‘deceitful’ in obtaining the property.
- For the ‘false pretences’ portion of ss. (e) to be satisfied, reliance on any representation need not be shown. Rather, it must be demonstrated that the debtor obtained its property by pretences which they knew to be false.
- There is no such thing as a cause of action called ‘obtaining property by false pretences.’ It would be unreasonable to require the plaintiff to plead a case to cover the possibility that the defendant will be filing for bankruptcy at some time in the future.
- A causal connection between the bankrupt’s wrongdoing and the creation of the debt or liability is required.”
The judge had no difficulty in determining that misappropriating confidential information fell within ss. (e). In doing so, he said: “The Defendant Knecht’s conduct is precisely the type of conduct that society frowns upon. He is not an ‘honest but unfortunate debtor’. I find that he is a deceitful wrongdoer and he should be precluded from benefitting from his dishonesty. … He willingly participated in the scheme to utilize confidential information that was not his to use. He knowingly partnered and/or employed individuals that had unlawful knowledge of trade secrets and he used this confidential information for his own financial gain.” He also said, “a dishonest bankrupt who has unlawfully obtained property by lying satisfies the requirements of ‘false pretences’ in (s. 178(e)). Such conduct is deceitful and wrong. It is this type of conduct that is morally objectionable to society. If the bankrupt engages in such a behaviour, they should not be shielded by bankruptcy.”
Not surprisingly, given this view of the bankrupt, the judge granted the requested declaration and lifted the s. 69 stay to allow the creditor to continue to attempt to collect the judgment debt and to move forward with the relief portion of the trial
The plaintiff appealed the decision to the Court of Appeal. The Court took no issue with the principles that the motion judge enunciated in the bullet points above. Rather, it took issue with the motion judge’s conclusion that morally objectionable behaviour, without more, could result in the debt surviving bankruptcy.
The Court noted the following:
- 178(1) listed a number of instances in which a debt survived bankruptcy; it did not, through ss. (e), set out a general version of morally unacceptable behaviour.
- The motion judge cited only one instance of deceit: the bankrupt lied in his examination for discovery. This deceit did not result in the bankrupt obtaining the property; that had already been done. It was deceit that merely resulted in a loss of credibility at trial.
- False pretences only applies to a debt that has arisen from one or more deceitful statements, by the debtor or for which the debtor is responsible, on the basis of which the debtor obtained services or property. It does not apply to other kinds of lying or wrongdoing, no matter how morally objectionable, that do not have these basic characteristics.
- Wrongful conduct that does not involve false statements by which property was obtained is not covered by s. 178(1)(e).
- Findings that the bankrupt was not an honest but unfortunate debtor or that his conduct was morally objectionable are insufficient to bring the matter within s. 178(1)(e).
The Court lifted the stay imposed by the bankruptcy to allow the damages and relief portion of the original trial to continue. However, the benefits of the trial would be limited. It would quantify the damages, but only for purposes of determining the plaintiff’s distributive share in the bankrupt’s assets; establish the identity of property or equipment in the bankrupt’s possession that incorporated the trade secrets and order its return to the creditor; and result in injunctive relief against the bankrupt restraining any future use of the trade secrets.
After reading the trial decision, we would have said: bankrupts should realise that if their actions reek, judges will have little hesitation in allowing creditors to continue to collect judgment debts regardless of the bankruptcy. However, given the Court of Appeal’s determination, the moral seems to be different. You can still wipe out your debts by objectionable behaviour as long as you do not lie in the course of separating your victim from its property.
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Written by Jonathan Speigel, the founding partner of Speigel Nichols Fox LLP, leads the litigation and construction practices.