A purposive approach to thwart fraudsters

In a pair of rulings, the Supreme Court of Canada has found that the doctrine of corporate attribution can be applied in a bankruptcy and insolvency context, but it must be done so in a purposive way in order to ensure that fraudsters do not benefit over legitimate creditors.

The doctrine, a common law principle that allows individuals’ actions to be attributed to the corporation they represent, has been applied in both the criminal and civil contexts in past decisions, but this is the first application under the Bankruptcy and Insolvency Act (BIA), particularly where there are one or two “directing minds” for those corporations.

The first case, Aquino, involved a false invoicing scheme by several individuals, including the owner of a pair of family construction companies that later declared bankruptcy. The second case, Scott, involved a rent-to-own real estate company that was, in reality, a Ponzi scheme. The doctrine was applied differently in both cases to prevent unjust enrichment and ensure that creditors' interests were best protected.

“This Court has established that the corporate attribution doctrine is not a ‘standalone’ principle; there is no one-size-fits-all approach,” Justice Mahmud Jamal wrote for the Court in Aquino.

“The corporate attribution doctrine must be applied purposively, contextually, and pragmatically to give effect to the policy goals of the law under which a party seeks to attribute to a corporation the actions, knowledge, state of mind, or intent of its directing mind. Rules of attribution that may be appropriate in one context for one purpose may be inappropriate in another context for another purpose.”

He continued: “When the rules of attribution undermine the purpose of the law under which attribution is sought, the court should adapt the attribution rules to promote the purpose of the relevant law.”

In Aquino, that meant the doctrine could apply to the company so that the courts could recover some of this money because the false invoice transactions were “transfers at undervalue” under s. 96(1)(b)(ii)(B) of the BIA.

Section 96 has been described as “a tool to address ‘asset stripping’ by a debtor.” It provides a remedy to reverse transfers at undervalue that occurred within a specified period of time before the date of bankruptcy.

In Scott, however, the doctrine could not apply for the same reason as it would frustrate the purpose of Section 96 when it came to recovering the interest paid to investors in the Ponzi scheme.

Clifton Prophet, a partner and head of Gowling WLG's Financial Institutions Litigation Group in Toronto, says these decisions bring great clarity.

“The Court went on to conclude that [the false invoice scheme involved several] badges of fraud, and therefore reached the conclusion that from the totality of the evidence, that the transactions were intended to defraud, then that was enough for you to obtain judgment for transactions that go back as five years from the initial bankruptcy,” he says.

“That clarity is important.”

Prophet points to language in Aquino that shows how the doctrine’s application in a criminal or civil context differs from the bankruptcy context, and the fact the Court has created a special understanding of corporate attribution relating to bankruptcy.

“In the criminal and civil contexts, attributing the directing mind’s intent to the corporation might be justified if the corporation benefits from the improper activities of the directing mind, but would be unjustified if the corporation does not benefit,” Jamal wrote.

“In the bankruptcy context, the Court [of appeal] noted, ‘the policy currents flow rather differently… [A]ttributing the intent of a company’s directing mind to the company itself can hardly be said to unjustly prejudice the company…, when the company is no longer anything more than a bundle of assets to be liquidated with the proceeds distributed to creditors.’”

He added: “The court found that it would make little sense to adopt an approach that would favour fraudsters over legitimate creditors.”

Prophet says this means there will be less debate over whether ‘no benefit and total fraud’ can be used to defeat a trustee’s claims.

“I would say they can’t, and that seems like justice to me,” he says.

Ian Aversa, a partner at Aird & Berlis LLP in Toronto, agrees that the decisions offer some much-needed and welcome clarity for the bar.

“It would be a completely perverse result to allow a directing mind like Mr. Aquino to avoid liability because he defrauded the company,” Aversa says.

“(The Court) clearly stated that the ‘fraud and no benefit’ exceptions don’t apply in the context of a transfer undervalue in Section 96. At least in this context, it would undermine the very purpose of Section 96.”

To that same effect, it applied in the opposite way in Scott because applying corporate attribution would have benefitted those who received the unjust enrichment rather than the creditors.

“They’re saying that same underlying principles that our court set out in Aquino to allow for sufficient flexibility in the doctrine of corporate attribution have to apply, including when it comes to one-person corporations, because in [Scott], you had the same argument saying that it has to be applied purposively,” Aversa says.

“The ability to be pragmatic flows from both cases.”

On a broader scope, Aversa says in cases of fraud or mismanagement, the decisions pave the path for recovery by creditors. Taking away the ‘fraud with no benefit’ exception in Aquino provides a way for insolvent estates to repatriate those funds and put them in the hands of deserving creditors.

He says it’s not uncommon to see cases of “small-f or capital-F fraud” be part of insolvency and restructuring cases.

“That’s why our bar was watching these decisions so carefully. Now the path is clear; the blockade is no longer there. This doctrine is not going to be able to be held up as a bar to this recovery."