Constructive solutions: the Alberta Court of King’s Bench offers insight into evaluating fraud claims against a debtor on the eve of a transaction

The Court of King’s Bench of Alberta (the Court) recently resolved how a creditor’s claim for unjust enrichment against a debtor is to be evaluated in the context of a proceeding under the Companies’ Creditors Arrangement Act (the CCAA)¹. In Long Run Exploration Ltd (Re), 2024 ABKB 710 (the Decision) the Court presented an analytical framework for evaluating such a claim, and identified the factors that the Court will consider when deciding whether a proprietary remedy in the form of a constructive trust imposed over the debtor’s assets is appropriate.

What you need to know

• The imposition of a constructive trust over the assets of a debtor is an exceptional remedy in the context of a CCAA proceeding, which will only be granted sparingly.
• A creditor alleging the unjust enrichment of a debtor by means of a fraudulent misrepresentation must prove elements of the fraudulent misrepresentation on a balance of probabilities within the CCAA proceeding.
• Courts are reluctant to substitute terms or rewrite agreements between sophisticated commercial parties in CCAA proceedings.

The details

Background

Long Run Exploration Ltd. (Long Run) is a private oil and gas company based in Calgary, Alberta. A court-appointed Monitor, acting on behalf of Long Run, sought an order from the Court approving a proposed subscription agreement and the granting of a reverse vesting order (RVO). The subscription agreement and RVO contemplated the cancellation of Long Run’s existing common shares and the issuance of new shares that would be free and clear of any existing liabilities not expressly retained. The assets and liabilities not retained by Long Run would be transferred to a creditor trust. The creditors whose claims were transferred would have recourse only against the creditor trust and not against Long Run. It was anticipated that those creditors would not receive any payment.

Creditor alleges debtor was unjustly enriched

The Monitor’s application was opposed by Henenghaixin Corp. (H Corp) on the basis of alleged unfairness. H Corp has been engaged in litigation with Long Run since February 2020. As plaintiff, H Corp alleges that Long Run was unjustly enriched at H Corp’s expense. Specifically, it alleges that certain individuals, while acting as directors and officers of Long Run, improperly induced H Corp to transfer funds by fraud and misrepresentation, including the presentation of false financial statements, bank records, and a false shareholder declaration. As compensation, H Corp sought proprietary restitution through the imposition of a constructive trust on Long Run’s assets to the extent of the funds transferred to Long Run.

Under the subscription agreement and the RVO, H Corp’s claim would have been transferred to the creditor trust, effectively extinguishing any possibility of recovery. While H Corp did not oppose the subscription agreement and the RVO in principle, it argued that its claim must be preserved.

Framework for evaluating as-yet unproven claims of unjust enrichment within a CCAA proceeding

When should an as-yet unproven claim of unjust enrichment by means of a fraudulent misrepresentation be preserved for later adjudication outside the CCAA regime? The Decision provides an analytical framework for evaluating such claims.

Did the claimant prove its case on a balance of probabilities?

The Court held that the threshold for establishing a constructive trust claim in the context of a CCAA proceeding is high. Specifically, a creditor alleging fraud and misrepresentation by the debtor and seeking a constructive trust over the debtor’s assets must prove, on a balance of probabilities, the following four elements:

1. the debtor made a representation to the creditor;
2. the representation was false;
3. the debtor knew that the representation was false; and
4. the false representation was made to obtain property or a service.

If the creditor successfully proves these four elements on a balance of probabilities, the creditor is in a better position than other ordinary creditors insofar as such a claim, while not conferring secured creditor status, cannot be dealt with by a compromise or arrangement (i.e., by the subscription agreement and RVO) without the creditor’s consent.

The Court held that H Corp failed to meet such threshold on a balance of probabilities due to the following factors:

• Wrongdoers identified as individuals. The evidence implicated individual directors and officers, rather than Long Run as an entity.
• Lack of connection to Long Run. The allegations centered on fraudulent financial statements concerning a wholly-owned subsidiary of H Corp, as opposed to specifically focusing on Long Run’s conduct.
• Evidentiary weakness. Previous affidavits submitted by H Corp relied heavily on hearsay. Although H Corp introduced new evidence, the Court found unresolved credibility issues and ambiguities in both the allegations advanced and the evidence itself.

When is a proprietary remedy in the form of a constructive trust appropriate?

In Canada, constructive trusts are recognized both as a remedy for wrongful acts like fraud and breach of an equitable obligation, as well as to remedy an unjust enrichment and the corresponding deprivation. While cases often involve both a wrongful act and an unjust enrichment, constructive trusts may be imposed on either ground. H Corp based its constructive trust claim on both wrongful acts and unjust enrichment.

The Court found that the imposition of a constructive trust was inappropriate in this case for the following reasons:

• Lack of knowledge or involvement by Long Run. There was insufficient proof that Long Run knowingly received the funds obtained by fraud or misrepresentation, or that Long Run played a role on its own account in perpetrating a fraud or misrepresentation against H Corp.
• No proof of retained funds. H Corp failed to demonstrate that the transferred funds, which were allegedly commingled, remained in Long Run’s possession.
• Sufficiency of monetary judgment. A monetary judgment would have been sufficient but for Long Run’s insolvency.
• Insolvency not grounds for a constructive trust. The insolvency of Long Run does not provide a valid reason to impose a constructive trust, as this would unfairly alter the established priorities in insolvency proceedings.
• Absence of specific or identifiable trust property. H Corp was unable to identify any specific, unique, or identifiable property within Long Run’s assets that would support a constructive trust.
• No recognized equitable obligation or breach. H Corp did not establish that there was a recognized equitable obligation owed by Long Run to H Corp, nor any breach of such an obligation that would render Long Run’s possession of the funds unconscionable.

What is the role of the equities in this case?

The Court emphasized that equitable considerations play a pivotal role in determining whether a constructive trust is appropriate, even in cases where wrongful conduct may be proven. The Court analyzed the equities by addressing three overarching questions:

1. Is there a juristic reason negating H Corp’s unjust enrichment claim?
2. Are there factors, including the interests of other creditors, that would render the imposition of a constructive trust unjust?
3. Would it be contrary to good conscience to deny a constructive trust in these circumstances?

The Court concluded that the equities weighed against preserving H Corp’s constructive trust claim and amending the subscription agreement and RVO. Specific findings included:

• Impact on negotiated agreements. The subscription agreement is a comprehensive, complex, and detailed series of interrelated promises and obligations, meticulously negotiated between sophisticated arms’ length parties. A request to modify this agreement to accommodate H Corp’s claim could have unforeseen consequences that could adversely affect either the parties or the viability of the transaction.
• Burden on innocent parties. It would be unfair to force Long Run’s new owner and its secured creditors to indemnify Long Run regarding its potential liability to H Corp, since neither had anything to do with the transactions between H Corp and Long Run that gave rise to the claim of unjust enrichment.
• Strength of H Corp’s claim. H Corp had not proven fraud or misrepresentation on a balance of probabilities.
• No identifiable trust property. There is no identifiable trust property, and the amount of the trust claim is uncertain.
• Preservation of the CCAA’s single proceeding model. Allowing H Corp’s claim to proceed independently would violate the CCAA’s single proceeding model, destabilizing the collective process designed to resolve claims efficiently and equitably.
• Interests of broader stakeholders. Equity requires a holistic evaluation of how any remedy impacts other financial stakeholders.

Implications

The Decision outlines a framework for evaluating claims of unjust enrichment by means of fraudulent misrepresentation within CCAA proceedings. A creditor must prove the four elements of fraudulent misrepresentation on a balance of probabilities. Even if the creditor successfully establishes a case for wrongful conduct, the Court will only impose a constructive trust over the debtor’s assets in exceptional circumstances, where there is identifiable property and a recognized equitable obligation. The Court’s analysis emphasizes that equitable considerations, such as the impact on innocent parties and the integrity of the CCAA process, will play a significant role in determining whether such a remedy is appropriate.