Disposing Assets on the Eve of Insolvency – Court Revisits the Test for Fraudulent Conveyance

Published on: July 2022 | What's Trending

A red house on a slanting stack of coins. Below one house that already fell.

When a debtor is facing insolvency, it is typically not permitted to liquidate or transfer assets.

However, in a recent decision from the Ontario Superior Court of Justice, it was held that a debtor was permitted to sell its commercial real estate units on the eve of insolvency, despite the fact that the sale left one of its creditors with no remedy. This case makes the important distinction that where an asset is already heavily encumbered, and is disposed of to satisfy the encumbrancers, it will be very difficult to argue that the conveyance was improper or fraudulent. It also serves as a stark reminder of the importance of using statutory rights, such as construction liens where possible to protect one’s position.

Vestacon Limited v. Huszti Investments (Canada) Ltd., 2022 ONSC 2104 dealt with a situation where a debtor sold off its few remaining assets, leaving an unsecured creditor without any means to satisfy a judgment. The unsecured creditor, Vestacon Limited (“Vestacon”) brought an action against the defendants, Huszti Investments (Canada) Ltd. o/a Eyewatch (“Huzsti”) seeking to set aside the sale of commercial units to 2603553 Ontario Inc. (“260”). Vestacon had constructed the units but had not been paid.

Hustzi had purchased three unfinished commercial units by securing a loan through a private mortgage lender, Benson Custodian Corporation (“Benson”). Benson brokered and administered a first mortgage loan to Huszti by two of its clients. Hustzi also obtained a vendor take back mortgage from the seller, which was registered in second position. Benson also financed a construction mortgage loan, which was registered in third position.

In March 2017, Huszti hired Vestacon to construct the three commercial units, which were substantially complete and ready for occupancy by June 2017. Vestacon delivered several invoices, totalling $449,819.31. The two companies had discussions beginning in summer 2017 about the outstanding balances and Huszti made promises to pay. Huszti proposed a payment schedule to satisfy the outstanding balance and Vestacon accepted the proposal on October 25, 2017. Vestacon trusted Huszti’s promises to pay and did not take any further steps, such as registering a construction lien, to protect its interests.

At the same time that Huszti was not paying Vestacon’s invoices, it was in default of its mortgage payments. On September 1, 2017, Huszti defaulted on the mortgages, and on October 11, 2017, the first mortgagees issued a notice of power of sale.

This was concerning for Benson for two reasons. First, Benson worried that the first mortgagees, who were its clients, would be unhappy with Benson due to the default. Second, Benson worried that if the property was sold under a power of sale, the proceeds from the sale would not be enough for it to recover its investment in the construction mortgage loan. To avoid this outcome, Benson purchased the units from Hustzi through a numbered company, 260, which took title to the units.

Vestacon commenced an action against Hustzi and 260 alleging breach of contract by Huszti for the unpaid invoices and allegeing that the transfer of the units to 260 was a fraudulent conveyance, in which 260 knowingly participated.

Vestacon relied on section 2 of the Ontario Fraudulent Conveyances Act (the Act”), which provides that a conveyance of property “made with intent to defeat, hinder, delay, or defraud creditors of their just and lawful actions, suits, debts (…) are void as against such persons”. The Act also provides that a transaction is not void if it was made “upon good consideration and in good faith” to a person who did not have knowledge of the transferor’s intention to defeat, hinder, delay, or defraud creditors.

Therefore, in order to void this transaction, Vestacon had to establish that Huszti had the intention to defeat, hinder, delay, or defraud it and that 260 had knowledge of these intentions. In order to make this determination, the court outlined the applicable factors. Namely, the court looked at whether:

  1. “the transferor has few remaining assets after the transfer;
  2. the transfer was made to a non-arm’s length person;
  3. there were actual or potential liabilities facing the transferor, he was insolvent, or he was about to enter upon a risky undertaking;
  4. the consideration for the transaction was grossly inadequate;
  5. the transferor remained in possession or occupation of the property for his own use after the transfer;
  6. the deed of transfer contained a self-serving and unusual provision;
  7. the transfer was effected with unusual haste; and
  8. the transaction was made in the face of an outstanding judgment against the debtor.”

Vestacon argued that the sale was self-serving since the initial purchase agreement provided that Huszti would remain in possession of the units. However, Huszti did not remain in possession and 260 leased the units to unrelated tenants.

Additionally, Vestacon argued that Huszti had accumulated significant debts and liabilities and was insolvent or facing imminent insolvency when the transfer occurred. The court considered this argument but recognized that the first mortgagees had issued a Notice of Sale and, if Huszti did not realize on its assets (the units), the first mortgagees were going to proceed to sell them.

The court found that although dispossessing oneself of one’s last asset while facing imminent insolvency is recognized as a badge of fraud, it creates a stronger suspicion of fraud when the conveyance at issue is of an unencumbered asset. In this case, the units were encumbered by three separate mortgages, and after paying out the mortgagees and discharging the arrears of property taxes, Huszti was left with only about $80,000.

There was also no evidence to support that 260 was a non-arm’s length party. Additionally, it was also noted that (a) 260 paid over 93% of the appraised value of the units; (b) the deal was done privately; and (c) negotiations that led to the conveyance took place over months.

Ultimately, the court reviewed each of the badges of fraud and found that “Vestacon’s evidence does not come anywhere near establishing a fraudulent intent on the part of Huszti.” The court also found that the evidence was even weaker when it came to establishing that 260 had knowledge of Vestacon’s fraudulent intentions. As a result, the claim against 260 was dismissed.

This decision is a grim warning to unsecured creditors that if a nearly insolvent debtor sells its last remaining assets and the transaction is found to not be fraudulent, the unsecured creditor may be left with no recourse.

Author: Daniel Waldman, Lawyer

The author would like to acknowledge the assistance of Pulkit Sahi in writing this blog.