Disposing of assets on the eve of insolvency – Court revisits fraudulent conveyance test
When a debtor faces insolvency, it is generally not allowed to liquidate or transfer assets.
However, in a recent decision by 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 the one of its creditors without recourse. This case makes the important distinction that where property is already heavily encumbered and is transferred to satisfy the encumbrancers, it will be very difficult to argue that the transfer was improper or fraudulent. It also serves as a stark reminder of the importance of using statutory rights, such as building privileges 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 his few remaining assets, leaving an unsecured creditor with no way to satisfy a judgment. The unsecured creditor, Vestacon Limited (“Vestacons”) sued the defendants, Huszti Investments (Canada) Ltd. o/a Eye watch (“Huzsti”) seeking to rescind the sale of business units to 2603553 Ontario Inc. (“260”). Vestacon had built the units but had not been paid.
Hustzi had purchased three unfinished commercial units by obtaining a loan through a private mortgage lender, Benson Custodian Corporation (“Benson”). Benson negotiated and administered a first mortgage loan to Huszti by two of his clients. Hustzi also secured a buyout mortgage from the seller, which was registered second. Benson also funded a construction mortgage, which was recorded in third place.
In March 2017, Huszti hired Vestacon to build the three commercial units, which were substantially complete and ready for occupancy in June 2017. Vestacon submitted multiple invoices, totaling $449,819.31. The two companies had discussions beginning in the summer of 2017 over outstanding balances and Huszti made payment promises. Huszti offered a payment schedule to settle the outstanding balance, and Vestacon accepted the proposal on October 25, 2017. Vestacon trusted Huszti’s payment promises and took no further action, such as filing a building privilege, to protect its interests.
At the same time that Huszti was not paying Vestacon bills, he was in default on his mortgage. 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 worrying for Benson for two reasons. First, Benson feared that the first mortgagees, who were his clients, would be unhappy with Benson because of the default. Second, Benson was concerned that if the property was sold under power of sale, the proceeds of sale would not be sufficient to allow him to recoup his investment in the construction mortgage. To avoid this outcome, Benson purchased Hustzi’s units through a numbered company, 260, which took title to the units.
Vestacon sued Hustzi and 260 alleging breach of contract by Huszti for unpaid invoices and alleging that the transfer of units to 260 was a fraudulent transfer, in which 260 knowingly participated.
Vestacon relied on section 2 of the Ontario Act Fraudulent Transfers Act (the “Law”), which provides that an assignment of property “made with intent to frustrate, hinder, delay or defraud creditors of their just and lawful actions, suits, debts (…) is void against such persons”. The Law also provides that a transaction is not void if it was made “after careful consideration and in good faith” to a person who had no knowledge of the transferor’s intention to frustrate, hinder, delay or defraud the creditors.
Therefore, in order to void this transaction, Vestacon had to establish that Huszti intended to thwart, obstruct, delay or defraud it and that 260 had knowledge of these intentions. In order to make this decision, the court set out the applicable factors. Namely, the court considered whether:
- “the transferor has few remaining assets after the transfer;
- the transfer was made to a person with whom you do not deal at arm’s length;
- there were actual or potential liabilities to the assignor, it was insolvent or it was about to engage in a risky business;
- the consideration for the transaction was manifestly insufficient;
- the transferor remained in possession or occupation of the property for its own use after the transfer;
- the deed of transfer contained a self-serving and unusual provision;
- the transfer was carried out with unusual haste; and
- the transaction was made despite an outstanding judgment against the debtor.
Vestacon argued that the sale was self-serving since the original purchase agreement provided that Huszti would remain in possession of the units. However, Huszti did not remain in possession and 260 rented the units to independent tenants.
Additionally, Vestacon argued that Huszti had accumulated significant debts and liabilities and was insolvent or facing imminent insolvency at the time of the transfer. The court considered this argument, but recognized that the first mortgagees had issued a notice of sale and, if Huszti did not realize his assets (the units), the first mortgagees would proceed with their sale.
The court concluded that although dispossession of one’s last asset in the face of impending insolvency is recognized as an insignia of fraud, it creates a stronger suspicion of fraud when the transfer in question involves unencumbered property. In this case, the units were burdened with three separate mortgages, and after paying the mortgagees and clearing the property tax arrears, Huszti was left with only about $80,000.
There was also no supporting evidence that 260 was a non-arm’s length party. Further, it was also noted that (a) 260 paid more than 93% of the appraised value of the units; (b) the transaction was entered into privately; and (c) the negotiations leading to the divestiture lasted for months.
Ultimately, the court reviewed each of the fraud badges and concluded that “Vestacon’s evidence falls far short of establishing fraudulent intent on Huszti’s part.” The court also found that the evidence was even weaker when it came to establishing that 260 had knowledge of Vestacon’s fraudulent intentions. Accordingly, the complaint against 260 was dismissed.
This ruling is a stark warning to unsecured creditors that if a nearly insolvent debtor sells its last remaining assets and the transaction turns out to be non-fraudulent, the unsecured creditor may be left without recourse.