Houlden & Morawetz On-Line Newsletter

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1 Houlden & Morawetz On-Line Newsletter Date: September 10, 2012 Headlines The Ontario Superior Court of Justice addressed the issue of how to distribute commingled funds to the victims of a fraudulent investment scheme. In doing so, the court considered both the pro rata ex post facto method and the Lowest Intermediate Balance Rule ( LIBR ). Based on the facts, the court held that LIBR should be applied. See Case Updates [Boughner v. Greyhawk Equity Partners Ltd. Partnership (Millenium)]. The British Columbia Supreme Court declined to make an order dismissing the action on the basis that the claim was bound to fail. The court considered whether the plaintiff had standing to bring the action, given that the plaintiff was a partner of an entity that had filed under the CCAA. See Case Updates [Barrie Family Trust (Trustee of) v. Norgaard Neale Camden Ltd.]. Case Updates [Boughner v. Greyhawk Equity Partners Ltd. Partnership (Millenium)] Boughner v. Greyhawk Equity Partners Ltd. Partnership (Millenium) (2012), 2012 ONSC 3185, 2012 CarswellOnt (Ont. S.C.J. [Commercial List]) The issue to be determined was how to distribute commingled funds to the victims of a fraudulent investment scheme called the Greyhawk Fund ( Greyhawk or the Fund ). Following the discovery of the fraud and the appointment of A. Farber & Partners Inc. as receiver (the Receiver ), a significant shortfall was confirmed. The Receiver wanted to distribute the funds; however, there was disagreement amongst the investors regarding the appropriate method of distribution. The Waldock Group ( Waldock ) argued that the remaining funds should be distributed pro rata based on original contributions to the fund. This method was referred to as the pro rata method or the pro rata ex post facto method. Mr. Gibson argued that distributions should be made pro rata based on actual fund performance during the period while each investor was invested in the fund. The method proposed by Mr. Gibson is generally known as the Lowest Intermediate Balance Rule ( LIBR ). The Receiver referred to it as the fund unit allocation method. It has also been referred to in case law and elsewhere as pro rata on the basis of tracing, the North American method, and the Rolling Charge method. Under LIBR, an investor cannot claim an amount in excess of the lowest balance in a fund subsequent to their investment and attributable thereto. An example fact pattern demonstrated the difference between the methods advanced by Waldock and Gibson. A invests $100 in a fund. The value of the fund then declines to $50. B invests $100, bringing the balance in the fund to $150. The value of the fund then declines to $120. If LIBR were applied, A could not claim more than $50, because that is the lowest balance in the fund prior to B s investment. In other words, the initial decline in the value of the fund from $100-$50 is borne entirely by A. When B contributes $100, his investment constitutes 2/3 of the $150 in the fund. As a result, when the fund declines to $120, 2/3 of the decline is borne by B, while 1/3 is borne by A. Therefore, of the $120 remaining in the fund, A can claim $40 while B can claim $80. If the funds were distributed pro rata based on original contributions, as Waldock maintained should have occurred in the present case, both A and B would receive $60, since both invested an equal amount: $100. Which method was applied in the circumstances would have significant financial consequences for the parties. The Receiver calculated that if the funds were distributed using the

2 pro rata method, Waldock would receive $695,000 and Gibson would receive $216,000. If the funds were distributed using LIBR, Waldock would receive $139,000 and Gibson would receive $958,000. Waldock was the first investor in the Fund, with an investment of $1 million in July By November 2002, Waldock had invested $4.2 million in the Fund. Mr. Boughner was the next investor in the Fund. Between November 2000 and December 2010, Mr. Boughner had invested $3 million in the Fund. Nobody else invested in the Fund until April By that time $4.7 million have been invested by Waldock and Boughner, but the Fund had been depleted to $542,000. Waldock recommended the Fund to Gibson in early 2008 and Gibson invested $1 million. By the time the Fund collapsed in January 2011, Gibson had invested $2.2 million. While total Fund losses were just over $4.2 million when Gibson made his initial investment, they were approximately $5.4 million by the time the Fund collapsed. The Receiver estimated a shortfall of approximately US $3.5 million. The Receiver suggested three methods of allocating the remaining funds to the remaining investors: (a) pro rata based on original contributions; (b) LIBR; (c) Last in, first out (or LIFO, also known as the rule in Clayton s Case ), which was not supported by any party in the motion. The Receiver s evidence was that it had been able to properly calculate the distributions to each party using both methods (a) and (b) above. With respect to calculating distributions based on LIBR, the Receiver was asked: is the [LIBR calculation] complete, or would further calculations and refinements be required before that methodology could be applied to accurately distribute the Greyhawk proceeds at issue? The Receiver responded: No further calculations remain to be done, unless any redemptions are repaid to the fund or otherwise made available for distribution, in which case the present calculations would need to be refined to account for the additional funds received by the Receiver. Counsel to Waldock took the position that the case law and equitable principles directed in favour of distributing the remaining funds pro rata based on original contributions. Counsel submitted that the courts have determined that, as a general rule, pro rata distribution is appropriate where an account is in a shortfall position, funds have been commingled by a wrongdoer, and the remaining funds are to be distributed amongst innocent beneficiaries. Counsel cited Law Society of Upper Canada v. Toronto Dominion Bank (1998), 1998 CarswellOnt 4757, 42 O.R. (3d) 257, 169 D.L.R. (4th) 353, 116 O.A.C. 24, 44 B.L.R. (2d) 72 (Ont. C.A.) [ Law Society ], leave to appeal to S.C.C. refused (1999), 130 O.A.C. 199 (note), 250 N.R. 194 (note), [1999] 3 S.C.R. xiii (S.C.C.); Ontario (Securities Commission) v. Greymac Credit Corp. (1986), 55 O.R. (2d) 673, 1986 CarswellOnt 158, 17 O.A.C. 88, 23 E.T.R. 81, 30 D.L.R. (4th) 1, 34 B.L.R. 29 (Ont. C.A.) [ Greymac ], affirmed (1988), 1988 CarswellOnt 597, 31 E.T.R. 1, 1988 CarswellOnt 964, (sub nom. Greymac Trust Co. v. Ontario (Securities Comm.)) [1988] 2 S.C.R. 172, 52 D.L.R. (4th) 767, 29 O.A.C. 217, 87 N.R. 341, 65 O.R. (2d) 479 (S.C.C.); Ontario (Securities Commission) v. Consortium Construction Inc. (1993), 1993 CarswellOnt 908, 1 C.C.L.S. 117 (Ont. Gen. Div. [Commercial List]) [ Consortium ]; and Winsor v. Bajaj (1990), 75 D.L.R. (4th) 198, 1 O.R. (3d) 714, 40 E.T.R. 66, 1990 CarswellOnt 505 (Ont. Gen. Div.). Greymac and Law Society were cited for the proposition that in determining the appropriate method to distribute remaining funds to innocent beneficiaries, where a portion of the funds had been misappropriated by a wrongdoer, the court should apply the method that is most just, convenient and equitable in the circumstances. Counsel submitted that a pro rata distribution was just and equitable because, unlike LIBR, it does not rely on happenstance and the timing of investments to prioritize certain investors over others.

3 Counsel to Gibson agreed with counsel to Waldock s assertion that the test as to how best to distribute remaining funds was to determine which method is just, convenient and equitable. In response to the assertion by counsel to Waldock that it would be unworkable to apply LIBR in these circumstances, counsel to Gibson submitted this was not the evidence of the Receiver. Rather, counsel to Gibson noted that the Receiver confirmed that its LIBR calculations were complete. Counsel to Gibson took the position that the opposing counsel had misconstrued the issue in this case, emphasizing that both parties were advocating a method of distribution that could be referred to as a pro rata distribution. The LIBR method still incorporated pro rata calculations, but the manner in which Gibson proposed that the proportionate shares be calculated differed from Waldock. Counsel to Gibson explained the differences as follows: Waldock advances what has been described in the jurisprudence as the pro rata ex post facto approach whereby commingled funds are distributed pro rata based on original contributions to the fund; whereas Gibson supports an approach whereby commingled monies are distributed pro rata based on the value of the contributions at the time the funds are commingled. In Greymac, Morden J.A. referred the latter approach as pro rata sharing on the basis of tracing. Counsel to Gibson also submitted that by advocating for pro rata distribution, Waldock was attempting to throw his losses on to Gibson and claim a portion of Gibson s deposit. Counsel also submitted that there was no reason in equity why Waldock should benefit from Gibson s investment, and noted Lord Justice Dillon s observation of same in Barlow Clowes International Ltd. v. Vaughan (1991), [1992] 4 All E.R. 22 (Eng. C.A.) [ Barlow ]: [pro rata] distribution among all seems unfair to late investors. Waters Law of Trusts in Canada, 3d ed. (Toronto: Thomson Carswell, 2005) was also cited for the proposition that the pro rata method is unfair to later investors. At page 1283, he offered comments: Although there is a certain fairness in proportionate sharing, this approach shifts earlier losses onto later contributions, whose money could not possibly have been implicated in those losses. Counsel to Gibson also disagreed that Greymac supported the position of Waldock, and submitted that a careful reading of Greymac demonstrated that Morden J.A. adopted LIBR as a general rule in circumstances such as the present case. At page 689 of Greymac, Morden J.A. cited the Restatement of the Law, Restitution section 213 (1937), stating: I am not persuaded that considerations of possible inconvenience or unworkability should stand in the way of acceptance, as a general rule, of [LIBR]. That it is sufficiently workable to be the general rule is indicated by the fact that it appears to be the majority rule in the United States. Counsel to Gibson argued that Morden J.A. s position in Greymac was that unless LIBR is not practically... possible, it is the general rule. Counsel again emphasized the Receiver s evidence that it has been able to successfully calculate distributions using the LIBR method. Counsel also submitted that Greymac was binding, as it was affirmed by the Supreme Court, which adopted the reasons therefore delivered by Morden J.A. on behalf of the Court. Justice Morawetz observed that both parties argued that Greymac supported their position. He concluded that the reasoning in Greymac aligns with the position put forth by Gibson. Morawetz J. found that the result in Law Society was consistent with the result in Greymac. Morden J.A. acknowledged in Greymac that, in circumstances where pro rata on the basis of tracing (LIBR) is not practically possible, distributions should proceed on a pro rata ex post facto basis. The court in Law Society determined that it was not practical to undertake a tracing exercise in the circumstances of that case. Further, Law Society expressly rejected the rule in Clayton s case. The court then considered Greymac, but arrived at the conclusion that was not practical to apply pro rata tracing on the facts of Law Society. Blair J. (ad hoc at the

4 time) found, in Law Society, at page 267: in my view, however, this approach is too complex and impractical to be accepted as a general rule for dealing with cases such as this. Morawetz J. went on to state that given the statements in Law Society, and the fact that Law Society follows Greymac, it was necessary to consider the statements of Blair J. in Law Society in the context of the decision. In doing so, it seemed to Morawetz J. that there was no direct contradiction between the two decisions. After a discussion of Law Society, Morawetz J. discerned the following: (i) The controlling authority, Greymac, clearly rejects the rule in Clayton s case as unfair, arbitrary, and based on a fiction. (ii) The court in Greymac held that, as a general rule, the mechanism of pro rata sharing based upon tracing (or LIBR) was the preferable approach to resolving competing claims to mingled trust funds. (iii) In Law Society, the outcome is consistent with Greymac. (iv) The finding in Law Society fell within the exception provided for in Greymac. In essence, the general rule as stated by Morden J.A. could not, in the view of Blair J., be applied in the circumstances of Law Society. Justice Morawetz also observed that there was no doubt that the issues, terms and concepts discussed at length in both Greymac and Law Society were complex. As noted by Blair J., in reference to the British Columbia Law Reform Commission in its Report on Competing Rights to Mingled Property: Tracing and the Rules in Clayton s Case (1983), terms like parri passu, pro rata, rateably, and proportionally are inherently ambiguous. Morawetz J. added that to this list of terms can be added LIBR, the rolling charge, and the North American approach. Morawetz J. was of the view that these terms have not always been used with precision and, as a result, considerable confusion has arisen in the cases. Justice Morawetz also referenced Re Graphicshoppe Ltd. (2005), 2005 CarswellOnt 7008, (sub nom. Re Graphicshoppe Ltd. (Bankrupt)) 205 O.A.C. 113, 21 E.T.R. (3d) 1, 260 D.L.R. (4th) 713, 2005 C.E.B. & P.G.R. 8178, 49 C.C.P.B. 63, 15 C.B.R. (5th) 207, 78 O.R. (3d) 401 (Ont. C.A.), and concluded that although the Court of Appeal did not, on the facts, apply LIBR in Law Society, it was accepted by Moldaver J.A. (as he then was) in Graphicshopppe. Thus, by virtue of the Supreme Court of Canada s affirmation of Greymac and the more recent decision in Graphicshopppe, LIBR was an available mechanism to distribute commingled funds. In the result, Morawetz J. concluded that the practical concerns cited in Greymac did not exist in this case as the Receiver had determined a practicable method for distributing the Greyhawk Fund pro rata on the basis of LIBR. Following Greymac, Morawetz J. directed the distributions be made pursuant to the fund unit allocation method (or pro rata on the basis of tracing, or LIBR). In recognition of the fact that this issue had to be determined prior to any distribution and given that both Waldock and Gibson were victims of a fraud, Morawetz J. found that it was appropriate that the costs of the parties be paid out of the assets of the Greyhawk Fund. See Houlden & Morawetz, Bankruptcy and Insolvency Law of Canada: F 14 Tracing Trust Property [Barrie Family Trust (Trustee of) v. Norgaard Neale Camden Ltd.] Barrie Family Trust (Trustee of) v. Norgaard Neale Camden Ltd. (2012), 2012 CarswellBC 2463, 2012 BCSC 1234 (B.C. S.C. [In Chambers]) The defendants applied for an order that the action be dismissed, submitting that the plaintiff s claim disclosed no genuine issue for trial or was bound to fail. The defendants also submitted that the plaintiff had no standing or legal capacity to bring this action, given that the Barrie Family Trust was a partner in the Bear Mountain Master

5 Partnership and was prohibited, pursuant to a Partnership Agreement, from bringing this action. The defendants also submitted that a British Columbia Supreme Court receivership order also prohibited the plaintiff from bringing the action. Mr. Barrie had filed this action in his capacity as trustee of the Barrie Family Trust ( Family Trust ). The defendant, Norgaard Neale Camden Ltd. ( Norgaard ), was a firm of chartered accountants. The defendant, Mr. Neale, was an accountant and a principal of the defendant Norgaard. Norgaard had been engaged by the Executive Committee of the Partnership to perform audits of the financial statements of the partnership for the years 2004 to During the summer of 2008, the Executive Committee requested Norgaard to provide a report involving certain specified auditing procedures, including transactions with Mr. Barrie and his related parties. As a result of this engagement, Norgaard prepared the report. Mr. Barrie did not agree with the contents of the report, taking the position that the defendants negligently and recklessly exceeded their engagement and purported to investigate broader issues. The plaintiff also stated in his pleadings that the report concluded that he misappropriated funds for personal use, engaged in deceptive transactions and failed to provide complete and accurate information in good faith, and made other allegations of inappropriate conduct. Mr. Barrie pleaded that the specific allegations in the report as well as the report as a whole were false, misleading, and defamatory of Mr. Barrie and he had suffered significant economic loss as well as humiliation, distress and embarrassment. Mr. Barrie sought damages for breach of contract. In response, the defendant said that the notice of claim failed to sufficiently plead the legal requirements of any valid cause of action and failed to expressly identify any cause of action other than breach of contract. The defendants also stated in their response that they were not engaged by the plaintiff for any of the audit work or work on the preliminary report. As a result, the defendants sought further particulars as to the alleged breach of contract. They said that they were engaged by the Executive Committee of the Partnership, not the Partnership itself nor the Barrie Family Trust in its individual capacity as a partner. In June 2012, counsel for the defendants advised that because of orders of the B.C. Supreme Court dated March 25, 2010 and July 5, 2010 in the Companies Creditors Arrangement Act ( CCAA ) proceedings affecting the Partnership, the defendants were of the opinion that Mr. Barrie had no standing to commence this particular action. This was in addition to an argument that because the contract was between the Executive Committee and the defendants, Mr. Barrie and the Family Trust had no contractual relationship with the defendants and, on that basis as well, had no standing to bring the action. In seeking to have the claim dismissed by way of summary judgment, the defendants also said that the Partnership Agreement gave the Executive Committee the right to operate and manage the Partnership and held the right, property and agreements in relation to the business of the Partnership in trust on behalf of the Partnership. The defendants therefore submitted that the terms of the Partnership Agreement prohibited the plaintiff from bringing an action in the name of the Partnership. The plaintiff s response was that this was not an action in the name of the Partnership but rather an action by the plaintiff alone. The plaintiff also took the position that the Partnership Agreement limited the Executive Committee s ability to manage Bear Mountain affairs in relation to the business of the Partnership and to manage, control, administer and operate the business. The plaintiff submitted that this action was entirely unrelated to Partnership Business as defined in the Partnership Agreement. The plaintiff submitted that he had the capacity to advance the claim, irrespective of how unusual the claim for breach of contract in

6 the circumstances may be, and even though the direct contractual relationship was between the Executive Committee and the defendants. The defendants advanced a similar argument based on the Supreme Court orders wherein the Partnership was placed under creditor protection in accordance with the CCAA. It was also noted that in the CCAA proceedings, the court appointed a chief executive officer ( CEO ) for the Partnership and granted him significant powers and responsibilities. As a result of this court order, the defendants took the position that the plaintiff had no standing to bring this action, because the CEO had exclusive standing in this regard. In response, the plaintiff took the position that the action had nothing to do with the business of Bear Mountain or the property, assets and undertakings of the Bear Mountain respondents. Rather, it was a claim by a partner for damages for economic loss and embarrassment caused by the defendant s breach of contract. Justice MacKenzie stated that in the circumstances, while he agreed that the claim was unusual and may not be strong or indeed might be considered novel, he was satisfied that the pleadings were sufficient to support an initial cause of action. Moreover, he was not satisfied that the applicant had established that it was manifestly clear or beyond a reasonable doubt that there was no bona fide triable issue. Turning to the submission that Mr. Barrie had no standing to bring this action because of the court orders, MacKenzie J. was of the view that the applicant had not established beyond a reasonable doubt that the CEO court orders from July 2010 precluded Mr. Barrie from instituting this action. MacKenzie J. also agreed with Mr. Barrie that on this application, the question was not which interpretation was preferable or likely to succeed, but whether or not it was beyond a doubt that the court order precluded the plaintiff from bringing this action. Similarly, given the particular articles in the Partnership Agreement and the argument advanced by Mr. Barrie with respect to the basis for his action, MacKenzie J. could not conclude that it was beyond doubt that the Partnership Agreement precluded the plaintiff from bringing this action. For the foregoing reasons, the application of the defendants was dismissed. See Houlden & Morawetz, Bankruptcy and Insolvency Law of Canada: L 5 Effect of Appointment of a Receiver N 65 Scope of Order under Initial Application