Breach of Trust - Are You Exposed? Duncan W. Glaholt Markus Rotterdam *

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1 228 CONSTRUCTION LAW REPORTS 49 C.L.R. (2d) Breach of Trust - Are You Exposed? Duncan W. Glaholt Markus Rotterdam * I. - Mortgage Lending After Dietrich Steel and Rudco Two recent decisions by the Ontario Court of Appeal have eliminated any possible uncertainty about the payment of overheads out of statutory trust monies. Such payments are categorically disallowed. These two decisions, however, may have far reaching consequences on other aspects of the construction industry, such as the business of mortgage lending, and their full effect has yet to be felt. The first of the two cases to reach the Court of Appeal was Rudco Insulation Ltd. v. Toronto Sanitary Inc. 1 The personal and corporate defendants in Rudco were sued for breach of trust for using project receipts to pay "wages, office expenses, rent, legal and accounting fees and the like", before paying their project trades and suppliers. At trial, Coo J. had held that the group of people receiving such payments, including lawyers, accountants and landlords, were not "other persons" to whom trust benefits were given by the Act. On appeal, the Ontario Court of Appeal agreed with Coo J.: the only payments that actually discharge the trust obligation are those permitted by s. 10 of the Act: Payment discharging trust Subject to Part IV (holdbacks), every payment by a trustee to a person the trustee is liable to pay for services or materials supplied to the improvement discharges the trust of the trustee making the payment and the trustee's obligations and liability as trustee to all beneficiaries of the trust to the extent of the payment made by the trustee. It was common ground in Rudco that none of the recipients of overhead expenses supplied "materials" to an improvement as defined by the Act. * Glaholt & Associates (Toronto). This paper was presented at a Toronto conference entitled "Hot Topics in Ontario Construction Law" on January 11, 2000, which was sponsored by Lorman Educational Services. 1 (1998), 41 C.L.R. (2d) I (Ont. C.A.).

2 Breach of Trust - Are You Exposed? 229 The Court therefore looked at whether they had supplied "services"., The Act defines "supply of services" as: any work done or service performed upon or in respect of an improvement, and includes, (a) the rental of equipment with an operator, and (b) where the making of the planned improvement is not commenced, the supply of a design, plan, drawing or specification that in itself enhances the value of the owner's interest in the land... As the recipients of the overhead expenses did not perform services "upon" an improvement, the question became even more narrow: were thee payments made "in respect of' an improvement? The contractor argued that but for the payment of overhead expenses, no work would have been done "upon" the project at all and therefore the payments had to have been made "in respect of' an improvement. O'Connor J.A. disagreed. He reasoned that sections 8(1) and 14(1) provide for a preference of one class of creditor over another that did not exist at common law and therefore that these sections of the Act must be strictly interpreted. He observed that if the recipients of overhead payments were included in the class of beneficiaries, the benefits to the group clearly intended to be within the class would be reduced proportionately and significantly. Consequently, the payment of overhead expenses by Toronto Sanitary for wages, office expenses, rent, legal and accounting fees did not reduce its trust obligations to Rudco. The next case to reach the Ontario Court of Appeal was Dietrich Steel Ltd. v. Shar-Dee Towers (1987) Ltd. 2 Dietrich differed from Rudco in several important respects, but mostly in its equities. The appellant, one of two personal defendants, had taken great pains to comply with the state of the law as it was then known. He set up a segregated account for the project in question and paid only direct, project specific overheads, trades and suppliers out of that account. He caused his development company to seek and obtain a court appointed trustee to complete minor deficiencies and sell the condominium units so as to be certain that the proceeds of sale were distributed fairly among a small group of residual lien claimants. One subcontractor, Dietrich Steel, alone among the group of unpaid subtrades, did not lien, and long after the distribution of holdback funds and the order discharging the court appointed trustee, sued the development company and its officers 2 (1999), 170 D.L.R. (4th) 475, 45 C.L.R. (2d) 178 (Ont. C.A.).

3 230 CONSTRUCTION LAW REPORTS 49 C.L.R. (2d) for breach of trust. With the exception of holdback, all of the invoices submitted by Dietrich had been paid. The case was argued on an agreed statement of facts in which the plaintiff candidly admitted that all funds received by the contractor had been deposited into a segregated bank account and used exclusively to either pay direct construction costs or direct overhead expenses such as insurance coverage, phone services, audit fees, corporate income tax and other taxes, car repairs, leasing charges, and other related items. It was admitted that no money had been used for internal overheads. No money had been used for personal benefit. Dietrich argued that even so, the payment of overheads constituted a breach of the section 8(1)(b) trust: All amounts... received by a contractor or a subcontractor, on account of the contract or subcontract price of an improvement constitute a trust fund for the benefit of the subcontractors and other persons who have supplied services or materials to the improvement who are owed amounts by the contractor or subcontractor. The Court of Appeal dealt with and dismissed the following arguments: 1. If the strict interpretation theory was correct, then statutory construction lien trusts are unique among all trusts in that they require the trustee to personally bear the costs of administration of the trust. The Court of Appeal held that the trusts under Part II of the Construction Lien Act are unique in this respect and are intended to be so. 2. The contractor had at least complied with the policy of the statute by segregating the bank account for the particular project and paying only direct project specific overheads. At the time of the payments there were only two authorities as to whether overhead payments could or could not be paid out of trust and they conflicted. In these circumstances, if the underlying policy of the statute had been met by the corporation then the quasi-criminal penalty of personal liability should not be visited on its officers and directors long after the fact on the state of the law many years later. The Court held that the use of a segregated account did not necessarily preclude either a breach of trust by the corporation or the personal liability of its directors, officers or persons in control. 3. The contractor had done none of the things listed as breaches of trust pursuant to s. 8(2). It had not appropriated or converted trust funds to its own use. It had not applied the funds to any use "inconsistent with" the trust. The previous version of the statute, the Mechanics' Lien Act, until its repeal in 1983, had prohibited payment to uses

4 Breach of Trust - Are You Exposed? 23 1 "not authorized by" the trust. It was argued that the amendment which changed the strict "not authorized by" to the more liberal "in= consistent with" broadened the list of permissible applications of trust money to include "consistent" uses, such as direct project specific overheads. It - was argued that to determine "consistency" one had to look at the purpose or utility of the overheads to the overall project. The Court agreed that the change may have made the section more liberal, but not so liberal as to permit payment for services that were otherwise non-lienable. 4. It was argued that as every payment to every lien claimant includes some component of overhead and profit, it would be consistent with the statute if the same overhead component could be paid by a trustee. This argument was rejected without discussion. 5. Finally, it was argued that the Act should not be "read up" so as to unnecessarily restrict entry of contractors and others into the marketplace. Only independently wealthy businesses can afford to pay all of their overheads out of non-project receipts until all trade payables have been satisfied. The effect of this decision is that small startup contractors will be forced either to operate in knowing breach of trust or go out of business. This policy argument was rejected by the Court. Thus, the Ontario Court of Appeal agreed with the trial judge on all material legal points related to the overhead issue. All overhead payments out of trust funds are impermissible and constitute a breach of trust for which both a corporate trustee and its officers, directors and persons with effective control may be liable. Owners, contractors and subcontractors must find some other source of funds out of which to pay the ongoing expenses of running their businesses until they can be sure all proper payees have been paid in full. As stated by Madam Justice McKinlay in Dietrich Steel, the trust created by the Construction Lien Act is unique and unlike any other trust in that expenses of the administration of the trust cannot be deducted from the income or corpus of the trust itself. These decisions should eventually change the way construction business is done in this Province. Bond premiums, for example, now cannot be paid by the contractor out of the first progress draw, nor can the amount of the bond premium be retained by the contractor out of the first draw, although such an amount is routinely included by the owner. Bond premiums must be funded in some other way

5 232 CONSTRUCTION LAW REPORTS 49 C.L.R. (2d) so that the full amount of the first draw is paid to lienable suppliers of services and materials. For parties concerned with mortgage financing, the question arises as to whether in case of a building mortgage, individual advances which are deemed to have been received by an owner and which constitute a trust fund under section 7 of the Act, become trust funds to the extent of the gross or the net advance. Mortgagees generally have the right to "net out" of any given advance a wide range of fees, charges, interest and costs. This right can arise by virtue of the Standard Charge Terms, wherein such fees, charges and interest comprise a principal debt from the mortgagor to the mortgagee, or they can arise on the commitment itself. The more adventuresome the financing, the more pervasive and substantial the fees and charges. A glance at any condominium construction financing at the time of writing will reveal a seemingly endless series of fees and deductions by "mezzanine" financiers. Consider s. 8 of the Standard Charge Terms, being Land Registry Reform Act filing no. 9320: The Chargee may pay all premiums of insurance and all taxes, rates, levies, charges, assessments, utility and heating charges which shall from time to time fall due and be unpaid in respect of the land, and that such payments, together with all costs, charges, legal fees (as between solicitor and client) and expenses which may be incurred in taking, recovering and keeping possession of the land and of negotiating the Charge, investigating title, and registering the Charge and other necessary deeds, and generally in any other proceedings taken in connection with or to realize upon the security given in the Charge (including legal fees and real estate commissions and other costs incurred in leasing or selling the land or in exercising the power of entering, lease and sale contained in the Charge) shall be, with interest at the rate provided for in the Charge, a charge upon the land in favour of the Chargee pursuant to the terms of the Charge and the Chargee may pay or satisfy any lien, charge or encumbrance now existing or hereafter created or claimed upon the land, which payments with interest at the rate provided for in the Charge shall likewise be a charge upon the land in favour of the Chargee. Provided, and it is hereby further agreed, that all amounts paid by the Chargee as aforesaid be added to the principal amount secured by the Charge and shall be payable forthwith with interest at the rate provided for in the Charge, and on default all sums secured by the Charge shall immediately become due and payable at the option of the Chargee, and all powers in the Charge conferred shall become exercisable. It is obvious in the face of Rudco and Dietrich that a mortgagor who received a gross advance and used the advance to pay insurance, taxes, levies, charges, assessments, utilities and heating bills would be in breach of trust. In view of Rudco and Dietrich the same may also be true of the mortgagee

6 Breach of Trust - Are You Exposed? 233 who capitalizes -such charges and makes a net advance. A mortgage loan officer could easily be held to be a person having effective control for this purpose. The only express statutory authority to make such payments can be found in s. 9 in respect of sale of the premises and in s. 11(2) in respect of the repayment of loans. Section 9, the "Vendor's trust", provides that: (1) Where the owner's interest in a premises is sold by the owner, an amount equal to, less (a) the value of the consideration received by the owner as a result of the sale, (b) the reasonable expenses arising from the sale and the amount, if any, paid by the vendor to discharge any existing mortgage indebtedness on the premises, constitutes a trust fund for the benefit of the contractor. (2) The former owner is the trustee of the trust created by subsection (1), and shall not appropriate or convert any part of the trust property to the former owner's own use or to any use inconsistent with the trust until the contractor is paid all amounts owed to the contractor that relate to the improvement. The vendor's trust attaches to a sum net of, inter alia, "any existing mortgage indebtedness on the premises". By article 8 of the Standard Charge Terms, this would include capitalized "overheads" paid by the mortgagee, but would not include charges, fees and the like paid under the commitment. Section 9, however, is confined to a sale by an "owner" and not by a "mortgagee". It may be arguable then that a mortgagee exercising a sale under power may have to consider its trust obligations. The mortgagee may turn to section 11, which deals with the statutory right to repay advances or loans used for trust purposes. Section 11 (2) limits the permitted repayment to the extent the original advance was used to pay for services and materials. Section 11(2) seems to limit the statutory ability to repay such borrowing to the net advance. In other words, you could repay the principal amount of the loan, to the extent it was used to pay trades, but not the interest or fees associated with the loan. Section 11(2) provides as follows: Application of trust funds to discharge loan Subject to Part IV, where a trustee pays in whole or in part for the supply of services or materials to an improvement out of money that is loaned to the trustee, trust funds may be applied to discharge the loan to the extent that the

7 234 CONSTRUCTION LAW REPORTS 49 C.L.R. (2d) lender's money was so used by the trustee, and the application of trust money does not constitute a breach of the trust. This section has been interpreted strictly to date. 3 The certification of payments also creates an interesting scenario in view of Rudco and Dietrich. When a certificate is issued on a project, a like amount "so certified that is in the owner's hands or received by the owner at any time thereafter" constitutes a trust fund for the benefit of the contractor (s. 7(2)). The long standing authority of Minneapolis-Honeywell Regulator Co. v. Empire Brass Manufacturing Co. 4 and Andrea Schmidt Construction Ltd. v. Glatt 5 establish the proposition of "deemed receipt" whereby an amount equal to the amount of a certified advance in the mortgagee's hands is deemed to be "received", and thus constitute an owner's trust fund. As such certificates are issued and advances are made, the gross certified advance becomes a trust fund whether or not the mortgagee has made set-offs under article 8 of the Standard Charge Terms. On this analysis Rudco and Dietrich Steel may place a mortgagee in breach of trust every time a net advance is made. II. - Personal Liability 1. - Legislative Framework Corporate status alone will not shield persons in control from personal liability for breach of trust in this Province. In 1983, the Ontario Mechanics' Lien Act was amended [rep. by Construction Lien Act, 1983, S.O. 1983, c. 6] to provide for the personal liability of officers, directors and persons in control. Section 13 reads as follows: 13. (1) In addition to the persons who are otherwise liable in an action for breach of trust under this Part, (a) every director or officer of a corporation; and (b) any person, including an employee or agent of the corporation, who has effective control of a corporation or its relevant activities, 3 See Ontario Electrical Construction Co. v. S.L Guttman Ltd. (1997), 104 O.A.C. 232 (Ont. C.A.). 4 [1955] S.C.R. 694, [1955] 3 D.L.R. 561 (S.C.C.). 5 (1980), 112 D.L.R. (3d) 371 (Ont. C.A.).

8 Breach of Trust - Are You Exposed? 235 who assents to, or acquiesces in, conduct that he or she knows or reasonably ought to know amounts to breach of trust by the corporation is liable for the breach of trust. (2) The question of whether a person has effective control of a corporation or its relevant activities is one of fact and in determining this the court may disregard the form of any transaction and the separate corporate existence of any participant. (3) Where more than one person is found liable or has admitted liability for a particular breach of trust under this Part, those persons are jointly and severally liable. (4) A person who is found liable, or who has admitted liability, for a particular breach of a trust under this Part is entitled to recover contribution from any other person also liable for the breach in such amount as will result in equal contribution by all parties liable for the breach unless the court considers such apportionment would not be fair and, in that case, the court may direct such contribution or indemnity as the court considers appropriate in the circumstances. This is a formidable and pervasive remedy. The extension of the remedy in Ontario to "persons in control" greatly assists in the effectiveness of the remedy in this Province. Notwithstanding British Columbia's recent recasting of their statutory trust provisions, that Province has not seen fit to extend liability beyond officers and directors to "persons in control". The amended sections of the British Columbia Builders' Lien Act, 6 proclaimed in force February, 1998, provide as follows: 11. (1) A contractor or subcontractor commits an offence if that person (a) appropriates or converts any part of a fund in contravention of section 10 [trust], or (b) contravenes section 13(2) [garnishment]. (2) A person who commits an offence under subsection (1)(a) is liable to a fine of not more than $ or to imprisonment for a term of not more than 2 years, or both. (3) If a contractor or subcontractor is a corporation, a director or officer of the corporation who knowingly assents to or acquiesces in an offence under subsection (1)(a) by the corporation commits the offence in addition to the corporation. (4)... (5) An information must not be laid in respect of an alleged offence under subsection (1) or (3) more than 3 years after the alleged offence occurred. 6 S.B.C. 1997, c. 45, s. 11(1)-(5).

9 236 CONSTRUCTION LAW REPORTS 49 C.L.R. (2d) Similar provisions in the Ontario Acts were discarded in the 1983 repeal of the Mechanics' Lien Act as it was thought that the criminalization of breach of trust was adequately dealt with in the Criminal Code. It will be interesting to see if the British Columbia sections prove to be a deterrent Case Law The policy behind the legislative scheme for personal liability is expressed in the April 1982 Report of the Ontario Attorney General's Advisory Committee on the Draft Construction Lien Act. 7 The Committee considered a section included in their earlier Discussion Draft dealing with liability of officers and directors. The Committee explained their proposal as follows: This new section was included in the Discussion Draft to prevent the use of a shell corporation as a device for defrauding creditors. The use of such corporations presents a problem in some segments of the construction industry. Section 13 allows the Court to disregard the limited liability of a corporation, and to impose liability upon those who are actually responsible for a breach of trust. The words "assents to or acquiesces in" in subsection I are intended to convey that only those who had the power to prevent a breach of trust are to be found liable under this section. The section replaces the penal provision of the Mechanics' Lien Act, contained in subsection 3(7). This type of provision is unnecessary in light of section 296 of the Criminal Code which makes it an indictable offence, punishable by up to fourteen years imprisonment, to convert trust funds with an intent to defraud. Where there is no intent to defraud, the civil liability for breach of trust should be sufficient to rectify any such breach. It is significant to note that subsection 3(7) of the present Act has rarely been used, even though it has been in force for over twenty years. Subsection 13(3) of the Discussion Draft adopted by reference the relevant provisions of the Negligence Act for the purposes of determining degrees of fault and apportionment of liability in an action for breach of trust. The Committee decided that section 13 should be expanded to explicitly deal with all aspects of a breach of trust under the Draft Act, without reference to other legislation. In addition, the Committee was of the view that the adopted provisions of the Negligence Act were inappropriate. Therefore, two new proposed subsections have been added to deal with liability for breach of trust and apportionment of compensation payable. Subsection 13(3) now expressly provides for the joint and several liability of persons found liable for a breach of trust. Subsection (4) then imposes an obligation on the parties to the breach to share equally the burden of compensation, unless the Court considers some other apportionment more appropriate in the circumstances of the particular case. 7 Report of the Attorney General's Advisory Committee on the Draft Construction Lien Act, 1982; reprinted in D.W. Glaholt, D. Keeshan, The 1999 Annotated Construction Lien Act (Toronto: Carswell, 1998) at 302 et seq.

10 Breach of Trust - Are You Exposed? 237 The Court adopted the essence of this reasoning in St. Mary's Cement Corp. v. Construc Ltd. 8 There, Molloy J. held that: The intention of the legislation was to set up a trust with respect to moneys received from owners in favour of unpaid trades. It would be inconsistent with that intention if individuals who by their conduct defeat the trust were not liable for breach of trust in the same manner as the corporate vehicles they control. It had initially been thought that an element of mens rea was required on the part of an officer or director against whom personal liability was claimed under section 13 of the Construction Lien Act. 9 This is not so. The contrary result was reached in Home Depot Inc. v. Fieder Painting Inc., 10 which held that section 13 had created its own standard by the words "knew or ought to have known", leaving no room for a requirement of mens rea. There is now further authority to the same effect. I l The weight of authority rejects any reading of section 13 that introduces a requirement of mens rea. In St. Marys Cement Co. v. MacDonald, 12 the Court held that direct dealings by officers and directors need not be proven to establish personal liability under section 13(1) of the Construction Lien Act. In the November, 1998, decision of Tam-Kal Ltd. v. Stock Mechanical Inc., 13 Ground J. rejected counsel's submission that the test under s. 13 was subjective: I reject such submission. The test in the statute is disjunctive i.e. "knows or reasonably ought to know". It seems to me that the second wing of the test must necessarily depend upon an objective analysis as to what a reasonable person ought to know in the circumstances. It is particularly significant in our case that [the personal defendant] was the chief executive officer of [the corporate defendant] and presumably the person responsible for making decisions as to payments to suppliers and others. 8 (1997), 32 O.R. (3d) 595, 33 C.L.R. (2d) 234 (Ont. Gen. Div.). 9 Steeplejack Services (Sarnia) Ltd. v. Stowe Nut & Bolt Co. (1988), 31 C.L.R. 115 (Ont. Dist. Ct.). 10 (1995), Kirsh's C.L.C.F (Ont. Gen. Div.). "Heritage Masonry Ltd. v. Building Team Ltd. (1995), 28 C.L.R. (2d) 101, 5 O.T.C. 53 (Oat. Gen. Div.). 12 [1995] O.J. No (Ont. Gen. Div.). 13 (1998), 43 C.L.R. (2d) 94 at 116 (Ont. Gen. Div.); aff d [1998] O.J. No (Ont. C.A.).

11 _ 238 CONSTRUCTION LAW REPORTS 49 C.L.R. (2d) After reviewing the decisions in Andrea Schmidt Construction Ltd. v. Glatt 14 and G. V.B.S. Inc. v. Hydro Guard Inc., 15 Ground J. held that: I must conclude that a person in the position of [the personal defendant] with his years of experience in the construction industry and being the chief executive officer of [the corporate defendant], on any reasonable person test, ought to have known that the payments referred to above, which I have disallowed as payments to trust, funds beneficiaries, were improper payments out of trust funds and that accordingly [the personal defendant] has personal liability for breach of trust pursuant to ss. 13(1) of the C.L.A. to the extent of the amount paid by [the corporate defendant] which were improper applications of trust funds. The Ontario Court of Appeal has now made it clear that mere status as an officer, director or person in control will not be sufficient to attract liability for breach of trust. In Dietrich Steel Ltd. v. Shar-Dee Towers (1987) Ltd., 16 a company was found to have breached the trust provisions of the Act. The case had proceeded on an agreed statement of fact, which, on this point, merely stated that the personal defendants were officers and directors of the trustee corporation. McKinlay J.A., for the Court, held that: From the Agreed Statement of Facts it is not clear that the personal defendants did have "effective control of a corporation [Shar-Dee] or its relevant activities" within the meaning of s. 13(1)(b) of the Act. We do know that both were directors and officers. However, neither being an officer and director, nor being a person with "effective control of a corporation or its relevant activities" is sufficient to satisfy the requirements of s. 13(1). To be liable under that provision, it is also necessary to show that the personal defendant is one "who assents to, or acquiesces in, conduct that he or she knows or reasonably ought to know amounts to breach of trust by the corporation". There were no such facts included in the Agreed Statement of Facts. While the finding of the company's liability was upheld, the judgment against the personal defendant was set aside. 17 What, then, constitutes assent or acquiescence in a breach of trust? The December 1, 1998, decision of the Ontario Court of Appeal in Don Park Inc. v. S.E. Mechanical Engineering Ltd. 18 gives some assistance. The plaintiff had supplied sheet metal to the defendant company and the defendant company had supplied the material to Mersin, the sole shareholder and officer 14 (1979), 25 O.R. (2d) 567 (Ont. H.C.), affirmed (1980), 28 O.R. (2d) 672 (Ont. C.A.). 15 (1998), 40 C.L.R. (2d) 272 (Ont. Gen. Div.). 16 (1999), 170 D.L.R. (4th) 475, 45 C.L.R. (2d) 178 (Ont. C.A.). 17 For a lower court decision to the same effect, see Pro Caissons Ltd. v. M & M Contracting Co. (1998), 43 C.L.R. (2d) 87 (Ont. Gen. Div.). 18 (1998), 43 C.L.R. (2d) 7 (Ont. C.A.).

12 Breach of Trust - Are You Exposed? 239 of which was the son of the officers and shareholders of S.E. S.E. invoiced Mersin for the material, charging exactly what it had been charged by the plaintiff. Mersin was involved in the construction of two schools. When it completed its work and was paid, it paid S.E. invoices. S.E. deposited the money into a commingled general account and used the money to pay trades on other projects, leaving the plaintiff unpaid. Among the payments made, $13,000 went to Mersin for an unrelated project. The trial judge held that the corporate defendants as well as the personal defendants were liable for breach of trust. Evidence showed that both personal defendants of S.E. played a very active role in Mersin's affairs, particularly in relation to the school projects in issue. The father actually hired the site foreman for Mersin, while the mother did administrative work and at one point signed a cheque from Mersin to S.E. While Mersin and its sole shareholder and officer had no direct relationship with the plaintiff, the Court held that his father's knowledge of the source of the material ought to be ascribed to both companies. The son knew or ought to have known of his father's activities on behalf of Mersin, including his part in the breach of trust. The Court of Appeal saw no reason to interfere with this judgment and dismissed the appeal. This case marks the first time in many years that privity of contract was not required to support a trust claim. The decision of the Court of Appeal is unsupported by detailed reasons and should not be taken as an endorsement of the proposition that privity is not required to support a trust claim, but the door is open. There are many Ontario cases in which individuals have been held liable as directing minds of their corporations. In Colella Excavating Ltd. v. All Types Excavating & Grading Inc., 19 however, the individual defendant was held liable under section 13 as much because of the attitude he displayed on the stand as anything else. In his evidence, he: [Betrayed] the attitude that has resulted in the breach of trust. He demonstrates that he has no regard for the rights of his subcontractors under The Construction Lien Act and he totally ignores any Construction Lien Act obligations to them. He proclaimed arrogantly that his subs know that when he gets paid, they get paid. That is not the basis of the Act. Such conduct can be most disadvantageous. In another case it might be a short step from such conduct to a finding of sufficient mens rea to warrant prosecution for criminal breach of trust under section 336 of the Criminal Code. 19 (1997), 34 C.L.R. (2d) 132 (Ont. Gen. Div.).

13 240 CONSTRUCTION LAW REPORTS 49 C.L.R. (2d) There are also cases in which the personal involvement of the defendant has been found insufficient to justify personal liability. In one such case, 20 the wife of a principal officer and director was relieved of liability for breach of trust, because apart from entering data into a computer and responding to requests for information, she played no part in the actual operation of the company. Although she undoubtedly enjoyed some of the financial benefits flowing from the company, it could not be said that she knew or ought to have known that the conduct of the company involved a breach of trust. Any element of personal benefit in a breach of trust case is usually sufficient to attract personal liability. 21 The problem of personal liability for corporate breach of trust is particularly acute with closely held corporations, where the dividing line between that which is corporate and that which is personal is easily blurred. In such cases, breach of trust is not always a matter of greed, it may simply be a matter of bad accounting. For example, in Jacobson v. Basile's Developments Ltd., 22 the owner advanced money to the defendant contractor, a closely held corporation. The corporation advanced a portion of those funds to its shareholder and director for doing work on the contract. The project failed and the owner sued for an accounting. It was held that the company's advances to its shareholder were not proper expenditures even though that person had actually done work and contributed value to the project. The individual behind the closely held corporation was held liable for breach of trust together with the corporation. In another British Columbia case involving a closely held construction company, 23 the sole officer and director managed one general corporate bank account through which all the company's money and trust funds were channeled. When the company ran into financial difficulties, the bank applied the balance in the account in partial satisfaction of the company's operating loan. The trade creditors were left to their remedies. A supplier eventually obtained a judgment upon which it could not collect. The sup- 20 J. (Jim) Quinn Plumbing Ltd. v. Avtec Engineering Inc. [1997] O.J. No. 17 (Ont. Gen. Div.). 21 Andrea Schmidt Construction Ltd. v. Glatt (1979), 25 O.R. (2d) 567, 104 D.L.R. (3d) 130 (Ont. H.C.), affirmed (1980), 28 O.R. (2d) 672, 112 D.L.R. (3d) 371 (Ont. C.A.). 22 (1983), 45 B.C.L.R. 199 (B.C. S.C.). 23 Henry Electric Ltd. v. Farwell (1985), 11 C.L.R. 67 (B.C. Co. Ct.), affirmed (1986), 22 C.L.R. 28 (B.C. C.A.), leave to appeal refused (1987), 75 N.R. 160 (note) (S.C.C.). See also Horsman Brothers Holdings Ltd. v. Panton, [1976] 3 W.W.R. 745 (B.C. S.C.); J. (Jim) Quinn Plumbing Ltd. v. Avtec Engineering Inc. [1997] O.J. No. 17 (Ont. Gen. Div.).

14 Breach of Trust - Are You Exposed? 24 1 plier sued the sole shareholder for breach of trust. The sole shareholder of the defendant corporation was held liable. Although the defendant did not directly or deliberately breach the trust provisions of the British Columbia statute, he had allowed trust money to be co-mingled with other funds in the company's general account and therefore ran the risk of withdrawal by a third party, such as the bank, for a purpose inconsistent with the trust. This was sufficient to attract liability. It was held to be not relevant that the director acted innocently, since liability was not based on mental state but on how the trust fund was actually dealt with. It appears from this line of cases that it is particularly necessary for closely held corporations to implement adequate accounting controls, or else lose the protection of limited liability. Inadequate or unsophisticated accounting practices can make conduct appear indistinguishable from an act of greed. In the Manitoba case of Wilson v. Parkin Enterprises Ltd., 24 the personal defendants were officers and directors of the defendant construction company. In what appeared to be the ordinary course of business, progress payments were deposited into a general account and drawn on for general purposes as well as for the payment of trades. The theory of the personal drawings on this account was that they represented reasonable compensation to the principals of the company for services they had provided to the projects in question. Upon closer scrutiny, however, it was found that the defendants' course of business was far from ordinary. Not only had they failed to set up separate accounts for progress payments, they had also blended draws from many projects, and had made direct payment of bills for the construction of the personal defendants' private residences and direct payments to mortgagees on the personal defendants', homes. This direct link to the personal defendants' homes allowed the plaintiff to seek and obtain certificates of lis pendens and eventual sale of those properties. The Court considered sections 4(1) and (3) of the Manitoba Builders' Liens Act, 25 which codified the trust provisions with respect to monies in the hands of contractors, and particularly section 27(5) thereof: Where the person primarily liable for payment under a contract is a corporation, and that person makes payment under the contract without deducting and retaining the holdback in accordance with this Act, if the corporation is unable to satisfy the liability under subsection (2), the directors and officers of the corporation who knowingly assented or acquiesced in the failure to deduct or retain the holdback are jointly and severally liable for the amount for which the corporation is liable under subsection (2) and which the corporation fails to satisfy. 24 (1988), 32 C.L.R. 63 (Man. Q.B.). 25 R.S.M. 1987, c. B91, C.C.S.M. c. B91.

15 242 CONSTRUCTION LAW REPORTS 49 C.L.R. (2d) The liability of the personal defendants in this case was not limited to the value of the holdback, but extended to all improper payments. The Court adopted the reasoning in Scott v. Riehl, 26 holding that where the conduct of an officer or director goes beyond mere negligence or mistake in judgment and consists of a wrongful act knowingly done, that director may be directly liable to third parties. In short, where a person is an active party to an improper disposition of trust property, although not actually a trustee, that person is liable for breach of trust. Personal liability may follow even the smallest amounts of money. In one reported case, the president of a corporate defendant was found personally liable for breach of trust simply by having used $1,000 of progress monies to pay for hotel bills for his workers. 27 The relative sophistication of the officers and directors in question can also be a relevant consideration in the application of a "deemed knowledge" standard of liability. In Shield Sprinkler & Fire System Ltd. v. Fahuki Construction Inc., 28 for example, the directors of the general contracting corporation were found to be well educated and well experienced in the construction industry. Accordingly, it was held that the directors knew or ought to have known that the payment of funds received from the owner towards their company's own overhead expenses would constitute a breach of trust as long as subcontractors remain unpaid. The directors were found jointly and severally liable together with their corporation. Obviously, the question of personal liability for overhead payments out of trust funds has become even more acute in light of the recent Dietrich Steel and Rudco decisions in the Ontario Court of Appeal. 26 (1958), 25 W.W.R. 525, 15 D.L.R. (2d) 67 (B.C. S.C.). 2 7 Acme Commercial Painting (Victoria) Ltd. v. Hoju Holdings Ltd. (1984), 5 C.L.R. 66 (B.C. Co. Ct.). 28 (1996), 30 C.L.R. (2d) 156 (Ont. Gen. Div.).

16 Breach of Trust - Are You Exposed? 243 III. - Criminal Liability for Breach of Trust 29 The Criminal Code 30 provides for criminal liability for breach of the Construction Lien Act trusts in section 336, under the heading "Offences Resembling Theft": Every one who, being a trustee of anything for the use or benefit, whether in whole or in part, of another person, or for a public or charitable purpose, converts, with intent to defraud and in contravention of his trust, that thing or any part of it to a use that is not authorized by the trust is guilty of an indictable offence and liable to imprisonment for a term not exceeding fourteen years. The section has survived a Charter challenge. In R. v. Sopko, 31 the accused moved for a declaration that section 336 of the Criminal Code was inconsistent with the Charter of Rights and Freedoms and the Constitution Act. It was argued that since no more than five provinces have statutory trust provisions, the Criminal Code unjustly identified conduct which would constitute an offence in some provinces, but not in others. This was said to result in an inequality which amounted to a deprivation of liberty or security of the person other than in accordance with the principles of fundamental justice, contrary to section 7 of the Charter. The Court rejected this argument: [T]he purported inequality in the application of Sec. 336 does not in fact exist. This section stipulates that anyone, and I say parenthetically, (wherever he or she lives), is guilty of an indictable offence If (sic) he or she converts with the intent to defraud and in contravention of a trust, the trust property to a use that is not authorized. Who is a trustee will depend on the facts of each case. A person may be a trustee by reason of an act of Parliament, an act of legislature or the common law. Someone may, of course, be a trustee pursuant to a deed or will or a parole arrangement. In determining who is a trustee, differences may arise from province to province. Those differences may, as in this case, come about because of differences in the statute law of the provinces, because of the differences between the common law and the civil law of Quebec,... the law will apply to that person in exactly the same way, no matter where he or she lives. A second argument made on behalf of the accused was that Section 133 of the Constitution Act, 1867, 32 required Acts of the Parliament of Canada and of the Legislature of Quebec to be printed and published in both English and French. It was argued that the Criminal Code incorporated by reference 29 This section first appeared in Duncan W. Glaholt, Construction Trusts: Law & Practice (Toronto: Carswell, 1999) and is reprinted by permission of Carswell, a division of Thomson Canada Limited. 30 R.S.C. 1985, c. C [1990] M.J. No. 68 (Man. Q.B.). 32 Constitution Act, 1867.

17 244 CONSTRUCTION LAW REPORTS 49 C.L.R. (2d) legislation of various provinces which at that time were published only in English and therefore section 336 must be regarded as partly unilingual, contrary to section 133 of the Constitution Act. This argument was also rejected: I am aware an accept without hesitation the admonitions that have been made in various decisions about the fundamental nature of Canada's linguistic duality, and of the special care which Courts must take to be faithful to the guarantees that have been enshrined in the Constitution and the Charter. This appreciation does not however require or even allow the good sense and practicality to be ignored. Cases involving the criminal breach of the statutory construction trust tend to be immensely time consuming. In R. v. Sopko, 33 the trial Judge noted that the trial lasted for the better part of three weeks, with twenty-three witnesses and three volumes of exhibits. Closing argument in that case alone took two days to present. In R. v. Nicolaides, 34 it was noted by the trial Judge that the case occupied thirty days of trial time during which the defendant was represented by counsel, and a further eighteen days during which the defendant represented himself. The trial involved sixty-one witnesses, forty-one for the Crown and twenty for the defence, four large cartons of documents comprising thousands of pages and final submissions both orally and in writing. The defendant corporation in R. v. Nicolaides was charged with criminal breach of the trust found in section 6(1) of Ontario's 1980 Mortgage Brokers Act. 35 This section provided that all funds received by a mortgage broker in connection with mortgage transactions other than those which are clearly made as a payment for fees earned shall be deemed to be trust funds. Generally speaking, in each of the counts against the defendant it was established that the various loan deposits were not used directly in regard to the procurement of the loan applied for but were spent on matters completely unrelated to the loan application. In each instance the defendants did not place their deposits in a trust account, but rather placed them in a general account. The trial Judge found that the elements of the offence created by then section 296 of the Criminal Code were as follows: 1. The accused must be in possession of property as a trustee for the use or benefit of another person; 33 (1991), 74 Man. R. (2d) 34 (Man. Q.B.). 34 [1987] O.J. No (Ont. Dist. Ct.). 35 R.S.O. 1980, c. 295.

18 Breach of Trust - Are You Exposed? The accused must have converted part of the property to a use not authorized by the terms of the trust; 3. The accused must have converted the property with intent to defraud and in violation of the trust. The form of the indictment in such cases is critical. The appeal in R. v. Rosen 36 was eventually successful because the accused individual had been charged with the substantive offence as a trustee whereas the actual statutory trustee was the company he controlled. The Crown had failed to prove that the personal defendant was the actual trustee of the funds. The convictions for fraud and theft stood. At trial in R. v. Rosen, it had been held that the accused had deliberately ignored his construction trust duties by knowingly diverting mortgage advances designated to pay suppliers and workmen. It was found that the accused had intended from the very start to divert this mortgage money. When he caused his company to borrow the money, he deliberately failed to disclose his intention to divert the subsequent advances and in so doing committed a fraud. It appeared that the accused had regarded his corporation's mortgage advances as a secret source of ready cash for the corporation to avoid bankruptcy on other unrelated projects. Although these "loans" were openly placed on the accused's books and shown as loans, they constituted nothing more than an attempt to disguise fraudulent acts. The accused's active diversion of funds to other companies controlled by the accused when the accused knew that these companies were bankrupt and had no reasonable hope of repaying the so-called loans constituted theft. The accused's persistent diversion of those funds elsewhere after he knew there was no reasonable hope of repayment was also sufficient to prove fraud. The Crown can charge an individual aider and abettor with the substantive offence of breach of trust provided that the accused knows the basis upon which the Crown is proceeding. 37 It is also true that an individual officer, director or person in control may be convicted as an aider and abettor even if the corporation itself has not been convicted of the offence in its capacity as trustee (1979), 12 C.L.R. 91 at 96, 55 C.C.C. (2d) 342 (Ont. Co. Ct.), affirmed (1980), 55 C.C.C. (2d) 342n (Ont. C.A.), reversed in part, [1985] 1 S.C.R. 83, 12 C.L.R. 91, 44 C.R. (3d) 232, 16 C.C.C. (3d) 481, 57 N.R. 13, 15 D.L.R. (4th) 317 (S.C.C.). 37 R. v. Harder, [1956] S.C.R. 489 (S.C.C.). 38 R. v. Zanini, [1967] S.C.R. 715 (S.C.C.).

19 24 6 CONSTRUCTION LAW REPORTS 49 C.L.R. (2d) The question of intent in R. v. Rosen was resolved by applying the wellestablished principles in R. v. Belanger 39 and R. v. Hammerling4 0 To constitute an offence, the unauthorized use of money must have occurred with the intent to defraud and in violation of the trust. The nature of this intent has been described as being "somewhat limited and directed to the trust duties" 41 and is contrasted with the kind of intent to defraud that is an essential element of theft. There was no necessity for the Crown to prove that the accused actually intended to cause detriment to a specific beneficiary. There is also no need to prove that the intent to defraud, when carried into effect by the accused, actually resulted in loss to any beneficiary. Indeed, in R. v. Hammerling, where the accused intended to and did in fact repay the monies which had previously been put to an unauthorized use such that there was no suffering or economic loss, it was sufficient that the accused had intended to defraud within the meaning of section 3(6) and the accused were convicted. Restitution may not bar conviction, but it can be a factor in the sentencing process. In R. v. Manolescu, 42 the accused was convicted of unlawfully converting, with an intent to defraud, trust monies totalling $349, contrary to section 336 of the Criminal Code. No restitution was made. The Court considered the following factors in sentencing the defendant: 1. Absolutely clear breach of trust; 2. High degree of moral culpability; 3. Planning and deliberation to create a complex scheme; 4. Illegal scheme conducted over a lengthy period; 5. Significant number of illegal transactions; 6. Large amount of money involved; 7. Damage to profession; 8. Damage to business reputation of the Province and of Canada. In this case mitigating factors were argued and the accused received a sentence of three and one half years imprisonment. In another example, the 39 (1925), 44 C.C.C. 129 (Que. K.B.). 40 [1981] 4 W.W.R. 741, 9 Man. R. (2d) 86 (Man. C.A.), affirmed [1983] 2 W.W.R. 193, (1982), 45 N.R. 135, 18 Man. R. (2d) 179 (S.C.C.). 41 R. v. Petricia (1974), 17 C.C.C. (2d) 27 (B.C. C.A.). 42 (1997), 202 A.R. 241 (Alta. Prov. Ct.).

20 Breach of Trust - Are You Exposed? 24 7 defendant fled the country with a sum of trust money, leaving a large sum owing to trades. 43 As the Ontario Court of Appeal observed, the defendant's conscience eventually drove him back to Canada some years later to plead guilty to charges under then sections 294(a) and 338 of the Criminal Code. The accused was sentenced to two.years less a day in prison, followed by a term of probation of three years. The probation order included an order for full restitution. On appeal, the Ontario Court of Appeal agreed with the term of imprisonment and noted that the defendant was to be deported immediately upon his release. In such circumstances, the Court held that it was improper to make a probation order for a period of three years in addition to the restitution order. 43 R. v. Hudson (1981), 65 C.C.C. (2d) 171 (Ont. C.A.).