Beware of the constructive trust

The existence of trusts that may be connected to a borrower’s assets can be a lending hazard. They do not appear on PPSA search print-outs and, in many cases, they are not shown on a borrower’s financial statements and cannot be searched through traditional due diligence methods. Yet they have the ability to take assets out of a borrower’s borrowing base or asset pool available to secured creditors, and thereby have the potential to deliver a nasty surprise to a lender realizing on its security.¹

One type of trust that can come out of the woodwork is a constructive trust, which is a claim that can be made by an unsecured creditor over specific assets of a borrower. It is traditionally a claim based upon the wrongful conduct of a borrower, or based upon the unjust enrichment of a borrower or someone claiming through that borrower, like a secured lender.

In Alrange Container Services, an unsecured creditor (Textainer) challenged the distribution of the estate of a bankrupt borrower (Alrange) to its sole secured creditor (306 Ontario). Alrange was in the business of storing shipping containers for various customers. It also serviced, refurbished, bought and resold those containers.² Textainer was a lessor of shipping containers and had entered into an arrangement for the storage and servicing of some of Textainer’s containers in Alrange’s yard. When Alrange encountered some severe financial difficulties, it allegedly sold some of Textainer’s containers without Textainer’s consent. Textainer claimed that Alrange was unjustly enriched by the sale of Textainer’s containers. It argued that but for Alrange’s use of the proceeds generated by these unauthorized sales to maintain its day-to-day operations, Alrange’s business would have failed sooner and would not have generated some of the accounts receivable that were ultimately collected by the receiver for 306 Ontario’s benefit.³

Textainer successfully argued that a constructive trust should be imposed over a portion of the proceeds of the unauthorized sale of its assets located in Alrange’s yard. Fortunately for the secured lender however, the Ontario Court of Appeal placed some fairly strict limits on the imposition of such a constructive trust in a commercial context (as opposed to a family law context in which constructive trusts frequently arise).

The Court held that in order for a constructive trust to be imposed, the property that becomes subject to the trust must be closely connected or linked to the loss suffered by the plaintiff and/or the benefit gained by the defendant.⁴ In the absence of that clear and direct connection, the Court was of the view that the imposition of the constructive trust would unfairly compromise the legitimate interests of secured creditors in funds held by a receiver.⁵

Ultimately Textainer was only able to meet the test established by the Court to successfully impose a constructive trust over the proceeds of five of the 127 containers alleged to have been sold without Textainer’s consent. There was forensic accounting evidence to show that the proceeds from the sales of these five containers were still in Alrange’s account at the time of the receivership order obtained by 306 Ontario.

The Court reconfirmed earlier case law that had established that a constructive trust attaches to specific assets that represent the enrichment, and that it is not a general charge on the general assets of the bankrupt for the amount of the plaintiff’s claim.⁶ Thus it held that any connections between the proceeds of the sale of the other 122 containers in dispute that occurred over a period of time and the funds sitting in the bankrupt’s bank account at any particular time were far too remote and indirect to justify the imposition of a constructive trust over any other funds.⁷ The commingling of funds made the tracing of specific proceeds extremely difficult.

Although claims for the imposition of a constructive trust can potentially trump the security of a secured lender by taking the assets subject to the trust out of a borrower’s borrowing base, it is comforting to know that the courts will apply a stringent test to the establishment of any such claim. Lenders should however keep these potential claims in mind in structuring their facilities, and in particular defining and setting the borrowing base formula, if the nature of the borrower’s business is likely to generate these types of claims.