Alberta court clarifies tracing principles in Ponzi schemes

The exposure of an alleged Ponzi scheme that deprived investors of over $80 million has helped clarify how trust funds deposited in a single bank account should be distributed to their beneficiaries.

The Alberta Court of Appeal in Easy Loan Corporation v Wiseman, 2017 ABCA 58 (the Appeal) recently upheld Justice Yamauchi’s decision in Easy Loan Corporation v Base Mortgage & Investments Ltd, 2016 ABQB 77 directing that investor funds held in trust that are commingled in one account should, subject to certain exceptions, be distributed according to the lowest intermediate balance rule (LIBR), unless the rule is unworkable or the beneficiaries of the funds agreed to another method of distribution.


Background

The alleged Ponzi scheme that led to this Appeal incited investors to invest in a company, Base Finance Ltd., on the false understanding that they would be the beneficial holders of mortgages on land in Alberta. In reality, Base Finance used investor funds to maintain interest payments and principal redemption requirements and invested the bulk of the funds in a US company. The Royal Bank of Canada (RBC) raised concerns about an account held by Base Finance with the Alberta Securities Commission, which later commenced an investigation into the alleged $83.5 million Ponzi scheme. The account, which RBC subsequently froze, held around $1.085 million of investor funds. The court appointed a receiver over Base Finance’s assets, including its RBC account.

Chambers’ decision

In chambers, Justice Yamauchi found that the frozen funds in the RBC account were subject to a constructive trust, meaning that the investors whose funds were pooled in the account could benefit from a proprietary remedy – tracing – to recover their funds. The method of distributing these funds became the subject of the Appeal.

In his decision, Justice Yamauchi rejected Easy Loan’s (the Appellant) argument that the funds should be allocated to the investors wronged by the alleged Ponzi scheme in proportion to the size of their investment with set-off for amounts already recovered. Rather, the court sided with the remaining investors (the respondents in the Appeal) in concluding that the funds should be distributed according to the LIBR. This rule limits the amount that a claimant can recover to the lowest balance in an account subsequent to the claimant’s investment but before the next claimant invests in the same account. Justice Yamauchi applied this method by finding that the LIBR is the general rule in Canada unless applying it is practically impossible. Easy Loan appealed Justice Yamauchi’s method of distribution that, due to the timing of the Appellant’s investment, left Easy Loan with $309.95 out of the $5.7 million it had invested in Base Finance.  

Decision on appeal

The Court of Appeal upheld Justice Yamauchi’s method of distributing the funds based on the LIBR. In reaching this decision, the court first examined the three methods currently used to trace commingled trust funds deposited in a bank account: (1) the rule in Clayton’s Case, (2) the pro rata approach, and (3) the LIBR.

The rule in Clayton’s Case is also known as the “first in, first out” rule. This rule provides that the first funds to be deposited into a commingled account are the first to come out. However, the application of this rule in Canada is unsettled, and, given agreement by the parties, the Court of Appeal proceeded on the basis that the rule in Clayton’s Case did not apply.

The pro rata approach divides the balance of the commingled account between the claimants according to the size of their investment.

Under the LIBR, a beneficiary cannot trace his or her investment in a commingled account once the account balance drops below the amount of his or her investment. Rather, beneficiaries of commingled trust funds under this rule are limited to the lowest balance in the account following their contribution. The Court of Appeal provided a helpful example to navigate this rule:

if X deposits $100 to a commingled account and the balance in the account later drops to $5, the most X can claim is $5, the lowest balance in the account; the ability to trace to anything more than $5 is lost because anything more comes from a funding source other than X. "Intermediate" refers to the period between X's contribution and when X makes the claim against the account. Once the lowest intermediate balance is determined for each beneficiary, each beneficiary is entitled to claim only the lowest balance's proportional share of the final balance of the account.

Determining which rule to apply, according to the Court of Appeal, must be considered in light of the equitable principles of fairness and justice in specific circumstances, balanced against the necessity for practicality and workability.

After surveying the leading decisions in Canada on the subject, stemming exclusively from Ontario, the Court of Appeal concluded that the “LIBR is the general rule for allocating funds among innocent beneficiaries when there is a shortfall in a trust account or in an account that has been impressed with a constructive trust by operation of law” (para 57). This general rule, according to the court, is subject to two exceptions: (1) where the LIBR is unworkable in that the calculations would be too complex to be properly executed or (2) where the beneficiaries expressly or impliedly intended another method of distribution.

The court noted that the LIBR will not be workable where the commingled account has many contributors, there are no supporting documents or the timeframe of the contributions is lengthy. These issues did not arise in this case. Only 20 of Base Finance’s 240 investors contributed to the RBC account, which only remained open for one year. Such relatively straightforward facts are not generally found in cases of commingled funds subject to a Ponzi scheme. Rather, these schemes commonly involve many contributors who invest over a lengthy period of time. Courts determining the method of distribution of commingled funds stemming from a typical Ponzi scheme may therefore opt against applying the LIBR in favour of a different, more workable approach given the complexity of the calculations that these cases would likely require.

The court did not find that any of these exceptions existed in the circumstances. It concluded the LIBR was workable given that Justice Yamauchi issued an order directing the amount that would be distributed to the beneficiaries using the LIBR. The court also found that there was no evidence in this case suggesting that the investors had agreed to a particular method of distribution.

Take-away

The Court of Appeal’s decision in Easy Loan Corporation sets a significant – and potentially fairly restrictive – precedent in Alberta by affirming the LIBR is the “general rule” for distributing commingled trust funds to beneficiaries, subject to certain exceptions. The decision reaffirms that the potential inconvenience of applying this method for allocating funds will not bar its implementation. The interests of fairness in applying this method of allocating traceable commingled funds, according to the court, will trump any inconvenience that falls short of unworkability.

In essence, this case upholds the principles of tracing by finding that the general rule (i.e., LIBR) precludes early investors from unfairly benefitting from the funds of a later investor. The case reminds investors that the timing of their investment may dictate the amount of their claim as funds cannot be traced when they are no longer present in the account. The fact that Ponzi schemes generally implicate many investors and operate over many years, however, may temper the applicability of the LIBR as the general rule for distributing pooled trust funds. Accounts subject to a typical Ponzi scheme could likely render the LIBR practically unworkable in most circumstances to require the imposition of a different method of distribution.

Given the nature of Ponzi schemes, it is also unlikely that defrauded investors could agree to an intended method of distribution prior to making their investment. However, victims of a Ponzi scheme should be aware that once the scheme has been uncovered, they can collectively agree to an intended method of distributing the pooled funds as a first step to the recovery process. This agreement can be facilitated by joint legal representation of the implicated investors and can mitigate the investors’ chances of having a court impose a tracing rule that may not be beneficial for all investors.


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