The Court of Appeal of Ontario recently made an interesting ruling concerning who ranks first in trying to recover from a fraudster. In the case, DBDC Spadina v. Walton, et al., the defendants (known as the Waltons) convinced investors to invest with them in various commercial real estate projects. They would claim they were investing equal amounts with their victims, but in fact would use the investment from one project to invest in the next one – never actually investing any of their own money.
The Waltons had taken money from Investor 1 and entered into an equal shareholding agreement with him in a corporation that held a property. The Waltons never invested any money with Investor 1, but instead basically took his money, heavily leveraged the properties in question, and then used his money to provide the funds necessary to enter into an agreement with Investor 2.
The court had to consider, among other legal issues, the doctrine of “knowing assistance” – where a stranger, with actual knowledge, participates or assists a trustee or fiduciary in a fraudulent and dishonest scheme. Here, the companies that were part of the fraud against Investor 2, were 50% owned by Mrs. Walton along with Investor 2. Investor 1 therefore wanted to trace his money into the second scheme and get it out. Of course, Investor 2 also wanted his/her money out – but there was not enough to pay them both back. So what does the court do when you have two equally innocent parties who both want their money back from fraudsters?
The initial judge who heard the matter felt that Mrs. Walton was not the directing and controlling mind of the second group of companies and so Investor 1 could not have judgment against them – therefore, that money would stay available for Investor 2. Since Mrs. Walton was only a 50% shareholder, she had no right to involve the second group of companies in her fraud.
But the Court of Appeal disagreed and felt that it was not the fact that Mrs. Walton did not have the right to do what she did with the second group of companies, but it was the reality of the situation that mattered most. The Court of Appeal found that Mrs. Walton was acting “within the field of operations assigned to her” with respect to those second group of companies. Mrs. Walton, who had permission to run the second group of companies (though obviously not to defraud the other shareholders) had therefore caused those companies to participate in her fraud.
As she was the only one who did anything or made any decisions for the second group of companies, then she was their directing and controlling mind regardless of the fact she was engaging in fraud. The Court of Appeal even found that the test is whether a directing mind is acting within the scope of her authority and the fact that she had no authority from the other shareholders to commit fraud against Investor 1 was irrelevant.
Thus, the Court of Appeal felt that the second group of companies had provided “knowing assistance” to the fraud and so should be liable to Investor 1. Obviously, this conclusion seems very unfair to Investor 2 who did nothing wrong. The decision is long and complicated and it should be noted that there was a vigorous dissent from a judge who did not agree. But it is very important for anyone investing on a passive basis to understand that in certain circumstances their investment could be lost due from the misdeeds of a partner, despite no knowledge or misdeed of their own.
This type of situation might be prevented by a properly worded shareholder agreement that limits the active shareholder only to actions that were legal. So once again, I would urge anyone considering entering into any partnership, joint venture, or joint shareholder arrangement to do their due diligence, know who you are dealing with, and most importantly, consult with an experienced corporate lawyer. Otherwise, you might end up in my office litigating and potentially losing everything.
The foregoing should not be considered to be legal advice and should not be relied upon as such. Please consult a lawyer to get advice and an opinion on your unique circumstances.