Supreme Court of Canada Rules on Secured Lender’s Rights Over Fraudulently-Obtained Collateral

Banks should take comfort from a recent decision of the Supreme Court of Canada, which considered the rights of secured lenders in situations where the assets that are subject to the security interest were originally obtained by fraud.

In i Trade Finance Inc. v. Bank of Montreal the contest was between two innocent creditors, and involved the proceeds of shares that were credited to an investment account, but which stemmed from funds that had been fraudulently obtained. The funds used to buy the shares had been loaned to the fraudster by i Trade Finance ("i Trade"), which was eventually forced to obtain a court order entitling it to any assets traceable to the funds that had been fraudulently obtained. On the other hand, the Bank of Montreal ("BMO") was a secured creditor, and had been pledged the fraudulently-obtained shares by the fraudster. The question was whether the Bank became a purchaser for value without notice of the fraud, which would essentially trump i Trade’s interest in the funds.

The Supreme Court of Canada determined that the fraudster’s rights in the shares were sufficient to legally support it granting BMO a security interest in them. This conclusion derived from the well-established legal principle that a contract tainted by fraud is merely voidable at the election of the party defrauded; it is not automatically void. When the shares were pledged to BMO, the fraud had not yet been discovered; therefore BMO in the role of pledgee was considered a "purchaser" within the concept of a bona fide purchaser for value, which in turn amounted to an exception to the tracing order obtained by i Trade.

This decision is important because it elaborates upon the law as to rights over collateral obtained by fraud. Still, banks and other lenders should be aware that this decision will likely not be of assistance where the fraud is uncovered prior to the point in time when their security interest attaches to the collateral. See i Trade Finance Inc. v. Bank of Montreal, 2011 (SCC).