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Ian Klaiman, Lipman, Zener & Waxman PC Barristers & Solicitors

Decision clarifies ‘false pretences’ requirements under Bankruptcy and Insolvency Act: counsel

Tuesday, January 11, 2022 @ 9:03 AM | By Amanda Jerome

The Court of Appeal for Ontario has allowed an appeal in a case where bankruptcy stayed the proceedings in a trade secrets dispute, clarifying that the requirements of s. 178(1)(e) under the Bankruptcy and Insolvency Act (BIA) “are more specific,” said counsel for the appellant.

Ian Klaiman, of Lipman, Zener & Waxman PC Barristers & Solicitors and counsel for the appellant, said “the main takeaway from this decision is that for a debt or liability to survive a bankruptcy discharge as resulting from ‘false pretences’ under s. 178(1)(e) of the Bankruptcy and Insolvency Act, it is not enough that the bankrupt engaged in morally unacceptable conduct, or told a lie, at some point, that was disconnected to the creation of the debt.”

“Rather, the Court of Appeal has clarified that the requirements of s. 178(1)(e) are more specific,” he explained.

Ian Klaiman, of Lipman, Zener & Waxman PC Barristers & Solicitors

Ian Klaiman, Lipman, Zener & Waxman PC Barristers & Solicitors

“The debt or liability must have resulted from the bankrupt obtaining property or services by making a deceitful statement, either willfully or recklessly. Where there is no false statement, either by words or conduct, s. 178(1)(e) is not engaged,” he added.

In Shaver-Kudell Manufacturing Inc. v. Knight Manufacturing Inc., 2021 ONCA 925, Shaver-Kudell Manufacturing Inc., the respondent, “successfully sued the appellant, Alexander Knecht, and others, for misappropriating the respondent’s trade secrets and confidential information.”

According to court documents, the “quantum of the damages and the granting of other relief was to be determined at a subsequent hearing,” but before that could happen “the appellant made a proposal to his creditors under the BIA, which automatically stayed the proceedings.”

The proposal, the court noted, was “rejected by a majority of those creditors; the appellant was, as a consequence, deemed to have made an assignment into bankruptcy, continuing the stay.”

The motion judge, Justice Marc Smith of the Superior Court of Justice, determined that the “debt or liability under the trial judgment arose from the appellant having obtained property or services by false pretences, and thus would survive the appellant’s discharge from bankruptcy.”

According to court documents, Justice Smith also determined that “the stay that the BIA imposes on proceedings or enforcement steps against a bankrupt did not apply to the respondent’s claims against the appellant.”

However, Justice Benjamin Zarnett, writing for the Court of Appeal, found that Justice Smith “erred in law in coming to the conclusion that the debt or liability arising under the trial judgment falls within s. 178(1)(e) of the BIA.”

“At the core of the concept of false pretences is the making of a deceitful statement — that is, a statement that is false to the knowledge of its maker (including through wilful blindness or recklessness). For s. 178(1)(e) to apply, the debt or liability to the creditor must have resulted from the bankrupt having obtained property or services by making such a statement,” he explained, noting that the “nature and substance of the liability of the appellant reflected in the trial judgment is not one that arose from such a statement.”

“Although the liability arose from morally unacceptable conduct of the appellant, that is insufficient to fit it within the exception in s. 178(1)(e) of the BIA,” he added, noting that he would “set aside the declaration that s. 178(1)(e) applies to the debt or liability arising under the trial judgment.”

Turning to details on the case, the court noted that in 2013, the respondent, “a corporation that manufactures electric motor sleeves, commenced an action against four defendants: Dusko Ballmer and Lucy Shaver, who were former employees of the respondent; the appellant; and Knight Manufacturing Inc., a corporation of which the appellant was the controlling mind.”

The court explained that the “thrust of the claim” was that “the defendants went into business together making use of misappropriated trade secrets and confidential information of the respondent.”

In 2018 the trial judge, Justice Robert Smith, “found the defendants jointly and severally liable to the respondent for misappropriation of trade secrets and breach of confidence.”

He determined that: “a. the respondent had developed a manufacturing process for its products and tooling that were trade secrets with the necessary quality of confidence; b. the respondent's trade secrets were acquired by Ms. Shaver and Mr. Ballmer in circumstances giving rise to an obligation of confidence; Mr. Ballmer then communicated the trade secrets to the appellant and Knight Manufacturing who knew or ought to have known that Mr. Ballmer and Ms. Shaver were breaching an obligation of confidence to the respondent; and c. the defendants made unauthorized use of the respondent’s trade secrets to its detriment, and also benefitted from the breach by Ms. Shaver of her duty of confidence and good faith to the respondent through her use of the respondent's confidential information, including her knowledge of the respondent's customers and their purchasing patterns and payment history, to solicit the respondent’s customers.”

Costs were awarded by the trial judge “against all of the defendants in the sum of $83,493 for a summary judgment motion, and $307,028 for the trial.” The court noted that the costs “remain unpaid” and the “trial of the issue of damages and other relief has not yet been held.”

The appellant, the court explained, “filed a Notice of Proposal to Creditors under the BIA on March 2, 2020” and on April 27, 2020 “the proposal was rejected, resulting in the appellant’s deemed assignment into bankruptcy.”

Therefore, the respondent brought a motion seeking: “(a) a declaration that any discharge from bankruptcy granted to the appellant will not release him from any debts or liabilities arising from the claims in the action against him by the respondent; and (b) a declaration that the stay under s. 69(1) of the BIA no longer operates with respect to the respondent’s claim against the appellant in the action.”

The motion was granted and Justice Smith “settled upon the following interpretation of the term ‘false pretences’ as it is used in the BIA: It is my view that a dishonest bankrupt who has unlawfully obtained property by lying satisfies the requirements of ‘false pretences’ in section 178(1)(e). Such conduct is deceitful and wrong. It is this type of conduct that is morally objectionable to society. If the bankrupt engages in such a behaviour, they should not be shielded by bankruptcy.”

After reviewing the pleadings and the trial judge’s findings, Justice Smith found “there was no plea of fraud, but that the statement of claim described ‘wrongful and morally unacceptable conduct’, and that it was unnecessary that there be an exact plea in the statement of claim of circumstances described in s. 178(1).”

Justice Smith wrote that the appellant’s “conduct is precisely the type of conduct that society frowns upon.”

“He is not an ‘honest but unfortunate debtor’. I find that he is a deceitful wrongdoer and he should be precluded from benefitting from his dishonesty,” Justice Smith added.

The court noted that Justice Smith found a “causal connection between the appellant’s wrongful conduct and the debts that arise under the trial judgment, including the costs awarded to date and damages when quantified.”

Consequently, Justice Smith granted the declaration that “the debts would not be released upon discharge from bankruptcy” as well as holding “the stay of proceedings under s. 69 of the BIA should be lifted without conditions.”

Justice Zarnett detailed the issues on appeal as: “a) Did the motion judge err in finding that the liability under the trial judgment comes within s. 178(1)(e) of the BIA? b) Did the motion judge err in declaring that the stay of proceedings in s. 69 of the BIA did not apply to the respondent’s claim against the appellant?”

One the first issue, Justice Zarnett determined that Justice Smith “erred in two interrelated ways in deciding that s. 178(1)(e) applied.”

“First,” he explained, Justice Smith “treated lying during the proceedings (that is, during examinations for discovery) as engaging the section.”

“What the section requires is that the debt or liability arose from false pretences — that is, deceitful statements on the basis of which the debtor obtained property or services. No matter how reprehensible telling falsehoods on examination for discovery may be, it does not turn a debt or liability into one resulting from obtaining property or services by deceitful statements,” he added.

“Second,” he wrote, Justice Smith “erred in focusing on the morally objectionable nature of the appellant’s conduct in participating in the misappropriation of the respondent’s trade secrets and confidential information, elevating that to a kind of implied deceit that could be present in any objectionable commercial behaviour, but without relating the conduct to the specific requirements of s. 178(1)(e).”

“The section applies to certain specific conduct that is morally objectionable; it does not equate all morally objectionable commercial conduct with false pretences,” he noted.

Justice Zarnett emphasized that “at the heart of this issue is a question of statutory interpretation — what conduct is captured by the phrase ‘debt or liability resulting from obtaining property or services by false pretences’ in s. 178(1)(e) of the BIA?”

He noted that s. 178(1)(e) “requires that the debt or liability owed to the creditor have resulted from the debtor having obtained property or services by false pretences.”

“False pretences,” he added, “is not defined in the BIA,” but it is “defined in the Criminal Code, s. 361(1) as follows: A false pretence is a representation of a matter of fact either present or past, made by words or otherwise, that is known by the person who makes it to be false and that is made with a fraudulent intent to induce the person to whom it is made to act on it.”

He noted that Justice Smith “rejected use of this definition” for two reasons: “first, that Parliament’s intent was not to require criminality in order for s. 178(1)(e) to apply; and second, that to do so would deprive the term ‘false pretences’ of any meaning beyond that conveyed by the term ‘fraudulent misrepresentation’, which is also used in s. 178(1)(e).”

Justice Zarnett agreed with agree with Justice Smith that s. 178(1)(e) “does not require the debtor to have been convicted of the offence of false pretences, or that it is necessary to show facts sufficient to prove that the debtor would be criminally convicted if charged.”

“But,” he stressed, “that does not mean the Criminal Code definition does not assist in determining the sense in which the words were used in s. 178(1)(e) of the BIA.”

“A phrase with legal meaning, chosen by Parliament for use in a statute, may have its meaning illuminated by the way the same phrase is used in other statutes of the same legislative body since interpretations ‘favouring harmony between the various statutes enacted by the same government should indeed prevail,’ ” he explained.

Justice Zarnett did not accept the motion judge’s second position on this point, noting “[M]ost cases, when discussing s. 178(1)(e), treat fraudulent misrepresentation and false pretences as closely connected terms with the same requirements.”

“The core concept of making a deceitful statement applies to both,” he added.

“Reading the text of s. 178(1)(e) with the benefit of the definition of false pretences in the Code illuminates its core concept: it only applies to a debt or liability that has arisen from one or more deceitful statements, by the debtor or for which the debtor is responsible, on the basis of which the debtor obtained services or property. It does not apply to other kinds of lying or wrongdoing, no matter how morally objectionable, that do not have these basic characteristics,” Justice Zarnett explained.

The judge also noted that “[R]eading s. 178(1) as a whole reinforces the view that s. 178(1)(e) refers to specific types of wrongdoing, within specific parameters.”

He explained that “rather than legislating a catchall of debts arising from morally objectionable conduct, the BIA identifies categories of specific wrongful conduct that give rise to debts that are not released, and specifies the criteria to be applied.”

“In doing so, Parliament must be taken to have intended that only these specific categories, on the specific terms identified, will be given this effect, even though other forms of morally objectionable conduct giving rise to debts can easily be imagined,” he added.

Justice Zarnett noted that the “purpose of s. 178(1) and the legislation as a whole supports reading s. 178(1)(e) as applying to debts or liabilities that result from the obtaining of property by the deceitful means of false statements.”

“It does not support reading the subsection as applying to any conduct without those attributes that a court might characterize as morally objectionable or that prevents a debtor being described as honest but unfortunate,” he added.

The court also determined that Justice Smith “did not find false statements within the meaning of s. 178(1)(e) and therefore erred in finding that the debt or liability came within it.” The court noted that Justice Smith’s list of findings by the trial judge “refers to only one incident of lying. The reference was to the appellant having lied on his examination for discovery.”

“Although lying on examination for discovery reflects on whether the appellant was honest, it is not the type of false statement that satisfies s. 178(1)(e), which requires a deceitful statement by which the debtor obtained property or services, causing the debt or liability of the creditor to arise,” Justice Zarnett explained, adding that “[B]y focusing on a lie told on examination for discovery, the motion judge failed to focus on whether false statements were the source of the liability.”

He determined that ‘[I]n the absence of deceitful statements from which the liability arose, the motion judge’s findings that the appellant is not an honest but unfortunate debtor, or that his conduct was morally objectionable, are insufficient to bring the matter within s. 178(1)(e).”

“I would therefore set aside the declaration the motion judge made that s. 178(1)(e) applies to prevent the release of any debts or liabilities arising from claims in the action, including any outstanding or future costs award,” he added.

On the second ground of appeal, Justice Zarnett found that “the premise of the motion judge’s order was the erroneous legal conclusion that s. 178(1)(e) applied to the appellant’s liability for the respondent’s claims.”

Therefore, he determined the “declaration that the stay does not apply at all to the proceedings in the action as against the appellant or to enforcement of any judgment against the appellant cannot stand.”

The court concluded that the stay “should be lifted to allow the action to proceed against the appellant for the purpose of quantifying any damages or accounting of profits owing by the appellant, establishing the identity of any property still in the possession of the appellant that incorporates the trade secrets, and for any forward-looking injunctive relief against the appellant.”

“Any monetary judgment shall only be a claim in bankruptcy against the bankrupt estate of the appellant and may not be otherwise enforced against the appellant,” Justice Zarnett noted.

In a decision released Dec. 29, 2021, Justice Zarnett, with Justices George Strathy and Herman Wilton-Siegel in agreement, allowed the appeal, set aside the declaration that s. 178(1)(e) applies, and varied the declaration on the stay.

Counsel for the respondent did not respond to request for comment before press time.

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