A recent Ontario case suggests that an unsecured creditor’s forbearance in requiring payment, together with its offer of new payment terms for a debt, may not be sufficient to support an insolvent debtor’s contemporaneous granting of security to that creditor.

In Snoek10, the Superior Court of Justice considered security granted to a group of individual creditors (“B”) of the bankrupt borrower (“HSLP”) in the context of a larger Ponzi scheme involving numerous unsecured creditors.11

B had initially advanced a series of unsecured loans to HSLP evidenced only by multiple promissory notes. When HSLP was unable to obtain additional Ponzi loans to service payments on B’s loans, B made demand for repayment and asked for security. HSLP granted security to B in the form of an undivided interest in a mortgage asset held by HSLP, and in exchange B agreed to capitalize the unpaid interest, and to accept new promissory notes with a reduced interest rate and an extended term.

The Trustee moved to have the security granted to B set aside on the grounds that it constituted an improper preference under the Assignments and Preferences Act 12. It was alleged that the security had been granted to B when HSLP was insolvent and with the intent to prefer B over other creditors.13

The Court initially concluded that the security constituted an improper preference under Section 4 of the Act as HSLP had clearly granted the security at a time when HSLP was insolvent. There was a clear intent to prefer B over several of HSLP’s other creditors who were also demanding repayment from HSLP at the same time but did not receive similar security.

The Court then further concluded that B had not shown the characterization of the security as an improper preference was saved by virtue of one of the exemptions available under Sections 5(1) or 5(5)(d) of the Act. In particular, B had not proven that either (i) the security was granted for a present actual advance of money, or (ii) the security was granted for a pre-existing debt and B made a new advance to HSLP in the belief that the advance would enable HSLP to continue its business and pay its debts in full.

Madam Justice Mesbur determined that the Act requires an actual advance of money to satisfy the saving provisions, and noted that Section 5 did not expand the plain meaning of the term “money” or expressly contemplate any other types of consideration like money’s worth or a forbearance. However, she questioned whether B’s actions in continuing to demand payment actually constituted a forbearance, and therefore she did not technically have to determine if a proper forbearance could in any circumstances be sufficient to qualify as an advance of money. In addition, in her view there was no cogent evidence to support any reasonable belief that B’s actions in capitalizing interest, reducing the interest rate and extending the term would mean that HSLP would continue in business and to be able to pay its debts in full. Madam Justice Mesbur accordingly concluded that the security given to B could not be saved and must be set aside.

The Court’s strict interpretation of the Act may have been based upon a desire to prevent B from elevating its status to that of a secured creditor to the detriment of many other unsecured victims of the Ponzi scheme. It is not clear if the court’s determination in this case would be applied in a situation where there was an existing secured institutional lender providing an operating line to a borrower where that lender received additional shore-up security in exchange for continuing to extend the line of credit. In that situation it would presumably be easier to establish that maintenance of the line of credit was essential to the borrower being able to continue its business and ultimately pay its debts in full. We understand that the case is presently under appeal14 and look forward to the Court of Appeal providing some clarification on this issue.