In a contest between two innocent creditors over the proceeds of shares credited to an investment account which were traceable to fraudulently obtained funds, the Supreme Court of Canada held in favour of the Bank of Montreal (“BMO”), a secured creditor. The decision should provide lenders with a degree of comfort where it is later uncovered that the assets subject to their security interest were purchased with funds obtained through fraud.

In i Trade Finance Inc. v. Bank of Montreal, the Court had to determine whether the pledge of fraudulently obtained shares granted to BMO made it bona fide purchaser for value without notice of fraud. Otherwise, i Trade Finance Inc. (“i Trade”), which had lent the defrauding party (the “Fraudster”) the funds used to purchase the shares in question, could rely on an order obtained through a civil proceeding entitling i Trade to obtain any assets traceable to the funds of which it is was defrauded (excluding assets in the hands of a bona fide purchaser for value without notice).

The Court’s reasoning that the Fraudster had rights in the shares sufficient to support the granting of a security interest to BMO hinged on the principle of contract law that fraud does not render a contract void automatically, but rather a contract tainted by fraud is voidable at the election of the party defrauded. The fraud had not yet been uncovered at the time of the pledge, so BMO was able to fit itself into the exception to the tracing order as a bona fide purchaser for value without notice as a pledgee.

The reasoning in this case should be helpful where a secured creditor’s interest is challenged on the basis that the collateral was obtained through fraud. However, lenders should remain diligent. The reasoning may not extend where the fraud is uncovered before the lender’s security interest attaches to the fraudulently obtained collateral as the Fraudster must have rights in the collateral for a security interest to attach.