COURT OF APPEAL FOR ONTARIO

DATE: 20000801

DOCKET: C32754

CARTHY, ROSENBERG and O’CONNOR JJ.A.

BETWEEN:

P.I.A. INVESTMENTS INC.
Megan Evans
for the appellant

Plaintiff

• and -

DEERHURST LIMITED PARTNERSHIP,
DEERHURST INC. and
DEERHURST RESORTS CLUB
Geoff R. Hall
for the respondent

Defendants

Heard: May 15, 2000

On appeal from the judgment of Lax J. dated August 4, 1999.

O’CONNOR J.A.

[1] The plaintiff, P.I.A. Investments Inc., was a secured creditor of the defendants (“Deerhurst”) which owned a vacation resort near Huntsville, Ontario. On February 6, 1998, on the motion of P.I.A., the court appointed the appellant, Mintz & Partners Limited (“the receiver”), to be the receiver and manager of the assets of Deerhurst. Prior to the receivership, Canadian Pacific Hotels Corporation managed and operated the resort for Deerhurst pursuant to the terms of a management agreement.

[2] This appeals concerns two claims made by the receiver against CP. First, the receiver sought repayment of $58,520 which CP paid to itself out of the resort’s operating bank account. The payment was for deferred management fees owed by Deerhurst to CP. CP made the payment about one month before the receivership.

[3] The receiver also claimed $120,639.93 for funds earned from the resort’s operations which were being held by CP in a bank account that it opened two days before the receivership.

[4] This appeal is from the order of Madam Justice Lax dismissing the receiver’s motion. At the time of the receivership, Deerhurst was indebted to CP for an amount greater than the two claims made by the receiver. In my view, CP is entitled to an equitable setoff against both claims and, accordingly, I would dismiss the appeal.

FACTS

(a) Background

[5] The Deerhurst Resort overlooks Peninsula Lake in Huntsville, Ontario. It is one of the largest and most integrated destination resorts in Canada. Under a management agreement with Deerhurst dated March 28, 1990, CP agreed to manage and operate the resort. CP’s responsibilities covered all aspects of the operation, including employing staff, marketing, establishing policies and prices, purchasing products, negotiating and entering into contracts and equipment leases, and maintaining and repairing the facilities.

[6] In performing its duties, CP was acting solely on behalf of and as agent for Deerhurst and not on its own behalf.

[7] In addition to its other duties, CP was required to open and maintain an operating bank account (the “Agency Account”). CP deposited revenues from the operation of the resort together with working capital provided by Deerhurst into the Agency Account. CP used the Agency Account to pay the operating expenses of the resort and certain agreed upon management fees. The excess, if any, less working capital, was to be transferred to Deerhurst on a monthly basis. I will have more to say about the Agency Account below.

[8] For many years, Deerhurst had been in financial difficulties. In 1995, an attempt to sell the resort fell through. In June 1997, Massachusetts Mutual Life Insurance Company (“Mass Mutual”) signed a letter of intent to purchase the assets of Deerhurst. Due diligence was carried out. In October 1997, P.I.A. retained the receiver to advise it on the proposed sale and on its options including the possibility of a receivership.

[9] On February 2, 1998, P.I.A. brought a motion seeking an order for the appointment of the receiver as receiver/manager of Deerhurst and for an order approving the receiver entering into an asset purchase agreement under which Mass Mutual agreed to acquire substantially all of the assets of Deerhurst. Under the purchase agreement, the receiver was required to pay the pre-receivership accounts of a substantial number of the unsecured trade creditors of Deerhurst. Although CP was owed money by Deerhurst at the time of the receivership, it was not included in the list of creditors to be paid by the receiver.

[10] On February 6, 1998, Mr. Justice Cameron made the orders requested by P.I.A.

[11] Pursuant to the purchase agreement, the receiver paid approximately $1.5 million to the trade creditors of Deerhurst for pre-receivership obligations. These payments ultimately maximized the value received on the sale because they enabled the resort to continue operating and to be sold as a going concern. At the time of the appointment of the receiver, Deerhurst’s secured creditors were owed approximately $40 million. The receiver has realized substantially all of the assets of Deerhurst and there remains a significant shortfall for the secured creditors of approximately $21 million.

(b) The payment of CP’s deferred management fees

[12] By the terms of the management agreement CP was able to earn two types of management fees. The first, “basic fees,” were calculated as a percentage of the total revenues from operations for a fiscal period (the calendar year). The second, “participation fees,” were calculated as a share of the net profits, if any, for a fiscal period.

[13] Initially, Deerhurst was not profitable. By a letter agreement dated December 3, 1992, CP agreed that, commencing January 1, 1993, it would defer receipt of 50 per cent of the basic fees until there was a net profit for any fiscal period. Deerhurst agreed to pay the outstanding deferred management fees once a year in the amount of the annual net profit, if any, for the previous fiscal year. The deferred management fees were to be paid after the completion of the yearly audit process described in the management agreement. Typically, this process was completed in March following the end of the fiscal year.

[14] The letter agreement also provided that the deferred management fees would become due and payable upon the termination of the management agreement. By its terms, the management agreement was deemed to terminate, inter alia, on the day prior to the appointment of a receiver. As consideration for the fee deferral and the letter agreement, Deerhurst agreed to extend the term of the initial management agreement for five years to December 31, 2004.

[15] At the end of December 1997, Deerhurst owed CP $58,520 for deferred management fees. In early January 1998, CP completed the financial statements for the year ended December 31, 1997. CP determined that Deerhurst’s net profit for 1997 exceeded $58,520. The audit of the financial statements, completed in March 1998, confirmed that there was enough profit in 1997 to retire the balance owing to CP for deferred management fees.

[16] On January 9, 1998, CP paid itself the balance of the deferred fees from the Agency Account. On this appeal, CP concedes that this amount, although a debt of Deerhurst, was not payable under the terms of the letter agreement until the completion of the yearly audit process in March 1998. CP submitted that the premature payament resulted from a misunderstanding by CP of the provisions in its agreements with Deerhurst. There is no evidence to support “the misunderstanding explanation.” I agree with the motions judge that it is likely that CP withdrew the deferred fees on January 9, 1998 to protect its own interests. CP was concerned about Deerhurst’s plans for the resort at the time and it was apparent that Deerhurst was not being forthcoming about those plans.

[17] The motions judge dismissed the receiver’s claim for the return of the $58,520 that CP paid to itself for the deferred fees.

(c) The second bank account

[18] The management agreement set out the provisions by which the Agency Account would be operated. The account was to be opened and maintained at all times solely by CP and was to be operated in the name of Deerhurst. Cheques and other withdrawal documents were to bear a legend indicating that the resort was managed by CP as agent for Deerhurst and could be signed by authorized representatives of CP. The Agency Account, which was referred to in the management agreement as a “special trust account,” was to be in a Canadian bank selected by CP and approved by Deerhurst. The funds in the Agency Account were not to be mingled with CP’s other funds. The agreement provided that Deerhurst could review the bank reconciliations at any time, but that its sole right with respect to the funds in the account was to receive, on a monthly basis, funds in excess of those required for working capital, operating expenses and management fees.

[19] Prior to February 2, 1998, the Agency Account was maintained at a branch of the Bank of Montreal in Huntsville, Ontario. It appears that in practice the account was not operated “solely” by CP as contemplated by the management agreement. Rather, one executive of Deerhurst was designated as a signing officer on the account along with three employees of CP. From time to time, Deerhurst unilaterally withdrew or transferred funds from the Agency Account. In January 1998, Deerhurst removed approximately $700,000 from the Agency Account without the knowledge or approval of CP.

[20] By February 2, 1998, the planning for the receivership of Deerhurst had been in the works for some time. On that day, P.I.A. filed the motion to appoint a receiver and to approve the receiver entering into the asset purchase agreement. On the same day, Deerhurst, without notice to CP, seized control of the Agency Account and blocked CP from accessing it. CP employees were removed as signing officers.

[21] Deerhurst took the position that it was justified in seizing the Agency Account because CP allegedly breached the management agreement by withdrawing the deferred management fees on January 9.[^1] Section 16.01 of the management agreement entitled either party to terminate the agreement if, on 30 days notice, a default under the agreement was not remedied. Deerhurst did not give CP notice of its alleged default or the opportunity to remedy as contemplated by s. 16.01.

[22] On February 4, 1998, CP opened a new bank account at the Royal Bank in Toronto. CP did not obtain Deerhurst’s approval for opening the account, however, it immediately advised Deerhurst of what it had done. Over the next two days, CP deposited receivables payable to Deerhurst worth $120,693.93 into this account. These funds continue to be held pending resolution of the dispute between the receiver and CP. The motions judge dismissed the receiver’s claim to the money held in this account.

(d) Money owing by Deerhurst to CP

[23] There are two sources of information about the amount of money that Deerhurst owed to CP on the date of the receivership. The first is the affidavit of Chris Lund who was an employee of CP and the General Manager of the Deerhurst Resort before the receivership.

[24] According to Mr. Lund, CP was responsible for all aspects of managing and operating the resort including dealing in the ordinary course with trade creditors of Deerhurst. CP continued to deal with Deerhurst’s trade creditors in the ordinary course, and continued to have those trade creditors extend credit to Deerhurst until it was served with the motion material seeking the appointment of a receiver. CP also continued, on its own account, to extend credit to Deerhurst by paying third party suppliers of Deerhurst, on the understanding that this credit would be repaid by Deerhurst.

[25] Between November 1997 and March 1998, CP paid a total of $280,906.59 on behalf of Deerhurst. On cross-examination, Mr. Lund indicated that this figure included an amount of $66,200.08 that was paid as severance pay to two employees who were terminated as a result of the receivership. The balance of approximately $214,000 represented obligations incurred by CP on behalf of Deerhurst prior to the receivership. CP has not been reimbursed for these payments.

[26] The second source of information about the amount of money owing by Deerhurst to CP arose from a request made by the court at the start of this appeal. The receiver produced a list of the unpaid trade (unsecured) creditors of Deerhurst as of the date of the receivership. The list shows a total of $260,432.89, of which counsel advised approximately $221,000 is owed to CP.

[27] I am not able to reconcile the amount set out in Mr. Lund’s affidavit with the list provided to the court by the receiver. However, given the way in which I would dispose of this appeal it is not necessary to determine the precise amount owing by Deerhurst to CP. On the basis of either calculation the amount exceeds the total of the two amounts claimed by the receiver.

ANALYSIS

[28] There are two issues raised in this appeal:

(a) Is the receiver entitled to recover the $58,520 in deferred management fees which CP withdrew from the Agency Account on January 9, 1998?

(b) Is CP required to pay to the receiver the $120,693.93 currently being held in the account at the Royal Bank?

(a) Deferred Fees

[29] As I pointed out above, CP concedes that it was not entitled to pay itself the deferred fees on January 9, 1998. In the normal course those fees would not have been payable until some time in March when the audit of the 1997 financial statements was complete. That said, there is no dispute that the amount of deferred fees owing in January 9, 1998 was in fact $58,520 and that the net profit for the fiscal period ending December 31, 1997 was more than enough to pay the amount owing.

[30] Accepting CP’s concession, the premature payment of the deferred fees created a debt owing by CP to Deerhurst in the amount of the fees paid. CP contends, however, that at the time of the receivership Deerhurst owed it an amount far in excess of this debt and that it is entitled in equity to a setoff against the receiver’s claim for payment of the debt.

[31] In determining whether equitable setoff should be allowed it is necessary to first look at the connection between the claims involved and to then consider the effect the setoff would have on the equities between the parties. Equitable setoff arises when there are cross obligations which are so closely connected or related that it would be unjust to permit one party to enforce its obligation without permitting a setoff to the other: Telford v. Holt, [1987] 2 S.C.R. 193; Canada Trustco Mortgage Co. v. Sugarman (1999), 1999 CanLII 9288 (ON CA), 179 D.L.R. (4th) 548 (Ont. C.A.).

[32] Setoff operates as a defence to a claim and may be set up against a receiver of a creditor. The principles which apply in determining whether a claim of setoff may be made against a receiver are those relating to the right of setoff as against an equitable assignee: Rother Iron Works Ltd. v. Canterbury Precision Engineers Ltd., [1974] Q.B. 1 (C.A.). In a case such as the present one, where the receiver is acting on behalf of a creditor and a claim of setoff arises out of a relationship that predates the receivership, the receiver is in no better position with regard to the claim of setoff than the creditor. If CP was entitled to make a claim of setoff against Deerhurst at the time of the appointment of the receiver it is equally entitled to make a claim of setoff against the receiver: See Aboussafy v. Abacus Cities Ltd. (1981), 1981 ABCA 136, 124 D.L.R. (3d) 150 at 152 (Alta. C.A.); Biggerstaff v. Rowatt’s Wharf Ltd., [1886] 2 Ch. 93 (C.A.).

[33] I am satisfied that the obligation of CP arising from the premature payment of the deferred management fees and the obligation of Deerhurst to reimburse CP for debts incurred on its behalf are sufficiently connected to allow CP to invoke the defence of equitable setoff. Both obligations arose out of the relationship between Deerhurst as owner and CP as operator of the resort and both of the obligations were incurred in the same general time period.

[34] There are two further reasons why, in my view, it is equitable that CP be permitted to claim a setoff. The first relates to the nature of the obligation upon which the receiver makes its claim for the return of the $58,520. By the letter agreement CP agreed to defer the payment of management fees on the understanding that it would receive the full amount of the net profits from the operation of the resort until such time as the deferred fees were paid.

[35] The management agreement provided for a year end process by which CP would prepare and certify the financial statements for the resort, which were then subject to audit by Deerhurst’s accountants. The letter agreement provided that the deferred fees were to be paid in the amount of the net profit after the audit. Clearly, the purpose of delaying the payment until the time of the audit was to ensure that the amount of the profit was independently and accurately ascertained.

[36] In January 1998, CP did not await the audit before paying itself the deferred fees. Although the withdrawal was premature, the resulting debt from CP to Deerhurst should be viewed in its context. The net profits giving rise to CP’s entitlement to payment of the deferred fees had been earned at the time of the payment on January 9, 1998. The spirit, if not the language, of the letter agreement was that CP was entitled to those net profits. As events turned out, the audit confirmed the amount of the fees CP had paid itself. The dispute arises only because the receivership intervened between the withdrawal and the audit. I recognize that this court should not rewrite the agreement between the parties; however, I think that the circumstances of the way in which CP’s debt to Deerhurst arose argue in favour of CP being permitted to an equitable setoff.

[37] The final reason why I think that this is a proper case to permit an equitable setoff, relates to the circumstances under which Deerhurst came to be indebted to CP in the months leading up to the receivership. It was in the interests of Deerhurst, as well as its secured creditors, that the resort continue to operate without interruption until a receiver was appointed and a sale could be completed. For this to happen it was necessary that the trade creditors continue to provide goods and services and that CP continue to operate the resort.

[38] During the period in which CP incurred the obligations on behalf of Deerhurst, Deerhurst was less than forthcoming with CP about its intentions regarding the resort. Although CP suspected that something was in the works, CP was not advised that Deerhurst and P.I.A. were actively considering a receivership and a subsequent sale. During this period, CP continued to manage the resort and to pay accounts and incur obligations on behalf of Deerhurst. This enabled the resort to be sold as a going concern and no doubt assisted the receiver in obtaining a higher price on the sale of the assets. That said, there was no prospect that the sale price would satisfy the secured creditors in full and it was clear there would be no recovery by the unsecured creditors. Had CP been advised of an impending receivership it would have made no sense for it to incur obligations on behalf of Deerhurst for which it would not be paid. It is reasonable to conclude that P.I.A., the secured creditor who had the receiver appointed, directly benefitted from the fact that CP incurred the obligations it now seeks to setoff. In my view, these circumstances also argue in favour of CP’s claim to setoff.

[39] Although factually somewhat different, I find support for the conclusion that equitable setoff is appropriate in the circumstances of this case in Gerry’s Distributors Ltd. v. Itwal Ltd., a judgment of the Ontario Court of Appeal, delivered January 22, 1999, [1999] o.j. 170; and in Coopers & Lybrand Ltd. v. Lumberland Building Materials Ltd. (1983), 1983 CanLII 615 (BC SC), 50 C.B.R. 150 (B.C.S.C.).

[40] For the above reasons, I am of the view that CP is entitled to an equitable setoff against the receiver’s claim for the return of the amount paid for the deferred management fees. I am satisfied that the motions judge correctly dismissed the receiver’s claim for the return of those fees.

(b) The amount held in the account at the Royal Bank

[41] The receiver also appeals the order dismissing its claim for the payment of $120,693.93 held by CP in the account that CP had opened with the Royal Bank in Toronto. The receiver first argues that this account was not a bank account governed by the provisions of the management agreement. As such, the receiver contends that the diversion of the accounts receivable to the Royal Bank account was a simple conversion and the funds must be returned.

[42] The receiver points out that the Royal Bank account was opened without Deerhurst’s approval as required by s. 7.04 of the management agreement. Despite this, I am satisfied that the Royal Bank account is a bank account to which the provisions of the management agreement apply. The account was opened after Deerhurst had shut CP out from the existing Agency Account on February 2, 1998, the same day that the receivership proceedings were commenced. The management agreement is clear that, prior to the receivership, Deerhurst had no claim to the funds in the Agency Account other than its entitlement to receive on the 15th day of each month any amount in excess of what was required to operate the resort. Moreover, Deerhurst had no right to remove the CP employees as signing officers for the account and to take over the operation of the account.

[43] The receiver argues that Deerhurst was justified in taking this step because CP had breached the management agreement by prematurely withdrawing the deferred management fees. Accepting this to be the case, Deerhurst’s remedy under the agreement was to serve notice of the default under s. 16.01 and to ask that the money be repaid. It had no right to, in effect, dislodge CP as the manager and operator of the resort.

[44] After Deerhurst barred CP from access to the Agency Account, CP received revenues for the resort in the amount of $120,693.93, which in the normal course would have been deposited in the Agency Account. CP made no effort either to hide the fact that it had received the funds or to appropriate them for its own use. On the contrary, CP notified Deerhurst that it had deposited the funds in the Royal Bank account, and has continued to hold the funds in that account pending a resolution of the dispute with the receiver.

[45] In these circumstances, I have no difficulty in finding that the provisions in the management agreement that applied to the Agency Account also governed the relationship between CP and Deerhurst in terms of the Royal Bank account. I do not accept the receiver’s argument that by depositing these funds in the new account CP converted the funds to its own use.

[46] Next, the receiver argues that if the provisions of the management agreement applied to the money held in the account at the Royal Bank then CP was obligated to transfer the money to Deerhurst when the agreement was terminated by the appointment of the receiver. In this regard, the receiver argues that s. 16.05(g) of the management agreement created a trust relationship under which CP held the funds in the bank account as trustee for the benefit of Deerhurst, to the exclusion of any claims by CP.

[47] CP, on the other hand, argues that the management agreement constituted both the Agency Account and the account at the Royal Bank as a trust for the benefit of the trade creditors of Deerhurst.

[48] I do not agree with either argument. For a trust to come into existence it must have three essential characteristics: certainty of intention to create a trust, certainty of subject matter and certainty of object: Air Canada v. M&L Travel Ltd. (1993), 1993 CanLII 33 (SCC), 108 D.L.R. (4th) 592 (S.C.C.) The language of the management agreement does not, in my view, demonstrate an intention to create either of the trusts urged by the parties.

[49] As to the receiver’s argument one need only look at the wording of s. 16.05(g) of the management agreement. It reads as follows:

16.05 Events of Termination. If this agreement has been deemed to have been or has been terminated, the following provision shall apply; …

(g) upon the payment to Operator of all amounts due Operator hereunder, all remaining amounts in the Agency Account shall be transferred to Owner.

[50] CP’s obligation to transfer funds remaining in an Agency Account to Deerhurst is subject to first paying all amounts due CP under the agreement. As between CP and Deerhurst, the agreement contemplates that on termination CP will be paid amounts owing to it before Deerhurst receives any amounts remaining in the Agency Account.

[51] The receiver argues that this requirement, that CP be paid amounts owing to it on a termination resulting from insolvency or a receivership, is void because it violates the “fraud on the bankruptcy law” principle set out in Canadian Imperial Bank of Commerces v. Bramalea Inc. (1995), 1995 CanLII 7262 (ON SC), 33 O.R. (3d) 692 (Gen. Div.). Assuming this principle applies at all, I do not think it helps the receiver’s argument. The “fraud on the bankruptcy law” principle would only operate to strike down the impugned provision insofar as it affects the interests of creditors of Deerhurst. It would not alter the relationship between the parties to the agreement so as to lead the court to conclude that there was an intention to create a trust where one did not otherwise exist.

[52] The language of s. 16.05(g) demonstrates an intention that, to the extent CP was owed money by Deerhurst under the management agreement on the date of termination, CP was to be paid from the Agency Account before Deerhurst. This intention is inconsistent with the trust urged by the receiver.

[53] CP’s argument that the funds in the account at the Royal Bank were held in trust for the benefit of the trade creditors of Deerhurst fails for the same reason. The language of s. 16.05(g) is also inconsistent with an intention to create a trust in favour of the trade creditors of Deerhurst. On the contrary, the section contemplates that amounts held in an Agency Account would be paid first to CP and then to Deerhurst, not to the trade creditors on the termination of the agreement.[^2]

[54] In my view, the receiver’s claim to the funds held in the account at the Royal Bank is one based in debt. In am of the view that CP should be permitted to set off in equity the amount owing by Deerhurst to it on the date of the receivership against this debt. The obligations of the two parties are closely and intricately connected. One of the purposes of the Agency Account was to pay the operating expenses of the resort. The obligations incurred by CP on which the claim for setoff is founded were to pay operating expenses of the resort. Deerhurst, and ultimately its secured creditor, P.I.A., received the benefit of CP incurring these obligations. The resort continued to operate and the sale price was in all likelihood higher as a result. That, taken together with the circumstances under which CP paid the expenses in the months leading up to the receivership, to which I referred above, lead me to conclude that the equities between the parties favour a setoff by CP against the receiver’s claim to the funds held in the account at the Royal Bank.[^3]

[55] Because the motions judge concluded that the funds in the account at the Royal Bank were being held for the benefit of all of the unpaid trade creditors she included in her order the following provision:

1. This Court orders that the Receiver shall return to the court within thirty (30) days with a list of the unpaid trade creditors of Deerhurst as of February 6, 1998 and as of the date of closing, together with a schedule showing a proposed pro rata distribution of the Agency Account.

[56] We were told by counsel that, as it now stands, the amount owing to CP comprises about 85 per cent of the unpaid trade creditor debt. The other unpaid trade creditors (apparently there are two) were not served with notice of the motion in the court below. Nevertheless, the order below conferred a benefit upon them.

[57] The basis on which I would dismiss the receiver’s appeal on this issue entitles CP to payment of the full amount held in the account at the Royal Bank. The two unpaid trade creditors were not given notice of this appeal and I am concerned about making a disposition that removes the benefit flowing to them from the order made below. CP has not asked this court to set that order aside nor does it object to a distribution to the other unpaid trade creditors on a pro-rated basis. Indeed, CP’s first position on this appeal is that the funds in the account at the Royal Bank are being held in trust for the benefit of all of the unpaid trade creditors.

DISPOSITION

[58] Accordingly, I would dismiss the appeal and allow the order of the motions judge to stand with the expectation that the receiver will comply with the order set out in paragraph 55 above and that the court below will order distribution of the funds held in the account at the Royal Bank in accordance with the list produced by the receiver. I would order the receiver to pay CP’s costs of the appeal.

Released: Aug. 1, 2000 “JJC”

“Dennis O’Connor J.A.”

“I agree J.J. Carthy J.A.”

“I agree M. Rosenberg J.A.”

[^1]: Deerhurst also alleged that CP breached the management agreement because it withdrew participation management fees on January 28. It is now conceded that CP was entitled to withdraw the participation management fees.

[^2]: The motions judge appears to have found that the agreement created a trust in favour of the trade creditors. Counsel advised this court that she was not referred to s. 16.05(g) of the management agreement.

[^3]: Given this conclusion it is not necessary for me to address CP’s alternative agreement that s. 16.05(g) of the management agreement created a contractual right of setoff in its favour.