Tainted contracts: Applying the defence of illegality to complex fraudulent schemes

In Youyi Group Holdings v Brentwood Lanes, the British Columbia Court of Appeal upheld the trial judge’s decision to refuse to enforce two real estate purchase contracts on the basis that the contracts were “tainted” by the illegality of a larger fraudulent scheme. 

Background

Youyi Group Holdings (Canada) Ltd. and DHI Holdings Inc. (the purchasers) and Brentwood Lanes Canada Ltd. and Maple Ridge Lanes (1981) Ltd. (the vendors) entered into two linked agreements of purchase and sale (the purchase agreements) for two commercial properties. 

The purchasers, with the assistance of their real estate agent, devised a scheme to deceive mortgage lenders, brokers, appraisers and potential joint venture partners into providing more financing than was warranted. The scheme comprised the following components: 

• Rent Reduction Scheme: It was a condition of sale that the vendors would lease back the properties for three years for a percentage of the purchase price. On its face, the purchase agreement appeared to provide for a lease-back rate of 5.5%. Unbeknownst to potential lenders, the purchasers prepared a separate lease addendum that set out the true lease-back rate of 3.5%. The purchasers presented the purchase agreement to potential lenders without disclosing the separately numbered schedule, thereby artificially inflating the lease revenue for the property.
• Fabricated Purchase Agreement: The purchasers directed their agent to prepare a false purchase agreement for one of the properties containing a number of misstatements, including that the purchase price was $10 million higher and they had paid a $10 million deposit. 
• False Deposit Scheme: The purchasers proposed a false deposit scheme to mislead lenders into believing the purchasers had contributed an additional $8 million in equity and to conceal second mortgages. The vendors refused to cooperate with the false deposit scheme.

Two weeks before closing, the vendors advised the purchasers they would not be proceeding with the sale due to the alleged wrongdoing of the purchasers and their common real estate agent. The purchasers commenced an action against the vendors for specific performance of the purchase agreements.

The trial judge concluded that the various agreements were interrelated and each an essential part of the overall transaction, which was intended to deceive third-party lenders. The trial judge declined to enforce the purchase agreements on the ground that they were tainted by the illegality of the overall scheme.

The British Columbia Court of Appeal 

In dismissing the purchasers’ appeal, the court made the following key points respecting the defence of illegality in Canada:

• The underlying rationale for the defence is the integrity of the justice system, and the premise that courts should not punish illegal conduct with one hand and reward it with the other.
• Contracts may be regarded as illegal in two distinct ways: (1) where the contract is illegal per se because its performance violates statute or common law; and (2) in the more nuanced situation, where the contract is not per se illegal but entered into, at least in part, with the object of committing an illegal act.
• The court rejected the purchasers’ argument that the illegality defence can only succeed where the plaintiff must rely on the illegal conduct to establish its claim. The court held that this theory (known as the “reliance rule” and recently rejected in the United Kingdom) is overly rigid. It is also inconsistent with the principled approach embraced in Canada, which considers whether enforcing the contract would undermine the integrity of the legal system.

The court held that by preparing separately numbered schedules that could be removed from lending applications, the purchasers had deliberately structured the transaction to facilitate fraud. It was therefore open to the trial judge to decline to enforce the purchase agreements.

The court left open the issue of whether the fraudulent schemes that were proposed as part of the transaction but not carried out (i.e., the false deposit scheme and the fabricated purchase agreement) could be considered as a basis to refuse to enforce the purchase agreements.

Takeaways

The court’s rejection of the rigid “reliance rule” is an acknowledgement that a principled, flexible approach is required to respond to the increasingly complex nature of fraud. It will be crucial to the illegality analysis to consider the context in which a document was created and its intended purpose within the larger fraudulent scheme.