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In a recent decision, the court considered the scope of lenders’ due diligence, concluding that assessing legal or title risk is entirely different from assessing credit risk. That distinction left the lenders in the case blameless for not detecting potentially fraudulent behaviour by the borrower, that might otherwise have rendered their mortgage security unenforceable.

The borrower, a corporation that owned a Toronto apartment building valued at $18.8 million, was represented by Huang, who was its sole director and officer. Huang granted second and third mortgages with high interest rates to separate private lenders: One was for $6 million, with 13% interest for one year, and the other was for $1.7 million, with interest at 15% over six months.

When the mortgages went into default, the second mortgagee exercised its power of sale, which the court approved. The property sold for about $16 million, with a $6 million holdback pending a ruling on whether the second and third mortgages were both tainted by fraud and thus unenforceable (the first mortgage had already been discharged).

Huang’s co-shareholders challenged the validity of the two mortgages, and asked the court to declare them invalid so that the holdback could be returned to the corporation. 

First, they alleged that Huang had acted recklessly, fraudulently and without authority. They claimed this left them oppressed as shareholders, and deprived of substantial funds.

Secondly, the co-shareholders claimed that the mortgagees themselves had been reckless or willfully blind in dealing with Huang, whom they did not know and should not have trusted and should have done a more thorough investigation.

It was also argued that a simple review of the rent roll Huang provided would have revealed “badges of fraud”, since it showed rents three times higher than the previous years.  Had the true income been known, it would have been obvious to the mortgagees that the property could not support the interest payments called for by the mortgage loans. 

The court rejected these arguments. The mortgagees had done all the due diligence required of them, and the resulting mortgages were both valid.

Huang, as sole director and officer, had both ostensible and actual authority to execute the loans, and the mortgagees were entitled to rely on the Indoor Management Rule without further inquiry. They were unaware of any internal shareholder dispute, and had no reason to suspect potential fraud by Huang nor had they been willfully blind, since Huang’s stated (and actual) purpose for the loans was to pay off prior mortgages.

The court emphasized that the underwriting risks taken by the mortgagees did not amount to “badges of fraud”. There was a distinction between legal risk, and financial risk.  On the legal side, the mortgagees had properly verified the legal validity of the mortgages: They had retained counsel, registered their security, demanded a higher rate of interest, and relied on an $18.8 million appraisal on a property that ultimately sold for nearly $16 million.

As for financial risk:  The second and third mortgage loans were based on a property valuation that left ample equity to secure the mortgagees’ positions. They also bore elevated interest rates to reflect the commercial risks. As non-institutional investors in mortgages, the mortgagees were fully entitled to take such risks – and could not be faulted for doing so.

Having acted without notice of any impropriety, these were bona fide mortgagees who were entitled to enforce their security, the court ruled. Both mortgage loans were declared valid and enforceable, and ordered they be repaid from what remained of the $6 million holdback. See Chen v. Huang, 2024 ONSC 6961.