The most recent edition of the Quarterly Trust Review (Vol 13, Issue 4) includes an interesting article, “A big step forwards for backwards tracing,” analyzing the recent Privy Council decision in Brazil v. Durant.1 In that decision, an appeal from a decision of the Jersey court, the Privy Council allows the respondents the benefit of what is called “backwards tracing.”
As the article’s authors, Alan Sheeley and Craig Connal, explain, tracing is the means by which a claimant can identify the proceeds of their misappropriated asset. For example, if a wrongdoer takes $500,000 from the claimant’s account and uses it to buy land, tracing allows the claimant to follow the original money into the land. Tracing follows the value of the original asset. If a claimant can successfully trace the proceeds of a misappropriated asset, he or she can then assert a claim, and can choose whether to bring a personal or proprietary claim. This makes tracing a powerful tool in the protection of a claimant’s interests.
A claimant’s ability to claim a proprietary interest in the traceable proceeds will be extinguished, however, in a variety of circumstances, such as if the asset is purchased by a bona fide purchaser for value without notice, or if the asset if used to discharge a debt (unless that debt is secured). Once the proprietary interest has been extinguished, it cannot be substituted for an interest in another asset that the wrongdoer acquires either before the misappropriation, or at some point after the proprietary right is extinguished. Tracing, in other words, must be chronological.
Backwards tracing refers to tracing into non-chronological transactions: the claimant traces into an asset which the wrongdoer acquired prior to acquiring the claimant’s asset. It therefore breaks one of the traditional rules of tracing.
In Brazil v. Durant, the former mayor of Sao Paulo, Brazil, had received 15 payments which the court determined were bribes. Thirteen of these payments, which together totalled $10.5 million US, were then transferred to an account in New York controlled by the mayor’s son, and from there were redistributed in 10 payments to accounts in Jersey controlled by two British Virgin Island (“BVI”) companies. The municipality sought the return of the $10.5 million, which it submitted the BVI companies were holding as constructive trustees. The issue was that the last three payments into the New York account occurred after the final payment to the BVI companies’ accounts. The defendant therefore held it was not liable for the approximately $3 million which those last payments represented. Under traditional rules of tracing, the defendant would have prevailed.
Privy Council Ruling
The Privy Council, however, disagreed with the defendant’s position, finding that in cases where there is a close causal and transactional link between the incurring of a debt and the use of trust funds to discharge it, backwards tracing could be allowed. The court held that there was a sound policy reason for allowing backward tracing in these circumstances, given that money laundering methods were becoming increasingly elaborate, with “a web of credits and debits between intermediaries.”
The court did not endorse a general expansion of tracing principles to allow money used to settle a debt to be traced back to whatever was acquired in exchange for the debt. However, it held that in certain circumstances, as here, backwards tracing was permissible. In determining whether backwards tracing was appropriate, the court directed that judges look at the whole transaction, and at the “substance of the transaction” rather than the strict order of payments. The court should be satisfied that the transactions are part of a coordinated scheme.
As Sheeley and Connal point out, the decision expands the available routes to recovery for victims of fraud, and will likely provide the courts with greater flexibility to avoid unjust decisions in cases of complex schemes of money laundering. The Privy Council’s direction to look to the substance of a transaction, rather than its form, allows the court to do justice in the particular circumstances of the case, without being hampered by strict adherence to the rules of tracing.
This direction to focus on the facts of the case, and the substance of the transactions at issue, coincides with a similar relaxing of tracing rules in Ontario jurisprudence, and perhaps is an indication of the end of the strict transactional and chronological approach to tracing.
In the family law context, tracing rules are often adopted more as guidelines than as strict limits on a claimant’s ability to trace. Tracing tends to arise in the family law context as part of the exercise of determining net family property, and what assets held by each spouse may be excluded from equalization. This often depends on tracing money back to a gift or inheritance.
Courts in this context have adopted what they refer to as a “common sense” approach to tracing. Even if the claimant cannot in fact account for the money from the time of the gift to the time of separation, a court will be willing to connect the dots, if there is evidence of the money coming in, and a short time later a similar amount reappearing elsewhere.
For example, in the case of Bennett v. Bennett, the court allowed the husband to exclude a parcel of land that he purchased for $35,000 around the same time he inherited $40,000 from his mother, even though there was no evidence of where the funds were in the interim. The court held that “Strict tracing rules would not provide for this result but common sense and a reasonable view of how this couple could have found the amount of money required for the purchase of the land leads to a conclusion that the strict tracing rules should be relaxed.”2
Similarly, in Ludmer v. Ludmer, the court allowed the husband to exclude from his net family property the traceable proceeds of a gift of $625,000 from his parents, which he had deposited into the parties’ joint bank account but, he submitted, used almost immediately in its entirety to acquire a property. The court found that although the husband could not demonstrate that the funds that he placed in the joint account were the same used to purchase the property, the proximity and context of the two events (the gift and the purchase) were sufficiently close, in the context of the parties’ means at the time, to warrant the conclusion that the gift was traceable to the property. The court cited Bennett, supra and explained the rationale for employing its “common sense approach” to tracing as follows: “It appears that some of the older, more technical tracing rules developed in the context of trust law are not applicable in the family law context where they would bring about an arbitrary or unfair result.”
In the general trusts context, courts have also shown a willingness to relax the strict approach to tracing when it is simply too complicated to be practical. In Law Society of Upper Canada v. Toronto Dominion Bank,3 the Court of Appeal held that in cases where there are a number of beneficiaries making claims to funds that have been mixed together in a single bank account and it is too complicated to engage in an exact tracing exercise, the method which should be followed is the pari passu ex post facto approach.
This approach involves taking the claim or contribution of the individual beneficiary to the mixed fund as a percentage of the total contributions of all those with claims against the fund at the time of distribution, and multiplying that factor against the total assets available for distribution, in order to determine the claimant’s pro rata share of those remaining funds.4
This approach has the advantage of workability and simplicity when compared to the traditional approach, which stipulates that an injured beneficiary can only claim a proprietary interest over the lowest intermediate balance in the account between the date its funds were deposited and the date of distribution. This is because any new money deposited into the account after the beneficiary’s funds were depleted is not technically part of the injured beneficiary’s trust funds. This “lowest intermediate balance rule,” however, requires the court to conduct a complex analysis when there are dozens or hundreds or beneficiaries, each limited by a potentially different intermediate balance. In some situations, such an exercise is simply not practical, and the court has demonstrated a willingness to take a more flexible approach.5
All of these approaches outlined above – the “substance” versus strict order of transactions; the “common sense” approach; and the pro rata sharing of the available funds between all claimants –represent the courts’ attempt to do justice in the specific circumstances, based on a larger view of the transactions in question. Each of these approaches is, so far, only endorsed by the court in a narrow set of circumstances, But given the courts’ willingness, in a number of discreet contexts, to depart from more formalistic rules of tracing to get at the substance underlying a series of transactions, perhaps we are approaching a time when the courts will be willing to embrace a more “common sense” approach to tracing, in all circumstances.
1.  UKPC 35.
2. Bennett v. Bennett, 1997 CarswellOnt 4682 (Ont Gen Div) at para. 79.
3. (1998), 42 O.R. (3d) 257 (C.A.).
4. Ibid. at para. 34.
5. See also Ontario (Securities Commission) v. Greymac Credit Corp. (1986), 55 O.R. (2d) 673 (C.A.)