Banking & Financial Services Law : Canadian and U.S. / Cross-Border Credit Market Lawyers & Attorneys : Osler Hoskin & Harcourt Law Firm

UPDATE

Saskatchewan has also introduced a bill to implement these location of debtor rules in that province's Personal Property Security Act.

ORIGINAL ARTICLE

As previously described (PDF) by Rupert Chartrand and Michael De Lellis of Osler, Hoskin & Harcourt LLP, a series of significant amendments to the Personal Property Security Act (Ontario) (the Ontario PPSA) were introduced through the Ministry of Government Services Consumer Protection and Service Modernization Act, 2006 (the Ontario Act) in 2007. Certain provisions of the Ontario Act have yet to be proclaimed into force, including certain amendments that would alter the “location of debtor” rules under the Ontario PPSA.

Current Rules

The Ontario PPSA contains conflict of laws rules which point to the law of the jurisdiction where the debtor is located to determine the validity, perfection, the effect of perfection or non-perfection and the priority of security interests in:

(i)                  intangibles (including accounts),

(ii)                goods that are of a type normally used in more than one jurisdiction (if the goods are equipment or inventory leased or held for lease by a debtor to others-- sometimes referred to as mobile goods), and

(iii)               non-possessory security interests in instruments, negotiable documents of title, money and chattel paper.

Under these rules, the location of the debtor is deemed to be located:

(iv)              at the debtor’s place of business if there is one;

(v)                at the debtor’s chief executive office if there is more than one place of business; and

(vi)              otherwise at the debtor’s principal residence.

Determining a debtor’s location for purposes of Ontario PPSA conflict of laws rules is rarely straightforward because the term “chief executive office” is not defined in the Ontario PPSA. Consider the following scenario. A Nova Scotia company has its registered or head office in Toronto, has offices in three other Canadian provinces, including executive offices in Calgary and Regina, and is controlled from the head office of its parent corporation in Missouri. Which of these offices is the “chief executive office”? That question is not easily answered and typically leads to lawyers registering in each jurisdiction where the “chief executive office” could potentially be located. This approach is inefficient and costly.

Amendments

The Ontario Act proposes to amend the conflict of law rules such that the location of a business debtor is no longer defined by reference to the debtor's place of business or chief executive office. Instead, the location of the debtor will be determined by rules (shaded gray) regarding the debtor’s jurisdiction of incorporation, which are much easier to apply. This would also make the Ontario PPSA rules regarding the location of a debtor substantively similar to those under Article 9 of the Uniform Commercial Code.

As noted above, amendments to “location of debtor” rules in the Ontario PPSA are not yet in force. It seems the Ontario government is waiting for other Canadian jurisdictions to follow suit before proclaiming the “location of debtor” amendments into force; uniformity of rules being the objective. A step toward uniformity was taken on March 31, 2010 when Bill 6 received Royal Assent in the British Columbia Legislature becoming the Finance Statutes Amendment Act, 2010 (the BC Act) (see s.43). The BC Act includes amendments to the Personal Property Security Act (British Columbia) (the B.C. PPSA) that adopt the same “location of debtor” rules as the Ontario PPSA. However as with the “location of debtor” rules in the Ontario Act, the B.C. PPSA amendments will not come into force immediately.

We will continue to provide updates in this space as to the progress of PPSA amendments across the remaining Canadian provinces and territories.

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On April 14, 2010, the New York Times DealBook reported on a survey of 48 top merger and acquisition advisors (including bankers, lawyers and others) published by Brunswick Group LLC. In that survey, 78% of respondents believed that M&A activity would increase for the rest of 2010, given the level of activity in Q1. 22% felt the level of activity would remain the same.

36% of respondents felt that “CEO/Board confidence” was the most important factor in this optimistic market view, outpacing “greater availability of credit and low interest rate environment” at 28%.

The report was published in connection with Tulane University Law School’s annual Corporate Law Institute in New Orleans.
 

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On April 7, 2010, the U.S. Securities and Exchange Commission (SEC) proposed new rules that would revise the disclosure, reporting and offering process for the issuance of asset-backed securities (ABS) in the United States. According to the related press release issued by the SEC:

“The proposed rules are intended to provide investors with more detailed and current information about ABS and more time to make their investment decisions. The proposed rules also seek to better align the interests of issuers and investors by creating a retention or “skin in the game” requirement for certain public offerings of ABS.”

There is a 90 day window in which to provide comments on the proposal to the SEC.

The proposals being considered include, among other things:

• new disclosure requirements for issuers to provide specific data for each loan in an ABS asset pool at the time of securitization of the assets and on an ongoing basis (there may be an exemption from “loan-level” disclosure for credit card securitizations, though more detailed information would be required);
• the filing of a computer program that would show the effect of the cash flow payments, or “waterfall”, in a proposed securitization transaction;
• revised filing deadlines to provide potential investors with more time to review information about the transaction;
• new shelf eligibility criteria for ABS which would include:
  • a repeal of the requirement for an investment grade credit rating, and
  • require the ABS sponsor to retain a portion of each tranche of the ABS issued.

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For much of the first quarter of 2009, U.S. credit markets continued to stumble through the aftermath of Lehman Brothers’ bankruptcy, with many segments of the markets effectively still frozen.

Fast forward about a year, and quite a different picture of 2009 emerges - at least in U.S. bond markets. 2009 new issuance activity turned out to be a record-breaker in the U.S. for investment grade bonds, and, depending on sources, at or near record-breaking levels in U.S. high yield bond markets as well. This exceptionally strong performance is all the more remarkable given how slowly 2009 began. U.S. high yield in particular saw a dramatic upsurge in 2009. Markets became frothy enough to produce, toward the end of 2009, the first PIK-toggle deal done since the end of the 2005-2007 credit boom (JohnsonDiversey), several dividend recapitalization financings (e.g. Quintiles) and the (admittedly, muted) return of covenant-lite.

By contrast, an examination of U.S. loan markets activity in 2009 reveals something of a dichotomy. Overall U.S. loan market activity remained largely moribund in 2009, roughly comparable in absolute levels to those last seen in the prior lending downturn of 2000-2001 - notwithstanding the much more significant decline in percentage terms (from a much higher peak during the 2005-2007 credit boom). One bright spot was an upsurge in U.S. institutional leveraged lending toward the end of the year (from an extremely low base), with 4Q2009 representing roughly half of 2009’s overall volume.

Underlying the activity in U.S. credit markets in 2009 were torrential, yield-chasing inflows into bond and loan mutual funds, and an associated dramatic increase in the secondary market prices of bonds and loans. For instance, average leveraged loan prices increased from the low 60s to the high 80s or low 90s. This took the boil off so-called loan buybacks (in which borrowers sought to monetize loan trading discounts), and made new issuance more competitive with decreased secondary market yields.

Interestingly, a closer examination of U.S. loan market statistics in 2009 reveals that a significant portion of the continued weakness in the sector was due to the ongoing freeze in the shadow banking system (CDOs, CLOs, SIVs, hedge funds, REITS, etc.), which at the height of the credit boom in 2007 represented 65-70% of overall U.S. leveraged lending volume. U.S. banks, by contrast, continued lending in 2009, although at significantly lower levels than were seen during the credit boom. Although some pieces of the shadow banking system, such as CDOs and SIVs, may never return, others, such as CLOs and hedge funds, have shown signs of improvement. CLOs in particular have benefited from the dramatic increase in secondary loan market prices, effectively curing existing CLOs’ breached overcollateralization ratios; while paydowns from high yield bonds, asset sales and other sources have provided existing CLOs much needed liquidity. For much of 2009 and until recently, no meaningful new CLO issuance was seen in the U.S. – but that too changed in mid March of 2010, when Citigroup underwrote a US$500 million issuance for a CLO managed by New York-based WCAS Fraser Sullivan Investment Management LLC. This transaction, in part a refinancing of an existing CLO, also increased the size of the CLO’s asset base by more than 50% with the addition of new, widely-syndicated loans – the first time in more than 12 months that a meaningful amount of new syndicated loans had been securitized in the U.S. The transaction was seen as a baby step toward the re-opening of new CLO issuance in the U.S., and may herald further reliquification of U.S. secondary loan markets.
 

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This outlook for the market for asset-based loans in Canada was drafted by Scott Horner in January, 2010.

Canada has experienced some economic turbulence as a result of the recent global economic crisis. However, Canadian banks have not suffered the losses experienced by many of their competitors in the US and European markets and their stability was not an issue during the financial crisis that has occurred in other markets. The reasons for the Canadian banks’ stability in the face of the financial crisis elsewhere are beyond the scope of this article. However, the banks’ stability; demand for the ABL product to fill the void created by cash flow lenders tightening credit availability; some US lenders repatriating some of their resources from the Canadian market in order to focus on resolving problems at home arising from the recent financial crisis there; and the ABL product working well with an active high yield bond market to fulfill issuers’ capital requirements have contributed to steady Canadian asset-based lending activity for lenders in the ABL business.

Factors Driving ABL Employment

One of the significant strengths of the ABL product is that it can withstand earnings volatility. The key to ABL’s employment is that the borrower owns quality current assets. Accordingly, the product works well with capital intensive businesses like retail, distributors and industrial manufacturers regardless of these businesses’ decreased earnings, or even losses, as a result of the recent recessionary period. Another significant strength of the ABL product is the flexibility that it may afford borrowers by way of its “covenant lite” aspect which may be appealing to borrowers whose financial performance has been adversely affected by the recent recession. Recent Canadian consumer surveys have shown consumers are increasingly confident about their employment, specifically, and about economic recovery, generally. We expect demand for the ABL product will further strengthen during the ongoing economic recovery as borrowers build inventory stock to satisfy increasing domestic consumer demand.

Risk Reward Profile of ABL for Borrowers and Lenders; Impact of Legal Developments on Such Profile

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The recent US Bankruptcy Court ruling in Lehman Brothers Special Financing Inc. v. BNY Corporate Trustee Services Ltd. has called into question the enforceability of a common provision used in securitization transactions. The ruling delivered by Judge James Peck on January 25, 2010 held that conditional priority or “flip” provisions, which are designed to subordinate swap termination payments in the event of swap provider bankruptcy, are unenforceable.

The priorities of payments in securitization transactions are usually set out in a provision known as the waterfall clause. Typically, certain payments to swap providers occupy a higher position in the waterfall when the swap provider is not in default than when the swap provider is in default – basically a “flip” provision. The bankruptcy of the swap provider is a default which brings into effect the flip provision and lowers the priority of the swap provider with respect to certain payments. Under the US Bankruptcy Code any contractual provision which purports to create a default or alter the rights of the debtor exclusively because the debtor files for bankruptcy is void (commonly referred to as ipso facto clauses). Judge Peck found that a flip provision was void on this basis.

This ruling conflicts with the English High Court of Justice (Chancery Division) and the English Court of Appeal (Civil Division) which ruled, in parallel proceedings, that a flip provision was enforceable.

The issue has arisen in recent Canadian transactions and while the better view may be that the US decision will not be followed in Canada, the issue has not yet been fully resolved in Canada either legally or from a market practice perspective.
 

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The recent receivership of Skyservice Airlines Inc. highlights the importance to airline creditors of having in place a certain, easily understandable and uniformly applied regime regarding the perfection and priority of various interests in aircraft.

The Convention on International Interests in Mobile Equipment, together with the Protocol to the Convention on International Interests in Mobile Equipment in Matters Specific to Aircraft Equipment, commonly referred to as the “Cape Town Convention”, establish an Internet and notice based electronic registry system with respect to aircraft, aircraft engines and helicopters (collectively, “aircraft”). The registry allows individuals and organizations to electronically register their interests in aircraft in one central registry which is easily accessible and searchable by anyone. The Cape Town Accord provides a simple “first to file” priority rule based on the registrations made in the new registry. The new registry system and related priority rule are simple, efficient and easy to understand by all participants, and most importantly, are intended to apply uniformly to everyone. Unfortunately, the Cape Town Conventions has not been fully implemented by many countries, including Canada. Given the need for liquidity and efficient financing by today’s airlines, and the need for certainty of remedies and protection by their lessors and financiers, it is unfortunate that the industry remains lost is a quagmire of inconsistent rules, complicated priority regimes and complex conflict of laws issues.

Currently, in order for an aircraft lessor or financier to ensure their interests are protected with respect to third parties, they are left with no choice but to determine which jurisdictions may from time to time be applicable, what the conflict of laws rules of each such jurisdiction determine to be the applicable jurisdiction for the perfection and protection of their interests, and then take the steps prescribed under each applicable jurisdiction to protect their interests. Obviously, this can be a very time consuming and expensive exercise.

For example, consider a debtor under an aircraft security agreement that is incorporated in the Province of Ontario, has its head office in the Province of Alberta, has registered the aircraft with Transport Canada and uses the aircraft on routes from Montreal, Quebec to locations in Europe. A secured party will need to understand the law of each of these jurisdictions to fully protect its interests. In this example, Ontario law provides that the relevant jurisdiction for determining the secured party’s rights is the jurisdiction where the place of business of the debtor is located, or if there is more than one place of business, the jurisdiction where the chief executive office of the debtor is located. That determination in itself is not an easy one to make and depends on many factors that will need to be considered by the secured party, which factors will be subject to change from time to time. In the above example, and assuming that the chief executive office analysis determines that the chief executive office of the debtor is the same as the head office of the debtor, Ontario law sends the secured party to Alberta. Under a similar analysis, Alberta law also sends the secured party to Alberta. However, as the aircraft may from time to time be located in the Province of Quebec, the secured party will need to know what the law of that Province provides. Under Quebec law, the applicable jurisdiction for determining the secured party’s rights vis-a-vis third parties is the jurisdiction of the debtor’s registered office, which is typically the jurisdiction of incorporation of the debtor. Thus, a Quebec court would look to apply the laws of Ontario, notwithstanding the fact that an Ontario court would apply the laws of Alberta. Further, as the aircraft may from time to time be in Europe, the conflict of laws rules of the applicable European country will need to understood. The conflict of laws rules of many European countries point to the jurisdiction where the aircraft is registered. In the above example, the applicable jurisdiction is Canada, as the aircraft is registered with Transport Canada. However, Canada does not have a federal system of registration with respect to perfection or priority of interests in personal property (including aircraft); perfection and priority issues with respect to personal property in Canada is governed by provincial and territorial law. A prudent secured party, therefore, will need to look to the perfection rules of each province and territory of Canada. Other European countries look to the jurisdiction of the debtor, which in this example could be Ontario or Alberta. Once all the applicable jurisdictions are determined, the laws of each such jurisdiction will need to be analyzed to determine what is necessary to perfect and protect (and maintain) a secured party’s interest and the priority thereof with respect to third parties. Of course, as soon as a debtor relocates its registered office, chief executive office, where it stores the aircraft or the routes that it flies, the entire analysis needs to be redone.

The Cape Town Convention and Aircraft Protocol is intended to create a simple registration system and priority regime that is uniformly applicable. For the sake of aircraft lessors and financiers, as well as their customers and clients, we can only hope that more countries adopt and implement them as soon as possible.

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