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

From time to time, we receive inquiries from foreign banks that do not have a presence in Canada on whether there are any Canadian banking regulatory restrictions on lending to Canadian borrowers. Under the Bank Act (Canada), a foreign bank can lend to Canadian borrowers by:

1. establishing a presence in Canada by creating a Canadian subsidiary or a foreign bank branch pursuant to the Bank Act (Canada); or
2. structuring its activities so that it is not considered to be engaged in or carrying on business in Canada.

The focus of this blog entry is option 2. A determination of whether a foreign bank is engaged in or carrying on business in Canada is a question of fact. Generally speaking, it is unlikely that a foreign bank that lends to a Canadian borrower would be found to be engaged in or carrying on business in Canada if:

• the foreign bank does not have a place of business in Canada;
• the foreign bank does not have a phone number in Canada;
• the foreign bank’s employees’ visits to Canada are for purposes of marketing; and
• the loan documentation is negotiated and signed outside of Canada by the foreign bank.
   

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On January 1, 2012, the Prescribed Entities and Classes of Mortgages and Hypothecs Regulations (the “Regulations”) under the Interest Act (Canada) (the “Act”) came into force.

The Regulations expand the class of “prescribed entities” that are exempted from the protections afforded by Section 10 of the Act.

Section 10 of the Act provides for mandatory prepayment terms for mortgages and hypothecs over real property with a term of more than 5 years. Such mortgages must provide that, at any time after the first five years of the mortgage term, the mortgagor shall have the right to pre-pay the full amount of the mortgage and any accrued interest outstanding at that time, subject to the payment of a penalty of three months interest. By providing these mandatory prepayment provisions, Parliament provided mortgagors with the ability to renegotiate long-term, high interest mortgages without having to pay unreasonable penalties imposed by lenders.

The Act provides exceptions to these protections – mortgages given by corporations and joint stock companies are specifically exempted from the prepayment provisions provided under section 10 of the Act. The policy behind the exceptions is to permit sophisticated commercial parties to negotiate their own mortgage terms. However, prior to the Regulations coming into force, enterprises not structured as corporations or joint stock companies occasionally had difficulty in securing long-term financing because prepayment terms were prescribed by the Act and some lenders were unwilling to advance funds with a prepayment penalty limited to three months interest.

The Regulations reflect the modern commercial reality that business enterprises are now structured in a variety of ways. As of January 1, 2012, in addition to corporations and joint stock companies, the following entities would be excluded from the mandatory prepayment protections under the Act:

• Partnerships
• Trusts that are settled for business or commercial purposes
• Unlimited liability entities under corporate/company legislation in Alberta, British Columbia and Nova Scotia.

Note that in Ontario, section 18 of the Mortgages Act (Ontario) contains similar mandatory prepayment terms for mortgages longer than 5 years.  This provincial legislation has not yet been updated to add exempt entities other than "corporations" or "joint stock companies" as mortgagors.

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In December 2011, the federal government launched a consultation aimed at updating Canada’s regime for combating money laundering and terrorist financing. The Department of Finance released a consultation paper setting out proposals to strengthen Canada’s anti-money laundering and anti-terrorist financing legislative framework, which is administered through the PCMLTFA. Comments on the consultation paper are requested by March 1, 2012.

The proposals in the paper are organized around the following key areas:

• strengthening client due diligence standards;
• closing gaps in Canada’s regime; 
• improving compliance, monitoring and enforcement; 
• strengthening information sharing in the regime; 
• introducing a list of potential countermeasures; and 
• updating reporting requirements.

Some interesting proposals include:

• expanding the customer due diligence requirements and cross-border currency reporting requirements to prepaid access;
• revising non-face-to-face identification measures for credit cards; 
• amending the definition of ‘politically exposed foreign person’ to include close associates of such person;
• eliminating the threshold of $10,000 for reporting electronic fund transfers to FINTRAC, and requiring financial entities, casinos and money service businesses to report all electronic fund transfers entering or leaving Canada; 
• expanding the application of client identification and record-keeping requirements to life insurance companies and brokers beyond current requirements for certain annuities and policies; 
• clarify the exclusion of reporting requirements for accounting firms when acting as trustees in bankruptcy; and
• expanding the list of designated information FINTRAC can give to law enforcement.
   

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Lenders should be cognizant that the granting of security by a debtor may be subject to challenge as a fraudulent preference in the event the debtor subsequently files for liquidation or proposal proceedings under the Bankruptcy and Insolvency Act (Canada) (the “BIA”) or restructuring proceedings under the Companies’ Creditors Arrangement Act (Canada) (the “CCAA”). Such risk arises if the debtor is insolvent the time the security was granted. Accordingly, lenders would be prudent to request financial and other information from the debtor to ascertain the debtor’s financial health prior to entering into any such transaction.

Challenging a Transaction as Preferential

A Trustee in bankruptcy or a proposal Trustee may challenge the granting of security by an insolvent debtor as a fraudulent preference under Section 95 of the BIA. Similarly, a CCAA Monitor may also challenge such a transaction as the CCAA incorporates by reference the BIA preference provisions. In order to challenge any such transaction, the Trustee or Monitor must establish a prima facie case that the following three factors exist:

1. the debtor was insolvent at the time of the transaction;
2. the transaction took place during the applicable statutory review period; and
3. the transaction was taken with a view to giving that creditor a preference over other creditors as discussed in more detail below.

If the court is satisfied that this onus has been met, the onus then shifts to the transferee/creditor to rebut the presumption of a fraudulent preference. At that point the court will review the evidence adduced by the transferee/creditor to see whether it rebuts that prima facie case. To be successful, the transferee/creditor must convince the court, on a balance of probabilities, that at least one of the three factors did not exist when the debtor made the payment. If the court concludes that there has been a fraudulent preference, the transaction will be void as against the Trustee (or Monitor in a CCAA proceeding).

The Applicable Lookback Period

The applicable lookback period will be three months from the initial bankruptcy event (being the date of bankruptcy, BIA proposal proceedings or CCAA proceedings, as applicable) if the creditor receiving the alleged preference was dealing at arm’s length with the debtor, or one year from the initial bankruptcy event if the creditor receiving the alleged preference was not dealing at arm’s length with the debtor. Related persons are deemed not to be dealing at arm’s length with one another absent evidence to the contrary. With respect to unrelated persons, it is a question of fact whether they were dealing at arm’s length at any particular point in time. Two parties will be deemed to be related if they are under common de jure control of the same entity or group of entities.

In connection with arm’s length transfers, transactions that have the effect of giving a creditor a preference during the avoidance period are, in the absence of evidence to the contrary, presumed to have been made with a view to giving such creditor a preference. The transferee/creditor must establish that there was no dominant intention on the part of the debtor to prefer one creditor over another, based on an objective assessment of the debtor’s circumstances at the time the debtor made the alleged preference.

In connection with non-arm’s length transfers, the debtor’s intention during the avoidance period is irrelevant - one only considers whether the impugned transaction had the effect of giving the transferee/creditor a preference over other creditors.

In the ordinary course where security is taken in connection with a new lending relationship with a new advance and does not secure past indebtedness, preference risk is reduced.

Transfers at Undervalue – “TUV”

One should note that in addition to the foregoing, a Trustee (or Monitor in a CCAA proceeding) may also attempt to challenge the granting of security as a transfer at undervalue (“TUV”) in accordance with the test set out in Section 96 of the BIA and incorporated by reference into the CCAA. This TUV concept is still a relatively new one and it is unclear how broadly the courts will interpret its scope when considering transactions that are already covered by preference provisions. The applicable lookback period for TUVs is one year before the initial bankruptcy event, if the parties are dealing at arm’s length, the debtor was insolvent at the time of the transfer and the debtor intended to defraud, delay or defeat its creditors. For parties that are not dealing at arm’s length, the applicable lookback period is one year regardless or five years if the debtor was insolvent at the time of the transfer and intended to defraud, delay or defeat its creditors.

By Richard Borins and Andrea Lockhart

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At the American Securitization Forum annual conference last month, a panel discussed the future of U.S. mortgage finance. Following the 2007 financial crisis and the collapse in U.S. housing values, there has been a transfer of U.S. mortgage funding from private sources of capital to government sources. At a basic level, the panel discussion was about the prospects for the return of private (as opposed to government) risk capital to the U.S. mortgage funding market. There was very little optimism that this transformation would take place in the foreseeable future.

Although with less intensity and clarity, the same debate is under way in Canada. Last month, CMHC announced limits on the amount of portfolio mortgage insurance it will provide. Portfolio mortgage insurance is used by Canadian banks and other mortgage lenders to insure conventional residential mortgages. The use of portfolio mortgage insurance for mortgages that are otherwise very low on the risk scale has been encouraged because of the favourable capital treatment it gives to regulated financial institutions holding mortgages and because it is a requirement for access to the federal government sponsored residential mortgage securitization programs. Directly or indirectly, portfolio mortgage insurance has been used to transfer mortgage funding risk to the federal government. This risk transference will now be reduced.

If this channel of mortgage funding is reduced, will other channels open up? One question to be answered is whether uninsured conventional residential mortgages will again be privately securitized in Canada? Will credit rating agencies, which operate globally, be willing to isolate Canadian experience from their world-wide experience? Should they? Questions that will be answered in the next year or so.

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A working group of the Personal Property Security Law Sub-Committee of the Ontario Bar Association’s Business Law Section has developed a proposal for amendments to the Ontario Personal Property Security Act to provide for perfection by control of deposit accounts and other forms of cash collateral. If approved by the Ontario Bar Association, the proposals will be submitted to the Ministry of Consumer Services for consideration. We understand that these proposals, if adopted, would amend the PPSA to create a new class of collateral – the “financial account” - and provide rights for secured parties to perfect a security interest in a financial account through control.

“Financial accounts” would be broadly defined to include deposit accounts and any other monetary obligation of a financial institution in respect of funds it holds or receives as security for an obligation.  Consumer accounts would be excluded from the definition of financial account, an approach which is consistent with Article 9 of the UCC.

The proposed amendments would allow a secured party to perfect a security interest in a financial account by 1) registration (this is already provided for under the PPSA and is a departure from Article 9 of the UCC) and 2) control.

The means by which a secured party could obtain control are very similar to those currently in place for securities accounts as a result of the Securities Transfer Act, 2006 (Ontario). Those methods would include:

1. automatic control if the secured party is also the financial institution that is obligated to the customer under the financial account; and
2. a control agreement entered into by the customer, the secured party and the financial institution maintaining the customer’s financial account whereby the financial institution agrees to comply with instructions originated by the secured party in respect of the financial account without further consent from the customer.

A secured party with control of a financial account would have priority over a secured party that does not have control, as well as over a secured party that perfected its interest in the financial account only by registration.

Importantly as well, the PPSA choice of law rules for financial accounts would mirror those in UCC Article 9 for similar collateral, such that the jurisdiction for determining issues of validity, perfection and priority of a security interest in U.S. cross-border deals could be easily established.

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