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

The Bank Act (Canada) (the “Act”) and a number of other federal statutes relating to financial institutions must, by law, be reviewed every five years. The most recent review process has culminated in Bill S-5 (the Bill) which is entitled the Financial System Review Act (the FSRA).The Bill had first reading in the Senate on November 23, 2011, and requires second and third readings in the Senate, first through third readings in the House of Commons and then Royal Assent before the FSRA can come into effect.

Bank Act Security and the Impact of Recent Judgments

Part VIII of the Act provides banks listed under Schedules I and II of the Act, and authorized foreign banks, the right to advance funds on the security of certain collateral listed in section 427 of the Act.

Last year the Supreme Court of Canada (SCC) issued two decisions in which it determined that an unperfected Personal Property Security Act (PPSA) security interest had priority over a subsequent but perfected security interest under section 427 of the Act. The result of these SCC decisions undermined the utility of the Act security and has resulted in its non-use by Canadian banks. 

Proposed Amendments

The Bill includes proposed amendments to the Act security regime addressing the priority of the Act security in light of these SCC decisions. In summary, the Act, when amended, will include a statement that security properly taken under the Act has priority over a PPSA security interest (or any other security interest) that was unperfected at the time the Act security was taken except if the relevant bank, when it acquires the Act security, has knowledge of such unperfected security interest. It remains to be seen whether Canadian banks are satisfied with the legal effect of such proposed amendments such that Act security will once again be used.

This entry is based on content from the Osler Update “Canadian Government Introduces Amendments to Back Act” authored by Stephen D.A. Clark, Kashif Zaman and Victoria Graham.

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In a contest between two innocent creditors over the proceeds of shares credited to an investment account which were traceable to fraudulently obtained funds, the Supreme Court of Canada held in favour of the Bank of Montreal (“BMO”), a secured creditor. The decision should provide lenders with a degree of comfort where it is later uncovered that the assets subject to their security interest were purchased with funds obtained through fraud.

In i Trade Finance Inc. v. Bank of Montreal, the Court had to determine whether the pledge of fraudulently obtained shares granted to BMO made it bona fide purchaser for value without notice of fraud. Otherwise, i Trade Finance Inc. (“i Trade”), which had lent the defrauding party (the “Fraudster”) the funds used to purchase the shares in question, could rely on an order obtained through a civil proceeding entitling i Trade to obtain any assets traceable to the funds of which it is was defrauded (excluding assets in the hands of a bona fide purchaser for value without notice).

The Court’s reasoning that the Fraudster had rights in the shares sufficient to support the granting of a security interest to BMO hinged on the principle of contract law that fraud does not render a contract void automatically, but rather a contract tainted by fraud is voidable at the election of the party defrauded. The fraud had not yet been uncovered at the time of the pledge, so BMO was able to fit itself into the exception to the tracing order as a bona fide purchaser for value without notice as a pledgee.

The reasoning in this case should be helpful where a secured creditor’s interest is challenged on the basis that the collateral was obtained through fraud. However, lenders should remain diligent. The reasoning may not extend where the fraud is uncovered before the lender’s security interest attaches to the fraudulently obtained collateral as the Fraudster must have rights in the collateral for a security interest to attach.
 

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A recent decision of the Ontario Court of Appeal illustrates that secured creditors should address their priority position relative to all other creditors of their borrower in order to achieve a complete subordination of competing security. Failure to do so in this case resulted in circular priorities that the Court was left to resolve. In light of the Court of Appeal’s decision, secured creditors should ensure they are a party to all subordination agreements with the debtor in order to achieve their expected result.

The Facts and Agreements

This case (C.I.F. Furniture Limited (Re)) involved a priorities dispute between two secured creditors of an insolvent corporation, C.I.F. Furniture Limited (the “Debtor”), arising out of conflicting subordination agreements. Under Ontario law, subordination agreements are generally valid. However, in this case the dispute arose because the two subordination agreements did not include all of relevant secured parties.

The shares of the Debtor were held by Kari Holdings (“Kari”). In 2004, the principals of Kari sold their shares in the Debtor to a purchaser for approximately $7 million. In connection therewith, Kari provided $1 million in vendor take-back financing secured by a general security agreement. The VenGrowth group of investment funds (“VenGrowth”) also provided $4.35 million in financing, secured by a senior subordinated debenture. In addition, VenGrowth advanced significant additional capital to the Debtor on a junior and/or subordinated basis to Kari, with certain of such advances being made in 2004 to finance the share purchase. At the time of the transaction, the Bank of Nova Scotia (“BNS”) as the operating lender to the Debtor, Kari and VenGrowth entered into an inter-creditor agreement setting out the following priorities between the parties:

• first, BNS to the extent of its loans to the Debtor;
• second, VenGrowth to the extent of its $4.35 million senior subordinated debenture;
• third, Kari to the extent of its $1 million secured note; and
• fourth, VenGrowth to the extent of the additional loans it had advanced on the purchase of Kari’s shares.

BNS was subsequently paid out in 2006. A priorities issue arose later when Comerica Bank agreed to provide a revolving credit facility to the Debtor in 2008. At such time, Comerica Bank and the Debtor signed a commitment letter which expressly provided that Kari’s $1 million note was to rank ahead of Comerica and required VenGrowth to provide Comerica with a $1 million guarantee, which guarantee would terminate on repayment of the Kari note. Comerica Bank and the Debtor also entered into a credit agreement for the provision of up to $2.5 million to the Debtor, secured by a general security agreement. The credit agreement recognized the Kari note as a first priority lien and Comerica’s security interest as a second priority lien. In connection with the financing, Comerica and VenGrowth entered into an inter-creditor agreement pursuant to which VenGrowth agreed to subordinate its security to Comerica’s security.

The Circularity

As a result of the foregoing inter-creditor agreements, a circularity in priorities was created:

• VenGrowth ranked ahead of Kari under the 2004 inter-creditor agreement;
• Kari ranked ahead of Comerica under the 2008 inter-creditor agreement; and
• Comerica ranked ahead of VenGrowth under the 2008 inter-creditor agreement.

The Decision – Partial or Complete Subordination?

The Court of Appeal considered whether the theory of complete subordination or partial subordination should apply to the priorities dispute. The Court held that complete subordination would confer a windfall on Kari, who would have jumped in the priorities queue from second position to first position. In contrast, partial subordination would produce an equitable result because Kari would not be burdened nor benefited by the 2008 inter-creditor agreement. In addition, the Court of Appeal held that complete subordination would only be justified if supported by “clear and unequivocal language”. In this case, there was no clear evidence in any of the documentation, including the 2008 inter-creditor agreement, that VenGrowth intended to subordinate its entire priority position. As VenGrowth was not a party to the 2008 commitment letter or credit agreement, Comerica and the Debtor could not by themselves subordinate the priority interest of the VenGrowth senior debenture to the Kari note.

Accordingly, the Court concluded that the theory of partial subordination should apply to the priorities dispute, resulting in the following priorities:

• first, Comerica to a maximum of $4.35 million, and then VenGrowth to a maximum of $4.35 million less Comerica’s claim;
• second, Kari;
• third, Comerica for any claim in excess of $4.35 million; and
• fourth, VenGrowth for all of its remaining claims.
   

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In May of 2010, we reported on the decision of the British Columbia Court of Appeal in Ted Leroy Trucking v. Century Services Inc. In that decision, the Court of Appeal upheld a decision of the B.C. Supreme Court which determined that employee “wages” recoverable under the Wage Earner Protection Program Act (Canada) ("WEPPA") include components from an employee's compensation package that are remitted by an employer to third parties on behalf of an employee. This would include payments for items such as union dues or extended health coverage provided by a third party service provider. The highest ranking secured creditor of the employer argued unsuccessfully that such protection only extends only to funds payable directly to employees.

This decision was important because it confirmed the scope of employee wage claims against a bankrupt employer that would benefit from a super-priority charge under the Bankruptcy and Insolvency Act (Canada).

The secured creditor sought leave to appeal to the Supreme Court of Canada. However, on December 9, 2010, the Supreme Court of Canada denied such leave.

As a result, lenders should continue to account for such indirect payments when structuring a loan transaction, including in the calculation of any borrowing base
 

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Section 38 of the Ontario Personal Property Security Act (the "Act") contains an exception to the general priority scheme of the Act. It provides that a secured creditor may, in the relevant security agreement or otherwise, subordinate its security interest to any other security interest, and that such subordination will be effective according to its terms. No distinction is drawn between perfected and unperfected security interests.

From a secured creditor’s perspective, section 38 is a potential trap for the unwary.

First, it overrides the common law doctrine of privity of contract. Indeed, it seems that a competing secured creditor may claim the benefit of the section in the absence of an actual subordination agreement with the first secured creditor, and without prior knowledge of the alleged intention of the first secured creditor to subordinate its security.

Secondly, there is relatively recent case law to the effect that the alleged intention of the first secured creditor to subordinate its security need not be explicit. If, for example, the loan documentation expressly or impliedly permits the possible existence of any other encumbrances on the relevant collateral without addressing the question of relative priorities, a court may determine that such permission makes no commercial sense unless one or more of the encumbrances are also permitted to rank ahead of the first secured creditor’s security. In the event of a dispute between competing creditors, section 38 has been interpreted to invite not only an examination of the documents evidencing the alleged subordination of the first secured creditor to the interests of the other (or a class of others), but a review of the intentions and actions of the first secured creditor and the debtor in the event of any ambiguity.

From a practical perspective, any risk of inadvertent subordination pursuant to section 38 should be avoidable by explicitly addressing in the loan documentation the question of priorities. In particular, it is desirable to include language to the effect that unless stated otherwise, no reference to other potential encumbrances on the relevant collateral should be construed as to subordinate any security of the first secured creditor in favour of any such encumbrances.
 

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The decision of the Ontario Court of Appeal in Fairbanx v. Royal Bank of Canada contains some useful information about how courts view inaccurate debtor names in financing statements and their approach to s. 46(4) of the Personal Property Security Act (Ontario)(“PPSA”) regarding materially misleading filings. The case also reminds secured parties to use a debtor corporation’s name as found in its articles of incorporation when filing a financing statement, in accordance with section 16(4)2 of the PPSA Minister’s Order.

In this case, a factor called Fairbanx Corp. purchased receivables from a debtor. The incorporated name of the debtor was “Friction Tecnology Consultants Inc.” However, it often carried on business with an additional letter “h”, as “Friction Technology Consultants Inc.”, and the company used that form of name on the receivables purchase documents entered into with Fairbanx. Fairbanx registered its PPSA financing statement in respect of the receivables purchase (an assignment of accounts) against the business name of the debtor but did not file against the debtor’s correct corporate name.

The debtor then obtained bank financing from Royal Bank of Canada (“RBC”). Over the course of negotiating the loan, RBC had searched the debtor’s name with, and without, the “h”. RBC then registered against the proper incorporated name. Subsequently, the debtor went bankrupt and a priority contest ensued between Fairbanx and RBC.

The first secured party, Fairbanx, argued that their registration against the misspelled debtor name remained effective to perfect their security interest due to section 46(4) of the PPSA, which provides as follows:

46(4) A financing statement or financing change statement is not invalidated nor is its effect impaired by reason only of an error or omission therein or in its execution or registration unless a reasonable person is likely to be misled materially by the error or omission.

Fairbanx asserted that since the debtor carried on business using the misspelled name, and RBC had searched against that name, a reasonable person would not be materially misled since they would search the incorrect name of the debtor. The Court did not agree. Its reasoning provides a good overview for interpreting s. 46(4):

• a financing statement with an error is prima facie effective - it loses effect if a reasonable person would be materially misled by the error;
• whether a person would be materially misled by the error is an objective test - RBC’s subjective knowledge of the registration against the wrong name was irrelevant;
• a financing statement with an error in a debtor’s name is unlikely to be saved by s. 46(4) of the PPSA because,
  • a search against the debtor’s correct name will not reveal the registration, or
  • even when a reasonable person searches against an incorrect name and finds the registration, that person may not be able to know whether the misspelled name is an error or the proper spelling of the name of another similarly named person or corporation. 

When registering a financing statement against a corporate debtor, a secured party should use the name found in a government certified copy of the articles of incorporation of the debtor.
 

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In its recent decision in Ted Leroy Trucking v. Century Services Inc., the Court of Appeal for British Columbia upheld a decision of that province’s Supreme Court which determined that employee “wages” recoverable under the Wage Earner Protection Program Act (Canada) ("WEPPA") include components from an employee's compensation package that are remitted by an employer to third parties on behalf of an employee. This would include payments for items such as union dues or extended health coverage provided by a third party service provider. This determination affects the scope of employee wage claims that would benefit from a super-priority charge under the Bankruptcy and Insolvency Act (Canada) ("BIA"). As a result, lenders should account for such payments when structuring a loan transaction, including in the calculation of any borrowing base.

Protection for “Wages” Under the WEPPA

The WEPPA and consequential amendments to the BIA were proclaimed in force in 2008. Under section 7 of the WEPPA, an employee can recover wages owing that were earned in the 6 months immediately before the date of bankruptcy or the first day on which there was a receiver in relation to the former employer.

"Wages" is defined in the WEPPA as follows:

2 (1) In this Act, "wages" includes salaries, commissions, compensation for services rendered, vacation pay, severance pay, termination pay and any other amounts prescribed by regulation.

The maximum amount recoverable is the greater of:

• $3,000, and
• an amount equal to four times the maximum weekly insurable earnings under the Employment Insurance Act (Canada)

Section 81.3(4) of the BIA creates a super-priority for outstanding wages of up to $2,000. The government is entitled to subrogate to recover any monies it pays under WEPPA and on such a proceeding is entitled to the benefit of the BIA $2,000 super-priority.

The Lower Court Decision

The union representing employees at the bankrupt trucking company argued that all monetary liabilities arising from the compensation package in the applicable collective agreement ought to be included in the calculation of wages protected by WEPPA, irrespective of whether the amount is payable directly to the employee or to a third party on an employee’s behalf. The receiver of the company disagreed, asserting that the only certain wages directly payable to an employee are protected.

The Supreme Court of British Columbia found that "wages" do include payments directed to third parties on an employee's behalf pursuant to an agreement, including a collective agreement. The Court stated, in part:

“To answer this question one must consider the definition of "wages" in s. 2(1) of the WEPPA. It is relatively expansive; it defines wages as including "compensation for services rendered". In my view any reasonable definition of "compensation for services rendered" must mean all compensation earned by the employee. It cannot be limited to only that portion of the compensation earned by the employee and due to be paid directly to him, as opposed to being paid to third parties at the direction of and for the benefit of the employee.”

The Appeal Decision

The Court of Appeal for British Columbia dismissed the appeal of a secured creditor. Many of the issues on the appeal focused on statutory interpretation. The Court of Appeal agreed with the interpretation of the lower court. The appellants also claimed that the lower court decision distorted the balance between workers and secured creditors. The Court of Appeal disagreed saying that the protection of wages under WEPPA is limited temporally and by amount, and that Parliament had considered this balance when passing the legislation. 

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