Traditionally, the view has been that the right to set off one debt against another does not constitute a security interest but it may be that this position is no longer as clear cut in light of the recent Canadian Supreme Court ruling in Caisse populaire Desjardins de l'Est de Drummond v. Canada, 2009 SCC 29 ("Caisse populaire") .
Security interest defined
A security interest is a right given to one party in the asset of another party to secure payment or performance by that other party or by a third party. A fixed or specific security interest is one which possesses the following features:
- it is a contractual right given by a debtor to a creditor in relation to an identifiable asset;
- that right is not by way of reservation of title to the creditor but by way of grant of an interest in the debtor's asset;
- the right is given for the purposes of securing an obligation;
- the asset is given in security only and not by way of outright transfer; and
- the debtor's rights to dispose of the asset free from the security interest is restricted by the agreement
What is set-off?
Set-off on the other hand, is the right (contractual, legal or equitable) which allows a debtor who is owed money by his creditor on another account or dealing to secure payment for what is owed to him by setting this off in reduction of his own liability. For instance, a banker is empowered to set off a credit balance on one account against a debit balance on another if the accounts are in the same name and in the same currency. It is an essential tool for debtors who have cross-claims against creditors and is widely utilised in both banking transactions and in mutual dealings in financial markets.
As mentioned above, the traditional view has always been that the right to set-off one debt against another does not constitute a security interest as the arrangement does not grant the creditor a property right in the asset against which set-off is to be effected. It merely involves the setting off of the respective personal obligations against each other and does not rely on a creditor having a property interest in the deposit. The creditor who is setting off has an obligation and has the right to satisfy that obligation by setting off an obligation which is owed to it by the debtor. It therefore does not have anything to do with the realisation of a property interest.
Ruling by the Supreme Court of Canada
Interestingly, in June 2009 the Supreme Court of Canada in Caisse populaire decided that set-off rights do create security interests in the case of a credit support arrangement involving cash collateral.
The facts: On 18 September 2000, Caisse populaire Desjardins de l'Est de Drummond (the "Caisse") granted its customer, a company called Camvrac, a line of credit of up to $277,000. A week later, Camvrac deposited $200,000 with the Caisse in accordance with a "Term Savings Agreement" (the "TSA"), under which the deposit was neither negotiable nor transferable. On the same day, the Caisse and Camvrac entered into a "Security Given Through Savings" agreement. Pursuant to this latter agreement, Camvrac agreed to maintain and permit the Caisse to retain the deposit of $200,000 for the duration of its indebtedness to the Caisse. It was also agreed that, in the event that Camvrac defaulted, there would be compensation between the credit agreement and the term deposit. Camvrac defaulted on the loan on 25 November 2000 and later made an assignment in bankruptcy. The Caisse noted on its copy of the "Term Savings Agreement": "To be closed on 21/2/2001 to realize on security".
As Camvrac had failed to remit to the Government of Canada (the "Crown") income tax and employment insurance premiums deducted at source, the Crown demanded that the Caisse pay Camvrac's unremitted unemployment insurance premiums and outstanding at-source tax withholdings out of the term deposit funds that it had set-off against Camvrac's credit line debt. It was argued by the Crown that the terms of the TSA created a "security interest" within the meaning of section 224(1.3) of the Income Tax Act ("ITA") and that the funds that were set-off against it were subject to a deemed trust in favour of the Crown1.
Section 224(1.3) of the ITA defines security interest as "any interest in property that secures payment or performance of an obligation and includes an interest created by or arising out of a debenture, mortgage, hypothec, lien, pledge, charge, deemed or actual trust, assignment or encumbrance of any kind whatever, however or whenever arising, created, deemed to arise or otherwise provided for.
The majority took a functional view of a security interest and held that the TSA did create a security interest in the deposit and that the means of enforcing that security interest was the right of set-off and in supporting the majority's conclusion, it was stated that "it is the encumbrances placed on the debtor's claim against the creditor that ensure that the creditor will remain liable to the debtor, and in this way, ensure an effective compensation remedy. In the view of the majority, these encumbrances placed on the deposit amounted to the acquisition by the Caisse of a property interest in Camvrac's deposit, primarily because they ensured that the Caisse would be continuously liable to Camvrac"2.
In analysing the concept of set-off, Mr Justice Rothstein referred to The Law of Set-Off (3rd ed. 2003) which in the court's view, argues persuasively that some contracts including a right of set-off should be said also to involve security. An example of a set-off situation described by Professor Derham (and which is very similar to that in Caisse populaire) was set out as follows:
. . . a bank as a condition to the grant of a facility requires that a deposit be made with it which the depositor is not permitted to access until all indebtedness under the facility has been paid, and the parties agree that the bank may appropriate the deposit in discharge of the debt in the event of default in payment. The essence of the arrangement is that the depositor's property, in the form of the account in credit, is to function as a security. Indeed, in the case of a charge-back in which express words of charge are used, a contractual set-off is the very remedy that would be contemplated..."
The essence of contractual set-off is that the terms of the contract reflect the mutual intention of the parties3. Further, if their mutual intention is to create a security interest to ensure that the right of set-off will be an effective remedy, there is no reason to think that a security interest does not exist simply because the parties have chosen one mechanism for realizing on the security, rather than another. What one must consider is the substance of the agreement.
As explained by the court in Caisse populaire, "the situation in this case is in contrast with one in which a bank has what may be a standard term in a deposit agreement that any credit in the customer's account may be appropriated by the bank in discharge of the customer's potential indebtedness to the bank. In that case there is no obligation on the customer to maintain a specific sum or, indeed, any amount deposited in the account at all as security for a loan that may or may not exist. There is no continuous right in the customer's property to protect the bank against default. The customer may withdraw any or all of the amounts in the account at any time. No specific property secures repayment. In these circumstances, based on this type of deposit agreement, the customer's property - its right to claim a deposit - cannot be said to secure its indebtedness to the bank. Unlike the case before this Court, this is a simple contractual right to set-off or compensation without attendant security."4
Implications of court ruling
The implication of Caisse populaire is that there is now a greater possibility that set-off rights in the context of cash collateral agreements where credit support is provided may be recharacterized as creating security interests in the cash collateral.
From a British Virgin Islands perspective, the impact of Caisse populaire remains uncertain and there is the possibility that it may set a precedent for the view that cash collateral arrangements and rights of set-off do, in fact, create security interests when they function as security for a borrower's obligation to a lender.
Until such time as Caisse populaire has been addressed by the English courts and/or the courts of the British Virgin Islands, a little more vigilance may be no bad thing. As a general rule, the British Virgin Islands position as regards set-off is that it does not create a security interest and is therefore not registrable. However, as a matter of prudence lenders should consider on a case by case basis, whether set-off in a given transaction might amount to a security interest as a matter of the governing law of the transaction documents and if so, take all appropriate steps to protect their security.
1. Caisse populaire Desjardins de l'Est de Drummond v. Canada, 2009 SCC 29
2. Per Rothstein J
3. Derham, at para. 16.86
4. Per Rothstein J
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