Canada: Fully Secured @ Gowlings - June 28, 2011 - Volume 2, Number 2

Last Updated: July 5 2011

Edited by Mr Richard Dusome



A Banker Asked Us: Cash Collateral Securit

By: Richard Dusome (Toronto)

(416) 862-5423

richard.dusome@gowlings.com

Q: A new customer is looking for the bank to issue a letter of credit secured by cash collateral held in an account with the bank in Ontario. If my customer signs the bank's cash collateral agreement and deposits the funds into the account, do I have everything I need to have first priority to the funds?

A: In Ontario, funds on deposit in a bank account are considered to be an "intangible" for PPSA purposes, not "money". Unfortunately, a security interest in intangibles cannot currently be perfected by possession or control. To perfect the bank's security interest in the funds on deposit with the bank, the bank will need to make a registration under the Ontario PPSA, and verify whether there are any prior registrations charging the same collateral or claiming a security interest in "Accounts" or "Other". If any such prior registrations do exist, the bank will need to obtain PPSA acknowledgments or estoppel letters from the other secured creditors, or alternatively enter into other subordination arrangements with them, in order to establish the bank's first priority security position to the funds on deposit. In addition, given recent case law, the bank will face challenges in relying upon rights of set-off contained in its account opening documents or cash collateral documents in attempting to prevail over the claims of other secured creditors to the funds or against government claims based upon unremitted source deductions, unpaid pension contributions and similar amounts. Thus, the bank will also want to do some due diligence on the status of those government remittances and contributions before issuing the letter of credit.

Unfortunately, the Ontario PPSA does not contain provisions similar to those which we understand exist under the Uniform Commercial Code of most US states where a secured party can perfect a security interest in cash collateral by obtaining a control agreement.



The Abolition of Financial Assistance Restrictions in Québec

By: Marie-France Béland (Montréal)

(514) 392-9418

marie-france.beland@gowlings.com

On February 14, 2011, with the coming into force of the new Business Corporations Act (Québec), the legal framework for companies incorporated under the laws of Québec ("Québec Companies") also changed. One of the benefits of this reform is undoubtedly the repeal of the financial assistance restrictions for Québec Companies.

Prior to this date, a Québec Company was not able to grant a loan, give security or furnish any other form of financial assistance, such as a guarantee to a shareholder, to a shareholder of its parent legal person or to a person to assist him in purchasing its shares if there was reasonable ground to believe that, as a consequence, a) the Québec company would not be able to discharge its liabilities when due or, b) the book value of its assets would be less than the sum of its liabilities and its issued and paid up share capital account. With the abolition of the financial tests (the solvency and the liquidity tests) provided for under section 123.66 of the former Québec Companies Act, it is no longer necessary to include a solvency restriction on a guarantee provided by a Québec Company securing the obligations of its shareholder or the shareholder of its shareholder. This change will facilitate the financing of groups of corporations as it will no longer be an issue for lenders to obtain unlimited guarantees from subsidiaries which are Québec Companies.

Under the new Business Corporations Act (Québec), the solvency test (a corporation's ability to discharge its liabilities as they become due) remains but only for specific situations relating to the purchase or redemption of shares, the reduction of a corporation's issued share capital, the payment of dividends, and for situations involving amalgamations.



Pledge of Shares Purchased with Fraudulently Obtained Funds Held to be Enforceable

By: Richard Dusome (Toronto)

(416) 862-5423

richard.dusome@gowlings.com

It is never a good situation: two innocent creditors, one fraudster and insufficient funds remaining to repay both creditors. Yet, this was the situation the Supreme Court of Canada had to resolve in i Trade Finance Inc. v. Bank of Montreal.

The fraudster's corporation obtained a loan from a finance company (i Trade) by virtue of fraudulent misrepresentations about the computer service contracts it held. Before i Trade learned of the fraud, that corporation had transferred the funds to the fraudster by way of corporate loans and various employment payments. The fraudster and his spouse used some of the funds to purchase shares held in an investment account with BMO Nesbitt Burns, which shares were pledged to BMO to support an increased personal MasterCard credit limit. BMO had no knowledge of the fraudulent scheme, or of any equitable interest of i Trade in the funds used to purchase the shares. After the fraud was discovered, the two creditors agreed to the sale of the shares and that the net proceeds would be held in trust pending the resolution of their dispute. In a separate civil proceeding against the fraudster, i Trade obtained a tracing order to try to recover any assets purchased with funds provided by i Trade, including the proceeds of the shares held in the BMO Nesbitt Burns account. The tracing order however exempted assets held by bona fide purchasers from its scope.

The Supreme Court did not treat this case as a PPSA priorities dispute as i Trade's rights to recover the funds arose from the tracing order rather than from a security agreement creating a security interest. However, the Court did use some PPSA concepts to work through the proprietary and other issues involved.

The Court held that the corporation had acquired rights to use the i Trade loan proceeds and was able to pass its interest in the funds to the fraudster, since i Trade's consent to using the funds had not yet been revoked at that time. It followed in the Court's view that the fraudster was therefore able to acquire rights in the shares purchased with the i Trade loan proceeds at the time of the pledge of those shares to BMO. Thus, BMO's security interest could attach to the shares at the time of the pledge, giving it a valid and enforceable security interest. As BMO's pledge constituted a valid and enforceable security interest, the Court held that BMO was both a "purchaser" for purposes of the PPSA and a bona fide purchaser for value without notice for purposes of the tracing order. As such, BMO was exempted from the tracing order and, in the Court's view, entitled to all remaining proceeds of the shares.

It appears that i Trade never obtained security over the assets of the fraudster's corporation. Thus, it is not clear if the result would have been different if i Trade had obtained security and asserted a claim that the shares purchased by the fraudster represented proceeds of the corporation's assets.



Helpful Judicial Confirmation of Some Basic Lending Principles

By: Christine Mason (Toronto)

(416) 862-4408

christine.mason@gowlings.com

In the recent decision of Bank of Montreal v Carnival National Leasing Limited1, the Ontario Superior Court of Justice reaffirmed some basic lending principles:

A lender can demand repayment of a demand loan at any time

Carnival National Leasing Limited ("Carnival") had two lines of credit with Bank of Montreal ("BMO"), (i) a demand wholesale leasing facility, and (ii) a demand operating loan. In addition, BMO reserved the right to cancel the two lines of credit at any time in its sole discretion. The Court reaffirmed that a lender can call on a demand loan at any time and no breach of the terms of a demand loan is required before a lender can demand repayment.

A borrower is entitled to reasonable notice following demand

Although over 70 days had passed since the date of demand by BMO, Carnival argued that it should be allowed "a little more time to obtain financing to pay out the BMO loans." The Court rejected this argument and confirmed that while a borrower must be allowed a reasonable amount of time to raise the necessary funds to satisfy the demand, this is usually not more than a few days and should not approach 30 days.

Failure by a lender to enforce its rights does not on its own constitute a waiver of such rights

Carnival had for some time exceeded the financing threshold for its wholesale leasing facility, which had required that advances to finance used vehicles could not exceed 30% of the overall advances for all vehicles. Carnival argued that BMO was aware of the breach and had waived compliance with the breach by continuing to provide financing in spite of it. The Court rejected this argument and found that there was no definitive evidence that BMO was fully aware of the breach or intentionally waived the financing threshold condition. The Court did go on to state that in the present case, the demand nature of the facilities permitted BMO to demand payment at any time, whether or not a breach had occurred.

Accordingly, although not specifically discussed in the judgment, if a lender is aware of a covenant breach and continues to provide financing despite such breach, it is still best practice to confirm in writing to the borrower that the lender is not waiving the breach or its related rights under the relevant loan documentation.



Spotlight on Security Documents: The Securities Account Control Agreement

By: Richard Dusome (Toronto)

(416) 862-5423

richard.dusome@gowlings.com

When taking a security interest in publicly traded or private company securities, lenders customarily require the debtor to execute a comprehensive investment property pledge agreement covering all types of investment property. Where the principal securities are certificated private company shares, lenders can establish perfection by control by obtaining a duly completed and executed stock power of attorney or other effective endorsement to supplement the pledge. However, where the principal securities are represented by securities entitlements held in a securities account (an "Account") maintained by the debtor with a securities intermediary (the "Intermediary"), a Securities Account Control Agreement is an essential companion document for that pledge.*

The Control Agreement will typically be entered into by the debtor, the Intermediary and the lender. It will contain a direction from the debtor to the Intermediary to act solely upon the instructions of the lender in executing trades following the issuance of a notice of exclusive control, with the underlying pledge agreement specifying the terms upon which such a notice can be issued. The debtor's ability to make withdrawals of dividends and distributions from the Account and to complete certain types of securities trades will also traditionally be restricted under the Control Agreement.

A representation on the part of the Intermediary that there are no prior existing control arrangements in place with other secured creditors will typically be included in the Control Agreement. As well, the Intermediary's rights to claim priority to the lender over the Account will usually be limited to the Intermediary's regular and customary trade commissions and fees for maintaining the Account.

Finally, the Control Agreement can be customized to feature special provisions required by a particular lender to limit the type of securities that can be deposited to and held in the Securities Account to avoid complications upon enforcement and sale.

Lenders should ensure their term sheets and commitment letters specifically refer to the requirement for a control agreement from each applicable Intermediary when taking security over investment property in the form of securities entitlements.

*Where the principal securities are uncertificated securities of an issuer held directly in the debtor's name, a control agreement will need to be entered into with the issuer of those securities.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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