Canada: Is Cash Collateral King Again In Quebec?

It is currently a challenge in Canada for Canadian entities in the derivatives, securities lending and repurchase space to offer a first priority security interest on cash to their counterparties. The Quebec government recently introduced an amendment to the Derivatives Act (Quebec) (the QDA) that, if passed as tabled, will restore confidence in the use of absolute transfer of cash and the related use of contractual set-off or compensation when dealing with cash as credit support for these types of transactions from Quebec counterparties. The amendments also specifically address cash collateral provided to a derivatives clearing agency by its members. We give some background to this issue and then outline the application of the proposed rule.

Background

Cash as credit support for obligations of counterparties to derivatives, securities lending and repurchase transactions has become more and more prevalent over the past numbers of years. ISDA has reported that 80% of collateral for derivatives contracts is in the form of cash. The use of cash collateral will increase in importance as more and more derivatives transactions are cleared by central counterparties.

In the US and many EU countries, a first priority security interest over cash in a deposit account may be obtained by control in a manner very similar to control under Canadian securities transfer legislation or by effective set-off arrangements. The same is not the case in Canada. If a secured party is granted a security interest in cash, the traditional view is that valid security under the laws of the jurisdiction of the grantor's location needs to be obtained, the security needs to be perfected by registration, a search of the relevant register needs to be undertaken and estoppels, subordinations or waivers from competing or prior ranking creditors need to be obtained. This may be a costly and time-consuming exercise and ultimately may not be successful.

As an alternative to such security, until recently, it was the practice to transfer cash absolutely (not by way of a security interest) and create a debtor creditor relationship and express right of set-off. This is indeed how many cash collateral arrangements are put in place generally, not only in the financial products market. If the cash provider defaulted, the creditor could set-off (or under Quebec law, compensate) its obligation to repay the cash against the debt (eg. the net termination amount). The effectiveness of this arrangement relied on the enforceability of contractual rights of set-off or compensation and not the creation of a first priority security interest in cash. Set-off or compensation were understood to operate outside of the general rules about the perfection and ranking or priority of security interests.The majority decision of the Supreme Court of Canada in Caisse Populaire Desjardins de l'Est de Drummond v. Canada, a federal income tax case out of Quebec, casts doubt on the effectiveness of this approach. The Supreme Court characterized the lender's contractual right to set-off or compensate a debtor's obligation to repay a loan against the lender's own liability under the term deposit that the debtor was required to maintain with the institution as the enforcement of a "security interest" in the term deposit for purposes of income tax legislation. The Court held that the Federal Government's claim in respect of employment insurance and Canada pension plan premiums ranked ahead of the lender under the Income Tax Act (Canada) provisions that confer priority on the government over other "security interests". One of the major challenges with the application of this case is that the definition of security interest in the Income Tax Act is not materially different from that under the provincial common law personal property security acts. The application under Quebec law is less clear given the very different regime applicable to security.

The challenges with cash collateral in Canada are now front and center given the G-20 undertaking to move to central clearing of standardized derivatives and the new Basel capital rules that will incent collateralization of uncleared swaps as well. The Federal Finance Minister has formally communicated with the provincial Ministers of Justice and Finance outlining the challenges in respect of cash collateral and encouraging provincial legislative modifications to address this issue. The letter addressed to the Quebec Minister of Justice was tabled with the Committee on Public Finance of the Quebec National Assembly by the Quebec Minister for Finance on November 10, 2011.

Quebec's Response

On November 10, 2011, the Quebec Minister for Finance introduced an amendment to a bill currently being studied by the Committee on Public Finance of the Quebec National Assembly. If enacted, an amendment would be made to the QDA in order to address cash credit support by way of contractual set-off or compensation associated with derivative contracts, foreign exchange contracts, securities lending and repurchase contracts (as well as master agreements related thereto) and contracts between a clearing agency and one of its members and the applicable rules of the clearing agency. We note that the QDA requires that "clearing houses" and other categories of "regulated entities" be recognized by the Autorité des marchés financiers (Quebec's financial services regulator) in order to carry on derivatives activities in Quebec.

What Will the New Provision Accomplish?

We believe that, once the provision is adopted and in full force, it will restore confidence in the use of an absolute transfer of cash, creation of a debtor-creditor relationship and the related use of contractual set-off or compensation when dealing with cash as credit support from Quebec counterparties with respect to derivatives, securities lending and repurchase transactions.

Some of our observations on the proposed amendment are as follows:

  1. The person posting the cash may be the counterparty or any other credit support provider.
  2. The type of transactions covered are derivative transactions (as defined under the QDA), foreign exchange contracts, securities lending contracts, securities repurchase contracts and all master agreements in respect of these. Contracts between a derivatives clearing agency and one of its members as well as the rules governing such relationship are also covered.
  3. The rule covers an arrangement of contractual set-off or compensation in respect of cash. Certain standard forms of credit support documents will therefore need to be modified in order to take this into consideration in order to establish an enforceable and perfected credit support arrangement over cash.
  4. The governing law in respect of the validity of such contractual set-off or compensation will be the law chosen by the parties or the law that >may be inferred with certainty from the terms of the agreement.

The provision does not purport to characterize whether a particular contractual set-off or compensation arrangement constitutes a security interest but rather indicates that such an arrangement in respect of cash is enforceable against third parties without any further formality. This means that no registration is necessary in order to make such arrangement enforceable against third parties; eliminating any perceived need to register in order "to perfect" this arrangement.

One of the potential issues in fixing this issue for financial product obligations only is that it might lead to an inference that these types of transfer and set-off arrangements in the context of other types of transactions (such as loans) do require perfection by registration. Hopefully such an inference will not be drawn given that the purpose of the amendment is really to achieve clarity in the context of the types of transactions for which cash credit support is particularly important and provided in substantial volumes on a daily basis. In our view, the proposed amendment only reflects the appropriate interpretation of the law in this area regardless of the type of obligation secured. 

The provision does not set out a rule in respect of priority. The general rules applicable to contractual set-off or compensation, as interpreted by the courts, will therefore apply. In Quebec, a contractual set-off or compensation arrangement over cash should therefore prevail over a movable hypothec without delivery (the mainstream consensual non-possessory security interest in Quebec) whether registered before or after the cash credit support arrangement, without any necessity for the cash credit support arrangement to be registered in Quebec.

Since the rule addresses the opposability or enforceability of contractual set-off or compensation arrangements as against third parties, we believe that most current continuing arrangements that fall within the scope of the rule will also benefit from the rule once it comes into force.

The amendment is not designed to cover all arrangements where cash may be used as credit support. As examples, it will not cover a cash collateral deposit with the letter of credit issuer as support in connection with a letter of credit facility nor will it provide an easy way of obtaining a first priority security interest on cash held in a deposit account at a third-party institution even if securing a financial product transaction. In these cases, the traditional route still remains applicable. We would hope that these situations would be addressed in the near future in a way compatible with both a contractual set-off or compensation arrangement, where applicable and the control construct applicable in the US and many EU countries.

Conclusions

The Quebec legislator has taken steps that will restore confidence to the use of contractual set-off or compensation as a means to offer cash as credit support in connection with derivatives, foreign exchange, securities lending and securities repurchase transactions. The initiative also supports derivative clearing agencies and their relations with their members.

If the amendment is passed as presented, cash should soon regain its preeminent position as collateral for transactions of this kind involving Quebec counterparties able or willing to provide cash credit support on an absolute transfer basis.

The amendment is available in French and English.

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions