Canada: Sheltering Unsecured Debt Under A Secured Party’s Security: Court Of Appeal Suggests Practice May Be Acceptable Under The Right Circumstances

In February 2012, we reported that the Saskatchewan Court of Queen's Bench ruled that an unsecured party could not shelter its unsecured debt by purchasing or receiving an assignment of a secured party's debt.1 The Saskatchewan Court of Appeal (the "Court of Appeal") has upheld this decision.2 However, the reasoning of the Court of Appeal was slightly different than that of the lower court. The lower court was very broad in its prohibition of securing prior unsecured debt while the Court of Appeal limited its decision to the specific facts in this case. As a result, there still remains uncertainty as to whether sheltering debt under a secured party's security would be permitted with a different set of facts.

In Eagle Eye, an unsecured creditor ("Eagle Eye") obtained an assignment of a secured creditor's debt and related general security agreement (the "GSA").  Eagle Eye then claimed that its prior unsecured debt was transformed into secured debt as a result of the "all obligations" clause contained in the assigned GSA, which stated that the GSA secured all obligations owing to the secured creditor under the GSA, whether such obligations were incurred prior to, at the time of or after the GSA was signed.

The debtor took the position that the GSA only secured liabilities that may have arisen between the original secured party and the debtor and argued that Eagle Eye was not acting in good faith or in a commercially reasonable manner.

Eagle Eye argued that, as a result of the assignment, it stepped into the shoes of the original secured creditor with the result that the assigned GSA covered all debts owing by the debtor to Eagle Eye, including the prior unsecured debt.

Without providing an indication of which reasons were primarily relied upon, the lower court cited several reasons for ruling that the assigned security did not extend to cover the prior unsecured loan between Eagle Eye and the debtor, including unfairness to the debtor and the destructive impact that accepting Eagle Eye's argument would have on the principle of pro rata sharing in bankruptcy law and the Personal Property Security Act (Saskatchewan) (the "PPSA") priority regime.

In upholding the decision of the lower court, the Court of Appeal chose to limit its analysis to the specific facts of this case and leave open the possibility that a different set of facts might result in an unsecured party being allowed to shelter its prior unsecured debt by purchasing debt and related security from a secured party. The Court of Appeal placed an emphasis on the intention of the parties, noting that although the GSA permitted an assignment by the original secured party without notice to the debtor, it did not state that upon assignment the GSA would act to secure any and all unsecured debts previously owed to the assignee. As a result, the Court of Appeal held that the debtor and the original secured party did not intend that the GSA would cover the unsecured debts owed by the debtor to a third party upon assignment.

Although the Court of Appeal held that on the specific facts of this case sheltering unsecured debt by purchasing a security agreement was not permitted, it went on to suggest that this practice may be interpreted differently on different facts. The Court of Appeal suggested that a prior unsecured party may be able to shelter its debt by purchasing debt and security from an existing secured creditor, provided that:

  • the priority system in bankruptcy and the PPSA are not affected;
  • the assignee behaves in a commercially reasonable manner; and
  • at the time the security was originally provided, the parties intended that the debt and security could be assigned with the result that the security would then also cover any unsecured debt of the assignee. To evidence such an intention, parties should consider including a specific statement in the underlying security agreement that addresses this scenario.

As a result, although the decision of the lower court has been affirmed, there still exists uncertainty and a possibility that this practice may be acceptable on facts different from those in Eagle Eye. It is difficult, however, to imagine a set of facts where the court's criteria could be met. It should also be noted that the court did not discuss whether future advances made by an assignee to a debtor after an assignment of security could be sheltered under the assigned security.

Footnotes

Note CPC Networks Corp. v. Eagle Eye Investments Inc., 2011 SKQB 436.
Eagle Eye Investments Inc. v. CPC Networks, 2012 SKCA 118 [Eagle Eye]. 

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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Jennifer Wasylyk
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