Swaps market participants accepting cash collateral from an entity subject to Ontario provincial pension benefits legislation will want to consider the implications of this decision on their priority. Unfortunately and somewhat surprisingly, the Supreme Court of Canada did not overturn a key part of the Ontario Court of Appeal's decision. Four of seven judges agreed that the deemed trust under the Pension Benefits Act (Ontario) (PBA) and, consequently, the statutory priority conferred on that trust under the Personal Property Security Act (PPSA) applied to the statutory liabilities of an employer to fund certain deficiency payments that arise during the wind-up of a pension plan. The secured creditor with an assignment of the DIP financing ultimately prevailed in its appeal on the basis of other arguments and was found to take priority over the deemed trust, but it did not prevail on this fundamental issue regarding the liabilities covered by the deemed trust.
In our blog post on the Court of Appeal decision we addressed whether the decision had a negative effect on credit support provided for derivatives transactions and other securities financing transactions, such as securities loans, repo and margin loans. As stated in that post, there is potential for the deemed trust to take priority over cash collateral accounts where Ontario law alone governs priority, because the PPSA gives the deemed trust priority with respect to "accounts", and cash collateral arrangements are characterized as "accounts". The priority and deemed trust applies not only to wind-up deficiencies, but also other amounts the employer owes to the pension fund (e.g. delinquent current service costs and remittances on behalf of employees). As a practical matter, the other liabilities subject to the deemed trust tend to be in a less significant amount and, consequently, they get paid from the assets readily available to the insolvency representative if they are in arrears. The wind-up deficiency amount, however, can be extremely large with respect to defined benefit plans, and essentially unascertainable until wind-up occurs. This is what makes the decision particularly concerning. There is no legal requirement to share the pain of the deemed trust among secured creditors, so the most readily accessible assets tend to fund the liability. The deemed trust beneficiaries may be looking further afield, however, when it comes to the deficiency liability and a nice healthy pool of cash collateral may look very attractive. Swap providers may not have the same influence in insolvency proceedings as the employer's lending syndicate to force the employer into bankruptcy (where the deemed trust is clearly subordinated to secured creditors). I'll first briefly review the parts of the decision that are relevant to the cash collateral issue. I will then tell you why I think it might affect priority for cash collateral (but not securities collateral) and offer some recommendations for dealing with this issue.
Insolvent Indalex Canada commenced a proceeding under the Companies' Creditors Arrangement Act (CCAA). Essentially it was a sale of the business as a going concern (what's called a liquidating CCAA) and the dispute was over part of the sale proceeds. A debtor-in-possession financing was put in place, which was guaranteed by a related US company. The sale proceeds were not sufficient to repay the DIP lenders so the guarantor paid out on the guarantee and became subrogated to the rights of the DIP Lenders. By the terms of the court order the DIP loan had priority over "all other security interests, trusts, liens, charges and encumbrances, statutory or otherwise".
There were two pension plans involved, one for the company executives and one for the salaried employees. The case revolved around whether a portion of the sale proceeds equal to the unfunded pension liability belonged to the pension funds, based on a statutory deemed trust under the PBA or an equitable constructive trust, or to the holder of the DIP loan, based on the priority conferred on the DIP loan by the court order.
Employers have a statutory obligation to make certain payments into a pension plan. There are three deemed trust provisions in the Ontario pension legislation; one for amounts collected from employees that were to be contributed but weren't, one for unpaid current service costs and one for amounts accrued to the date of the wind up but not yet due under the plan or regulations. The latter deemed trust only arises on a wind-up of the plan. The case related to this third type of deemed trust. An employer must pay (over a five year period) amounts in addition to the current service costs if there are insufficient assets to cover the value of the pension benefits (deficiency liability). The amount can depend on certain elections made after wind-up by the employees and can change over time based on changes in underlying actuarial and other assumptions. The question was whether the amounts that became payable by the employer over the period extending beyond the wind-up date for this deficiency liability were "accrued" obligations at the date of wind-up or not. The executive plan was not in the process of being wound-up so no deemed trust under the PBA arose or it.
Helpfully the SCC confirmed that the deemed trust only arose where a wind-up order was made in relation to the plan and the majority found that a constructive trust over the employer's assets was not an appropriate remedy for any breach of fiduciary duty on the part of the employer. The salaried plan was in the process of being wound up before commencement of the proceeding so the court did consider the deemed trust issue with respect to that plan.
The deemed trust provision is in section 57(4) of the PBA. Where a pension plan is wound up, it deems the employer to hold in trust an amount "of money" equal to "employer contributions accrued to the date of the wind-up but not yet due under the plan or regulations". The PPSA provides that the PBA deemed trusts have priority over a security interest in "accounts" and "inventory". Because of the reference to "accrued" liabilities, the majority of the SCC judges (4 of 7) agreed with the Court of Appeal that it included all the liabilities, including the unfunded deficiency liability that would otherwise be paid over the period following the wind-up. One can easily criticize the majority's interpretation of the PBA, but what would be the point! What is positive news, however, is that unlike the rather incoherent approach in the Court of Appeal reasoning, the majority made it clear they were relying on the priority granted by the PPSA and not simply on the creation of the deemed trust.
Justice Deschamp (with whom Moldaver J. agreed), before dealing with the issue of priority of the DIP charge, addressed the issue of whether the PPSA priority for the deemed trust would apply in a CCAA proceeding. She first considered the argument that the PBA deemed trust did not apply in a CCAA proceeding because the priorities must be determined under the federal insolvency scheme, which does not include provincial deemed trusts. There is a disappointing lack of analysis on this point by the court. Deschamp J. noted that in order to avoid a "race to liquidation under the BIA. Courts will favour an interpretation of the CCAA that affords creditors analogous entitlements." She then stated, apparently to contrary effect, that this does not mean that courts may read bankruptcy priorities into the CCAA at will.
Provincial legislation defines the priorities to which creditors are entitled until that legislation is ousted by Parliament. Parliament did not expressly apply all bankruptcy priorities either to CCAA proceedings or to proposals under the BIA. Although creditors of a corporation that is attempting to reorganize may bargain in the shadow of their bankruptcy entitlements, those entitlements remain only shadows until bankruptcy occurs.
Deschamps J. concluded that the PBA and PPSA priorities continue to apply in CCAA proceedings, subject to the doctrine of federal paramountcy.
The case then focused on whether the DIP financing charge primed the deemed trust on the basis of the federal paramountcy doctrine. The court was unanimous in its decision that the DIP charge did prevail. It is not entirely clear how much of Deschamps J.'s analysis with respect to the survival of PBA and PPSA priorities in a CCAA proceeding was adopted by the other justices. While Cromwell J. (giving the judgment for two others) seems to adopt these paragraphs of Deschamps J.'s analysis, he does so in a very cryptic fashion.
What this reasoning suggests is that the deemed trust on the basis of the super-priority conferred by the PPSA would prevail over all other secured creditors with an interest in accounts or inventory outside of a CCAA or BIA proceeding and in a CCAA proceeding as well, unless the federal paramountcy doctrine could be invoked. This, however, was an issue that was not before the court and which none of the judges were expressly considering. They were focused on the priority of the DIP charge.
Collateral for Derivatives
In a typical credit support arrangement for derivatives, the collateral is securities or cash. Securities are delivered through the book entry system to the secured party (or transferee in the case of a title transfer arrangement) and in Securities Transfer Act terms, the secured party becomes the entitlement holder. Cash is also typically transferred directly to the account of the secured party. Cash collateral is an "account" in PPSA terms so the question is whether the deemed trust's priority over accounts could apply to that cash collateral account. Based on that other questionable SCC decision in Caisse Drummond even absolute transfer and set-off arrangements with respect to cash may be characterized as security interests subject to statutory priorities.
Doesn't apply to securities or securities accounts. An important point to note is that priority for this deemed trust (or others) would not extend to securities, securities entitlements or securities accounts or other forms of collateral such as precious metals, and futures contracts. The statutory priority for the deemed trust conferred by the PPSA applies only over "accounts" and "inventory" and their proceeds, and investment property is specifically excluded from the definition of "account". The Securities Transfer Act also protects a purchaser for value (which would include a secured party under a Credit Support Annex) from adverse claims of which it has no notice and as an entitlement holder, secured parties should not be subject to these provincial law claims that arise after the transfers.
(There is also a statutory lien under the PBA (not discussed in the case) for the same amounts, but the same STA protection against adverse claims would apply in favour of a secured creditor with control.)
Deemed trust may not apply to cash collateral accounts. The PBA deemed trust requires the employer to hold "money" in trust for the beneficiaries. The PPSA priority only applies if the deemed trust itself attaches to the assets in the first place. This suggests that the contemplated assets are ones that the employer has a property interest in. If the account is itself a cash collateral account and the account debtor is the secured party, then any money the employer will realize from that account is only the net amount after payment of the secured obligation. In other words, a flawed asset analysis and right of set off may prevail in this circumstance. If funds are wired to a secured creditor for its own account (even if intended as a collateral arrangement), then the funds are no longer property that the employer can hold for itself or anyone else. The property which the employer has is the rights against the secured party with respect to the cash collateral account and those rights are limited by the credit support agreement. While this argument may be attractive, there is no assurance it would prevail.
In CCAA proceedings protections for cash collateral for eligible financial contracts may prevail. The CCAA provides that no order made in the proceeding can have the effect of subordinating financial collateral for an eligible financial contract. If a DIP charge can defeat a deemed trust but a DIP charge cannot defeat financial collateral for an eligible financial contract, it logically should follow that it would be inconsistent with the CCAA for the deemed trust to prevail over the cash collateral arrangement if it was securing derivatives exposures or securities financing arrangements. Of course, this does not help with priorities outside of insolvency.
Payment Clearing and Settlement Act may help. Where the PCSA applies, it also provides for enforceability of credit support arrangements involving cash collateral securing eligible financial contracts, which may also create a conflict between federal law and the PPSA super-priority. The PCSA says that a party to an eligible financial contract may deal with its financial collateral. This is a reflection of the policy (based on concerns about systemic risk in the financial system) that laws, including insolvency laws, should not interfere with these rights. While it overrides insolvency laws, it is not restricted in its application to insolvency laws. It could be considered as a paramount federal law. It only applies, however, where the agreement is between two financial institutions (as defined) or between a participant in a clearing house and its customer with respect to the cleared transactions.
Windup only. The deemed trust only arises on wind-up of the plan. Wind-up very often occurs after an insolvency proceeding has already commenced. By that time, a derivatives counterparty, not being subject to the normal insolvency stays, will have realized on its cash (or securities collateral) and, therefore, the deemed trust cannot attach to that property for that reason alone. In other words, collateral holders should not sit on their rights.
To be clear, the Indalex reasoning would not apply to federally regulated pension plans such as those provided by banks for their employees or under provincial legislation. While the federal and other provincial legislation provide for deemed trusts, the priority of those trusts is not clearly given priority by a provision similar to s.30(7) of the PPSA.
I continue to believe that parties should use the ISDA English law Transfer Annex CSA or amend the NY Form of CSA to provide for title transfer of cash where that is possible. While there is no assurance it will defeat the problematic Caisse Drummond analysis, there is certainly a good basis for that position. If the set-off is effective, the only property the deemed trust could attach to is the excess collateral value.
If you are taking cash collateral, it would be prudent to determine whether a counterparty has a defined benefit pension plan, to monitor its funding status and to include a termination event triggered by any step taken by the employer or regulator to wind-up the plan.
Where possible, hold cash collateral outside of Ontario in a jurisdiction that would not apply Ontario law to priority issues. If the collateral is held outside of Canada by a non-Canadian entity (which is often the case), the deemed trust claimants would have to assert the claim in a foreign jurisdiction. That may be a tough case to make in a foreign court, especially in jurisdictions like the U.S., which apply the law of the depositary intermediary to priority issues.
At the end of the day, there is a risk that this statutory deemed trust could take priority over cash collateral accounts. Hopefully the Ontario legislature will accept the strong recommendation of the OBA PPSL Committee as part of its cash collateral proposal to clarify that section 30(7) does not apply to cash collateral accounts over which a secured party has control. Industry participants may want to take this opportunity to communicate to the government the importance of this point and generally of moving forward quickly with its promise to make the cash collateral amendments as soon as we have a working Legislature again in Ontario. If the law is not clarified secured creditors may not have confidence that they prime this deemed trust when dealing with entities subject to the PBA with defined benefit plans. There is no point in implementing reform designed to reduce systemic risk (requiring collateral for uncleared swaps for example) if it ends up creating more of it or limits the access of Ontario entities to important swaps markets.
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.