Canada: Priority In Security Interests: Lessons For Secured Creditors

Last Updated: January 29 2015
Article by M. Sandra Appel

In the opening paragraph of his decision in CFI Trust v. Royal Bank of Canada 2013 BCSC 1715, Supreme Court Justice Elliot Myers drew a parallel to the dark comedy Fargo, but this case was no laughing matter to the two creditors involved, who were left fighting over the remains after the fraudulent use of funds by Vancouver's Totem Automotive Group Ford Lincoln Sales and Leasing Inc. ("Totem"), a large but now-defunct car dealership.

CFI Trust and CFI Leasing Limited (together "CFI") and the Royal Bank of Canada (the "Bank") were both lenders to Totem, which leased and sold new and used vehicles. Each had security agreements with the dealership and had effected registrations pursuant to the Personal Property Security Act of British Columbia (BCPPSA). (Although the registration by CFI was inadvertently discharged and re-registered, the validity of the registration did not really factor in the Court's decision.) CFI and the Bank also had entered into a priority agreement to determine which financial institution had priority over which assets of Totem.

Totem had its general operating account with the Bank. Proceeds from sales and leases of vehicles secured to the Bank were deposited into that account. The Bank deducted monies daily from the account to reduce the dealership's operating line or transferred funds to that account to enable Totem to operate.

When Totem finally closed, CFI discovered that proceeds from terminated lease agreements for 242 motor vehicles funded by CFI – and in which CFI had a security interest – had been paid into the dealership's account with the Bank. CFI then sued the Bank for these funds (the "misappropriated funds"), arguing that it had priority over the funds. CFI also argued that the Bank was liable as it had knowledge of the security interest of CFI in these CFI deposits. After a thorough analysis, the Court ruled in the Bank's favour. The decision is being appealed by CFI.

To understand the impact of the decision and what it means for secured creditors, it is necessary to consider the language of the priority agreement, the value of the provisions of the BCPPSA and Personal Property Security Act of Ontario (OPPSA) dealing with proceeds, and the concept of knowledge in these statutes.

The Priority Agreement

Section 40(1) of the BCPPSA and section 38 of the OPPSA are similar in their essential concept: a secured party may subordinate the secured party's interest to any other security interest and such subordination is effective according to its terms.

In the priority agreement, CFI granted the Bank priority over any security interests that CFI had or may acquire in the dealership assets secured to the Bank under the Bank's security (the "Bank's Assets") and postponed the CFI security to the Bank's security, save and except for certain assets that were not part of the Bank's Assets. This is set out in what the Court calls the "notwithstanding clause." This clause provided that notwithstanding the extensive description of the Bank's Assets, these did not include any motor vehicles that are the subject of leases or contracts that are the subject of the CFI security agreements (the "CFI Assets"; emphasis added). The Bank's Assets included

all present and after-acquired personal property in any form (including money, chattel paper, intangibles, goods, documents of title, instruments and securities) derived directly or indirectly from any dealing with any Collateral (as hereinafter defined) described in paragraphs (i) through (vii) above or any proceeds therefrom, including any payment that indemnifies or compensates for any Collateral that has been lost, destroyed or damaged or any proceeds therefrom1.

The Bank's Assets therefore specifically included proceeds whereas the notwithstanding clause did not.

CFI argued that both the Bank and CFI had security in all assets of the dealership and that the Bank had priority over the Bank Assets only while CFI had priority over all assets of the dealership except those over which it had agreed to grant priority to the Bank. CFI also argued that it should have priority over the funds related to the CFI lease portfolio to give business efficacy to the priority agreement.

The Court did not find that CFI had a security interest in the proceeds arising from its leases or contracts because the priority agreement did not specify proceeds. In considering the language of the priority agreement the Court stated:

Quite simply, the unambiguous wording of the priority agreement gives RBC priority over all of CFI's security interest, except what is dealt with in the notwithstanding clause, and that is only the vehicles that are the subject of CFI leases or contracts. The three required words missing in the notwithstanding clause to support CFI's position were: "... do not include any motor vehicles or their proceeds 2 ".

The Court did not appear to consider the remaining words in the notwithstanding clause: "motor vehicles that are the subject of leases or contracts that are the subject of the CFI agreements (emphasis added). It is likely that the CFI security agreements referred also to proceeds of those vehicles as throughout the earlier stages of the CFI relationship with Totem, CFI had been receiving proceeds from its contracts and leases. While it is unclear why the Court did not consider this additional language and the previous manner of handling of the proceeds, what is clear is that the Court, was specifically looking for these three words "or their proceeds."

This decision is contrasted with the Court of Queen's Bench of Alberta decision in Alberta Treasury Branches v. Macleod Dixon3. This was an appeal of the decision of a Master dealing with a postponement agreement.

The Court determined that the postponement agreement was a contract between the parties and should be given its plain meaning. The Court further determined that the phrase "all present and after-acquired personal property" included proceeds, without the need to specifically use the three words "or their proceeds."

The language in this postponement agreement is different from the language in the priority agreement between CFI and the Bank. However, if the CFI security agreements referred to proceeds from the vehicle contracts and leases, then to give plain meaning to the language in the notwithstanding clause, it can be argued that proceeds were included without the need to specifically use the three words. Some meaning should be given to the additional language "that are the subject of the CFI agreements" and the prior actions of the parties.

The Proceeds Provisions

Section 28 of the BCPPSA basically provides that if collateral is dealt with or otherwise gives rise to proceeds, the security interest extends to the proceeds. A security interest in proceeds is a continuously perfected security interest if the interest in the collateral was perfected when the proceeds arose. Proceeds mean identifiable or traceable personal property derived directly or indirectly from any dealing with collateral or the proceeds of the collateral.4 Section 25 of the OPPSA has similar language.

In Secured Transactions in Personal Property in Canada5, Richard H. McLaren establishes that "proceeds are included within the security interest regardless of whether the secured party authorized the dealing with the collateral, and arise as of right through the legislation irrespective of the contents of the security agreement."6

McLaren states:

even if this (i.e. the interest in proceeds) is not explicitly provided for in the security agreement, s. 28(1) of the Act indirectly creates a statutory extension of the security interest to proceeds where the original collateral is dealt with so as to give rise to them.7

Based upon the foregoing, the security interest of CFI in the CFI Assets should have continued in the proceeds from the dealing with those CFI Assets. Apparently that was how the parties dealt with their respective security interests during the normal operations of Totem. The Court did not apparently deal with the prior handling of these proceeds. Nor did it look at this section of the BCPPSA in discussing the language of the notwithstanding clause.

It is acknowledged that McLaren does state that section 38 (of the OPPSA; section 40 of the BCPPSA) allows for a secured party to subordinate the priority of its interest to that of one or more secured parties. The effect of such an agreement is to permit secured creditors to avoid the priority framework of the Act and permit secured creditors to have the freedom to agree to their particular agreed upon priority rules amongst themselves.8

The decision regarding the priority agreement may have remained the same because of the language in the notwithstanding clause; however, an argument could have been made about the additional language in that clause, the provisions that extend a security interest in collateral into proceeds, and that the three specific words are not always necessary. Nevertheless, for secured parties, when entering into priority agreements, if the intent is to provide for priority in specified collateral "and their proceeds", these three words should be included.

Purchaser for Value without Knowledge

Although the Court advised that it did not need to deal with section 31 of the BCPPSA as the language of the priority agreement was determinative of the action9, the Court did a thorough analysis of the Bank's argument that section 31 of the BCPPSA and in particular section 31(3) gave the Bank priority over the misappropriated funds.

Section 31 of the BCPPSA has a number of provisions that protect transferees of negotiable collateral. The first, under section 31(1), essentially provides that a holder of money has priority over a security interest in money perfected by registration if the holder acquired the money without knowledge that it was subject to a security interest or is a holder for value, whether or not the holder acquired the money with knowledge that it was subject to a security interest. There is no comparable provision in the OPPSA. Interestingly, although the Bank argued relying on this section, the Court determined that it was not relevant as the Bank did not receive money.

The second argument the Court considered was in respect of section 31(3) of the BCPPSA, dealing with the purchaser of an instrument. The purchaser of an instrument has priority over a security interest in the instrument perfected by registration if the purchaser gave value for the instrument, the purchaser acquired the instrument without knowledge that it was subject to a security interest and the purchaser took possession of the instrument. This is similar to section 28(4) of the OPPSA. Section 31 (5) of the BCPPSA goes on to provide that for the purpose of section 31(3), a purchaser of an instrument who acquired his or her interest under a transaction in the ordinary course of the transferor's business has knowledge only if he or she acquired the interest with knowledge that the transaction violates the terms of the security agreement creating or providing for the security interest. There is no comparable provision to section 31(5) in the OPPSA.

In considering what the Bank knew, the Court also noted that because the amount of misappropriated funds was so small in comparison to the monies being deposited into the account, the Bank would not have noticed this de minimis amount.

The Court referred to the Flexi-Coil decision10 to establish a number of points. Firstly, it determined that the cheques were instruments deposited into the account at the Bank. Secondly, it decided that the Bank was a purchaser of the cheques since, in the aggregate, Totem's accounts were in a negative balance at the time of deposit. The most important question, however, was the knowledge of the Bank and whether the Bank knew that the transaction violated the terms of the security agreements (of CFI).

The Court reviewed case law on the question, summarized the knowledge of the Bank and determined that the Bank needed to have actual knowledge of the security agreement of CFI being violated. The Court decided that the Bank did not have the knowledge that the cheques were deposited in violation of the CFI security agreements. In reaching this conclusion, the Court commented that CFI had more knowledge than the Bank, and that if CFI did not take action to stop the misappropriated monies from being deposited into the Totem account at the Bank, then how could CFI expect the Bank to take action? With respect, neither of these factors is relevant to this section of the BCPPSA and the actual knowledge of the Bank. The Bank should have known what was in the CFI security agreements as the Bank and CFI had entered into the priority agreement. The priority agreement gave CFI priority over the vehicles subject to the CFI leases and (arguably) proceeds therefrom. The two financial institutions had operated for years dividing the pie on these dealership vehicles and proceeds. The Bank had actual knowledge that the dealership was in financial difficulty. The Bank had actual knowledge that the dealership had previously converted vehicles and funds. So what is really necessary for actual knowledge?

The Court then determined, in contrast to Flexi-Coil, that the electronic funds transferred into the account at the Bank were not instruments, and accordingly not protected by section 31(3). It is apparent that the Court did not address this issue further, as the Court had determined that the issues in this case were determined by the language of the priority agreement.

Implications for Secured Parties

Dealing with proceeds is always a challenge. It is apparent from this decision of the Supreme Court of BC that if a secured party entering into a priority agreement wishes to maintain its interest in proceeds in respect of certain assets, then the interest in these proceeds must be provided for in the terms of the priority agreement. A subordination is effective according to its terms. The proceeds language in Section 28 of the BCPPSA is apparently not relevant when dealing with priority agreements.

In addition, if a secured creditor wants to maintain its security interest in the proceeds from the disposition of assets secured to it, and the debtor also has provided security to an operator of an account, the secured creditor should require that its proceeds be deposited into an account at a different financial institution than the account operator. This may be one way to try and ensure that the account operator financial institution need not argue that it is a purchaser for value without knowledge and the secured creditor can better monitor its proceeds.

The author wishes to thank Robert Groves for his assistance with this

Footnotes

1. 2013 BCSC 1715, paragraph 40.

2. Ibid, paragraph 54.

3. 1 P.P.S.A.C. (3d) 235; reversed 2 P.P.S.A.C. (3d) 258 (Alta. Q. B.)

4. Section 1(1) BCPPSA; Section 1(1) OPPSA

5. Richard H. McLaren, 2013 Thomson Canada Limited, Third Edition,

6. Ibid at page 5-98

7. Ibid at page 6-13

8. Ibid at page 7-65

9. Supra, paragraph 67

10. Flexi-Coil Ltd. v .Kindersley Credit Union (1993), 107 D.L.R., 129

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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