The new legislation
Lenders will need to re-examine their approach to taking security over shares and other securities now that Ontario’s new Securities Transfer Act (STA) and amendments to the Personal Property Security Act (PPSA) have been passed and will be proclaimed in force as of January 1, 2007. Some of the PPSA amendments will affect security over other types of collateral as well. Substantially similar legislation has been enacted in Alberta and is expected to be proclaimed in force at the same time as the STA and PPSA amendments.
The Western provinces and Quebec are expected to introduce legislation in the first half of 2007, with the other provinces and territories hopefully following suit over the next few years. It is not unrealistic to expect that the eventual result will be harmonized rules for the transfer and pledging of securities across Canada. Because the STA and PPSA amendments are based on Articles 8 and 9 of the U.S. Uniform Commercial Code, the Canadian laws will also be harmonized with those in the United States.
Pledges of certificated securities
How will this affect a pledge to a lender of shares (or other securities) in a company that has issued a share certificate to the borrower? In addition to filing a financing statement under the PPSA to perfect its security interest (ie perfection by registration), the lender normally would either (1) get a stock transfer form duly endorsed by the borrower in blank and take possession of the share certificate registered in the name of the borrower, or (2) take possession of a new share certificate registered in the name of the lender. Under the existing rules, possession gives the lender the higher priority.
Once the STA becomes effective, either of these methods will still work, but new terminology will be used to describe the process: the taking possession of the share certificate will give the lender what is referred to as "delivery" and the additional step of getting the stock transfer endorsed in blank, or the share certificate registered in its own name, will give the lender what is referred to as "control" (this applies to all types of securities, not just shares). Control gives the best assurance of a first priority.
Indirect holdings - security entitlements
What about shares and other securities where the borrower holds them indirectly, through an account with a securities dealer, broker, bank or other intermediary? The STA refers to the borrower’s rights in these as "security entitlements". A security entitlement is itself a form of property different from the underlying securities themselves. It is a combination of personal rights against the securities intermediary as well as an interest in the financial assets in the securities account (eg the underlying securities if they are held directly by the intermediary, security entitlements held by the securities intermediary, credit balances in the account). This interest is not a direct interest in the underlying security (or securities entitlement) held by the securities intermediary.
The current PPSA (together with the OBCA) operates under the fiction that an indirect holder could obtain a notional possession of the underlying securities, even though they were physically held by CDS or even completely dematerialized and registered to CDS or its nominee. However, because this fiction did not reflect the commercial reality the legal analysis regarding perfection and priority was uncertain in many respects. Under the new STA, lenders will be able to achieve more certainty that they have a perfected security interest and a priority over other creditors with respect to securities entitlements or financial assets held by a borrower in a securities account. Perfection and priority are now functions of obtaining "control". Lenders will want to revisit their existing security arrangements over this type of collateral. There are, however, transitional and other rules in the STA and PPSA that will limit the need for specific changes to existing documentation.
A lender that becomes the entitlement holder with respect to a securities account in the place of the borrower will achieve the highest level of protection. Essentially this creates a new security entitlement that belongs to the lender. However, this is not always an acceptable arrangement to a borrower. For example, where a borrower has financial assets held in a securities account that it trades or deals with regularly, it would be impractical to have the lender become the entitlement holder if that "dealing" by the borrower is to continue.
Another way a lender can obtain control over a security entitlement belonging to the borrower is by entering into a control agreement with the securities dealer (ie securities intermediary) and the borrower that allows the lender to give "entitlement orders" to the securities dealer in certain circumstances. An entitlement order is the STA terminology for an order given to a securities dealer or other intermediary instructing them to transfer or redeem a security or security entitlement. However, in theory more than one person can have control at the same time if the intermediary had made a similar agreement with another secured party. As a result, it is important that control agreements be carefully drafted to ensure the lender gets the required assurances from the intermediary to maintain its priority.
The changes to the PPSA extend beyond securities and security entitlements. For example, there are also new provisions dealing with futures and futures accounts as collateral, whose treatment under the current PPSA is very unclear.
There are also new conflict of laws rules that make it easier to determine which jurisdiction’s laws apply to the taking of security over certain types of property. In some cases, there may be a risk of existing security arrangements becoming ineffective because of a change in which jurisdiction’s laws apply. However, there are transition provisions intended to protect lenders from this happening for a period of time after the new rules come into effect.
Other PPSA amendments have been introduced in Bill 152 and are expected to pass and come into effect in 2007. Some of those amendments are transition rules with respect to the PPSA amendments enacted by the STA and they will be given retroactive effect to January 1.
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.