Canada: Easing The Rules For Receivables-Based Financing And Securitization

Originally published in Blakes Bulletin on Financial Services, May 2007

The upcoming amendments to the Ontario Personal Property Security Act (PPSA) address, at least in part, three separate issues that receivables financiers face in Ontario: (i) the nonassignability of certain types of receivables, which are therefore not available as collateral; (ii) the conflict between the rights of receivables financiers and inventory financiers; and (iii) certain technical concerns relating to the rights of an account debtor against an assignee of a receivable. This article discusses what the amendments achieve, what they don’t achieve, and how borrowers and financiers can best react to the new rules.

Non-assignable receivables

The general rule in Canada – and in the U.K. and the U.S. as well – is that, with few exceptions, any contract can be assigned. This is a basic legal underpinning of receivables financing. It means that companies can, in most circumstances, sell receivables – for example, in a securitization or factoring arrangement – or secure them as collateral in a lending arrangement.

There are, however, exceptions to this general rule. Most are not usually relevant to financing arrangements, but two of them are. First, most receivables owing by the Canadian federal government – and certain other governments – cannot be sold or secured without government consent. Most receivables financiers are well aware of this rule and, therefore, it is quite common for government receivables to either be classified as completely ineligible under receivables financings, or to have additional conditions apply to them before they can be included as eligible.

Secondly, Ontario law respects "anti-assignment clauses" – clauses in contracts that restrict or prohibit the assignment of the contract or rights under the contract. As a result, financiers in Ontario typically do not give credit for contracts with antiassignment clauses. A common part of the due diligence for many receivables transactions is to check the forms of contracts under which the receivables arise to ensure they do not contain anti-assignment clauses. This is easy to do where standard forms are used. However, that type of due diligence is much harder for a company which sells its products or services under negotiated agreements or in response to standard forms provided by its customers. There may be numerous contracts to review, and these contracts may well have anti-assignment clauses in them. If they do, it can be a serious impediment to financing a company’s business.

Under Article 9 of the Uniform Commercial Code, which is the corresponding legislation in the U.S. to our PPSA, antiassignment clauses are generally ineffective to prevent the assignment of receivables. This approach has been followed by every province and territory in Canada, with the exception, until now, of Ontario and Quebec. Ontario has now adopted the same approach. Once these PPSA amendments become effective on August 1, 2007, contractual restrictions on the assignment of a receivable, whether arising under a normal account, a lease or a conditional sale contract, will no longer be enforceable against purchasers or secured parties. Therefore, third party financiers will be able to more safely advance money on the security of contracts with antiassignment clauses. This should give many companies more flexibility on how to raise capital.

Here is what the legislation does not do, however:

• The changes to the PPSA only address contractual restrictions on assignment – legal restrictions, such as those that prohibit the assignment of government receivables, are still effective.

• The new PPSA only applies to the assignment of "the whole of the account or chattel paper". It is common, particularly in securitizations, to sell interests in receivables, rather than selling the whole receivables. A sale of an interest in a receivable will still be subject to any anti-assignment clause. This approach was taken purposively by the drafters of the amendments, on the basis that allowing the assignment of a partial interest could cause undue hardship to the account debtor. It was concluded that the issue warranted more study. The expectation is that this will be addressed when the PPSA is ultimately conformed with the UNCITRAL Convention on the assignment of international receivables, once that Convention is ratified by Canada.

• There is an interesting difference between the language in the new Ontario provision and the corresponding language in the PPSAs of the other jurisdictions in Canada. The other PPSAs state that an anti-assignment clause "is binding on the assignor only to the extent of making the assignor liable in damages for breach of contract …" (emphasis added). Since, in many cases, there will not be any damages, this gives some real comfort. The new Ontario provision, however, does not refer to damages. It says that such a clause "is binding on the assignor only to the extent of making the assignor liable to the account debtor for breach of their contract". Does the difference matter? It does seem to leave a door open for some interesting arguments. One question is whether it could allow the other party to such a contract to terminate for breach or seek an injunction to prevent the assignment. It seems unlikely that a court would allow a termination to prejudice the assignee, given the express statement that these clauses are "unenforceable against third parties". Even to allow such a right against the assignor would potentially render the whole provision of very little use. As such, a court should strive to avoid that result. However, there may be some interesting arguments being made until this omission is corrected. Again, we understand that the Ontario government will likely address this as part of the next round of changes to the PPSA once the UNCITRAL Convention is ratified by Canada.

Overall, while this change should facilitate receivables financing, there are still some potential traps for the unwary. Companies that generate pools of receivables should continue to resist agreeing to anti-assignment clauses, or if they must agree to such clauses, include express carve-outs for the assignment of amounts owing under the contract. In many cases, the account debtor may not care about the assignment of the receivable, but only to whom it has to perform the balance of its obligations. Therefore, often it will not be difficult to negotiate this type of carve-out. In addition, financiers and borrowers should still do their due diligence to make sure any anti-assignment clauses are identified.

Under the current PPSA, there is a potential conflict between an inventory financier and a receivables financier. A receivables financier with a first-ranking registered interest in receivables can be defeated by an inventory financier who comes along after the fact and obtains the super-priority associated with a purchase-money security interest (or PMSI) in inventory. That result follows from the fact that the PMSI in inventory extends to proceeds of the inventory – that is, to receivables and, therefore, the inventory financier’s superpriority in those proceeds can defeat the pre-existing interest of the receivables financier.

Often this issue is addressed practically, as the same entity finances both inventory and receivables, but this is not always the case, especially for factors and in securitizations. This problem was recognized in the U.S. many years ago, and Article 9 of the UCC addresses it. In the U.S., the accounts receivable financier is given express priority in the case of an overlap. The same approach was adopted in the western Canadian provinces and territories. The Atlantic provinces also address this problem, however, they have adopted a different solution. In the Atlantic provinces, a new purchase money inventory financier must give notice of their PMSI to anyone claiming an interest in accounts. Therefore, the accounts receivable financier will at least know about the potential threat to its security.

Ontario has been left as the only Canadian common law jurisdiction that does not expressly address this problem. Once the amendments to the PPSA come into effect, this will change. Ontario has now adopted the Atlantic provinces’ approach.

Therefore, the good news is that, going forward, receivables financiers will get notice before being exposed to this type of leapfrogging super-priority in favour of an inventory financier. Remember, however, that this does not solve the problem. Receivables financiers must build into their procedures and documentation a mechanism to respond if these notices are received. In many cases, that will be there already in the documentation through a combination of a covenant by the borrower not to grant any competing prior security in receivables and an event of default for any breach of covenant, but the documents should be checked to make sure that an appropriate course of action can be taken once these types of notices are received.

At common law, the only right that an account debtor had against an assignee of a receivable was, in effect, the right to set-off against the receivable, certain claims against the assignor that arose before the account debtor received notice of the assignment of the receivable. The current PPSA repeats this concept but, in doing so, the language used suggests perhaps broader rights – specifically the right to hold the assignee personally responsible for breaches of the contract by the assignor. The amendments do away with this concern, so that we are more clearly back to the traditional common law position. An assignee may be met with a claim for set-off, but absent an agreement to the contrary, will not be sued for breaches of the underlying contract by the assignor.

Overall, the changes to the PPSA will help receivables financing. While we can hope the Ontario government will address the few gaps that still exist, even if they do not, the practice in Ontario should evolve relatively easily to ensure that there are practical solutions.

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.