Copyright 2008, Blake, Cassels & Graydon LLP
Originally published in Blakes Bulletin on Financial Services, October 2008
The province of Quebec has now joined British Columbia, Alberta, Saskatchewan, Manitoba, Ontario, and Newfoundland and Labrador in the process of implementing uniform securities transfer laws across Canada. Bill 47, called An Act Respecting the Transfer of Securities and the Establishment of Security Entitlements (the STA), will come into force on January 1, 2009. Among other things, the STA will amend certain provisions of the Civil Code of Québec (CCQ) and will change how we understand the transfer and hypothecation of securities (including book-based securities) and other financial assets.
This bulletin is not a comprehensive exploration of the many intricacies of the STA. Our aim instead is to provide a bit of background on what the STA is and where it came from, and then to focus on two issues that many of us will encounter – the new requirement for secured creditors to obtain "control" over pledged securities (particularly book-based securities) and the new role of the "control agreement" in securities pledge transactions.
THE STA: ORIGINS AND INNOVATIONS
The STA is closely modeled on securities transfer legislation already introduced in certain common law provinces of Canada. Essentially, the STA represents the importation into Quebec – with some necessary modifications – of modern U.S. law on securities transfer. For Quebec, a key goal in drafting the STA has been to maintain uniformity with the legislation already introduced elsewhere in Canada while at the same time adapting it to fit the unique structure of the CCQ and other existing Quebec laws.
The major innovation of the STA is to provide a complete and coherent set of rules to govern the "indirect holding system" – that is, the chain of book-based holdings (or, more accurately, computer-database-entry-holdings) that begins with the issuer and the Canadian Depository for Securities (CDS), passes down through one or more tiers of brokers and other securities intermediaries, and ends with the individual investor. Until now, this gap in Quebec law has often turned a pledge of book-based securities into an exercise fraught with legal uncertainties. Happily, these will largely vanish when the STA is implemented. The STA, and the corresponding changes being made to movable hypothec legislation, will provide us with a relatively simple and secure means of taking a pledge of book-based securities and similar financial assets.
The introduction of the STA will be accompanied by important changes to existing movable hypothec legislation.
Among these changes are:
- the recognition of new categories of collateral called "securities" and "financial assets" (which will expressly include, for example, securities held in book-based form in a securities account) and of the term "security entitlement", which is essentially the rights that an entitlement holder has to securities or other financial assets credited to a securities account,
- the introduction of a new method (called "control") for rendering opposable hypothecs on securities and security entitlements,
- the adoption of new rules to determine priorities among secured creditors who have obtained control and those who have simply registered their hypothec,
- an amendment to the CCQ to provide that a natural person not carrying on an enterprise will have the right, under certain circumstances, to grant a hypothec on a universality of present and future securities and security entitlements, and
- a presumption in the CCQ that, by obtaining control, a creditor has satisfied the delivery and holding of the pledged property requirements of the CCQ for the granting and publication of a pledge.
All of these changes will have a direct impact on existing procedures for taking a pledge of securities.
TAKING CONTROL AND PRIORITY
For secured creditors, obtaining control of pledged securities is made almost essential by the new priority rules. In all but a few instances, registration alone won't be adequate to obtain and maintain priority over other creditors. With the STA:
- a secured creditor having control will take priority over a secured creditor who merely registers its hypothec, and
- a secured creditor who obtains control first will take priority over a secured creditor who obtains control afterwards.
In addition, a securities intermediary benefiting from a hypothec with delivery on a security entitlement to a financial asset credited to a securities account maintained by it will take priority over other secured creditors in certain circumstances.
Control means different things for different types of assets. For paper certificates, it is synonymous with taking possession (plus endorsement if in registered form). For security entitlements, on the other hand, taking control means exactly that – either transferring the financial assets into an account that is owned by the secured creditor or, as will occur more often, by entering, with the pledgor's consent, into a "control agreement" between the secured creditor and the securities intermediary who holds the financial assets for the pledgor.
THE CONTROL AGREEMENT
In its simplest form, a control agreement for security entitlements to financial assets (including publicly-traded securities) is a contract made between a secured creditor and the securities intermediary of the pledgor in which the securities intermediary gives "control" over the pledged financial assets to the secured creditor. In practical terms, a secured creditor would obtain control when the securities intermediary agrees to act upon the instructions of the secured party without the additional consent of the pledgor in the event of a realization on the pledged property.
From a secured creditor's perspective, the control agreement is a useful tool that brings with it some potential problems:
- Neither the STA nor the changes being made to the CCQ require public registration of control agreements, so a search at the Register of Personal and Movable Real Rights will not be a reliable guide to existing hypothecs with delivery arrangements.
- Unless specifically requested to do so by the pledgor, a securities intermediary has no obligation to disclose the existence of a control agreement to a secured creditor (or to anyone else), so due diligence will always require the active co-operation of the pledgor.
- Most importantly, a securities intermediary can simply refuse to enter into a control agreement, even if the pledgor requests that it do so. Although the securities intermediary will ordinarily wish to retain the pledgor's business by complying with such a request, this discretion may give considerable leverage to the securities intermediary in negotiations on the terms of the control agreement.
Moreover, the STA says little about the actual content of a control agreement, other than to indicate that it entails the securities intermediary giving "control" to the secured creditor with the consent of the pledgor. Almost everything else is left open to negotiation between the parties. As a result, the preparation of every control agreement will require careful consideration of a range of issues, including:
- the extent to which the pledgor can continue to trade securities held in a pledged securities account (and any corresponding obligation of the securities intermediary to supervise trading activities);
- the identification by the securities intermediary of any existing control agreements, and the imposition of restrictions on the ability of the securities intermediary to enter into control agreements with other secured creditors;
- subordination of the securities intermediary's own hypothec on the pledged securities;
- provision for payment of the securities intermediary's fees and commissions; and
- indemnities, if any, from the secured creditor and the pledgor in favour of the securities intermediary for risks relating to the control agreement.
Many of these issues will often be challenging to negotiate. This is hardly surprising, given that a third party – the securities intermediary – is being asked to take on compliance risk for little or no compensation.
The CCQ will also be modified to allow a creditor holding a hypothec on securities or security entitlements to sell, in certain circumstances, the securities or security entitlements without giving any prior hypothecary notice.
IMPACT OF THE STA ON MARKET PARTICIPANTS
The STA will have a material impact on many different stakeholders' practice and documentation:
- Financial institutions and other secured creditors will need to update their documentation to accommodate the new terminology and new concepts introduced in the STA, and to comply with the STA's transitional rules. They will also need to develop new due diligence procedures for securities collateral, and become familiar with the STA's technical requirements for obtaining control over hypothecated securities and other financial assets – including the negotiation of effective control agreements. They will also have to adapt internal guidelines in terms of governing law as they will have in certain circumstances, according to new conflict of law rules of the STA, the option of selecting the law applicable to the control agreement and to the encumbering security.
- Brokers, custodians and other securities intermediaries will need to revise their customer account documentation, and will have to know how to respond to requests for control agreements from their customers' secured creditors. Their legal and compliance staff will also have to understand how the STA rules will affect (though usually not change) their obligations to customers,
- particularly with respect to the holding of financial assets and the operation of securities accounts.
- Lawyers, bankers and other professionals involved in secured lending, derivatives and securities purchases and sales will need to become adept at assessing the impact of the STA on their specific transactions.
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.