Canada's Supreme Court decides that they do in the case
of a credit support arrangement involving cash
Set-off rights in the context of cash collateral arrangements providing credit support now stand a much greater chance of recharacterization as creating a security interest in the cash collateral as the result of a recent Supreme Court of Canada ruling in Caisse populaire Desjardins de l'Est de Drummond v. Canada, 2009 SCC 29. The issue was whether an agreement between a lender and borrower with respect to set-off against a term deposit gave rise to a "security interest" within the meaning of s. 224(1.3) of the federal Income Tax Act (ITA).
Concurrently with the extension of a business line of credit,
Caisse populaire Desjardins de l'Est de Drummond (the Caisse)
and its customer, a company named Camvrac, entered into a
"term savings agreement" (TSA) requiring Camvrac to
deposit $200,000 for a five-year term. The deposited funds were not
transferable, could not be charged or given as security to any
person other than the Caisse, and there was no right of withdrawal
or redemption prior to the maturity date. The TSA provided
explicitly for set-off ("compensation" under Quebec law)
between the funds owed by Camvrac under the line of credit and the
funds owed by the Desjardins to Camvrac under the TSA - the set-off
being effected in the event that the company defaulted on the line
of credit. The two parties also entered into an unadvisedly named
"Security Given Through Savings" agreement, under which
it was agreed that Camvrac would maintain the deposit to
"secure the repayment of" a line of credit, among other
things. Camvrac defaulted promptly after the arrangements were put
in place, but the Caisse did not take any steps until two or three
months later, two weeks after Camvrac had made an assignment in
bankruptcy. At this point, the Caisse made a note on its copy of
the TSA: "To be closed on 21/2/2001 to realize on
security" (another unfortunate choice of language). In the
aftermath of Camvrac's assignment in bankruptcy, the Government
of Canada (the Crown) demanded that the Caisse pay Camvrac's
unremitted employment insurance (EI) premiums and outstanding
at-source tax withholdings out of the term deposit funds that it
had set off against Camvrac's credit line debt. The Crown
argued that the terms of the TSA created a "security
interest" within the meaning of Section 224(1.3) of the ITA,
and that the funds that were set off against were subject to the
deemed trust in favour of the Crown. Like the courts below, the
majority on the Supreme Court agreed.
Both the ITA and the Employment Insurance Act (EIA) create deemed trusts in favour of the Crown over property of an employer that has deducted income tax and EI premiums at source. The deemed trust also applies to property of the employer held by any secured creditor of the employer that, but for its security interest, would be the employer's property. "Security interest" is defined as:
The point of dispute between the majority and minority judgments
turned on whether the set-off arrangements created an interest in
property of the employer Camvrac. The majority held that in the
circumstances of the case they did, while the minority drew the
Traditionally it has been held that a right of set-off does not constitute a security interest because it is not an arrangement that gives a creditor a property right in the asset against which set-off is effected. Set-off is a right (contractual, legal or equitable) that allows a party owed an amount to use that right to satisfy its own obligation. For example, a lender owed money by a borrower could employ that asset (the receivable) to satisfy its own obligation to the borrower pursuant to a deposit agreement. Under the deposit agreement, the lender has an obligation to return the amount on deposit to the borrower. The set-off does not depend on the lender having a property interest in the deposit. The party setting off, the lender, has an obligation and is entitled to satisfy that obligation by setting off an obligation owed to it by the other party, the borrower. Set-off has nothing to do with realizing on a property interest. Even if there is a security interest in one's own obligation (i.e., the lender held a security interest in the funds it owed to the borrower), as there was in this case, that set-off right can exist quite independently of that interest (and in a properly drafted agreement, that would be clear).
The majority's reasons
In this case, however, the majority - embracing a contemporary
"functional" understanding of a security interest - held
that the TSA did create a security interest in the deposit and that
the right of set-off was the means to enforce that security
interest. Restrictions on the company's ability to deal with
its term deposit were equated with a security interest.
In support of the majority's conclusion, Mr. Justice Rothstein stated:
The majority stressed that they were not saying that a
contractual set-off right is per se a species of security interest.
Rather, they held that, in light of the fact that the term deposit
was structured so as to be available for set-off as long as the
credit line continued, the terms of this particular agreement
justified the recharacterization of the transaction as a whole as
the grant of a security interest.
In dissenting reasons, Madam Justice Deschamps strongly
disagreed with the majority view. Taking a position reflecting that
of many practitioners in the banking industry, and invoking a
rather impressive range of academic commentary, she concluded that
security interests can only be derived from "real rights"
in property and never from the attenuated type of contractual right
to which the majority referred. She concluded that a security
interest is created only where a real right is acquired, a right in
the property itself, as opposed to the right to compel a person to
perform an obligation, which is the essence of a personal right.
Not all interests in property are security interests. In this case,
she noted, the Caisse had no right to realize on its interest to
secure performance of the obligation owed to it. The potential to
appropriate the underlying property, she maintained, is one of the
distinguishing features of a security interest. The
"encumbrances" that the majority relied on did not give
an appropriation right - "neither the term for repayment, nor
the obligation to maintain, nor the right to withhold, nor the
limit on the right to transfer, hypothecate or negotiate would
enable the Caisse to realize on the deposit or appropriate the
deposit amount to ensure performance of the secured
obligation." A bank deposit creates a debtor-creditor
relationship in which the bank is indebted to the depositor for the
sum on deposit. The clause establishing the term merely stipulated
the time for repayment of the indebtedness. The right to withhold
and deduct is a right of the Caisse not to perform an obligation to
repay its indebtedness to the depositor as long as a debt is owing
by the depositor to the Caisse. The obligation to maintain is an
undertaking to perform an obligation. The restriction on transfer
and hypothecation is an obligation not to do something. Deschamps
J. concluded: "I cannot see how these rights, whether
considered in isolation or as a whole, might constitute a security
interest as that term is defined in s. 224(1.3) ITA. None of them
provides a basis for using the property to ensure performance of
the obligation, and none of them constitutes an interest in
property that secures performance of an obligation."
Implications of the ruling
As a result of the Court's decision that a security interest
existed, the Caisse became liable to the Crown for the unremitted
EI premiums and at-source income tax deductions, because those
funds were impressed with a deemed trust in favour of the Crown
over Camvrac's property in which the Caisse merely had an
unperfected and subordinated security interest.
Normally, priority with respect to security interests perfected by filing would be determined by order of registration. However, given the contractual right to set-off, the recognition of the paramountcy of defences in section 40 of the Ontario Personal Property Security Act (PPSA) (and its equivalent in other common law provinces) should ensure priority over other secured parties that have filed under the PPSA. Section 40(1.1) of the Ontario PPSA provides that an account debtor may set up by way of defence against the assignee all defences available to the account debtor against the assignor arising out of the terms of the contract or a related contract (unless it has contractually waived defences). By way of example, where a lender takes a deposit of cash collateral from a borrower, the lender is the account debtor of the borrower, the borrower is the assignor and a third party is the assignee, i.e. another secured party who has a security interest in all the borrower's assets. The "account" in this case is the amount owing by the lender to the borrower for the cash collateral it has received from the borrower and the defence is the right under the agreement between them to set-off against the amounts owing to the lender any of the amounts on deposit. The lender, following the exercise of its set-off right, would only be obligated to return to the borrower the net amount, if any, following such application. In this example, perfection should not be relevant to priority as against other consensual security interests or other assignees. It is somewhat unclear, however, how Section 40 would relate to the rights of a trustee in bankruptcy as representative of the unsecured creditors or other non-consensual lien claimants, so it may be advisable to file a financing statement in any event to preclude any argument that there is an unperfected security interest.
A central problem with the majority's analysis is that it fails to differentiate between an agreement that provides credit support or assurance and a security interest. While all security interests provide credit support, the converse is not true: not all credit support arrangements are security interests. For example, a guarantee provides credit support but does not grant an interest in property to secure payment or performance of an obligation. It is in the nature of a personal right - a right to compel a person to perform an obligation. The intention to provide credit support is quite distinct from the intention to confer a security interest in one's property. Such distinctions may have been lost on the majority partly because of the drafting of the agreement, which unwisely used "security language." The majority did agree that a property interest must be created in the debtor's property, but its conclusion that there was such a property interest and that the right of set-off was the means to enforce that interest is dubious. One can only hope that it will be restricted in any subsequent application to situations where the intention to create a security interest is present on the face of the document and where the set-off rights are not part and parcel of the asset itself (i.e. the terms of the deposit itself do not provide for the set-off).
However that may be, the ruling is now a part of Canadian law and may require adjustments to lending practices. In particular, it is important to note that while the case dealt with the deemed trust provisions of the ITA and the EIA, its implications could extend further into the realm of personal property security law. Moreover, it potentially affects not only cash collateral arrangements but title transfer arrangements, escrow arrangements, prepayment arrangements and consignments. The decision clearly increases recharacterization risk in all of these situations.
For parties who have required credit support, a review of the documentation should be considered, in addition to the possibility of making a cautionary PPSA filing. Care will need to be taken in ensuring that any cash collateral arrangements entered into are clearly drafted to avoid being recharacterized by avoiding language implying an intention to give a "security interest" in relevant documentation and even by specifically disclaiming the intention to create such an interest, much as occurs already with respect to title transfer arrangements in credit support agreements.
Note: Stikeman Elliott has commented on this ruling from the perspective of structured finance practice. See our September 2009 Structured Finance Update for more.
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.