A recent British Columbia Supreme Court case took a fresh look at the old question of how to tell a true sale from a financing or loan transaction. The ruling in Coutinho & Ferrostaal GmbH v. Tracomex (Canada) Ltd. is a welcome addition to the relatively sparse body of case law on this topic, as it reaffirms and applies a number of the principles set out in the 2003 Ontario decision in Metropolitan Toronto Police Widows and Orphans Fund v. BC Tel Communications Inc. (Widows and Orphans).

The facts of Coutinho are too complicated (and, truthfully, too boring) to recount in detail. Suffice it to say that various players in the scrap metal industry were interested in a stockpile of old railroad rails located just outside Vancouver. The dispute was ultimately about who owned the rails after a series of transactions had taken place among parties of various nationalities who, by the end, all seemed to be accusing one other of various forms of duplicity. The court eventually (and wisely) decided the ownership issue in favour of the plaintiff, Coutinho & Ferrostaal (C&F), which appears to have been the most innocent of the dramatis personae.

The true sale point came up in connection with one of the sales (or purported sales) that the rails underwent during the period in question. The seller in that case, Trac Chile, had acquired the rails for about $1.2 million from C&F on a delayed payment basis. However, before it had paid more than a small fraction of that price, it sold (or purported to sell) the rails on to Imbamar, a Uruguayan concern. Imbamar’s price was just $462,494 but its contract included a repurchase option that allowed Trac Chile to buy the rails back after 180 days for $554,993 – which just happened to equal $462,494 plus 20%.

Whatever suspicions one might have about the substance of this transaction (i.e. that it looks, walks and quacks an awful lot like a financing), it was, in the strictest formal sense, a sale. In other words, the documentation did not refer to a loan, did not characterize the repayment as involving 20% “interest” or anything of the sort. As the court noted, however, substance is what matters when it comes to the financing/true sale distinction, i.e., the court must determine the “true nature” of the transaction, which is a function of its “broader commercial objectives” rather than of the words in which the contractual documentation was drafted.

In determining the true nature of this transaction, the court looked first and foremost to the “factual matrix” of the contract, which in this case primarily meant the pre-contractual negotiations and discussions. It found that the communications between the parties almost uniformly used financing language rather than sale language. The deal was clearly understood as a short-term financing by means of a repurchase transaction. That the price was far below market was also consistent with a financing (and obviously not at all consistent with a true sale), as was the fact that the repurchase price was based on an interest calculation. The court also considered the fact that the parties had discussed a prepayment penalty to be indicative of a financing intent, even though this type of penalty was not ultimately included in the contract.

In addition to all the indicia of a financing objective in the pre-contractual phase, the court referred to certain considerations that had emerged from the Widows and Orphans case, notably the existence of a repurchase option. In Widows and Orphans itself, the securitization was held not to have created such an option, prompting the Ontario courts to find a true sale in that case. Here, however, there was no doubt that such an option existed, which again militated strongly in favour of a “financing” analysis. Furthermore – another very important point to take note of – the Widows and Orphans ruling stressed the importance of a transfer of ownership risk to the purchaser. In this case, while ownership did (purportedly) pass to Imbamar, Trac Chile was required to continue to pay general liability insurance for the rails and also to reimburse storage costs in the event that it decided to repurchase them. As the B.C. court noted, the existence of such rights of recourse was also consistent with the financing analysis.

In another Ontario case, Kaak v. Bank of Montreal, the court had found a true sale where the repurchase option was at or even greater than the market price, creating uncertainty about whether the option would be exercised. While agreeing with this analysis – which suggested the opposite conclusion in the present case, where the repurchase price was far below market – the B.C. court expressly rejected the Kaak court’s blanket statement that “an option does not create a security interest”. The B.C. court noted that this clearly does not reflect the state of the law and, in particular, overlooks the emphasis on substance over form in this area.

Coutinho does not change the existing law, other than insofar as it may have reined in the Kaak court’s overbroad generalization that options can’t create security interests. But it does serve as a useful guide to the principles that courts will rely on in deciding whether, in substance, a transaction is a financing or a true sale.