Taking Security
Types of Security Agreements
Personal Property Security Acts
Real Property Registrations
Bank Act Security
Canada Transportation Act
Canada Shipping Act
Enforcement
Typically, banks and other financial institutions lend funds to businesses either on demand or on a term basis, and in most cases require personal and/or real property security for their loans. The effect of a secured loan is that, should the debtor default in payment, the lender is entitled to look to specified assets of the debtor in priority to certain other creditors for the satisfaction of the debt owed. A secured debt is thus a debt claim coupled with a proprietary interest in one or more assets of the debtor ranking in priority to the debtor's unsecured creditors and subsequent secured creditors.
In contrast to secured debt, an unsecured debt is not coupled with any such proprietary interest. As a result, an unsecured creditor holds no specific claim against the property of the debtor. Instead, it is left to look for its payment only to such property of the debtor, if any, as remains after all the persons having interests in that property have enforced or abandoned their interests.
Since there are few legal restrictions in Canada on commercial loans, the range of possible lending arrangements is limited to a large extent only by the imagination of lenders and borrowers. However, in major transactions involving a loan or other form of credit, a prudent creditor should always consider the need or desirability of requiring security to ensure payment or performance of the debtor's obligations.
In Canada rights of ownership of property are generally governed by provincial law, not federal law. Consequently, each of the 10 provinces in Canada has laws dealing with perfection and enforcement of security, both for real and personal property. In Quebec these laws are largely codified in the Quebec Civil Code and in the other nine provinces the laws are determined both by common law and statute. The following commentary is therefore general in nature and reference should be made to the particular legislation and practices in each province.
While there are various types of security agreements, most share a common number of features including:
- the grant of security;
- the description of the nature of the obligation secured;
- restrictions concerning dealings with the charged assets;
- representations and warranties related to the security that is given and the party giving the security;
- a list of certain acts and events the occurrence of which will constitute a default under the agreement; and
- contractual remedies in the event of default.
The following is a list and description of some of the most common types of security agreements used in asset finance transactions, for both real and personal property.
Real property
Generally speaking, real property is any interest in land, and everything annexed to it. The most common types of security agreements used to create a security interest in real property are mortgages or charges and debentures. General security agreements are also occasionally used to create security over fixtures.
A mortgage or charge is an interest in real property granted by a debtor (mortgagor or chargor) to a creditor (mortgagee or chargee) as security for the payment of a debt or the performance of some other obligation, on the express or implicit understanding that upon payment of the debt or performance of the obligations concerned, that interest will be extinguished. Mortgages or charges may be granted by the owner of any kind of interest in real property, and may include mortgages or charges of fee simple (ownership) interests, leasehold interests and mortgages of mortgages.
A debenture is essentially an instrument issued by a borrower (normally a corporation) which contains a promise to pay a specified principal amount plus interest, on demand or at the times and in the manner stated therein. While a debenture need not create a charge on or a security interest in the borrower's assets, in a commercial loan transaction a debenture normally contains a mortgage and a charge on some or all of the real and personal property of the borrower, both present and future, as security for repayment. The advantage of a debenture is that the enforcement remedies which it creates (eg, appointment of a receiver or power of sale) are comprehensive and generally apply to both real and personal property.
Personal property
Generally, personal property is anything that is not real property. The most common types of security instruments used to create a security interest in personal property include general security agreements, assignments of accounts receivable, conditional sale agreements, equipment leases and pledges.
A general security agreement creates a security interest in all of the personal property of the borrower and generally purports to cover both present and future personal property. Assignments of accounts receivable create a security interest in the borrower's present and future accounts receivable. Conditional sale agreements and title retention agreements generally apply to specific tangible personal property (usually equipment and motor vehicles).
The nature of an equipment lease depends on its purpose and effect. A lease that provides for short-term rental of equipment is sometimes called a 'true lease'. A lease that secures payment or performance of an obligation is sometimes called a 'financing lease' and will be treated as a security agreement under the Ontario Personal Property Security Act (PPSA). In order to determine whether the parties have entered into a financing lease, Ontario courts will typically look at certain factors such as:
- whether the purchase option price (if any) in the lease could be considered nominal;
- whether the lessee is obligated to purchase the property at the end of the lease; and
- whether the lease term exhausts the useful life of the property.
An affirmative answer to any of these questions may be an indication of a financing lease or disguised sale as opposed to a true lease, and therefore the lessor will need to perfect the security interest created in the lease in accordance with PPSA rules. Outside Ontario the rules applying to leases are generally uniform in that leases of a term of more than one year are deemed to create a security interest in the leased property, regardless of whether they secure payment or performance of an obligation.
A pledge usually involves the delivery or transfer of possession of a chattel or negotiable security by its owner to a creditor pursuant to a security agreement as security for the payment of a debt or the performance of another obligation. Upon such a pledge, ownership remains with the borrower, but possession of the collateral is physically transferred to the lender or an agent of the lender. Note: securities pledge agreements sometimes contemplate the transfer of the registered ownership of the underlying securities to the lender.
While the execution of such agreements will result in the creation of a security interest and give the creditor a measure of protection in the event of the debtor's default, in order for such security interests to be enforceable as against third parties and trustees in bankruptcy, it is necessary to comply with registration and other statutory perfection requirements. Examples include those provided under provincial personal property security acts, the Bank Act (Canada), the Canada Transportation Act, the Canada Shipping Act, certain federal statutes dealing with intellectual property and, in the case of security interests in real property, provincial land registration legislation.
Personal Property Security Acts
Canada's various provincial PPSAs provide comprehensive sets of rules to govern the rights of creditors and debtors when personal property is used as collateral to secure payment of a debt. While there are differences between the various PPSAs enacted by the provinces, in all cases the PPSA applies to every transaction that, in substance, creates a security interest in personal property to secure the payment or performance of an obligation, without regard to who holds title to such property or the form of the security delivered. Modeled substantially on the success of Article 9 of the American Uniform Commercial Code (UCC), one of the primary objectives of the PPSA is to provide a structure under which commercial transactions can be concluded with reasonable simplicity and certainty.
The PPSA typically defines 'personal property' as chattel paper, documents of title, goods (eg, equipment, inventory, consumer goods), instruments, intangibles (eg, accounts receivable, contractual rights), money and securities, and includes fixtures, but does not include building materials that have been affixed to real property. Intangible personal property can also include intellectual property rights. However, a security interest over certain intellectual property (eg, trademarks and patents) may also be registered under the registry system provided for under applicable federal legislation (such as the Trademarks Act) because of conflict of law issues yet to be settled by Canadian courts.
Perfection
'Perfection' is a term of art used to identify the point in time when the secured party has obtained the greatest bundle of rights under the PPSA with respect to the secured collateral. Pursuant to the PPSA, perfection can be accomplished in one of two ways. Firstly, a creditor may register a financing statement under the applicable PPSA, which constitutes disclosure to third parties that a security agreement has been or will be concluded between the parties and providing appropriate description of the collateral subject to the security interest. Perfection by registration is necessary in most secured transactions.
The second way a creditor can perfect its interest is by obtaining possession of the collateral. However, the various PPSAs may limit the types of collateral that may be perfected by actual possession. From a practical perspective, perfection by possession is typically used in financing transactions involving security in documents of title, instruments and securities.
Registration and searches
The timing of registration under a PPSA varies from province to province. In certain provinces (such as Ontario), a financing statement may be registered at any time before or after the security agreement is executed. However, since one of the primary mechanisms for determining priority in perfected security interests is the date of registration, secured parties should register as early as possible. One exception to this occurs where the collateral consists of consumer goods, in which case the PPSA generally prohibits the registration of a financing statement until the security agreement has been signed.
To be acceptable for or to validate the registration, a security interest must provide all necessary information prescribed by the regulations enacted under the PPSA. Such information generally includes the correct name of the debtor, correct vehicle identification number in the case of motor vehicles, proper description of the collateral being secured, and more.
Registration alone does not ensure priority. Prior to registration the creditor should make a search under the applicable PPSA against the debtor to identify all other security interests previously granted by the debtor. Since priority among competing secured creditors is often determined by the order of registration, steps should then be taken to discharge or limit any prior registrations disclosed by the PPSA search.
Purchase-money security interests
Also modeled on Article 9 of the UCC, a purchase-money security interest (PMSI) is a security interest to which the PPSA attributes a special priority. It is created when a creditor gives value to enable a debtor to acquire rights in certain specific collateral and complies with special statutory requirements.
The objective behind the PMSI rules is to protect a new financier's interest as against prior security interests granted by the debtor which purport to cover after-acquired property. PMSI rules allow a debtor to obtain financing from a new creditor when it wishes to acquire particular assets, usually equipment or inventory. Essentially, the PMSI rules allow a new creditor to look to the collateral which it financed or supplied as security for its loan, in priority to other claims on that collateral.
However, as mentioned above, it is critical to ensure that the additional technical requirements of the applicable PPSA have been met in order to qualify as a PMSI. Failure to do so would result in the secured party holding only a 'regular' security interest subordinate to all prior security interests perfected against the same collateral.
Other priority exceptions
Due to the absence of a registration system concerning title to personal property in each of the Canadian provinces and the complexity of the law regarding priorities, it is not possible to verify with certainty the title of a debtor to the personal property intended to be subject to security interests or the relative priorities of particular security interests and any registered or unregistered interests in the same collateral held by other parties. In that respect, the lender may only rely upon representations of the debtor and its own due diligence inquiries, including searches conducted under various statutes, to determine whether any other parties have registered encumbrances against the personal property of the debtor.
As indicated, other secured creditors may obtain security interests in personal property of the debtor ranking in priority to the security interest granted to a proposed lender by application of the PMSI rules. In addition, the priority of a security interest may also be subject to certain liens and interests arising pursuant to statute or common law, such as statutory liens or trusts for unpaid taxes, employee source deductions and vacation.
To secure a mortgage or charge against a specific parcel of real property, that parcel must be described with sufficient particularity to permit the mortgage or charge to be registered under the appropriate provincial land registration legislation. The general rule is that no specific language is required in order to create a charge, provided that the parties make clear that it was their intention to confer such an interest. As well, certain provincial statutes set out a number of implied covenants that are presumed to form part of every charge unless otherwise stated in the agreement. Typically, the mortgage or charge document provides that:
- the charge of real property attaches to the land, and to all buildings, structures and appurtenances on the land;
- where an improvement is made to the land after the granting of a security interest, the interest will also extend to that improvement; and
- if any chattel is annexed to the land so as to render it a fixture, the charge will also extend to the fixture, subject to the rights of any secured parties who have registered their interests in such chattels under the PPSA prior to them becoming affixed to the land.
In practice, most institutional lenders insist upon the exclusion of the statutory covenants and replace them with their own charge terms.
Security under the Bank Act (Canada), a federal statute, is an exception to the general rule that perfection and enforcement of security is a matter of provincial law. Security under the Bank Act is only available to Canadian chartered banks as creditors. Essentially, a bank may take special forms of security under the act from certain classes of borrowers, as well as lend money on the strength of such security. The class of borrowers from whom such security can be taken are:
- wholesale and retail purchasers, shippers or dealers;
- manufacturers;
- aqua-culturalists;
- farmers;
- fishers; and
- forestry producers.
The Bank Act also creates a registration scheme in respect of such security and provides a basis for determining the relative priority of securities granted under the act. The standard form agreement will usually provide that the bank can go into, occupy and use the premises, plant and equipment of the borrower for the purpose of securing and realizing upon assets covered by the security taken pursuant to the act.
It is unclear in Canadian case law whether security taken under the Bank Act has priority over PPSA security in respect of the same collateral, and there is no statutory scheme for regulating disputes between the two. Therefore, it is standard practice for eligible lenders to register their security interest under both the Bank Act and the PPSA or to enter into some form of inter-creditor agreement with prior lenders to contractually establish their respective priorities as against the collateral.
Railway companies in Canada and their assets are also governed by federal legislation. The Canada Transportation Act (CTA) states that agreements documenting security interests in rolling stock, or any accessories or appurtenances relating thereto, may be deposited with the Office of the Registrar General of Canada. The CTA defines 'rolling stock' as including a locomotive, engine, motor car, tender, snow plough, flanger, and any car that is designed for movement on its wheels on the rails of a railway.
However, depositing such a security interest with the Office of the Registrar does not preclude creditors from registering security interests against railway companies' locomotives pursuant to provincial PPSAs. Thus, while it is likely that in the event of conflict between the two schemes, the federal registration will prevail due to the doctrine that federal legislation is paramount, creditors should, as a precaution, register their security interests under both regimes.
While the CTA also regulates aircraft, it does not establish for aircraft any specific registry system similar to that for locomotives and railroad cars, nor do any other Canadian statutes. Lenders financing aircraft (including aircraft engines and parts) generally perfect their security interests by registering under the PPSA. However, lenders should be aware that enforcement of security interests in airplanes may be affected by specific federal laws regulating licensing, ownership and use of aircraft and air services in Canada.
The Canada Shipping Act (CSA) provides for the mandatory registration of certain ships with the chief officer of customs of an approved Canadian port. The CSA further provides that a registered ship or any share therein may be used as security for a loan. The instrument creating the security interest in any registered ship is called a mortgage and its form is prescribed by the regulations.
The CSA also establishes a registry system under which such mortgage can be registered to perfect the security interest in the registered ship and provides for a specific order of priority in the event of conflict between various security interests so registered. Specifically, upon production of a mortgage to the registrar of the ship's port of registry, the mortgage will be recorded in the register book in the order in time in which it was produced, stating the date and hour of the record. Where there are several mortgages registered in respect of the same ship, the priority among such mortgages is determined according to the date on which each mortgage was recorded in the registry book, and not according to the date of the mortgages themselves.
Typically, default in a lending or finance transaction occurs when the borrower fails to make payment on the debt in accordance with the agreed terms of payment or to satisfy other obligations under the applicable security agreement. In the event of default, a secured creditor is entitled to various statutory and common-law remedies, depending on the type of property secured and the rights granted under the security agreement itself. In most cases, creditors have to comply with procedural requirements prescribed in the applicable statutes.
Personal property security
Under the PPSA, a secured party may enforce its security interest "by any method permitted by law". While this may seem ambiguous, the language is purposely broad so as not to limit a creditor's right to recovery in any lawful manner, as long as such recovery is not commercially unreasonable.
Nevertheless, the PPSA does provide specific statutory rights. For example, the Ontario PPSA provides that upon default, the secured party may take possession of the collateral or, in the case of accounts receivable and documentary intangibles, proceed to collect from the account debtors.
Further, the secured creditor may realize on the collateral by public or private sale after due notice to the debtor and other interested parties.
The proceeds of enforcement must be distributed in accordance with the scheme provided in the PPSA, and any surplus belongs to the debtor. In the event of such sale, the debtor remains liable for any deficiency. In the event that the collateral is not sold, the secured party may seek to foreclose the debtor's equity and to retain the collateral in full satisfaction of the debt.
Alternatively, rather than exercising these remedies, the secured party may elect to appoint a receiver, or apply for a court appointed receiver, both of which options are provided for by the PPSA.
Lenders should be aware that federal statutes regulating specific items of personal property (eg, the CSA) establish their own enforcement regimes and grant specific remedies which should be considered in addition to those provided for under the PPSA.
Real estate security
In the case of default under real property security, some of the options that may be available to the chargee or mortgagee include:
- taking possession of the charged property;
- obtaining judgment for payment;
- obtaining a judicial order for the sale of the property;
- proceeding with an action for foreclosure; and
- exercising a power of sale either under the terms of the charge itself or the applicable statute.
Care must be taken when choosing the appropriate remedy. For example, once a foreclosure action has commenced, court approval is required to amend the claim or to proceed with a power of sale. However, enforcement by way of foreclosure is generally expensive and relatively inefficient, and is a court-driven process where the lender is left only with the value of the land to recover the full value of the debt.
In summary, when a default occurs in respect of the payment or performance of an obligation, the enforcement alternatives available to a lender must be given careful consideration in order to determine whether or not enforcement will be necessary or advantageous. To properly consider this question, it is important to make a realistic determination of how the security could be enforced and what the likely result of such enforcement would be given the lender's relative priority to certain of the debtor's assets.
Most importantly, when faced with an event of default a lender should ensure that it carries out a careful review of its security in order to determine the alternatives available under the applicable security agreement, in addition to a review of the remedies available at law.
For further information on this topic please contact David Thring, Eric Friedman, Francois Potvin or Kevin von Bargen at Lang Michener by telephone (+1 416 360 8600) or by fax (+1 416 365 1719) or by e-mail ([email protected], [email protected], [email protected] or [email protected]).
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