In dealing with collateral provided by a third party to support the obligations of the prime debtor, lenders and their counsel need to remember the impact of the federal Bankruptcy and Insolvency Act.

Ontario’s Personal Property Security Act (PPSA) was amended to broaden the definition of the word “debtor.” However, the Bankruptcy and Insolvency Act’s (BIA) definition of a “secured creditor” is still restricted to a person holding a charge or a lien “as security for debt due or accruing to the person (lender) holding the debt.”

There are several reasons why the Ontario PPSA was amended. Prior to the amendment it was not clear whether the definition of “debtor” included an owner of collateral who makes the collateral available as security without itself assuming any personal obligation to the secured party. Further, the PPSA amendment facilitated cross border transactions, as the United States uses similar language (the PPSA is based on Article 9 of the Uniform Commercial Code). Finally, the amendment created increased uniformity with other provincial PPSAs, notably Alberta and British Columbia, where the definition of “debtor” clearly encompasses persons who provide their property as collateral for the obligation of another person.

The old Ontario definition of “debtor” required the security to be granted by a party who owed payment or performance. For example, in a loan to a subsidiary where a security agreement was signed by the parent corporation which had not expressly covenanted to pay the lender, the argument was that there was no attachment of the security interest to the collateral because the parent corporation was not a “debtor” under the PPSA.

Following the amendment, Subsection 1(1) “debtor” means,

a) a person who, i. owes payment or other performance of the obligation secured, and ii. owns or has rights in the collateral, including a transferee of or successor to a debtor’s interest in collateral.

b) if the person who owes payment or other performance of the obligation secured and the person who owns or has rights in the collateral are not the same person, i. in a provision dealing with the obligation secured, the person who owes payment or other performance of the obligation secured ii. in a provision dealing with collateral, the person who owns or has rights in the collateral, including a transferee of or successor to a debtor’s interest in collateral, or iii. if the context permits, both the person who owes payment or other performance of the obligation secured and the person who owns or has rights in the collateral, including a transferee of or successor to a debtor’s interest in collateral.

Miller Thomson Analysis

This new definition allows an entity who has rights (or owns) collateral to provide a security interest in that collateral, as a “debtor,” even if that entity does not owe payment or the performance of an obligation to the secured party. For example, a shareholder can pledge his/her or its shares but not grant any payment covenants, including an indemnity or guarantee to the secured party. However, as mentioned above, the definition of a “secured party” under the BIA still requires that the lender holds a charge or lien as security for a debt due or accruing due to the person from the giver of the collateral.

A “secured creditor” is defined under section 2 of the BIA as a person holding a mortgage, hypothec, pledge, charge or lien on or against the property of the debtor or any part of that property as security for a debt due or accruing due to the person from the debtor, or a person whose claim is based on, or secured by, a negotiable instrument held as collateral security and on which the debtor is only indirectly or secondarily liable…..

In essence, what this means is that without an underlying guarantee, indemnity or other covenant a secured creditor who holds a third party pledge from A (securing the obligations of B) cannot prove against A’s estate in bankruptcy since it is not a “secured creditor” of A.

While there currently is no jurisprudence where the court has considered whether security given by a party for another’s payment obligations without a guarantee would enable a recipient to be a “secured creditor” under the BIA, it is prudent to continue to utilize indemnities or guarantees. Some commentators note that the grant of a security interest without a guarantee or indemnity is also not desirable as the lender will not have the benefit of all of the common law remedies and rights that go with these documents.

One alternative to this situation is to ensure that language is inserted into the security document which creates a debt that is only enforceable by realization on the security.

Consequently, prudent lending practices should still include co-borrowers or guarantees or indemnities to ensure “secured creditor” status over the collateral.