As new provincial statutory requirements come into play, lenders need to re-evaluate their approach to taking security over shares and other securities, and borrowers and their CFOs need to understand how to respond to new requests and considerations. In Ontario, the Securities Transfer Act (Ontario) (the “STA”) and related amendments to the Personal Property Security Act (Ontario) (the “PPSA”) are now in force.
Substantially similar legislation now exists in Alberta and it is anticipated that the rest of the provinces will follow suit soon.
This legislation, once fully implemented, will provide harmonized rules for the transfer and pledging of securities across Canada that better reflect and deal with market practices that have moved away from the issuance of certificates for publicly-traded securities to various book-based systems. Since the STA and PPSA amendments are based on Articles 8 and 9 of the U.S. Uniform Com-mercial Code, the Canadian laws will also ultimately be harmonized with those in the United States.
In North America, securities are held under two systems: the “direct holding system” and the “indirect holding system.” The direct holding system is characterized by direct relationships between issuers and investors, such as the relationship between a private company and its shareholders. The indirect holding system is characterized by indirect relationships between issuers and investors, where the securities are held through a securities intermediary, such as a bank or trust company acting as a custodian, a broker, or Clearing and Depository Services Inc. (“CDS”).
Although the terminology used in the PPSA has changed slightly, the STA has not substantially changed the relevant rules applicable to secured transactions in the direct holding system. The most important changes relate to the indirect holding system, where secured parties have a new ability to perfect their security interest by way of a tripartite “control agreement” between the securities intermediary, the secured party and the pledgor.
PPSA Amendments – New Terms and Concepts
The changes to the PPSA resulting from the STA introduce several new important terms and concepts which are not fully canvassed in this abridged version of the article, except to note that “investment property” is now a PPSA term establishing a broad new category of collateral including securities, securities entitlements, securities accounts, futures contracts and futures accounts.
“Control” as a New Method of Perfection and New Priority Rules
The new method of “control” for perfecting security interests in investment property and the adoption of new rules to determine priorities among secured creditors who have perfected by control and those who have simply registered against the pledgor dictate best practices for taking a pledge of securities.
For secured creditors, obtaining control of pledged securities is made essential by the new priority rules. In all but a few instances, registration alone will not be adequate to obtain and maintain priority over other creditors. Under the new regime: (i) a secured creditor having control will take priority over a secured creditor who merely registers against the pledgor; (ii) a secured creditor who obtains control first will take priority over a secured creditor who obtains control afterwards; and (iii) the securities intermediary itself (which is deemed to have control in many circumstances) will take priority over secured creditors.
As can be deduced from the new priority rules, control is not necessarily an exclusive arrangement. For certain types of investment property, like book-based securities, more than one secured creditor (as well as the securities intermediary) can have control over the same securities.
For different types of investment property, control means different things. In the case of a certificated security, control requires endorsement as well as possession of the certificate, except for a bearer certificate. In the case of book-based securities, control involves having the securities transferred into an account that is owned by the secured creditor or, more commonly, by entering into a tripartite “control agreement” among the pledgor, the securities intermediary who holds the book-based securities for the pledgor and the secured creditor.
The Control Agreement
The control agreement is not a substitute for a security agreement, which will continue to be entered into separately between the lender/secured party and the borrower/ pledgor to grant the required security interest in the securities. Rather, the control agreement is a method of perfecting the security interest and, in its most basic form, is a contract made among a secured creditor, a pledgor and the securities intermediary of the pledgor in which the securities intermediary grants “control” over the pledged securities to the secured creditor.
Essentially, having control means that the secured creditor has the right to give “entitlement orders” to the securities intermediary in certain circumstances (such as upon default by the borrower/ pledgor) and the securities intermediary has agreed that it will comply with such instructions from the secured creditor without further consent of the borrower/pledgor. An entitlement order is the terminology under the STA for an order given to a securities intermediary instructing it to transfer or redeem a security or security entitlement. The borrower/pledgor will be precluded from giving, and the securities intermediary from accepting, any conflicting instructions.
Control Agreements – Potential Problems and Drafting
As noted, a control agreement need not give exclusive control to the secured party. Further, a borrower/pledgor can retain rights to give (non-conflicting) instructions and other secured parties can obtain (or may already have) a concurrent right to give instructions. Especially in light of such facts, lenders, borrowers and other parties need to be cognizant of various potential problems in respect of control agreements and certain issues which may arise in the negotiation and preparation of control agreements. Although not discussed in this abridged article, there are potential problems and issues in respect of control agreements that are likely to be encountered.
Some Final Remarks
The STA and PPSA amendments have provided more certainty to the law related to pledges of securities and are bound to greatly facilitate and increase the use of book-based securities as collateral, thereby bringing value to borrowers and lenders alike and the market as a whole. However, the new regime has ushered in new challenges: Lenders need to re-evaluate their approach to securities pledge transactions and borrowers/pledgors need to understand how best to respond to the new requests and considerations.