In June of 2009, the Supreme Court of Canada dismissed an appeal from the Federal Court of Appeal in the Caisse populaire Desjardins de l’Est de Drummond v. Canada case.
The facts of this case are as follows: On September 18, 2000, Caisse populaire Desjardins de l’Est de Drummond (Caisse Drummond) granted Camvrac Enterprises Inc. (Camvrac) a line of credit up to $277,000 under a credit agreement. A week later, Camvrac deposited $200,000 with Caisse Drummond under a "Term Savings Agreement." This deposit matured in five years, was not negotiable or transferrable, and could not be hypothecated or given as security in favour of any person other than Caisse Drummond. On the same day, Caisse Drummond and Camvrac entered into a "Security Given Through Savings" agreement under which Camvrac, "to secure the repayment of" the line of credit, agreed to maintain and permit Caisse Drummond to keep the $200,000 deposit for as long as Camvrac owed money to Caisse Drummond. Upon a default by Camvrac under the credit agreement, Camvrac agreed there would be compensation (set-off) between the credit agreement and the term deposit. Camvrac defaulted on the loan on November 25, 2000, and later made an assignment in bankruptcy. On February 21, 2001, Caisse Drummond noted on its copy of the "Term Savings Agreement": "To be closed on 21/2/2001 to realize on security." In June, the Crown gave notice to Caisse Drummond to pay all of the remittance arrears owing by Camvrac to the Crown out of the term deposit.
Based on the terms of the agreements between Caisse Drummond and Camvrac, the majority of the Supreme Court found that Camvrac had "conferred on the Caisse an interest in the property of Camvrac," principally by denying Camvrac the ability to withdraw the term deposit as long as the line of credit was still outstanding, and that this created a security interest within the meaning of Section 224(1.3) of the Income Tax Act (Canada) (ITA). The majority of the court contrasted such an arrangement with a simple set-off agreement that permits a bank to apply any credit in the depositor’s account to any potential indebtedness of the depositor to that bank. The distinguishing features in a simple set-off agreement are that: (i) there is no obligation on the depositor to maintain any amount deposited in the account as security for any indebtedness of the depositor to the bank, and therefore no "continuous right in the customer’s property to protect the bank against default"; and (ii) the depositor may withdraw any amount on deposit at any time and, therefore, "no specific property secures repayment."
In a dissent, Justice Deschamps decided that security interests can only be derived from "real rights" in a debtor’s property and never from contractual undertakings. As such, a right of set-off cannot meet the definition of security interest, even though its effect may be analogous to a security interest.
The decision of the Supreme Court was based on the provisions of the ITA. However, since the definition of "security interest" in Section 224(1.3) of the ITA is similar to that used in provincial personal property security acts (PPSA), this decision might have the unfortunate effect of providing a basis for claiming that a right of set-off in circumstances similar to those considered by the Supreme Court creates a security interest within the meaning of the PPSA, thereby requiring registration in order to perfect the creditor’s interest as against third parties. One example of how this case affects current practice can be found in the derivatives industry.
The vast majority of derivative contracts are documented under an International Swaps and Derivatives Association, Inc. (ISDA®) standard form master agreement. Collateral arrangements under this agreement are documented under the ISDA® Credit Support Annex (CSA). The Canadian recommended language for cash for the ISDA® CSA creates a debtor-creditor relationship with respect to cash and provides for a right of set-off against the cash. The ISDA® CSA does not by its terms create a security interest in the cash; however, there is an obligation to transfer the cash to the "secured party," and the "secured party" does not have an obligation to return that cash unless the "secured party’s" exposure has declined. As well, the purpose of the transfer of cash is to provide credit support, or to "secure" the potential obligations under the ISDA® master agreement.
As a result, even though there are factors that distinguish the Caisse Drummond case from collateral arrangements under the ISDA® CSA (with the Canadian amendments), there are also some similarities. There is a risk, therefore, that the set-off arrangement that is intended may be recharacterized as a security interest. The question then would be whether a financing statement should be registered to perfect the interest of the secured party (unless the cash is held in a securities account, in which case perfection may be obtained by taking "control" of the cash under a control agreement in the same way that control is obtained with respect to securities) or whether the set-off rights of the creditor/secured party still provide an effective remedy. There is specific legislative support for the continued effectiveness of set-off rights in Section 40 of the Personal Property Security Act (Ontario). Set-off rights are also preserved in Section 97(3) of the Bankruptcy and Insolvency Act (Canada), so that perfection by registration should not be necessary to protect against a claim by a trustee in bankruptcy. At the moment, however, whether set-off would be effective to protect an unregistered creditor/secured party in the context of a PPSA and bankruptcy analysis remains uncertain and further judicial reasoning may be required before clarity is achieved.