The coming into force on January 1, 2009 of An Act respecting the transfer of securities and the establishment of security entitlements (the "Act") represents a significant development in securities legislation. In particular, the Act will have a major impact on security affecting securities.
A Brief History
The Act modernizes legislation that is no longer considered an adequate reflection of current realities in the capital markets. The Act sets out clear rules on the transfer and taking of security in securities, whether these be directly held or, as is increasingly the case, indirectly held. Indirect holding refers to securities being held through one or more securities intermediaries (such as brokers, banks and clearing houses, to name but a few). The Act sets forth a series of rules for the establishment of security entitlements in securities and other financial assets and the legal relationship between the investor or holder of the security entitlement and the intermediary.
The Act is part of a common effort to modernize and harmonize legislation relating to the transfer of securities. In 1994, the United States enacted article 8 of the Uniform Commercial Code which introduced precise rules relating to the direct and indirect holding of securities. In 2004, the Uniform Law Conference of Canada enacted the Uniform Securities Transfer Act as a model law enshrining these concepts. In 2007 and 2008, a majority of Canadian provinces adopted a similar statute and, in January 2009, the Act will bring Québec’s regime in line with the other Canadian provinces and the United States.
Control: The New Way to Obtain First Ranking Security
The Act establishes "control" as the means of obtaining first ranking security. By "control" one acquires a valid and enforceable pledge, without any registration requirement, ranking ahead of any other registration. A creditor obtains control of a certificated security by delivering and endorsing the share certificate. The control of an uncertificated security or of a security entitlement is acquired by entering into a control agreement, by which the issuer or the securities intermediary, as the case may be, agrees to comply with instructions from the creditor without the further consent of the investor.
In the case of an uncertificated security, control may also be obtained by becoming the registered holder of the security. It is important to note that the creditor may also obtain control of a security entitlement by becoming its holder, in which case its hypothecation will rank ahead of a hypothec affecting the security entitlement of another creditor who obtained control by way of a control agreement (articles 55, 56 and 113 of the Act and new article 2714.2 of the Civil Code of Québec introduced pursuant to article 136 of the Act).
Significant Effects of the Act on the Taking of Security
Requirements relating to valid pledges
One of the major consequences of the coming into force of the Act is that it will henceforth be impossible to grant "dematerialized" pledges (namely, pledges without physical delivery and holding), unless the pledge affects securities and security entitlements as provided by the Act, in which case the physical delivery requirement may be satisfied by the creditor acquiring control of the securities or the security entitlements in accordance with the Act (articles 135 and 136 of the Act respectively amending article 2702 and introducing article 2714.1 of the Civil Code of Québec). For all other pledges, physical delivery will be necessary. Note, however, that a natural person who does not carry on an enterprise will not benefit from this exception pursuant to the Act and the regulations which are currently in force.
This amendment to the current legislation will have a particular impact on the property which may be hypothecated by a natural person who does not carry on an enterprise. Such property will be limited to property that may be physically delivered and property that may be subject to a hypothec without delivery, namely the property listed in sections 15.01 and 15.02 of the Regulation respecting the register of personal and movable real rights (the "RPMRR Regulation") and which includes, inter alia, certain road vehicles and boats. There is some speculation that a new regulation may be enacted which would broaden the definition of such permitted property to include uncertificated securities as well as security entitlements. Nevertheless, until such a regulation comes into force, it is essential to pay particular attention to pledges granted by natural persons who do not carry on an enterprise, which will be restricted to corporeal (i.e. tangible) movable property that may be subject to physical delivery. Pursuant to the Act, such a pledge is limited to certificated securities which can be physically delivered.
Publication and ranking of hypothecs
It should be noted that the Act will take effect immediately upon its coming into force and its impact on security which is already in place will differ according to the means of publication of the security.
The holder of a hypothec with delivery published in a manner that is not recognised by the Act will need to publish its security in conformity with the Act within a grace period of one year following the coming into force of the Act, failing which the initial publication will cease to have effect upon the expiry of the grace period. This provision will apply, inter alia, to a pledge granted before the coming into force of the Act for which there was no "physical delivery", i.e. where delivery was obtained by way of control. For example, if an enterprise had granted a hypothec with delivery on a claim by giving control of such claim to the creditor, such creditor would have to register the hypothec at the Register of personal and movable real rights (the "RPMRR") prior to January 1, 2010 for the hypothec to remain enforceable following such date. Note that if this hypothec had been granted by a natural person who does not carry on an enterprise, the hypothec could be deemed unenforceable if the current regulation is not expanded prior to the expiry of the grace period as mentioned above since claims are not included in the property that can be hypothecated without delivery by a natural person who does not carry on an enterprise under sections 15.01 and 15.02 of the RPMRR Regulation. We, nonetheless, recommend that every affected creditor register its hypothec at the RPMRR.
With respect to hypothecs registered at the RPMRR (before or after the coming into force of the Act) which affect securities or other financial assets, it is imperative to keep in mind that control, pursuant to the terms of the Act, provides its holder with a rank superior to that of a secured creditor who has not obtained control. Consequently, if a new creditor should obtain control of a security entitlement previously charged under a hypothec simply registered at the RPMRR, its security will rank, as of January 1, 2009, ahead of such prior registered hypothec. It is therefore crucial that creditors holding hypothecs registered at the RPMRR over securities or other financial assets wishing to preserve the priority of their hypothecs see to acquiring "control" of such property as soon as possible (if not already acquired), by way of, as applicable, physical delivery or a control agreement or, alternatively, by becoming the registered holder of the uncertificated security or the holder of the security entitlement.
In conclusion, the Act introduces substantial amendments to the law of security, by limiting the scope of pledges and by favouring control as a means of publication in respect of interests in securities and other financial assets. Hypothecary creditors will hereafter need to ensure that they acquire control over financial assets hypothecated in their favour, at the risk of being out-ranked by competing hypothecary creditors.