Bank Act Security
Section 427 of the Bank Act1 provides a comprehensive scheme for the giving of security over certain assets (usually inventory) from certain types of borrowers. The current scheme has existed in substantially similar form since its enactment in 1890.2 Sections 425-436 of the current Bank Act are similar to ss. 82 and 86-90 of earlier Bank Acts and ss. 177-180, 186-187 and 189 of the previous Bank Act3. This scheme was designed to facilitate the development of the natural resource industry in Canada through secured lending.4 Courts have held that ss. 425-436, and its predecessors, should be interpreted in a “fair, large and liberal” manner to “best ensure the attainment of the object of the Act.”5
Requirements for Valid Security
The types of borrowers permitted for the purposes of Bank Act security are set out in s. 427(1). It provides that a bank may advance money to, among others, purchasers and dealers in natural products, manufacturers, aqualculturists, and farmers on the security of specific items such as crops and livestock or for the purchase of seed, fertilizer, agricultural implements and equipment.
Bank Act security must be registered in accordance with the provisions set out in ss. 427(4)-(6). Clause 427(4)(a) provides that a “notice of intention” must be registered in the appropriate agency not more than three years before the security is given. Failure to register makes the security void against subsequent creditors or purchasers of the property acting in good faith.
In sum, s. 427 security is generally comprised of four elements:
- an application for credit;
- a notice of intention;
- a grant of security of inventory; and
- an agreement concerning loans and advances.
The Nature of the Security and its Priority
Subsection 428(1) provides that the giving of security under s. 427 is “the same as if the bank had acquired a warehouse receipt or bill of lading” and has “priority over all rights subsequently acquired in, on or in respect of that property.”
The combined effect of ss. 427(1), 427(2) and 428 is to transfer the title of the subject property to the bank, thereby giving the bank all the right and title to the property enjoyed by the previous holder. Where the holder was the owner, then the bank will likely have full title, but where the holder had some lesser interest, then the bank will get that lesser interest.6 This puts the bank “in the position of a mortgagee holding the legal title subject to the borrower’s right of redemption.”7 Accordingly, Bank Act security has been commonly compared to a chattel mortgage. In Royal Bank v. Nova Scotia (Workmen’s Compensation Board)8 the court described Bank Act security in the following manner:
… the security did not operate to transfer absolutely the ownership in the goods but that the transaction was essentially a mortgage transaction and subject to the general law of mortgages except where the statute has otherwise expressly provided … Section 88 [now 427] set up by the Bank Act enables manufacturers, who desire to obtain large loans from their bankers in order to carry on their industrial activities, to give to the bank a special and convenient form of security for the bank’s protection in the large banking transactions necessary in the carrying on of industry throughout the country. Until the moneys are repaid, the bank is the legal owner of the goods but sale before default is prohibited and provision is made for the manufacturer regaining title upon repayment. To say that Parliament did not use language to expressly provide that the bank shall have a first lien on the goods is beside the mark. The bank acquires ownership in the goods by the statute.9
Priority between Bank Act Security and PPSA Security
The most difficult priority problems that courts have struggled to resolve have involved priorities between Bank Act security and security under the various provincial personal property statutes.
With respect to determining the priority of Bank Act security vis-à-vis a registered or perfected security under the Personal Property Security Act (Ontario)10, the common law “first in time” rule applies. This means that Bank Act security will be subordinate to PPSA security if the PPSA interest is perfected prior to the bank taking its security interest.11 The reason for this is twofold. First, as mentioned above, a bank can receive no greater interest in the property than the debtor himself has. Once a PPSA security interest in the property is registered, a debtor no longer has unfettered interest with respect to that property. Second, registration provides a way for banks to gain knowledge of the existence of a prior PPSA security interest.
With respect to the priority between Bank Act security and an unregistered or unperfected PPSA security, two Supreme Court of Canada decisions concluded that the latter has priority, if obtained prior to the bank’s security.12
Following these two decisions, there was concern that banks would be exposed to PPSA security interests which they would have no way of discovering.
As a result, the Minister of Finance introduced Senate Bill S-5, entitled the Financial Systems Review Act, in November 2011. In our newsletter dated March 2012, we provided an update on the status of Senate Bill S-5, the effect of which would be to amend the Bank Act and overturn the two Supreme Court of Canada decisions.
The Financial Systems Review Act received royal assent on March 29, 2012 and became law on May 24, 2012. It expressly provides that s. 427 security will have priority over the rights of “any person who had a security interest in that property that was unperfected at the time the bank acquired its security in the property.” Subsection 425(1) was also amended by broadening the definition of the term “unperfected” to include a security interest that has not been registered under the law which the security interest was created.
The amendments also created an exception to a bank’s priority if the bank has “knowledge” of the prior unperfected security interest. While the PPSA provides a definition of “knowledge”, the Bank Act is silent on this issue. As a result of this ambiguity, banks should tread cautiously when discussing finances with a debtor so as to avoid inadvertently obtaining what may be construed as “knowledge”.
Priority between Bank Act Security and Landlord’s Right of Distraint
When it comes to Bank Act security and a landlord’s right of distraint, who has priority? The short answer is that the bank will have priority if its security is obtained prior to the tenant being in arrears of rent.
Two court decisions have provided guidance in this area. In International Wood Products Ltd. v. Royal Bank13, the Ontario High Court confirmed that s. 89(1) [now s. 428] gives priority to the bank’s security acquired pursuant to s. 427 over “all rights subsequently acquired in, on or in respect of” the property of a debtor.14 The Court held that a landlord’s right of distraint is a right “in, on or in respect of” the property, and as a result, if the arrears of rent (and thus the right of distraint) arises before the s. 427 security is taken, the bank’s security under s. 427 will be subordinate to the landlord’s rights.15 Similarly, if the tenant is in arrears at the time the bank obtains s. 427 security and the tenant continues to default in payment of rent after the security is granted, the landlord will continue to have priority over the bank with respect to all of the rental arrears. This is because a landlord’s right of distraint is only “lost” once the total amount of arrears is paid.16
In contrast, if security is obtained by the bank before the tenant enters into arrears, the bank’s security will have priority. This is because the tenant no longer holds title to the assets. Accordingly, the landlord’s right of distraint cannot attach to the tenant’s assets once title has passed to the bank.17 This was the finding by the Quebec Court of Appeal in Fermo’s Creations Inc. Re18.
Priority between two Bank Act Securities
Although Bank Act security is equivalent to the taking of title in the borrower’s property, more than one bank can take security over the borrower’s property, regardless of whether it is the same property or not.
The Saskatchewan Court of Appeal considered this issue and held that priority between two banks is determined based on the “first in time” rule.
In Royal Bank v. Bank of Montreal19, a farmer - Mr. Dietz - borrowed money from the plaintiff and defendant banks and granted the banks s. 88 [now s. 427] security over his grain. The defendant, Bank of Montreal (“BMO”), had advanced three loans to the farmer – in August 1968, February 1969 and October 1969. The August 1968 loan was made for the express purpose of enabling Mr. Dietz to purchase a tractor.20 Schedule “F” of the security document described the property that was assigned as security as follows:
... the undersigned hereby assigns to the Bank as security for the payment of the said loan ... the property hereinafter described of which the undersigned is now or may hereafter become the owner, to wit, ...
All of my threshed grain and without limiting the generality of the foregoing, the following:
5000 bus wheat
1800 bus barley
and which is now or may hereafter be in the place or places hereinafter designated, to wit, ...
On or about my farmlands comprising ... (emphasis added)
The subsequent two loans advanced by BMO were also secured by Mr. Dietz’s grain and the security documents were similarly worded as referenced above.
In July 1969, the plaintiff, Royal Bank of Canada (“RBC”), advanced a loan to Mr. Dietz and obtained s. 88 security over “all grain”.21
The Court ultimately concluded that BMO’s security had priority with respect to the August 1968 and February 1969 loans while RBC had priority with respect to the July 1969 loan (versus BMO’s October 1969 loan).22 In its reasoning, the Court noted that BMO’s initial security document which referred to specific grain owned by Mr. Dietz did not limit the scope of the security since the overall wording of the document made it clear that security was assigned over all of the grain.23
Similarly, in another decision, the Court stated the following24:
A first in time priority rule has also been applied in a priority dispute between two banks each claiming section 178 [now s. 427] security interests in after-acquired property.
Although Bank Act security is not as common as it once was, it is important that banks understand and appreciate the requirements for this type of security interest. If applicable, Bank Act security has priority over an unperfected or unregistered security interest under the PPSA, provided that the bank has no knowledge of such security, and has priority over a landlord’s right of distraint, if obtained prior to the borrower defaulting on rent.
Similarly, when it comes to competing security interests between two banks, the first bank to properly register its security will have priority. Banks will want to be proactive and avoid situations where their security could be subordinate to another bank’s rights. While this could theoretically be avoided by taking security over some other inventory belonging to the borrower, banks must be cautious in using this approach. As evidenced in Royal Bank v. Bank of Montreal, above, courts have taken a liberal approach to interpreting the descriptions of the security in the documents giving security.25 Though a bank may have the intention of securing a specific type of property, its security description may be interpreted broadly. Therefore, subsequent lenders should be cautious to avoid extending credit where the property provided for security may already be subject to a prior Bank Act security document.