Section 38 of the Ontario Personal Property Security Act (the "Act") contains an exception to the general priority scheme of the Act. It provides that a secured creditor may, in the relevant security agreement or otherwise, subordinate its security interest to any other security interest, and that such subordination will be effective according to its terms. No distinction is drawn between perfected and unperfected security interests.
From a secured creditor’s perspective, section 38 is a potential trap for the unwary.
First, it overrides the common law doctrine of privity of contract. Indeed, it seems that a competing secured creditor may claim the benefit of the section in the absence of an actual subordination agreement with the first secured creditor, and without prior knowledge of the alleged intention of the first secured creditor to subordinate its security.
Secondly, there is relatively recent case law to the effect that the alleged intention of the first secured creditor to subordinate its security need not be explicit. If, for example, the loan documentation expressly or impliedly permits the possible existence of any other encumbrances on the relevant collateral without addressing the question of relative priorities, a court may determine that such permission makes no commercial sense unless one or more of the encumbrances are also permitted to rank ahead of the first secured creditor’s security. In the event of a dispute between competing creditors, section 38 has been interpreted to invite not only an examination of the documents evidencing the alleged subordination of the first secured creditor to the interests of the other (or a class of others), but a review of the intentions and actions of the first secured creditor and the debtor in the event of any ambiguity.
From a practical perspective, any risk of inadvertent subordination pursuant to section 38 should be avoidable by explicitly addressing in the loan documentation the question of priorities. In particular, it is desirable to include language to the effect that unless stated otherwise, no reference to other potential encumbrances on the relevant collateral should be construed as to subordinate any security of the first secured creditor in favour of any such encumbrances.