As previously reported in our post of November 28, 2014, the Quebec Minister of Finance presented Bill 28 to the National Assembly on November 26, 2014. The proposed legislation includes provisions in respect of cash collateral, and would make Quebec the first Canadian province to propose legislative modifications in order to facilitate cash collateral. The purpose of this post is to provide some background as to the necessity of these new provisions as well as an overview of the specific rules before proceeding to give examples of application.
Historically, it has been a challenge for Canadian entities to offer a first priority security interest on cash to their counterparties. By contrast, in the United States, a debtor may grant a first priority security interest over cash in a deposit account by way of control pursuant to the provisions of Article 9 of the Uniform Commercial Code. The same is not currently the case in Canada for cash not in a securities account. If a secured party is granted a security interest in cash, the traditional view is that valid security under the laws of the jurisdiction of the grantor’s location needs to be obtained, the security needs to be perfected by registration, a search of the relevant register needs to be undertaken and estoppels, subordinations or waivers from competing or prior ranking creditors need to be obtained. This may be a costly and time-consuming exercise and ultimately may not be successful.
As an alternative to a security interest in cash, a practice developed in Canada to transfer cash absolutely (not by way of a security interest) and create a debtor/creditor relationship and an express right of set-off. The majority decision of the Supreme Court of Canada in Caisse populaire Desjardins de l'Est de Drummond v. Canada, a federal income tax case out of Quebec, cast doubt on the effectiveness of the use of contractual compensation.
One of the possible avenues to explore in attempting to use cash as collateral has been to have the same in a securities account and use the provisions of the securities transfer legislation in the applicable provinces to create security over a security entitlement. Unfortunately, it is not always possible or obvious that cash in fact gives rise to a security entitlement in a securities account. At the end of 2011, the Quebec Minister for Finance introduced amendments to the Quebec Derivatives Act and the Quebec Securities Act in order to reassure the derivatives, foreign exchange, securities lending and repurchase markets, as well as clearing agencies, in respect of the effectiveness of contractual set-off without necessity for registration in order to "perfect" the arrangement.
There has been some discussion in Canada, particularly in Ontario, concerning proposed legislative changes to provide for cash collateral. The Quebec legislation is the first to move in this direction. The basic conceptual building block for the provisions in respect of cash collateral is the notion of control, similar to that applicable to granting a first priority security over a security entitlement. The provisions also compare favorably in important aspects to the security-interest regime applicable to deposit accounts under Article 9 of the Uniform Commercial Code.
Overview of Provisions
The proposals in respect of cash collateral are set out in modifications to the Civil Code of Québec.
The new provisions adopt a broad definition of "pecuniary claim" (a monetary claim), essentially being the obligation of a debtor to reimburse, return or restore an amount of money or make any other payment in respect of an amount of money. Notable exclusions from the definition are claims represented by a negotiable instrument, presumably since the Bills of Exchange Act (Canada) has a special regime in respect of taking security on negotiable instruments subject to such legislation. Another important exclusion exists for claims that are securities or security entitlements, since the Quebec securities transfer legislation has its own particular regime.
In order to obtain a valid and perfected pledge over a monetary claim, the secured party must obtain control. No registration is necessary. It is important to distinguish between obtaining control of a monetary claim that the grantor of the pledge has against its secured party and a monetary claim that the grantor has against a third party.
In order to obtain control of a monetary claim that the grantor has against its secured party, the grantor simply has to give written consent to the effect that such claim secures performance of an obligation towards the creditor. This may be an obligation of the grantor itself or of a third party.
It is not all monetary claims that a grantor has against a third party for which the grantor can give control to a creditor. Claims in regards to the credit balance of a financial account (to a large degree similar to the deposit accounts under the UCC) as well as other claims in regards to an amount of money deposited with a third-party to secure performance of an obligation to the secured party are the only ones available for such type of control. In these circumstances, the secured party, the grantor of the security and the third party need to enter into a control agreement in writing whereby, without the additional consent of the grantor, the third party will comply with the secured party’s instructions in respect of the credit balance or such amount of money. All of these notions are very similar to those applicable to control agreements used in connection with obtaining control of a security entitlement in a securities account.
One key part of the cash collateral proposal provisions is to grant a super priority to secured parties with control. Hence, once a secured party obtains control, it has a security on the relevant monetary claim which security has priority over any other movable hypothec on the same claim, regardless of when the other hypothec is published. However, the debtor of the monetary claim that is also a secured party having control will have priority over other secured parties having control. Other than such secured party, as amongst secured parties having control, it is the moment of obtaining control that determines priority. This will mean that secured parties will not need to do searches nor obtain waivers or subordinations of prior registered hypothecs.
One of the proposed transitional rules for Bill 28 contemplates that arrangements currently in force that would comply with the cash collateral provisions if such provisions had been in force at the relevant time will benefit from the rules once they come into force.
Examples of application.1
Some important examples of the application of the proposed provisions follow.
ISDA Credit Support Annexes
Under the New York credit support annex frequently used in connection with International Swaps and Derivatives Association, Inc. derivatives documentation, there is a possibility of designating credit support as eligible collateral or other eligible support. A practice developed in Canada to elect cash as other eligible support only and to modify such credit support annex in order to create a debtor-creditor relationship in respect of such cash and then rely on contractual set-off not a security interest in cash.
It will now be possible to include cash as eligible collateral and rely on the provisions in the New York credit support annex for a pledgor to indicate that all cash transferred or, more properly, the obligation of the secured party to return an equivalent amount of the cash received as collateral, is subject to a security interest. Cash would include cash collateral in any freely tradable currency. In these circumstances, it would be anticipated that cash would not be designated as other eligible support and it would not be necessary to modify such credit support annex in order to provide for a debtor-creditor relationship and contractual set-off. It will be clear, once the provisions are adopted, that using the New York credit support annex and designating cash as eligible collateral is an arrangement that will give a super priority to the secured party in the claim that the pledgor has against it for the return of the equivalent amount of the cash provided as collateral.
Alternatively, the parties could use or continue to use the UK transfer annex or the New York credit support annex modified for cash to be other eligible support with the provisions for the debtor-creditor relationship and contractual set-off. Bill 28 does not preclude this approach. In fact, for these credit support annexes currently in place, Bill 28 acknowledges that they continue to be effective.
Deposits for Rental Payments
It is common in commercial real estate leases for a tenant to have to post a deposit as security for rental payments. Once the cash collateral provisions come into force, a tenant will be able to consent to such deposit being collateral subject to a security for its obligations to pay rent. Such would constitute a pledge by the tenant on the landlord's obligation to repay the deposit in accordance with the lease provisions. A landlord would have a first priority security on such rights.
As a general observation, the cash collateral provisions could be used in any commercial situation where a deposit is to be given as security for an obligation.
Asset Back Lending
We assume for purposes of this example that the asset back lender is not the deposit-taking institution. In these circumstances, it is common that the asset back lender will require that its debtor obtain, from the deposit-taking institution where the debtor holds its accounts, a blocked account agreement. By virtue of the blocked account agreement, the debtor may continue to deal with the accounts until the lender sends an activation notice to the deposit-taking institution requiring that the institution only take instructions from the lender.
Once the cash collateral provisions come into force, it is very likely that this arrangement would constitute a control agreement and that the ABL lender would have a first priority security in the accounts without the need of any registration, subject to any rights the deposit-taking institution may have in the accounts.
Letters of Credit Facilities
It is sometimes the case that letters of credit facilities are cash collateralized. Imagine for a moment that a particular borrower has a specific account with a deposit-taking institution who is also the issuer of the letters of credit. By way of the simple mechanism provided under the cash collateral provisions, the borrower will be able to grant a first-priority pledge in such specific account to the issuer in order to support the borrower’s indemnification obligation to the issuer. The borrower and the secured party may also wish to review current arrangements in order to determine if they will benefit from the cash collateral provisions once such provisions come into effect.
If, for instance, the borrower wishes to offer up a cash account at a third party deposit-taking institution as security for its indemnification obligation to the issuer, the secured party issuer, the borrower and the third party institution would need to enter into a control agreement. As is the case with respect to tripartite control agreements with securities intermediaries, it is anticipated that such control agreement will address any potential priority interest that the third party deposit taking institution may have in the account including by way of any right of set-off.
Coming into force of provisions
The National Assembly will be receiving comments concerning Bill 28 and it is probable that the legislation will be adopted early next year. We do note that the draft proposals suggest that the cash collateral provisions will only come into force at a date determined by the government. This could be a date after the adoption of the law itself.
It is very encouraging to see that the Quebec legislature has proposed the concept of control and other similar rules in a manner that we hope courts will interpret to be harmonious with the rules under Article 9 (UCC). Given that Quebec practitioners now have experience with the notion of control, as applicable to security entitlements, one would hope that the extension into the realm of cash collateral will facilitate comprehension and use.