Late in 2018, the Saskatchewan Legislature introduced Bill 151, which amends The Personal Property Security Act, 1993 (Saskatchewan) (the PPSA). To inform you about the upcoming changes and how they may impact you, our Saskatchewan Financial Services team have been tracking the progress of Bill 151 and have brought you a number of posts that discuss the amendments.
To follow our posts, you need only to go to one place, this Financial Services & Insolvency Communiqué, which includes broad descriptions of various aspects of the amendments and links to all of our posts covering many of the amendments in detail – we have been updating it with new links and status reports on the progress of Bill 151 on an ongoing basis.
Bill 151 was passed into law on March 12, 2019. It awaits Royal Assent and a date to be set for it to come into force.
One of the objectives of the proposed amendments is to recognize the increasing prevalence of commerce conducted in an electronic and digitized fashion, and accordingly to align the secured financing practices set out in the PPSA with the requirements presented by the growing use of electronic documentation.
What is chattel paper?
Chattel paper is a concept and type of collateral that was “created” by the PPSA, and did not exist prior to the enactment of the law. As defined in the PPSA it is “one or more writings that evidence both a monetary obligation and a security interest in, or lease of specific goods”. It is personal property in its own right, distinct from its underlying collateral.
Chattel paper is integral to the functioning of large Canadian industries, including the sale of vehicles and equipment through dealer networks. To illustrate, the following provides a common example of chattel paper.
Jane wants to purchase a new vehicle from the local vehicle dealer and requires a loan to do so. The vehicle dealer is able to offer credit to Jane from a financial institution (FI) with which it has a business relationship. The FI approves Jane’s credit risk. The dealer enters into a conditional sale contract with Jane for her new vehicle. The conditional sale contract is chattel paper as it contains the terms of repayment for her loan as well as a security interest in the vehicle which secures the repayment.
The dealer then sells and assigns the conditional sale contract to the FI and the FI administers the loan and collects the payments from Jane.
In this example, the FI is considered the chattel paper “purchaser” and the “secured party” under the PPSA and the dealer is the “debtor” for the purposes of the security interest in the chattel paper. The relationship and security interest is distinct from the security interest in the vehicle which is the subject of the chattel paper, where Jane is the debtor and the dealer (and the FI after assignment) is the secured party.
What are the current rules under the PPSA? How is security currently taken in chattel paper pending the amendments?
An FI that has purchased chattel paper may wish to use it as collateral to raise funds for its operations, such as by way of a securitization financing. The PPSA contains priority rules that govern the perfection and priority of chattel paper, which apply both to the purchase of chattel paper by the FI and the purchase of the portfolio from the FI.
The PPSA permits the perfection of a security interest in chattel paper either by registration of a financing statement or by possession of the chattel paper. Perfection by possession is the strongest approach under the current PPSA, as it confers a super-priority on the purchaser of chattel paper where the following requirements are met:
- the purchaser takes possession in the ordinary course of its business;
- the purchaser gives “new value” (can’t consolidate existing credit, for example); and
- the purchaser must not have knowledge that the chattel paper is already subject to a security interest (unless the prior security interest is the result of proceeds of inventory, in which case the prior knowledge of the purchaser doesn’t matter).
Given the negotiable nature of chattel paper, under existing PPSA rules a chattel paper purchaser can not avail itself of the benefit of the super-priority if it has knowledge of the existence of a registered security interest in the chattel paper (except, as noted, where that security interest is proceeds of inventory). This has resulted in some legal counsel suggesting it might be advantageous for purchasers of chattel paper to not search the Personal Property Registry prior to purchasing and taking possession of chattel paper, so that they would not have knowledge of a prior registered security interest.
The PPSA contains an exception to the requirement for possession: a security interest in chattel paper may attain super priority where the security interest in the chattel paper is clearly marked on the chattel paper (for example: “This contract is assigned and sold to ABC Bank”). The underlying theory is that “control” of the chattel paper by either possession or clear marking on the original contract, will ensure other parties are not prejudiced in attempting to subsequently take security in the chattel paper. Establishing control, either by possession or marking the original, is paramount.
What is electronic chattel paper? Why is the PPSA being amended to provide for its use?
Canada has virtually uniform provincial and federal electronic commerce legislation that allows parties to agree to contract electronically. However, in terms of secured personal property financing, a seller (or lessor) of goods cannot use electronic chattel paper as collateral to raise money in its own business because of the PPSA super-priority rule that gives priority to the person who holds the original, “wet ink” copy of the contract (i.e. the chattel paper). This greatly increases the cost to the industries that use chattel paper for financing, since the PPSA rules necessitate processing, printing and storing paper contracts in order for the secured party purchaser of the chattel paper to ensure priority to its security by taking possession (or physically marking) of the hard copy documents.
Recognizing the increasing demand to facilitate electronic commerce, Saskatchewan is the first province in Canada to adopt the concept of perfection by control of electronic chattel paper in its PPSA, largely following the approach found in the Uniform Commercial Code (UCC) in the United States, which has contained rules providing for electronic chattel paper for about 20 years. Ideally, companies in Saskatchewan will benefit from the similarity between the PPSA and the UCC by being able to adopt the same or similar computer software as those already used in the United States to secure electronic chattel paper.
Bill 151 amends the PPSA to add a definition for electronic chattel paper – chattel paper in digital or other intangible electronic form. In addition to the definition for electronic chattel paper, a definition for “tangible chattel paper” has been added to the PPSA to differentiate between chattel paper that is in hardcopy versus chattel paper that is in electronic form.
What are the new rules? How is the PPSA being amended to provide for electronic chattel paper?
The rules relating to validity, perfection, and priority for chattel paper discussed earlier are largely unchanged, except for some differentiation on how super-priority is obtained for electronic chattel paper.
As mentioned earlier, a chattel paper purchaser is afforded a super-priority where it establishes control, either by possession of the original chattel paper or clearly marking the original. These rules continue to exist in the amended PPSA, but only with respect to tangible chattel paper.
Electronic chattel paper is inherently non-tangible. With electronic documentation there is no “originally executed copy” or “wet ink original”. Also, it is impossible to take physical possession of an electronic document. This issue of control presents a particular challenge for electronic chattel paper.
Accordingly Bill 151 introduces rules on how a purchaser may obtain perfection by control of electronic chattel paper. This occurs through the creation of “an authoritative record”, which is the functional equivalent of an original paper contract. Below we will discuss the PPSA requirements for establishing the authoritative record for electronic chattel paper.
The UCC provides for two methods of establishing control of electronic chattel paper. There is a general rule (described below) followed by enumerated “safe harbour” provisions.
The UCC general rule provides that “a secured creditor has control of electronic chattel paper if a system employed for evidencing the transfer of interests in the chattel paper reliably establishes the secured party as the person to which the chattel paper was assigned.” A secured creditor will have super-priority where it has control of electronic chattel paper in any fashion which meets this general test. However, the secured creditor can ensure control of electronic chattel paper by complying with all of the requirements in the safe harbour provisions.
Bill 151 does not adopt the UCC general rule. Instead, the safe harbour provisions will represent the only method for establishing control of electronic chattel paper in Saskatchewan. All of the safe harbour requirements must be satisfied in order to establish perfection by control. These requirements to establish a super-priority in electronic chattel paper are at proposed subsection 2(1.2):
A secured party has control of electronic chattel paper if the record comprising the chattel paper is created, stored, and transferred in a manner such that:
(a) a single authoritative record of the electronic chattel paper exists that is unique, identifiable and, except as otherwise provided in clauses (d), (e), and (f), unalterable;
(b) the authoritative record identifies the secured party as the transferee of the record;
(c) the authoritative record is communicated to and securely maintained by the secured party or its designated custodian; (d) copies of or amendments to the authoritative record that add or change an identified transferee of the authoritative record can be made only with the consent of the secured party;
(e) each copy of the authoritative record and any copy of a copy is readily identifiable as a copy that is not the authoritative record; and
(f) any amendment of the authoritative record is readily identifiable as authorized or unauthorized.
The view of the authors of the Canadian Conference on Personal Property Security Law Report, which informed the drafting of many of the amendments to the PPSA contained in Bill 151, is that the inclusion of the general rule would be likely to lead to litigation where a chattel paper purchaser takes the position it has met the general standard but has not satisfied all the safe harbour provisions.
On the other hand, commentary from the American experience suggests that the uptake on use of electronic chattel paper was very slow until the general provision was added by way of amendment to the provision on control of electronic chattel paper in the amendments to the UCC provisions introduced in 2010 which included changes to the electronic chattel paper rules (the “UCC 2010 Amendments”). While this may simply be coincidental given the 2008 market crash which severely hampered both the credit sector and the vehicle finance sector, combined with dramatic advances around electronic documentation, the US approach does provide more flexibility to meet the control test.
In any event, from a technological system design perspective, meeting the legislated control requirements is easier said than done. The chattel paper purchaser must safeguard its control of the electronic chattel paper by ensuring that only it may make changes to the electronic information which forms the basis of the chattel paper as well as by controlling future transfer of the chattel paper to any further assignees. In this way, the authoritative record can be controlled by the electronic chattel paper purchaser in the same way that a hard copy paper contract can be controlled by possession or marking by a tangible chattel paper purchaser. In addition to establishing the authoritative copy of the electronic chattel paper, any copy of such record must be readily identifiable as a copy of the authoritative record.
The major hurdle which an electronic control system must overcome is: whereas the original wet ink copy of tangible chattel paper is easily identifiable, the reality for electronic chattel paper is that it exists in numerous “bits and bytes” which are stored in various places on a computer hard drive. Computer systems in the early days of electronic chattel paper were not generally sophisticated enough to easily recognize a single authoritative copy of an electronic record, given the ease with which numerous exact copies can be produced in seconds. The literature on the early American experience with electronic chattel paper suggests that creating a control system to overcome these problems was challenging for computer scientists and technology systems engineers. Needless to say, the fact that an electronic document exists in numerous bits, in various locations on a computer, makes it much more difficult to “control”.
In practice, how do purchasers of electronic chattel paper establish control?
The intent in the proposed amendments is to require that a chattel paper purchaser establish perfection by control of the chattel paper by essentially ensuring that there exists a single authoritative record of electronic chattel paper, and that any copies are easily identified as such.
However, Bill 151 provides no guidance on how this is to be done and is technologically neutral. This is, we believe, an intentional omission. Technological advances occur so rapidly that it would be difficult to draft specific guidance that would endure. For example, the development of Blockchain and smart contracts may soon greatly simplify the logistics for those entities in the business of electronic chattel paper purchases.
Practically speaking, how will the requirements for control established in the PPSA be met by purchasers of electronic chattel paper? The American experience is instructive because the UCC has provided for security in electronic chattel paper for about two decades. In fact, until the UCC 2010 amendments, the UCC provision for control was the same as under Bill 151 – containing only the safe harbour provisions. The UCC has contained the general rule for less than a decade. American commentary on electronic chattel paper suggests that electronic control systems which satisfy the requirement for control of electronic chattel paper under the UCC have become more common since the UCC 2010 amendments.
Today, the solution that has received the broadest acceptance by US insurers and rating agencies is electronic vaulting. Electronic vaulting involves a third party custodian, usually pursuant to an electronic control agreement. The electronic vault logs and controls all activities related to a document in the vault by encrypting and time-date stamping the electronic records, and recording all functions including every request to view, copy or print a document as well as a transfer of the authoritative copy to another vault.
As a US commentator has suggested: “a robust and properly maintained electronic vault must generally perform the following functions to meet the requirements imposed pursuant to UCC 9-105:
- Protect, encrypt and time-date stamp the electronic records and wrap them in a virtual “tamper-evident seal” that will instantly identify and reject any changes to the record post execution;
- Grant and maintain privileged access rights to the party in control;
- Maintain an extensive audit trail on the records, tracking access to the records, the number of copies made and by whom, any transfer of location of the records, and any transfer of location of the records;
- Perform regular integrity checks on the records to ensure that no alteration or degradation of the bits and bytes have occurred since execution; and
- Recognize a method to destroy the electronic records after predetermined periods or status changes, while also providing the ability to create a paper document that will thereafter be recognized as the “original.”
Because the safe harbour provisions in the UCC and in the control requirements in Bill 151 are virtually identical, one expects that the American experience and jurisprudence will inform the Saskatchewan practice in exercising control over electronic chattel paper, in particular in the adoption of electronic vaulting, until technological advancement makes a better option available.
Elimination of the knowledge rule
Bill 151 eliminates the rule that a chattel paper purchaser must not have knowledge of a prior security interest in the chattel paper in order have a super-priority. The new sections 31(9) and (10) dispense with the current knowledge test.
The knowledge test is replaced with objective requirements that the chattel paper “indicate that it has been assigned to an identified assignee”. If the objective requirements are met, the holder of chattel paper will have priority over a subsequent purchaser. A subsequent purchaser’s knowledge will be irrelevant to whether it is able to claim priority. The state of the chattel paper itself, and whether it has been appropriately marked (physically or electronically), will govern.
As a result, one no longer needs to carry out a fact-sensitive analysis concerning the actual knowledge of a chattel paper purchaser that could vary from one purchaser to another.
Issues relating to “converted” chattel paper
What about situations where tangible chattel paper is converted to electronic chattel paper, where the original paper contract is scanned and saved electronically, which is a very common current business practice?
Effect of existence of a hard copy
Bill 151 also introduces rules to govern converted chattel paper.
Under the new subsection 31(9), a purchaser of chattel paper in the ordinary course of business and for new value (a) takes possession of the tangible form, or (b) obtains control of electronic chattel paper, will have priority over any security interest in the chattel paper if it is not marked as having been assigned to another party.
Section 31(10) addresses the situation, which one hopes will be rare, where a party holding chattel paper fraudulently transfers to one person in electronic form and another in tangible form. In that scenario, the purchaser of the tangible chattel paper (where it gave new value and operated in the ordinary course of its business) will have priority unless the tangible chattel paper was marked as having been assigned to another party.
The authors of the Report observe that sections 31(9) and 31(10) play an important role. According to the Report, these sections ensure that electronic chattel paper remains perfected where tangible chattel paper in the same contract also exists.
Neither a trustee in bankruptcy nor a judgment creditor would qualify as having given value in the ordinary course of business, so they could not rely on sections 31(9) and 31(10) to claim priority over the holder of electronic chattel paper. For reasons discussed more fully below, the drafters of Bill 151 would have, ideally, addressed the priority competitions resulting from these sections more transparently, but the authors of the Report provide the following analysis:
… many purchasers of electronic chattel paper will want to leave the hard copy form of the chattel paper in the possession of the seller, lessor or lender. This avoids the administrative cost of having to destroy or mark the hard copy. If these measures are required in order to have control in all cases, the purchaser could just as easily perfect by possession of the hard copy. The risk with which the purchaser of the electronic chattel paper is likely to be concerned is not the chattel paper seller’s dishonesty, but the seller’s bankruptcy. The proposed approach addresses this concern. There would be no requirement to destroy or mark the hard copy in order to prevail against the trustee.”
Thus, as with other parts of Bill 151, the amendments lead to a different result where the competition is with other third parties who have not given value, such as a trustee in bankruptcy and unsecured creditors.
We expect that it would be rare for the tangible form of chattel paper to end up in the hands of different purchasers from the electronic form of the same chattel paper, whether inadvertently or fraudulently, though there will always be desperate debtors who are looking for a way to stay afloat. As electronic vaulting becomes more prevalent, it should further minimize the likelihood. Purchasers or holders of the electronic form of converted chattel paper would be wise to carefully monitor their sellers/borrowers, but we expect that most seasoned parties already have those controls in place.
There is an additional practice note that parties need to ensure they follow. Consumer protection legislation will generally require that where the asset being financed is a consumer good, a copy of the contract (which ultimately becomes the subject of the chattel paper) must be given to the debtor. It is crucial that the debtor’s copy be marked as a “copy” to avoid potential priority risks.
According to the Report, sections 31(9) and 31(10) depart from the UCC approach since the UCC does not contain any equivalent provisions. The UCC approach is summarized in the commentary to UCC section 9-105:
when tangible chattel paper is converted to electronic chattel paper, in order to establish that a copy of the electronic chattel paper is the authoritative copy if may be necessary to show that the tangible chattel paper no longer exists or has been permanently marked to indicate that it is not the authoritative copy.
The conclusion is that the continued existence of the tangible chattel paper means that the electronic chattel paper is not the authoritative copy. Consequently the electronic chattel paper purchaser is at best unperfected (and at worst, has no interest) and would be defeated by third parties who claim an interest in the chattel paper.
The authors of the Report observe that sections 31(9) and 31(10) do not preclude the holder of electronic chattel paper from having control (and thus perfection) in respect of the electronic chattel paper by reason of having permitted the tangible version of the chattel paper to continue to exist. But neither section actually says that. In fact, according to the Report the addition of sections 31(9) and 31(10) ensures that control of electronic chattel paper would exist where tangible chattel paper is still in existence.
That interpretation adopted by the Report is not easily confirmed by reviewing the express language of sections 31(9) and 31(10), which state:
31(9) Subject to subsection (10), a purchaser of chattel paper who takes possession of the tangible chattel paper, or who obtains control of electronic chattel paper as provided in subsection 2(1.2), in the ordinary course of the purchaser’s business and for new value, has priority over any security interest in the chattel paper if the chattel paper does not indicate that it has been assigned to an identified assignee other than the purchaser.
(10) When the rights arising under tangible chattel paper are transferred to a purchaser as electronic chattel paper and the tangible chattel paper is transferred to another purchaser who takes possession of it for new value and in the ordinary course of that purchaser’s business, the interest of the purchaser of the tangible chattel paper has priority over the interest of the purchaser of the electronic chattel paper if the tangible chattel paper does not indicate that it has been assigned to an identified assignee other than the purchaser of the tangible chattel paper.
The analysis of the Report is, we assume, the result of a combination of inferences that are drawn from section 2(1.2) (which sets out the requirements for control of electronic chattel paper) together with section 31(10). Section 2(1.2) is the source of the first inference. As previously indicated, it states:
2(1.2) A secured party has control of electronic chattel paper if the record or records comprising the chattel paper are created, stored, and transferred in such a manner that:
(a) a single authoritative record of the electronic chattel paper exists which is unique, identifiable and, except as otherwise provided in paragraphs (d), (e), and (f), unalterable;
(italics added for emphasis)
The remaining subsections of section 2(1.2) each use the term “authoritative record” but it becomes clear that they don’t refer to an “authoritative record” of the contract or of the totality of the chattel paper concerning that contract, but rather to the same authoritative record of the electronic chattel paper described in section 2(1.2)(a). It is a subtle point, and one that (to us) was not immediately apparent.
Section 2(1.2)(a) differs from the equivalent provision of the UCC which simply states that a secured party has control of electronic chattel paper if a single authoritative copy of the record exists which is unique, identifiable and unalterable. That distinction, and the structure of section 2(1.2), combine to provide the first inference that the control test will be satisfied if there exists a single authoritative record of the electronic chattel paper, even if a tangible form of the chattel paper continues to exist.
The second inference arises from the existence of section 31(10). The function of section 31(10) is to determine priority disputes where tangible chattel paper and electronic chattel paper for the same contract have ended up with different purchasers. There would be no priority dispute if the existence of the tangible chattel paper precluded control (and thus perfection) of the electronic chattel paper.
That said, our view is that it would have preferable for the drafters to have made that highly fundamental point clear through direct drafting, i.e., to have included an explicit rule that control of electronic chattel paper could be established where the tangible chattel paper remains in existence.
The provisions also lack an express rule to govern priorities with bankruptcy trustees and judgment creditors, though it appears that the drafters intend that section 31(10) would decide such priority disputes in favour of holders of electronic chattel paper who have established control (as trustees and judgment creditors cannot qualify under section 31(10) as purchasers for new value in the ordinary course of their business). Again, a priority competition is decided by an inference rather than a clear and express rule.
It would not be surprising to see litigation on those points, at least until the foregoing inferences are firmly confirmed in case law. That is disappointing, as in our view a more direct approach to the drafting could have resulted in greater clarity.
While one might wonder whether that lack of clarity could initially deter industry parties from use of electronic chattel paper, it should be remembered that by purporting to give priority against bankruptcy trustees and judgment creditors, Bill 151 provides greater protection to holders of the electronic form of converted chattel paper than does the UCC. Electronic chattel paper has proliferated in the U.S. so the Saskatchewan rules and drafting do not seem likely to preclude its use in Canada.
Adoption of Electronic Chattel Paper in Canada
Saskatchewan is often at the forefront among Canadian provinces in modernizing its PPSA. The adoption of electronic chattel paper appears to represent a continuation of that trend. There might have been a question of how quickly industry parties would move to embrace the new form of chattel paper if it was available only in the small market of Saskatchewan, but now Ontario is not far behind. Ontario’s budget bill – Bill 100 – which had First Reading April 11, 2019, proposes to amend the Ontario PPSA to provide for electronic chattel paper. Industries that commonly use chattel paper as security to raise funds will doubtless benefit from the cost-savings of no longer needing to print and physically store paper contracts.