BACKGROUND

The adoption of the Act respecting the transfer of securities and the establishment of security entitlements (the “STA”) by Quebec’s National Assembly on June 18, 2008 is in line with a series of measures taken by legislators in a number of jurisdictions in an effort to make their laws reflect the reality of the “indirect holding system” for financial assets. After the authorities in the United States began the process of modernizing Article 8 of the Uniform Commercial Code entitled Investment Securities, legislators in several Canadian provinces, namely, British Columbia, Alberta, Saskatchewan, Manitoba, Ontario and Newfoundland and Labrador, followed their lead. Now Quebec has joined the trend by passing the STA, which will come into force on January 1, 2009.

As a result of the new legislation, financial institutions and other hypothecary creditors will need to review the security they hold in order to ensure that they do not lose their priority of rank over the hypothecated financial assets of their corporate customers (certain rules of the STA, which are not discussed in this bulletin, apply more specifically to the hypothecation of financial assets by individual consumers). They will also need to review the wording of their deeds of hypothec and familiarize themselves with the role of “control agreements”.

NEW TERMINOLOGY

The STA aims to adapt the rules contained in the Civil Code of Québec and certain other laws to the emergence of new categories of financial instruments, the prevalence of electronic book-entry systems rather than paper certificates and the resulting “indirect holding system” for financial assets (including through an intermediary such as the Canadian Depository for Securities (CDS) or a broker). In order to do this, the STA introduces some new terminology, which includes the following:

“Financial Asset”

This term covers: (i) a security, (ii) a share or other participation right or obligation that, without being a security, is, or is of a type, dealt in or traded on financial markets or is a medium for investment in the area in which it is issued or dealt in or traded, (iii) any property that is held by a securities intermediary for another person in a securities account if the securities intermediary has expressly agreed with the other person that the property is to be treated as a financial asset under the STA and (iv) a credit balance in a securities account, unless the securities intermediary has expressly agreed with the person for whom the account is maintained that the credit balance is not to be treated as a financial asset under the STA.

This definition is worded very broadly so as to encompass interests in partnerships or limited liability companies, banker’s acceptances, commercial paper and a multitude of financial instruments, one of the objectives of the legislation being to anticipate any new products that could be introduced to the market.

“Securities Account”

This term refers to an account maintained with a securities intermediary, to which financial assets are or may be credited, whereupon the account holder is entitled to exercise the rights relating to the financial asset concerned.

“Security Entitlement”

This term refers to the rights to any financial asset credited or to be credited to a securities account.

A NEW WAY OF PLEDGING FINANCIAL ASSETS: THE CONTROL AGREEMENT

Until now, a pledge (conventional hypothec with delivery) of a security was constituted by means of the physical delivery of the title to that security. Thus a pledge of shares was obtained by requiring a share certificate to be endorsed and delivered to the hypothecary creditor. That method of obtaining a pledge is still possible under the STA where a certificated security is being hypothecated, and a pledge established in this manner will result in the creditor obtaining “control” of the security concerned. However, the STA introduces an innovation in that it now allows, in the case of a pledge of uncertificated securities or security entitlements, the requirement that the hypothecated property be held by the creditor to be met through the registration of the securities or security entitlements in the creditor’s name or through the signing of a control agreement.

A control agreement, in this context, is an agreement entered into by the pledgee, the pledgor and the issuer or securities intermediary (as the case may be) whereby the issuer or securities intermediary agrees to comply with instructions originated by the pledgee without the further consent of the registered holder of the security or security entitlement. This type of agreement is now commonly used in the provinces that have adopted similar legislation, and with the coming into force of the STA, is likely to become equally common in Quebec. It should be noted that the pledgee has control even if the pledgor retains the right to originate instructions to the issuer or securities intermediary or to make substitutions for or dispose of the security or security entitlement.

NEW PRIORITY RULES

The STA provides that, effective January 1, 2009, from the time a creditor holding a movable hypothec with delivery on securities or security entitlements obtains control of those securities or security entitlements, that hypothec ranks ahead of any other hypothec on the same securities or security entitlements, regardless of when the other hypothec is published.

Consequently, a hypothecary creditor, even one holding a first-ranking hypothec duly published prior to the coming into force of the STA, could find its rank surpassed by a subsequent hypothecary creditor who obtains control over the same financial assets.

With the adoption of the STA, it thus becomes essential for every creditor holding a movable hypothec on financial assets to ensure that it obtains control over those assets in order to preserve its rank over them.

A SIMPLIFIED WAY OF REALIZING SECURITY

The STA amends certain provisions of the Civil Code of Québec in order to simplify the system for realizing upon hypothecs granted on securities or security entitlements covered by the STA. Thus a creditor holding a hypothec on securities or security entitlements will be able, on certain conditions, to sell or dispose of them without being required to give a prior notice, obtain their surrender or observe the time limits otherwise prescribed by the Civil Code of Québec.

CONFLICT OF LAWS

The STA enacts a set of rules for determining the laws governing the validity and publication of a security interest created in a security or security entitlement. Thus, the STA amends the Civil Code of Québec to clarify that the validity of security encumbering a certificated security will be governed by the law of the country where the security certificate is located at the time the encumbering security is created. Movable hypothecs with delivery of uncertificated securities or security entitlements will, unless specified otherwise, be governed by the law of the country under which the issuer is constituted or, as the case may be, the law governing the account with the securities intermediary.

However, it should be noted that publication of a hypothec without delivery granted on a security or security entitlement will be governed by the law of the country in which the grantor is domiciled.