It is currently a challenge in Canada for Canadian entities in the derivatives, securities lending and repurchase space to offer a first priority security interest on cash to their counterparties. The Quebec government recently introduced an amendment to the Derivatives Act (Quebec) (the QDA) that, if passed as tabled, will restore confidence in the use of absolute transfer of cash and the related use of contractual set-off or compensation when dealing with cash as credit support for these types of transactions from Quebec counterparties. The amendments also specifically address cash collateral provided to a derivatives clearing agency by its members. We give some background to this issue and then outline the application of the proposed rule.
Cash as credit support for obligations of counterparties to derivatives, securities lending and repurchase transactions has become more and more prevalent over the past numbers of years. ISDA has reported that 80% of collateral for derivatives contracts is in the form of cash. The use of cash collateral will increase in importance as more and more derivatives transactions are cleared by central counterparties.
In the US and many EU countries, a first priority security interest over cash in a deposit account may be obtained by control in a manner very similar to control under Canadian securities transfer legislation or by effective set-off arrangements. The same is not the case in Canada. 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 such security, until recently, it was the practice to transfer cash absolutely (not by way of a security interest) and create a debtor creditor relationship and express right of set-off. This is indeed how many cash collateral arrangements are put in place generally, not only in the financial products market. If the cash provider defaulted, the creditor could set-off (or under Quebec law, compensate) its obligation to repay the cash against the debt (eg. the net termination amount). The effectiveness of this arrangement relied on the enforceability of contractual rights of set-off or compensation and not the creation of a first priority security interest in cash. Set-off or compensation were understood to operate outside of the general rules about the perfection and ranking or priority of security interests.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, casts doubt on the effectiveness of this approach. The Supreme Court characterized the lender's contractual right to set-off or compensate a debtor's obligation to repay a loan against the lender's own liability under the term deposit that the debtor was required to maintain with the institution as the enforcement of a "security interest" in the term deposit for purposes of income tax legislation. The Court held that the Federal Government's claim in respect of employment insurance and Canada pension plan premiums ranked ahead of the lender under the Income Tax Act (Canada) provisions that confer priority on the government over other "security interests". One of the major challenges with the application of this case is that the definition of security interest in the Income Tax Act is not materially different from that under the provincial common law personal property security acts. The application under Quebec law is less clear given the very different regime applicable to security.
The challenges with cash collateral in Canada are now front and center given the G-20 undertaking to move to central clearing of standardized derivatives and the new Basel capital rules that will incent collateralization of uncleared swaps as well. The Federal Finance Minister has formally communicated with the provincial Ministers of Justice and Finance outlining the challenges in respect of cash collateral and encouraging provincial legislative modifications to address this issue. The letter addressed to the Quebec Minister of Justice was tabled with the Committee on Public Finance of the Quebec National Assembly by the Quebec Minister for Finance on November 10, 2011.
On November 10, 2011, the Quebec Minister for Finance introduced an amendment to a bill currently being studied by the Committee on Public Finance of the Quebec National Assembly. If enacted, an amendment would be made to the QDA in order to address cash credit support by way of contractual set-off or compensation associated with derivative contracts, foreign exchange contracts, securities lending and repurchase contracts (as well as master agreements related thereto) and contracts between a clearing agency and one of its members and the applicable rules of the clearing agency. We note that the QDA requires that "clearing houses" and other categories of "regulated entities" be recognized by the Autorité des marchés financiers (Quebec's financial services regulator) in order to carry on derivatives activities in Quebec.
What Will the New Provision Accomplish?
We believe that, once the provision is adopted and in full force, it will restore confidence in the use of an absolute transfer of cash, creation of a debtor-creditor relationship and the related use of contractual set-off or compensation when dealing with cash as credit support from Quebec counterparties with respect to derivatives, securities lending and repurchase transactions.
Some of our observations on the proposed amendment are as follows:
- The person posting the cash may be the counterparty or any other credit support provider.
- The type of transactions covered are derivative transactions (as defined under the QDA), foreign exchange contracts, securities lending contracts, securities repurchase contracts and all master agreements in respect of these. Contracts between a derivatives clearing agency and one of its members as well as the rules governing such relationship are also covered.
- The rule covers an arrangement of contractual set-off or compensation in respect of cash. Certain standard forms of credit support documents will therefore need to be modified in order to take this into consideration in order to establish an enforceable and perfected credit support arrangement over cash.
- The governing law in respect of the validity of such contractual set-off or compensation will be the law chosen by the parties or the law that may be inferred with certainty from the terms of the agreement.
The provision does not purport to characterize whether a particular contractual set-off or compensation arrangement constitutes a security interest but rather indicates that such an arrangement in respect of cash is enforceable against third parties without any further formality. This means that no registration is necessary in order to make such arrangement enforceable against third parties; eliminating any perceived need to register in order "to perfect" this arrangement.
One of the potential issues in fixing this issue for financial product obligations only is that it might lead to an inference that these types of transfer and set-off arrangements in the context of other types of transactions (such as loans) do require perfection by registration. Hopefully such an inference will not be drawn given that the purpose of the amendment is really to achieve clarity in the context of the types of transactions for which cash credit support is particularly important and provided in substantial volumes on a daily basis. In our view, the proposed amendment only reflects the appropriate interpretation of the law in this area regardless of the type of obligation secured.
The provision does not set out a rule in respect of priority. The general rules applicable to contractual set-off or compensation, as interpreted by the courts, will therefore apply. In Quebec, a contractual set-off or compensation arrangement over cash should therefore prevail over a movable hypothec without delivery (the mainstream consensual non-possessory security interest in Quebec) whether registered before or after the cash credit support arrangement, without any necessity for the cash credit support arrangement to be registered in Quebec.
Since the rule addresses the opposability or enforceability of contractual set-off or compensation arrangements as against third parties, we believe that most current continuing arrangements that fall within the scope of the rule will also benefit from the rule once it comes into force.
The amendment is not designed to cover all arrangements where cash may be used as credit support. As examples, it will not cover a cash collateral deposit with the letter of credit issuer as support in connection with a letter of credit facility nor will it provide an easy way of obtaining a first priority security interest on cash held in a deposit account at a third-party institution even if securing a financial product transaction. In these cases, the traditional route still remains applicable. We would hope that these situations would be addressed in the near future in a way compatible with both a contractual set-off or compensation arrangement, where applicable and the control construct applicable in the US and many EU countries.
The Quebec legislator has taken steps that will restore confidence to the use of contractual set-off or compensation as a means to offer cash as credit support in connection with derivatives, foreign exchange, securities lending and securities repurchase transactions. The initiative also supports derivative clearing agencies and their relations with their members.
If the amendment is passed as presented, cash should soon regain its preeminent position as collateral for transactions of this kind involving Quebec counterparties able or willing to provide cash credit support on an absolute transfer basis.