NORTH OF THE BORDER UPDATE
This article has been contributed to the blog by Steven Golick and Artem Miakichev. Steven Golick is a partner in the Insolvency and Restructuring Group of Osler Hoskin & Harcourt LLP and Artem Miakichev is an associate in the group.
A recent decision of the Supreme Court of Canada in Bank of Montreal v. Innovation Credit Union, 2010 SCC 47 and its companion case has caused a serious blow to the Canadian chartered banks, which may trigger a legislative reform of the Bank Act, a federal legislation with a long history.
In its unanimous decision, the Supreme Court of Canada has ruled that a security interest taken by a lender under the provincial personal property security legislation does not need to be registered pursuant to such legislation in order to take priority over a bank’s subsequent security in the same collateral registered under the Bank Act (Canada).
Since about 1890, Bank Act security has been a backbone of secured lending for Canadian banks. The security provisions of the Bank Act provide a mechanism for certain classes of borrowers (including wholesale and retail purchasers, manufacturers, aquaculturists, farmers, fishermen, etc.) to borrow from banks and grant security over specified goods and inventory. Bank Act security is premised on the concept that the title (but not possession) to the secured assets is transferred to the bank until the borrower exercises its right of redemption by repaying the debt in full. In this sense, the Bank Act security is “property based”. One of the advantages of Bank Act security is that it allows a bank to take the security in the inventory of the borrower across Canada with only one registration under the Bank Act, rather than the bank having to rely on security interests perfected by registration under each provincial statutory regime. This was significantly more important to banks historically, before personal property security legislation was enacted in each of the provinces which facilitated registrations under provincial law.
The provincial personal property security regimes on the other hand provide a mechanism for a borrower to grant a security interest (usually in a signed agreement) and for the lender to file a financing statement under the appropriate provincial Personal Property Security Act (the “PPSA”) (an equivalent to Article 9 of the Uniform Commercial Code) (or the lender can take possession of certain types of collateral) in order to perfect its security interest in the collateral. Generally, registrations must be made provincially in each province where the collateral is situated.
Priorities between competing secured creditors, or between secured and unsecured creditors are generally determined under the priority rules set out in the PPSA. Thus, the PPSA regime is “priority based” and not “property based”.
Under the PPSA, the general rule is that perfected secured creditors take priority over unperfected secured creditors, and as between competing perfected secured creditors, the first in time to perfect takes priority. There are exceptions to this general rule (for example, purchase money security interests). The PPSA does not govern priorities between PPSA and non PPSA interests.
Banks taking security under the Bank Act have customarily searched the PPSA registries in the appropriate provinces to determine whether the assets in which they were taking security were encumbered. If no registrations under various PPSA’s were discovered, the banks generally assumed that in taking title to the collateral under the Bank Act, they were taking the collateral free and clear of any prior claims. This can no longer be assumed to be correct in light of the holding in the Innovation case.
At issue in Innovation was a priority dispute between an unregistered security interest granted to a credit union under the Saskatchewan PPSA in the assets of a farmer, and a subsequent interest in the same collateral granted to and registered by a bank under the Bank Act.
The facts in the case are not complex. Innovation Credit Union (the “Credit Union”) advanced a loan to a Saskatchewan farmer on October 7, 1991 and was granted a security interest governed by the PPSA in all of the present and after-acquired personal property of the farmer. The Credit Union did not register its security interest until June 28, 2004, and accordingly its security interest was unperfected until that date. Between 1998 and January 2004, the Bank of Montreal took Bank Act security over much of the same property. The farmer did not disclose to the Bank either the Credit Union’s loans or its security interest and the Bank’s searches of both the PPSA and Bank Act security registries disclosed no prior interests. After the debtor defaulted, the Bank seized and sold some of his property covered by its security.
The Credit Union brought an application before a trial court seeking a declaration that it had a priority claim over the proceeds of the disposition. The trial judge held that priority rules of the Bank Act gave the bank’s security priority over the property in question and the proceeds of disposition. The trial judge reasoned that a security interest under the PPSA would only have priority over a subsequently taken Bank Act security where the PPSA interest had been perfected prior to the bank taking and registering its security, which did not occur in this case.
The Court of Appeal overturned the trial court’s decision holding that the proper interpretation of the Bank Act requires consideration of the provincial property law to determine the effect of a prior security interest. The Court of Appeal held that the Credit Union’s unperfected PPSA security interest had priority over the bank’s subsequent Bank Act security because the PPSA security was granted before the Bank Act security. The reasoning was that the bank could not acquire any greater interest in the collateral than the debtor had at the time when the Bank Act security was taken. When the farmer granted the security to the bank, he had already given the Credit Union an interest in that collateral under the PPSA pursuant to the security agreement. Accordingly, the bank’s security was subject to the Credit Union’s prior security interest, notwithstanding the fact that the Credit Union’s security interest was unperfected at the time the Bank Act security was granted to the Bank of Montreal.
The Supreme Court of Canada upheld the decision of the Court of Appeal. The Court emphasised the distinction between the “property based” and “priority based” regimes of the two Acts and noted that unless a bank makes the appropriate registration in accordance with the provisions of the Bank Act, its security will be void as against third parties. In contrast, the PPSA does not void a secured creditor’s rights vis-a-vis third parties if the security interest is not registered. In other words, the lack of registration under the PPSA regime will make the PPSA security interest vulnerable to priority claims of secured parties who have perfected under the PPSA, but will not impact the security interest itself. The principal requirements of the PPSA for the creation of a security interest is that there must be a signed security agreement that contains a description of the collateral and that a security interest must “attach” to the collateral, i.e. the value must be given by the lender and the debtor must have rights in the collateral.
The Court noted that the Bank Act security cannot compete in the same scheme with the PPSA security interest in terms of priority of registrations because the PPSA specifically excludes its application to a security agreement governed by the Bank Act.
On the facts of the case, the Court concluded that at the time the bank took its Bank Act security, the Credit Union already held an interest in the same collateral. Therefore, the bank could only take its interest subject to this prior interest of the Credit Union.
The result of this decision is that Bank Act security taken by banks in Canada is vulnerable to loss of priority to any prior security interest, even if such prior security interest has not been registered under the appropriate PPSA. Of course, since there is no way that a bank contemplating taking Bank Act security can search for unregistered PPSA security interests, this is a thorny problem.
The Supreme Court of Canada acknowledges in its decision that this result echoes the cry by many commentators for a legislative reform. The Court leaves it open to Parliament to amend the Bank Act and to expressly add a priority rule which would subordinate an unperfected PPSA security interest to a subsequent registered Bank Act interest. Until that happens, banks will have to go beyond just searching the PPSA registry in their diligence efforts to determine whether the collateral is encumbered. They should strongly consider taking and registering security under the appropriate provincial PPSA and not simply relying
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Royal Bank of Canada v. Radius Credit Union Ltd., 2010 SCC 48.