Fully Secured @ Gowlings: June 27, 2012 - Volume 3, Number 2

Edited by Richard Dusome

In this issue:

Court Disallows Sheltering of Unsecured Debt under Prior Ranking GSA Update on Bank Act Security Amendments British Columbia: The Dangers of Using the Prescribed Standard Mortgage Terms Security on Commercial Licences: Developments Since the Saulnier Case A Banker Asked Us: What is a "fondé de pouvoir" and Why do I need one in Québec Syndicated Loan Transactions? Security Granted Following Payment Default Held to be Improper Preference Spotlight on Security Documents: The Forbearance Agreement Court Disallows Sheltering of Unsecured Debt under Prior Ranking GSA

By: Lisa MacDonnell (Toronto)

A Saskatchewan court has recently struck down an unsecured creditor's attempt to elevate its position by taking an assignment of the prior ranking debt of another creditor and the security related to that debt.

The claim arose out of a dispute between two adverse shareholder groups of the borrower ("CPCN"). One shareholder group ("EE") had made several advances of unsecured debt to CFCN over a period of time.

At issue in Eagle Eye1 was whether a general security agreement ("GSA") entered into by CPCN in favour of the Business Development Bank of Canada ("BDC") could be used to secure CPCN's previously unsecured debt owing to EE.

In 2008, CPCN entered into a loan agreement with BDC. As security for the loan agreement, CPCN entered into the GSA in favour of BDC. The GSA contained an "all obligations" clause which provided that the security interest granted was intended to secure the repayment of all present and future indebtedness of CPCN to BDC. In 2011 BDC assigned the debt and related security to EE.

When CPCN tried to pay-out the BDC debt and obtain a discharge of the BDC security, EE included the originally unsecured debt in the pay-out statement and claimed that it also had to be paid in order to discharge the security due to the "all obligations" clause in the GSA.

CPCN then brought an action for the court to determine the amount of the debt required to be paid in order to obtain a discharge of the GSA. CPCN argued that the actions of EE were contrary to section 65 of the Saskatchewan PPSA2 which requires that parties to a security agreement act "in good faith and in a commercially reasonable manner". Additionally, CPCN argued that the assigned security was subject to the terms of the original loan agreement and related debt documents which did not contemplate the prior unsecured loan between Eagle Eye and CPCN.

Following a review of case law in England, Australia, New Zealand and the United States, the court agreed with CPCN. It strictly construed the "all obligations" clause and determined that the amount required to discharge the GSA did not include the prior unsecured loan. In its decision the court cited several public policy reasons for not allowing EE's actions and noted:

In exercising its rights under the GSA, EE had not been acting in good faith or in a commercially reasonable manner as required by the PPSA. Rather, EE had been acting to gain an advantage over the other shareholders in an oppression action; The "all obligations" clause in the GSA should be given a literal interpretation in order to limit the indebtedness secured to the indebtedness arising between the original parties to the original loan documents, and not to loans of third parties; A broad interpretation of an "all obligations" clause would be unfair to a debtor as a debtor would not reasonably anticipate that such a clause could be used by an unsecured creditor to convert itself into a secured creditor by virtue of obtaining an assignment of a security agreement; Permitting an unsecured creditor to transform unsecured debt into secured debt by way of assignment of a security agreement would have a destructive effect on the principle of pro rata sharing between unsecured creditors in bankruptcy law; and Allowing unsecured indebtedness to acquire priority over other secured claims through the assignment of a secured claim with higher priority would be inequitable to the debtor and would cause a disruption of traditional PPSA priorities. This would create uncertainty for other secured creditors in respect of their priority under future security agreements. It remains to be seen whether Ontario courts will follow the Eagle Eye decision. As such, when planning any loan restructuring, creditors should be mindful that courts will likely not permit the conversion of unsecured debt into secured debt by virtue of an assignment of secured debt and underlying security documents.

Update on Bank Act Security Amendments

By: Christine Marchetti (Toronto)

In our last edition of Fully Secured (March 28, 2012 – Volume 3, No. 1) we reported on the upcoming amendments to the Bank Act contained in Bill S-5 (Financial System Review Act) which were designed to address the issue of priority as between registered security taken pursuant to Section 427 of the Bank Act and an unregistered (unperfected) security interest taken pursuant to the provisions of the provincial personal property security statutes across Canada. The amendments to Sections 425, 426 and 428 of the Bank Act contained in Bill S-5 were drafted to reverse the effects of the Supreme Court of Canada's decisions in Bank of Montreal v. Innovation Credit Union and Royal Bank of Canada v. Radius Credit Union Ltd.

As reported in our December 2010 issue, the Supreme Court had ruled in the Innovation and Radius cases that an unregistered security interest granted to a credit union by way of a general security agreement had priority over subsequent, but registered, Bank Act security granted to a bank. In each case, because the debtor had already granted a security interest in all of its present and after-acquired personal property to the credit union, the Court held that the debtor could not subsequently transfer an unencumbered...