According to the 2003 Survey of Operating Statistics compiled by the Commercial Finance Association, total asset-based loans outstanding in the United States in 2003 were valued at $328.9 billion. By contrast, in Canada, total asset-based loans outstanding in 2003 were valued at approximately $7.6 billion.1 While the total figures for Canada pale considerably in comparison to the U.S. figures, the market is clearly growing.2 The growth is being fueled by continued entry of U.S. asset-based lending financial institutions into the Canadian market, the establishment by several Canadian banks of asset-based lending divisions and the increasing market acceptance of asset-based lenders as a standard alternative rather than as "lenders of last resort."
There have been recent legal developments in Canada that have a particular impact on asset-based lenders because they affect two very important focal points of an asset-based loan, namely, "priority of security interests" and "dealings with collateral."3
Third-Party "Implicit" Subordination and the Impact of the Engel Case4
As a result of Engel Canada Inc. v. TCE Capital Corp.5, asset-based lenders may find that their security is inadvertently subordinated to other liens even though it has not entered into any agreement to do so. Generally, the subordination of one security interest to another is not effective absent a contract between the two secured parties. In other words, there must be privity of contract.
Under the doctrine of privity, a person cannot acquire rights or be subject to liabilities under a contract to which he is not a party.6 An exception to this rule is created by section 38 of the Personal Property Security Act (Ontario) (the "PPSA") (and the parallel provisions of the personal property security acts of the other provinces in Canada). Pursuant to section 38 of the PPSA, a secured party can subordinate its security interest in the collateral of the debtor to the security interests of other secured creditors without entering into a formal subordination agreement with such creditors.
The approach of Ontario courts to this type of third-party subordination has traditionally been conservative, applying such subordination only where the agreement in question used clear words of subordination in favour of a specified class of creditors. However, more recently, Ontario courts have shown a tendency to find an intention in favour of third parties even where the agreement in question contained no express subordination language and nothing more than a permitted encumbrance exception. The leading case in this regard is Engel, wherein the court implied an intention on the part of a secured creditor to subordinate in the complete absence of any words of subordination or priority.
Previous Case Law
In Euroclean Canada Inc. v. Forest Glade Investments Ltd.,7 the agreement in question contained the following clause:
(e) Not Encumber. The Corporation shall not, without the consent in writing of the Holder, create any mortgage, hypothec, charge, lien or other encumbrance upon the mortgaged property or any part thereof ranking or purporting to rank in priority to or pari passu with the charge created by this Debenture, except that the Corporation may give mortgages or liens in connection with the acquisition of property after the date hereof or may acquire property subject to any mortgage, lien or other encumbrance thereon existing at the time of such acquisition and any such mortgage, lien or other encumbrance shall rank in priority to the charge hereby created.8 [emphasis added]
The Ontario Court of Appeal found that the exception to the negative pledge contained in the debenture represented a clear intention on the part of the debenture holder to subordinate its security interest to the subsequent holders of mortgages or liens granted in connection with the acquisition of property (now more commonly referred to as "PMSIs"). This subordination was enforceable against the debenture holder by the PMSI holder, notwithstanding that such mortgages or liens were unperfected or not perfected in time to achieve "super" priority pursuant to the PPSA.
It was found that in order for a third party to rely on the exception to the rule of privity under section 38 of the PPSA, the purported subordination clause should meet the "principled exception" test set out by the Supreme Court of Canada.9 Under this test, intention is determined on the basis of two factors: (i) the parties to the contract must intend to extend the benefit of the third party seeking to rely on the contractual provisions; and (ii) the activities performed by the third party seeking to rely on the contractual provision must be the very activities contemplated within the contractual provision, as determined by reference to the intention of the parties. It should be noted that the decision in Euroclean did not provide any judicial basis for expanding the scope of the exception to privity of contract to include "implicit" subordinations which do not evidence a clear intention to subordinate in favour of a class of third parties.
Based on the specific language of the debenture in Euroclean, it is difficult to disagree with the conclusion reached by the Ontario Court of Appeal. The test for the principled exception to the doctrine of privity set out by the Supreme Court of Canada was clearly met on the facts in Euroclean in that the language clearly evidenced an intention to confer priority on a specified class of beneficiaries not party to the agreement (i.e., "and any such mortgage, lien or other encumbrance shall rank in priority to the charge hereby created"). The language in the debenture in the Euroclean case represented an express subordination in favour of the specified third-party beneficiaries.
In Sperry Inc. v. Canadian Imperial Bank of Commerce,10 the court refused to find an intention to subordinate on the part of the parties involved. The relevant agreement in that case contained the following clause:
4. Ownership of Collateral. The undersigned represents and warrants that, except for the security interest created hereby and except for purchase money obligations, the undersigned is, or with respect to Collateral acquired after the date hereof will be, the owner of the Collateral free from any mortgage, lien, charge, security interest or encumbrance.11
The Ontario Court of Appeal concluded that the document fell short of showing an agreement by the bank to subordinate its security interest to holders of PMSIs. Morden J.A., delivering the judgment for the Ontario Court of Appeal, stated that the clause stood in contrast with the terms of the debenture in Euroclean. While the court did not elaborate on the differences between the applicable agreements in Euroclean and Sperry, we note that the agreement in Sperry did not contain express "priority" language, and the operative clause was a representation and warranty rather than a negative covenant (it would be difficult to argue that a representation and warranty by a debtor could be interpreted as an agreement by the secured party to subordinate its security interest).
The Engel Case
The decisions in Euroclean and Sperry are in line with commercial realities. Unfortunately, the same cannot be said about the more recent decision of the Ontario court in Engel, where the court seemed to have misinterpreted the commercial intention of the parties involved. In Engel, the security agreement in question contained the following standard representation by the debtor:
The Collateral is genuine and owned by the Debtor free of all security interests, mortgages, liens, claims, charges, licenses, leases, infringements by third parties or other encumbrances (hereinafter collectively called "Encumbrances"), save for the Security Interest and those Encumbrances shown on Schedule "A" hereto or hereafter approved in writing, prior to their creation or assumption, by the Creditor (here-inafter collectively called "Permitted Encumbrances").12
The debtor also agreed to keep the collateral free from all encumbrances except for Permitted Encumberances.
After reviewing the provision of the security agreement, Wilson J. stated:
Schedule A confirms existing exclusions as at the date of the General Security Agreement, as well as future exclusions. It permits future "purchase money liens, or other encumbrances created, issued or assumed to secure the unpaid purchase price in respect of such property or asset." This clause explicitly permits and anticipates future encumbrances, although wording with respect to priority or rank is not used.
In my view, the applicable clauses of the General Security Agreement including Schedule A, when read together are more similar to the governing clauses in Chiips than those in Sperry.
The provisions of the General Security Agreement, particularly the covenant provisions when read with Schedule A, clearly allow the debtor to purchase specified encumbered assets, including purchase money liens. According to the Encyclopedia of Words and Phrases Legal Maxims Canada, 4th ed, Vol. 2, "encumbrance" means a "claim, lien or liability that is attached to property."
Allowing the purchase of specified encumbered assets without granting priority in the encumbrance appears to be a hollow right that does not make commercial sense unless subordination is implicit.13[emphasis added]
With respect, Wilson J. appears to have misinterpreted the commercial intention of exceptions to a negative pledge and appears to have overlooked the PMSI priority regime of the PPSA. The exception to the negative pledge allows the debtor to grant certain types of security interests to certain types of creditors without being in default of the covenants or the representation and warranty in the security agreement. Exceptions to a negative pledge covenant or a representation and warranty should not be interpreted to evidence an intention to give the permitted encumbrances priority unless clear and unequivocal language with respect to relative priority is used. Priority is otherwise governed by the statutory priority rules of the PPSA, which the PMSI holder ignores at its peril. Under those rules, a subsequent PMSI holder can achieve "super" priority through compliance with the provisions of the PPSA. One effect of the Engel decision is to confer a windfall on a PMSI holder who ignored the PPSA.
Practice Points
However flawed the reasoning may be in the Engel case, it seems to represent the current state of the law in Ontario. Accordingly, where an asset-based lender has no intention of subordinating its security interests, the credit and/or security agreements must be carefully drafted to avoid any implication of an intention to subordinate. One practical solution is to include an express disclaimer of any intention to subordinate in the security agreement. For example, in an attempt to mitigate the risk created by the Engel decision, an asset-based lender may wish to include a disclaimer of any intention to subordinate in the definition of "permitted encumbrances."
"Permitted encumbrances" means any one or more of the following:
(a) ………;
(b) ……….;
provided that nothing in this definition or this Agreement shall (x) be construed as evidencing an intention or agreement on the part of the Lender that the Security or the Secured Obligations hereunder be or have been subordinated to any such Permitted Encumbrance, or (y) cause any such subordination to occur.
Although not yet tested before the courts, the use of such a disclaimer should be effective in mitigating the effect of the Engel case. If the courts are serious about "intention," one can hardly imagine that they could simply ignore a clear disclaimer of such intention. Asset-based lenders should be cautioned to obtain legal advice in respect of new and existing credit or security agreements in order to ensure that provisions in such agreements cannot be misinterpreted as implicitly subordinating the asset-based lenders' security interests to third-party creditors and to add appropriate disclaimers if there is any possibility of such misinterpretation.
It should be noted that this issue is of concern where the agreement containing the negative pledge is governed by the laws of Ontario. Where the agreement containing the negative pledge is governed by the laws of a different jurisdiction, counsel need to consider whether the reasoning in Engel is applicable. For instance, in a very recent decision of the court of appeal in Newfoundland,14 the reasoning of the court seemed to be more in line with previous case law rather than the decision in Engel.
Interim Receivers as Successor Employers
The recent decision of the Ontario Court of Appeal in T.C.T. Logistics Inc. et al.15 may have a significant effect on how receivers realize on assets of a business where a union holds bargaining rights for employees of an insolvent company. The decision appears to have materially increased the risk that a receiver who operates a business of a debtor may be found to be a successor employer and personally liable in situations where arrears to employees are not paid in full or assumed by a purchaser of the business. This is especially relevant for asset-based lenders who appoint receivers and as part of the appointment are asked to indemnify the receiver from liability.
Prior to the decision in T.C.T. Logistics, receivers routinely obtained orders that purported to effectively immunize them from successor employer declarations. Such orders would typically empower the receiver to engage the service of employees without such employment resulting in the receiver becoming a "successor employer" within the meaning of provincial labour relations statutes and therefore party to a collective agreement. These orders were virtually always obtained without notice to the employees or unions and, prior to the T.C.T. Logistics case, were usually granted by the court.
Historically, it has been difficult for unions to obtain a successor employer declaration against a receiver. In Ontario, such a declaration can only be made by the Ontario Labour Relations Board (the "Board"). However, the Board has recognized that the stay of proceedings issued by a bankruptcy court applies to proceedings before the Board. Accordingly, the union is required to first seek leave from the bankruptcy court to commence a proceeding for a successor employer declaration.
In T.C.T. Logistics, the union asserted that the bankruptcy court did not have the authority to make an order that immunized the receiver from the obligations of a successor employer. Feldman J.A., writing for the majority of the Ontario Court of Appeal, held that section 14.06(1.2) of the Bankruptcy and Insolvency Act ("BIA") only protects a receiver or trustee from liability with respect to the obligations of a debtor company, but not necessarily from any obligations that the receiver or trustee may incur going forward after it takes possession of the debtor's assets. The court went on to say that nothing in the BIA authorizes the court to deem, in an appointment order, that actions undertaken by a receiver or trustee will not make it a successor employer. Accordingly, many of the protections that were previously obtained in the appointment order for an interim receiver may no longer be available.
The Court of Appeal did, however, preserve the bankruptcy court's ability to deny the union leave from the stay of proceedings to apply to the Board for a declaration of successor employer status against a receiver. The court of appeal confirmed that section 215 of the BIA gives the bankruptcy court the jurisdiction to play "gatekeeper" in this regard. Accordingly, as was the case prior to T.C.T. Logistics, before a union can bring a successor employer application before the Board, the proceeding must first be sanctioned by the supervising bankruptcy court pursuant to the test under section 215.
In determining whether leave should be granted to a union to commence successor employer proceedings before the Board, the following factors should be taken into account: the timing of the application, the complexity of the receivership, the demands on the receiver as it carries out its obligations, the potential duration of the period that the receiver intends to operate the business before it can be sold, the availability of potential purchasers and their financial strength and the likelihood that a purchaser will be declared a successor employer and assume all of the obligations under the collective agreement.
Practice Points
In realization scenarios, an asset-based lender can avoid the impact of the T.C.T. Logistics decision and the possibility of liabilities arising as a result of the indemnification by the asset-based lender of the receiver by permitting a voluntary sale of assets by the debtor under the Companies' Creditors Arrangement Act ("CCAA"). Voluntary asset sales by the debtor under the CCAA avoid the need to appoint a receiver to take possession and control of the assets and operate the business until a sale of the business or assets can be completed. In recent years, courts have permitted asset sales or liquidations under the CCAA prior to or without a plan of arrangement being filed.
Prior to developing its exit strategy, an asset-based lender should consider the likelihood that the business will need to continue to operate as a going concern prior to the asset sales being concluded. If the business will need to be operated and employees retained prior to the completion of the asset sales, the lender should consider whether a filing under the CCAA is a viable option. Clearly, the greater the amount of the potential successor employer liabilities, the greater the incentive will be to avoid a receivership and move toward a CCAA filing. If the debtor is cooperative and the asset-based lender has confidence in management (or can otherwise provide for the governance of the debtor during the course of the proceedings), the CCAA may be a workable option to avoid the risk of potential successor employer liabilities that could arise if a receiver takes control of the assets and operates the business.
The 2002 report of the Insolvency Institute of Canada/ Canadian Association of Insolvency and Restructuring Professionals Joint Task Force on Business Insolvency Law Reform recommended that the BIA be amended to provide that receivers and trustees have no personal liability for employee claims (including severance and termination pay) arising "upon the commencement of or during the course of insolvency proceedings." The timing for completion of the insolvency law reform process is uncertain, and it remains to be seen whether this recommendation will be adopted. In the interim, asset-based lenders should continue to be guided by the considerations discussed above.
1 http://www.cfa.com/Statistics/stats _2003_exhibit_list.htm
2 Total asset-based loans outstanding in the United States from 2002 to 2003 grew by approximately 2.8%. In Canada over the same period, total asset-based loans outstanding grew by 153%.
3 The authors acknowledge the valuable contribution of our colleagues Jeffrey Gollob, Jeffrey Rogers and Waël Rostom in the preparation of this paper.
4 This summary discussion on "third-party implicit subordination" is intended only to identify the potential risk to a secured lender of inadvertently subordinating its security interest over the collateral of a debtor to the security interests of other secured creditors and is not intended to be an exhaustive discussion of all of the relevant cases or all of the legal issues and facts that impact the analysis. Asset-based lenders should obtain legal advice based on the specific facts and circumstances surrounding a secured financing arrangement.
5 [2003] 4 P.P.S.A.C. (3d) 124 (Ont. S.C.J.) [hereinafter Engel].
6 G.H. Treitel, The Law of Contract, 11th ed. (London : Sweet & Maxwell, 2003) at 606.
7 (1985), 16 D.L.R. (4th) 289 (Ont. C.A. ) reversing (1984), 8 D.L.R. (4th) 260 (Ont. H.C.J.), leave to appeal to the Supreme Court of Canada refused on June 3, 1985 [hereinafter Euroclean].
8 Ibid. at 297.
9 Ibid. at 301.
10 (1985), 17 D.L.R. (4th) 236 (Ont. C.A. ) varying (1982), 141 D.L.R. (3d) 119 (Ont. H.C.J.) [hereinafter Sperry].
11 Ibid. at 239-240.
12 Engel, supra note 5 at para. 31.
13 Ibid. at para. 51.
14 Hickman Equipment (1985) Ltd. (Re), 2004 N.L.C.A. 47, online; QL (CLS).
15 GMAC Commercial Credit-Corp.-Canada v. T.C.T. Logistics Inc. (2004), 238 D.L.R. (4th) 677 (Ont. C.A. ) [hereinafter T.C.T. Logistics].