commercial notes march 28th and 30th

8/3/2019 Commercial Notes March 28th and 30th

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Commercial March 28th

Bank Act Security Interests; Asset Securitization

Bank Act - S.427 Security Interest

Described scope and nature

Only covers Goods NOT A/R - b/c there are not documents of title for A/Rs

Described method for taking a s.427 interest in debtors property Notice of intention, filed with Bank of Canada office Simple form for granting a security interest in debtors collateral Rights acquired are same as though the rights had been acquired under a bill of lading or

warehouse receipto i..e they are equivalent to legal title

Recap

Bank ActSecurity Interest ss. 425 436 BA Original form of taking a security interest in personal property dates from the 1840s Scope and nature As provincial security interest capacity developed, especially PPSA, some saw clash in the

priority regimeso Courts were trying to work out what the priority regimes wereo Analysis is triggered by the fact that the s. 428 (priority) refers to subsequent

interests, but not prior interestss.428 Bank Act

Priority of banks claim 428. (1) All the rights and powers of a bank in respect of the property mentioned in or

covered by a warehouse receipt or bill of lading acquired and held by the bank, and the

rights and powers of the bank in respect of the property covered by a security given to thebank under section 427 that are the same as if the bank had acquired a warehouse receipt or

bill of lading in which that property was described, have, subject to subsection 427(4) and

subsections (3) to (6) of this section, priority over all rights subsequentlyacquired in, on or in

respect of that property, and also over the claim of any unpaid vendor. [emphasis added] i.e. Bank trumps all rights that follow on afterit Thus, if there was a s.427 BA interest, and then a subsequent PPSA interest, no question

that s.427 BA interest would prevail Problem is with a prior PPSA interest - courts get into a tortured analysis of ownership right

- revert to the 'proprietary interest'

Recap - s.427

From the 1980s onwards, the courts have struggled to harmonize the PPSA and s. 427 priorityinterests

Walked you through a series of cases in which courts used proprietary analysis to sort out thepriorities

Basically, courts have stated: Federal interest is paramount, therefore look to the language of the Bank Act interest to

resolve priority disputes


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Language in the BA is one of ownership What ownership rights did the debtor have when it granted a s.427 interest to the bank? Nemo dat quod non habetprevails This trend and form of analysis led to the rather absurd result in BMo v. Innovation Credit

UnionWhat's wrong with the Bmo v Innovation Creditanalysis?

Ignores vendor in possession provisions of the SGA these provisions are a codification of therule in Twynes Case

Ontario Sale of Goods Act s. 25 - "possession after sale" Where vendor remains in possession of goods after a sale, the delivery or transfer of documents

of title under apledge, to a third party who does not have notice of the first sale, has the same

effect as if the party making the sale was expressly authorized by the owner (i.e. the first

purchaser) to make that sale Twyne's case / "vendor in possession" provision - the major exception to nemo dat quod non

habetdoctrine Even if you accept, as the SCC does, that it is a chattel mortgage - then it is a transfer of title and is

equal to a sale - THUS s.25 should apply regardless(1): vendor in possession

(2): buyer in possession after sale - for CSAs

(3): PPSA prevails for (2)

Headnote ofBmo v Innovation: "Where the priority dispute is between a Bank Act security interest and a conflicting securityinterest acquired prior to the bank taking its security in the collateral, the priority rule set out in s.

428 does not assist in resolving the dispute. In such cases, the provisions of the Bank Act

nonetheless govern. Here, the priority dispute must be resolved by determining what proprietary

rights were granted to the Bank under s. 427(2) of the Bank Act." "As the combined effect of ss. 427(2) and 435(2) is that the Bank can acquire no greater interest in

the collateral than the debtor has at the relevant time, it becomes necessary to determine the

nature of the debtors interest in the collateral at the time the Bank took its security interest." Para 16BA silent as to

"The Bank Act contains relatively few provisions which explicitly address whether a Bank Actsecurity....The Bank Act is silent with respect to conflicting third party interests acquireprior

to the...." [of course it's silent - that's because it's in the SGA!] Johnson: reason why there are few provisions explicitly address it is b/c everyone knew

about Twyne's Case !! - the rule was simple (1840-1980):o For Subsequent interests, Bank Act takes priority over all subsequent interesto For prior interest, the Twynes Case doctrine (SGA) takes precedent
http://www.e-laws.gov.on.ca/html/statutes/english/elaws_statutes_90s01_e.htmhttp://www.e-laws.gov.on.ca/html/statutes/english/elaws_statutes_90s01_e.htm


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S. 30, 33, 34, 35, 26 priority rules b/w two perfected secured creditors - it is the FIRST TO REGISTER, NOT FIRST TO PERFECT

o Remember, you can register BEFORE you attacho Why? b/c SP2 was aware of SP1's registration - AWARENESS IS CRUCIALo PPSA does not accept constructive or actual knowledge of interesto PPSA has very limited forms of publicity that it allows

s.33: major exception - incl. long-term leases - must register - effectively treat them like aPMSI party - if they don't then they luck out (s.20(1)(b))

S. 25 legal consequences of the transfer of assets to which a security interest has attached (1): unless secured party... Authorizes for debtor to deal with the collateral free of the

security interest...then security interest remains in the collateral and follows into the 3rd

parties (1)(b): and continues in the proceeds

S. 28 major exception to the nemo datdoctrine good faith purchasers Describes different types of good faith purchasers: some with notice and some without

notice Describes the different expectations

And so on.QUESTION: whether you need a subordination clause within the agreement to enforce a PMSI

against a prior

SP1's agreement includes negative covenant: if the party grants an interest subsequentlythat purports to grant an interest in priority orpari passu to their interest, then it will

constitute a defaulting event (exception made for PMSIs)

Letting PMSI in b/c it is of benefit to them Thus, If it is a perfected PMSI, it will trump SP1's secured creditor to the extent that it wasstated in the PMSI - Clark Credit, etc.

Where you have an unperfected but secured (i.e. Attachment) SP2 and there is a priornegative covenant with a PMSI exception in it, the SP2's PMSI will trump SP1 for the assets

in the PSMI - see Chips and SkyviewoRationale: agreement is binding to its terms s.9

If SP1's agreement did not have the PMSI exception, then the SP2's unperfected PMSI doesnot rank ahead of SP1 - HOWEVER, if SP2 has a perfected PMSI, then by statute they have

super priority over SP1 over the collateral under PMSI (s.33)Asset Securitization:

Start with our typical retail cycle Car Dealer - had lead lender (bank) FinCo will buy the cars from the manufacturer at cost and puts them on the floor of the

dealer Dealer sells them to customer, but on financing plan/lease s.25: proceeds on that car flip over to the Chattel Paper


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Chattel Paper has 2 elements: (i) written evidence of a financial obligation; (ii) securityinterest

Dealer can't afford to keep the Chattel Paper - FinCo sees that Dealer sold a car See Maple City Ford- can't sell a car out of trust - when you sell a car, you give us the

proceeds Dealer essentially pays the FinCo via Chattel Paper

o s.20: rights of the assignor/assignee of chattel papero s.28(3): rights of a buyer of Chattel paper

At this point:o FinCo has chattel paper from all sales (big Co's like Honda have $billions worth per

year) - are they going to sit around and wait for customers to pay it back (i.e. Be a

FACTOR)?o FinCo instead engages the public markets - there are big pools of capital out thereo Sovereign Wealth Fund - fund put together by a sovereign entity (i.e state, province,

etc.) looking for investments Largest are coming out of China, ME, Singapore, Norway Canada has sovereign wealth funds in the form of Pension

CPP, teachers Pension - funds in the 10s of billions - they need to investb/c they need to generate about 6% yield per year in order to keep ahead

of their claimantso To get a higher yield investments, you need to take on more risk

Asset Securitization:o liquid capital markets - don't want to put it into bonds (only 1%)o FinCo's Chattel Paper - is A/R for interest + principal + secured collateralo FinCo can sell ('issue') bonds/or commercial paper to capital market investors -

basically BORROW money from investors at e.g. 5% interest rate Investors will ask for the pool of chattel paper as collateral Bond/commercial paper is thus a security agreement

Credit Card Example: Instead of cars, these are Credit Card accounts - interest is at 20% Investors do not want to deal with administrating the Chattel Paper dealing with c/c

accounts - so they are willing to take only a 5% interest rate while FinCo manages the c/c

accounts In the case of default on the 5%, the investors will get a right to the c/c CP and will go after

the c/c accounts personally Essentially, FinCo is able to make 15% interest from C/C accounts and investors able to take

5% interest - win/win


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Remember our financial institution and their chattel paper?

What happens when FinCo has various Secured Creditors

On insolvency, SPs are able to look to FinCo's assets Can look to assets of FinCo that were sold at less than market value or entitled to look at

assets of FinCo that they assigned to someone else

Remember: two forms of dealing with A/R:1.Selling outright (absolute assignment)2.Assigning rights via security agreement as collateral

If CP has been assigned as collateral to security agreement (ie. to investors), then SPs canclaim CPs b/c they are deemed to still be FinCo's assets

If investors are only getting 5%, they cannot afford to have the SPs chasing the investors for

the collateral that they made the security agreement on (investors would be bottom of list

of SPs) However, if investor is SP1, then risk is lower b/c they are first in line - would justify a lower

interest rate (i.e. 5%) Alternative to reduce the risk?

Make it an absolute sale/assignment - (i.e. s.28(3) assignment of Chattel Paper) Provided investors gave value, this gives the investors first right to the CP It will create a BREAK b/w FinCo's assets and investors - Bankruptcy Remoteness

SPs FinCo |||| Investors

Claim --> Assets Bankruptcy

Remoteness

Collateral/Assignment on Chattel

Paper

||||

FinCo can also do this by SELLING the CP to a Trustee Trustee only has assets in CP --> then issues the bonds out to the market


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Assume that you are a trustee or fund manager for an institutional investor, such as an insurancecompany or a superannuation (i.e. pension) fund.

You need to generate returns that will beat inflation, and allow your fund to grow in such a waythat it can meet its obligations when the beneficiary calls on the fund.

Assume that you need to grow the fund at an annual return of 6% Assume further, that the annual interest rate on a 5-year Govt bond is 2%

You would be in a search for yield at this rate. As we have seen, you will probably be regulated asto the type of alternative investment


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Commercial March 30th

SCC decided that nemo datprevailso Johnson finds that very hard to believe b/c there is a body of commercial law that deals with

good faith possession after sale doctrineo Surprising that the pleadings got so political

Asset Securitization

Start with our typical retail cycle Remember our financial institution and their chattel paper?

Typical Retail Financing Cycle:

Assume that you are a trustee or fund manager for an institutional investor, such as an insurancecompany or a superannuation (i.e. pension) fund.

You need to generate returns that will beat inflation, and allow your fund to grow in such a waythat it can meet its obligations when the beneficiary calls on the fund.o Assume that you need to grow the fund at an annual return of 6%o Assume further, that the annual interest rate on a 5-year Govt bond is 2%

You would be in a search for yield at this rate. As we have seen, you will probably be regulated asto the type of alternative investment

Bond/Debenture Ratings:


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There are rating agencies that rate bonds

o Started with municipal and railway bondso 3rd party rating agencies of issuers of bonds based on the probability of default (i.e. Risk of

the bond purchasers not getting paid)o The higher the risk, then a higher return is required for people to buy your bondso Lowest Risk Bonds = State/Soveriegn Bondso AAA = very few trip A corporationso AA = quality corps.. Like IBMo A = influenced by economic fluctuations

Start at the End:

SPV = special purpose vehicle (entity)o SPV in Canada will typically be a trusto They issue bonds onto the capital market - selling them to institutional investors


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Securities:o Exception to regular disclosure rules: if you are selling $_____ of securities to one party,

they will be considered a 'sophisticated buyer'o If they are considered a 'sophisticated buyer', there are no disclosure buyers - they are

considered to be big enough players to do their own due diligenceo Thus, b/c Institutional Investors are so big, they are exempt from the disclosure

requirementsThe institutional investors might invest in debentures or ABCP issued by the SPV. The investors

would like a yield of about 6% on the debentures, to cover their obligations to their policy holders

or pensioners. As we have seen, they are often restricted by regulation as to the type of

investment that they can make. The debentures would need to be investment grade, at least.

Consider the issuance of the debentures. A debenture is a debt instrument, and under s. 9, it is a

security. Is it regulated? Not if it comes within one of the exemption provisions of the

Securities Act

What are the legal obligations of the SPV under the debentures? Assume that the debentures

contain a legal obligation to pay 6% interest for the term of the debentures, and then to repay the

principal at maturity.o e.g. Bond pays at 6% for 5 years then plus repay principalo Commercial Paper vs Bonds :

Where it is SHORT TERM bonds - called COMMERCIAL PAPER In the US, if it is less than 270 days it is commercial paper In Canada, typically not longer than 1 years

o By selling in large amounts, it is also exempt from Securities disclosure requirements - thusthe buyer is really dependent on the Bond Rating Agency ratings of that bond

oAsset-Backed Commercial Paper Usually issued for 30 days At end of 30 days, SPV would pay interest and supposed to pay back principal, but

usually just rolled on to the next term....

This is very high yieldDebenture:

...debenture of a body means a chose in action that includes an undertaking by the body to repay

as a debt money deposited with or lent to the body. The chose in action may (but need not) include

a charge over property of the body to secure repayment of the money. However, a debenture does

not include:...

Who is the Seller (SPV)?

Q: What are SPVs assets? A: Interest-bearing A/R. SPV is a trust that only owns Chattel Paper

Gets this flow of cash from e.g. People who purchased cars and have A/R Q: Where did it get the money to buy these assets?


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A: From the sale of securities to institutional investors. Note that a sale of debt instrumentsis essentially a loan.

i.e. They sold the bonds to investors and then reinvests it into new Chattel Paper As long as their obligation on the bond is LOWER than the rate that they are getting

from the CP, they will make a profit (e.g. 6% bond rate, but you've got 12% on the CP -

thus you get a 6% profit) Why is bond rate lower? b/c the SPV has reduced their risk by putting collateral

behind the bond (i.e. Asset-backed commercial paper) If SPV defaults, then the investor gets the CP as collateral

Thus, SPV issues bond (i.e. Debtor) to investors (i.e. Creditors) and it is covered underthe PPSA w/ security interest on the collateral (CP) - THESE ARE INTANGIBLES (A/R)

Q: How much did it have to pay for this loan? A: Approximately 6% (it had to beat the Govt rate, in order to be attractive to the

institutional investors) Q: Does the SPV earn any income?

A: Yes, it earns the income from its interest-bearing A/R that it bought from an Originator. Ituses some of that income to meet its obligations to the debenture holders.

e.g. Car Dealerships - how do they make money on 0% financing? Especially when the FinCois giving 6% bonds? Doesn't add up?

The dealers build in the 10% financing into the sales price (you'll note that they are muchless likely to budge on the price when it is 0% financing b/c they can't afford it)How does FinCo make income?

They charge the SPV a service fee for administrating the A/R

Q: Why is an SPV a trust (usually, but not always)? A: Because as a trust, it only pays tax on the retained earnings at the end of each taxation

period. Provided it flows its income / revenues to its beneficiaries before that taxation

assessment date, the SPV will not pay tax on those revenues. Trusts in Canada do not pay tax as long as there is a flow-through of the assets Tax is on the beneficiary - if at the end of the year there is nothing in the trust, they pay

nothing If there's any residual amounts left over, the SPVs will donate to charity so it's not taxed

(SPVs are thelargest donors to charities in Canada) Q: When the SPV bought its interest-bearing A/R, who did it buy them from, and by what legal

mechanism? A: It bought them from an Originator at a discounted rate, in all likelihood. It would have

purchased the A/R in the same way that a factor might purchase its A/R - through an

absolute assignment (as against an assignment by way of security for a loan). Q: Why did the Originator sell them?

A: There are many reasons. One of the principal reasons might be to improve its balancesheet. Another might be to access inexpensive debt on the capital markets (6% plus any fees

charged by the SPV). Or it might be a combination of these two motivators


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Our Originator:

The party that is getting the stream of income (i.e. A/R) FinCo is the originator

Q: What are examples of Originators? A: They could be any entity that has assets consisting of interest-bearing A/Rs that they

would like to sell. This means that they might be: a large credit card company; or a large department store; or the financing division of an auto manufacturer; or a factor who is purchasing accounts receivable; or a deposit-taking institution that has a pool of mortgage loans on residential or commercial

propertiesFurther Up the Chain:

Suppose that the Originator is the financing division of an auto manufacturer. What concernswould you have, as an SPV purchasing a pool of interest-bearing A/Rs from this party? You'd have to rate the type of customer you are selling to e.g. Doctors, lawyers, etc. would be AAA rated customers But once all those AAA customers are had, how do you continue your business?

you can sell to other people who have no income or collateral, etc. --> lower ratingsb/c higher chance of default (i.e. BB rating)

You can start leasing your products as well But have to put conditions in the car lease to make sure that the returned car

still holds its value (i.e. Key conditions are mileage limits, damages, etc.) - they

need to be able to recapture the value of the car that they calculated as its

residual valueOriginator is Auto Manufacturing Financing Division

General principle of contract law: assignee assumes the obligations of the assignor In other words, in this example...

what are some of the obligations that the finance division might have assumed? what are some of the obligations that the finance division is unlikely to have assumed?

To answer these questions, think of our finance division as though it is a factor, buying A/R from aretailerSPV is buying CP from the FinCo - SPV is just a modern form of a factor

Have to negotiate contract with FinCo Issues with notification - who is responsible for notifying customers? Administration - who is to collect A/R? If FinCo is to collect, they will want service fee Who takes the risk of customers defaulting?

This is risky: SPV can account for 2% of defaults by incorporating it into theprice, they will be okay ... But what if 10% of customers default? Then SPV is in

trouble - SPV no longer has cashflow to pay the 6% rate to

investors/bondholders SPV can also be selective of the A/R that the FinCo has

i.e. SPV will only buy the AAA A/Rs


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Dealer will then go on to another SPV who is willing to take on the riskier A/R What are some of the obligations that the finance division might have assumed / not assumed?

Purchaser (financier) might purchase all of the a/r (Whole turnover discounting) Might purchase some of the a/r (Selective discountingonly sell me approved a/r) Even where whole turnover purchased, different arrangements may be made for certain

types of accountso E.g. early payment for approved accountso Payment only when amount collected from account debtor for disapproved

accounts

What are some of the obligations that the finance division might have assumed / not assumed? Assignment of A/R from auto dealer to auto manufacturer division might be with

recourse; or without recourse It might be notification, or non-notification

Those concepts might take care of the issue of credit risk of account debtors, but what aboutother matters?

Need to think about warranties on the mechanical aspects of the automobiles Who will bear responsibility for that? Assignee of assignor?

What about product liability suits? Who will bear responsibility for that? And so on....

Put the Pieces Together

Customers are Auto lessess under the PPSA (i.e. Longer than 1 year) Originator is FinCo - via factoring arrangement, they have a bundle of CPs Assign the CP (A/R) to the SPV SPV sells asset-backed commercial paper (secured on the CP) to the institutional investors

If you want to grow your business, you have to dig deeper into the customer market - RISKIER


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How do you get the rating agencies to give a higher rating than what the risk of thecustomer type actually is?

Major Concerns of some of the Players

Institutional Investor: I am only allowed to buy (e.g.) AAA-rated debt instruments What rating has the rating agency given these securities?

Rating Agency: Are the A/R of the SPV bankruptcy remote? Will require that assignment of A/R from

Originator to SPV is a true sale. Why the need for b/ruptcy remoteness?o Big concern as a Rating Agency on an SPV - is there a sufficient break between the

original creditors on the Originator such that those creditors can't touch SPV's rights

to the CP? (i.e. Is there sufficient bankruptcy remoteness?)o How to get Bankruptcy Remoteness?

There must be a true sale b/w Originator and the SPV of the CP Rating Agency will need to see a lawyer's opinion to say they actually sold the

A/R in absolute assignment to SPV and it was sold for FMV i.e. Originator has no residual interest in collateral after sale is done

b/c the alternative situation is that it is a secured loan (SPV loaned to originator)- assignment by way of security for a loan (it looks the same as an absolute

assignment)

i.e. when originator finishes paying, it gets the collateral back Test is in BC Tel****

Re a true sale If it is transfer of collateral for a secured loan, then SPV is only a

subsequent creditor If it is a true sale, then SPV is the owner of the assets - thus it can't be

related back to the originator or originator's claimants

What is the credit risk of the A/R account debtors?Bankruptcy Remoteness:


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commercial notes march 28th and 30th

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