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Modernizing Canada's Secured Transactions Law: The Bank Act Security Provisions

4. Problems Caused by the Bank Act Security Provisions

Four categories of problems caused by the Bank Act security provisions seriously compromise the efficiency and effectiveness of Canadian secured transactions law: statutory obsolescence, competing federal-provincial/territorial priorities, dual registry and pre-emption of provincial/territorial legislative objectives.

a. Statutory Obsolescence

One set of problems arises because the Bank Act security provisions date back to 1890. While the security device has undergone a series of amendments, at no time has it been rationalized or modernized to eliminate some of its more archaic features. There are two aspects to the problem of statutory obsolescence. The first is the legal uncertainty that results from the archaic terminology and concepts used in the federal statute. The second is the decreased use of the Bank Act security because the federal provisions fail to provide banks with a fully effective and comprehensive security device.

The Bank Act provisions are replete with obscure language. For some kinds of collateral, the bank also obtains “a first and preferential lien”, but for other types of collateral this status is not conferred. [1] Other examples of obscure language include the provisions that give the security priority over an unpaid seller's lien. [2] Again, there is considerable debate over the effect of these provisions. [3] These controversies add to the legal uncertainty associated with using the Bank Act security, since the matter can only be resolved through expensive litigation. When such uncertainty exists, commercial parties are unable to predict outcomes or conduct meaningful risk assessments.

Another problem associated with the obscure language of the federal provisions concerns the “document of title fiction”. A bank that is given a Bank Act security obtains the same rights and powers as if the bank had acquired a warehouse receipt or bill of lading in which that property was described. [4] In the common law provinces and territories this operates in much the same way as a common law mortgage. There is a transfer of legal title to the bank, but the debtor also retains a proprietary interest in the collateral in the form of a right of redemption. Therefore in common law jurisdictions, the bank's ownership of the collateral does not generally give rise to characterization problems. This is not the case in Quebec. Under the civil law, the concept of ownership is unitary. If the bank is deemed to be the owner, then the debtor cannot also be the owner, but must be regarded as holding the property on the bank's behalf. However, the bank's ownership is restricted; the bank is required to retransfer the

property when the obligation is satisfied, and the debtor has the right to retain possession of the property prior to any default. Unfortunately, this approach is completely out of step with the civil law concept of ownership, and introduces a high degree of irrationality and incoherence into the civil law. [5]

In addition to the legal uncertainty created by archaic statutory provisions, there are several features of the Bank Act security that make it unsuitable as a lender's primary security device. The Bank Act security can only be given to certain classes of debtors on certain classes of the debtor's assets. [6] Unlike provincial or territorial security interests, the Bank Act security cannot be granted on all of a business debtor's present and after-acquired personal property. It is also restricted in the types of obligations that it can secure. The Bank Act security cannot be given for past indebtedness. [7] The remedial scheme is also less comprehensive because the Bank Act provisions do not give the bank the power to appoint a receiver–manager upon default. Because of these limitations, it is uncommon for banks to rely on a Bank Act security as their primary security device. Instead, banks predominantly take the Bank Act security as a back up, relying on it only if there is a problem with their provincial or territorial security interest. As will be explained, double documentation creates a number of legal difficulties.

b. Competing Federal–Provincial/Territorial Priorities

The most serious problem with the co-existence of two secured transactions regimes is the legal uncertainty that arises when a Bank Act security competes with a provincial or territorial security interest. This occurs when a borrower gives the same asset as a Bank Act security to a bank and as a provincial or territorial security interest to another creditor. Neither the Bank Act nor the provincial or territorial personal property security statutes provide a complete set of priority rules to govern such a competition. This lack of compatibility between the federal and provincial/territorial systems has created a myriad of problems and has produced an intolerable degree of legal uncertainty. Moreover, the nature of the problem and its analysis differ substantially when the security interest is from a common law jurisdiction or from the civil law jurisdiction of Quebec.

At least four priority problems are caused by this gap in the common law jurisdictions. The first problem concerns the status of an unperfected, or unregistered, provincial or territorial security interest in competition with a Bank Act security in the common law jurisdictions. A priority competition between a Bank Act security and a provincial or territorial security interest is generally determined according to their order of creation. The Bank Act security only attaches to the interest that the debtor has in the property. A prior provincial or territorial security interest therefore has priority over a subsequent Bank Act security. The Bank Act provides that a Bank Act security has priority over any subsequent interest. Therefore, a prior Bank Act security has priority over a subsequent provincial or territorial security interest. However, a failure to register a Bank Act security will result in its subordination to competing interests. The problem is that a similar loss of priority does not result when it is the provincial or territorial security interest that is not registered or otherwise perfected. [8] This produces a commercially unacceptable

outcome, as there is no means by which a bank can learn of the existence of the unregistered security interest. This particular problem does not arise in the civil law jurisdiction of Quebec, since the hypothecary (secured) creditors' rights do not arise until the publication of the hypothec (security). [9]

The second problem concerns the priority status of provincial or territorial purchase-money security interests. Under the reformed provincial and territorial secured transactions regimes, a secured party can obtain a single security agreement that will automatically cover new property that is acquired by the debtor after the security agreement is signed. So long as the security interest is properly registered, the secured party will obtain priority over any subsequently registered security interests. An exception is made when the subsequent secured party extends credit to permit the debtor to acquire a new asset. This transaction is referred to as a purchase­money security interest. Often the credit is supplied by a seller who reserves a security interest in the goods that are sold to secure the unpaid purchase price. In other situations, the credit is supplied by a lender who advances funds that enable the debtor to acquire the new asset. So long as certain procedural requirements are satisfied, the holder of the purchase-money security interest will be entitled to priority even though it was not the first to register its interest. For this reason, the rule is sometimes said to create a super-priority favouring the purchase-money security interest.

The priority status of a purchase-money security interest is only partially recognized when a provincial or territorial purchase-money security interest comes into competition with a prior Bank Act security that covers after-acquired property. If the purchase-money security interest was given by a seller, the purchase-money security interest will have priority over the Bank Act security. [10] But if the purchase-money security interest was given by a lender, the bank will be entitled to priority. [11] This creates a hidden trap for the purchase­money lender. Although the lender ordinarily enters into a loan transaction anticipating priority over competing security interests, this expectation can be defeated if the prior security interest is a Bank Act security.

The third problem, which is closely related to the second one, concerns production security interests. Provincial or territorial personal property security legislation provides that a security interest in crops given to enable the debtor to produce or harvest the crops has priority over another security interest given in the same collateral. In addition, most provinces and territories provide a similar priority for animals when the credit enables the debtor to acquire food, drugs or hormones for the animals. Although these production security interests are given priority over a prior provincial or territorial security interest in the crops or animals, the situation changes if the prior secured party is a bank which holds a Bank Act security. In this case, the production security interest super-priority is not available. [12] Instead, priority is given to the bank on the basis of the usual first­in-time rule of priority. This substantially undercuts the value of the production security interest super-priority and makes it more difficult for agricultural and aquaculture producers to finance the acquisition of production inputs.

The fourth problem concerns the status of a bank's claim to the proceeds of a sale of collateral covered by a Bank Act security. Unlike the provincial or territorial personal property security statutes, the Bank Act does not extend its security interest to proceeds. Banks typically include in their security agreements a trust proceeds clause that requires the debtor to hold the proceeds in trust for the bank. There is uncertainty over the application of the provincial or territorial statutes to the bank's claim to the proceeds and uncertainty about the priority rules that would govern the outcome of a dispute between the bank's proceeds claim and a secured party who has a provincial or territorial security interest in the same collateral. [13]

A different set of problems arise and a different analysis must be brought to bear if the interest that is in competition with the Bank Act security is governed by Quebec law. There are at least three situations in which the lack of compatibility between the federal and provincial systems produce significant legal uncertainty. [14] The first situation concerns the unpaid seller's right of resolution, which allows the seller to annul the contract of sale. The right of resolution ordinarily reverts the ownership of the property to the seller retroactively. However, there is uncertainty whether this right can be exercised against property that is subject to a Bank Act security. The second situation concerns the non-compatibility of the Bank Act security provisions when a competition arises with a moveable hypothec. Since the hypothecary creditor's rights are acquired at the time of publication of the hypothec, a Bank Act security has priority over a subsequently published hypothec. This undermines the provincial priority rule giving priority to a vendor who publishes the hypothec within fifteen days of the sale. The third situation concerns property that is subsequently acquired by the debtor. Both the Bank Act security provisions and the civil code permit a lender to cover after-acquired property. It is unclear how a competition between a hypothecary creditor and a bank can be resolved when both claim such property.

A problem common to Quebec and the common law jurisdictions concerns the practice of double documentation under which a bank is given both a Bank Act security and a provincial or territorial interest in the same collateral to secure the same obligation. The issue is whether the bank must choose which interest to rely on, or if it can assert its Bank Act security against one party and its provincial or territorial interest against another party. In Quebec, it is argued that the concept of ownership by the bank is such that double documentation is not conceptually possible, but the matter has not yet been tested in the courts. Some cases in common law jurisdictions suggest that the bank must choose one or the other, [15] while other cases suggest that the bank can pick and choose as it sees fit. [16] Saskatchewan is the only common law province that has dealt directly with this issue. The Saskatchewan legislation provides that a security interest in collateral is void to the extent that it secures payment or performance of an obligation that is also secured by a Bank Act security. [17] The use of overlapping security agreements therefore results in the non-application of the Personal Property Security Act (PPSA) for any collateral on which a bank holds Bank Act security.

c. Dual Registry

One of the fundamental changes brought about by the reform of provincial and territorial personal property security law in the common law jurisdictions, was the creation of a single registry system and a single set of registry principles that govern regardless of the particular form of security agreement used. Under the previous law, the provinces and territories had separate registry systems for different types of security agreements. As well, the registry rules which governed such matters as the duration and renewal of the registration and the effect of non-registration often differed depending on the type of security agreement that was used. A single registry system makes it easier for parties to determine if property that they wish to acquire is subject to pre-existing security interest. They no longer have to conduct multiple registry searches; searching a single registry suffices.

The co-existence of the Bank Act security regime with the provincial/territorial security regimes frustrates the ideal of a single registry system. A party must search both the provincial/territorial registry system and the federal Bank Act registry whenever dealing with the kinds of goods that might be subject to a Bank Act security. Multiple searches add an additional layer of costs. Over the past four years, annual search fees collected by the registry are, on average, in excess of one million dollars. [18] Since private search and registration companies conduct many of the registry searches, the fees paid by searching parties are actually considerably higher than this figure.

In addition to the direct costs of conducting additional registry searches, there are other costs associated with a dual registry system. The existence of two registry systems, each governed by their own set of registration rules, increases the chances of legal error. If a searching party does not realize that the collateral may be subject to a Bank Act security, they may not search the Bank Act registry. Alternatively, a searching party may conduct a search, but choose the wrong registry office. [19] As well, the federal registry places a greater burden on searching parties when there has been a change of name or a transfer of the collateral to another person.

d. The Pre-emption of Provincial/Territorial Legislative Objectives

In several instances, the approach taken by the federal provisions conflicts with the legislative objectives of valid, in force provincial/ territorial legislation. A good example of this phenomenon involves the application of provincial or territorial legislation that restricts the ability of a secured party to enforce a security interest on a default by the debtor.

The Bank Act security provisions set out a number of rules that govern the enforcement of the security in the event of default. [20] The bank is given the right to seize and sell the goods. This statutory right is in addition to other contractual rights that may be conferred upon the bank by the security agreement. In exercising these rights, the bank must act honestly and in good faith and must give the debtor reasonable notice of the sale and must deal with the property in a timely and appropriate manner with regard to the nature of the property and the interests of the debtor. The Bank Act provisions do not give the bank the right to appoint a receiver–manager, and this deficiency, together with the inability to confer an all-encompassing security interest on all of the debtor's present and after-acquired personal property, explains why a Bank Act security is now widely regarded as an inferior security device.

There is, however, one situation in which Bank Act security may be seen as providing banks with an advantage that is not available under provincial or territorial law. The provinces and territories impose limitations on the enforcement remedies of secured parties in certain instances. Usually these restrictions relate to secured consumer credit transactions. For example, in some provinces a secured party is prohibited from suing for a deficiency after the collateral is sold pursuant to an enforcement sale. In others, certain types of goods that are needed by the debtor to gain a livelihood are exempt from enforcement. Because the Bank Act security cannot be taken to secure a consumer credit transaction, no problem arises in these cases. However, to the extent that the remedies of secured parties are restricted in relation to business or agricultural financing, there exists a potential for conflict between the federal and provincial/territorial legislative provisions. This conflict is largely limited to Saskatchewan. Saskatchewan has legislatively restricted the enforcement remedies of secured parties in relation to farming operations to a much greater extent than other provinces and territories.

The federal Bank Act provisions provide that on default a bank has the right to seize and sell the collateral. The Saskatchewan farm protection statutes prohibit a secured party from enforcing its security interest against the collateral. This constitutes an operational conflict between the federal and provincial statutes. This conflict is resolved by the paramountcy doctrine which gives precedence to the federal statutes and renders the provincial or territorial statute inoperative. [21] This means that the Saskatchewan farm protection legislation operates when a non-bank creditor, such as a credit union, is involved and when a bank chooses to take a provincial security agreement rather than a Bank Act security to secure the obligation. However, a

bank that takes a Bank Act security on the collateral is immune from any provincial limitations on the statutory enforcement remedies.

The federal pre-emption of provincial and territorial legislation undermines the legislative policy objectives in other jurisdictions as well. In Alberta, the legislation curtails the self-help remedies of secured parties and lessors. [22] Any seizure or repossession of personal property by a secured party must be carried out by a properly licensed and bonded civil enforcement bailiff. However, because of federal paramountcy, this restriction does not apply to banks. Therefore, banks can use private bailiffs to effect seizures whereas no other secured party can. [23]

1. Bank Act, s. 427(2)(d).

2. Bank Act, s. 428(2).

3. See B. Crawford and J.D. Falconbridge, Banking and Bils of Exchange, Vol. 1, 8th ed., (Toronto: Canada Law Book, 1986) at 446–8; J.S. Ziegel, “Interaction of Provincial Personal Property Security Legislation and Security Interests under the Bank Act” (1986–87) 12 Canadian Business Law Journal73 at 84–8; R.C.C. Cuming and R.J. Wood, “Compatibility of Federal and Provincial Personal Property Security Law” (1986) 65 Canadian Bar Review 267 at 273–4.

4. Bank Act, s. 427(2)(c).

5. See R.A. Macdonald, “Security Under Section 178 of the Bank Act: A Civil Law Analysis” (1983) 43 Revue du Barreau 1008.

6. Bank Act, s. 427(1).

7. Bank Act, s. 429(1).

8. Rogerson Lumber Co. Ltd. v. Four Seasons Chalet Ltd. (1980), 113 D.LR. (3d) 671; Bank of Nova Scotia v. International Harvester Credit Corp. of Canada Ltd. (1990) 74 O.R. (2d) 738 (C.A.).

9. P. Ciotola, Droit des sûretés, ^3rd éd., (Montréal: Thémis, 1999) at 359.

10. Kawai Canada Music Ltd. v. Encore Music Ltd. (1993), 10 Alta. L.R. (3d) 105 (C.A.); YMCFv. 406248 B.C. Ltd. (1998), 52 B.C.L.R. (3d) 359 (B.C.S.C.).

11. Royal Bank of Canada v. Moosomin Credit Union, [2003] S.J. 749 (C.A.).

12. United Grain Growers Ltd. v. Royal Bank of Canada, [2001] 6 W.W.R. 677 (Sask. C.A.).

13. See R.C.C. Cuming and R.J. Wood, “Compatibility of Federal and Provincial Personal Property Security Law” (1986) 65 Canadian Bar Review 267 at 292–301; J.S. Ziegel and D.L. Denomme, The Ontario Personal Property Security Act: Commentary and Analysis, 2^nd ed., (Markham: Butterworths Canada, 2000) at 52–5.

14. See M. Poirier, “Security under Section 427 of the Bank Actand Provincial Law: Interaction, Harmonization and Reform” [unpublished report provided by the author and archived at the Law Commission of Canada] at 94–9.

15. Kassian v. National Bank of Canada, (1998), 61 Alta. L.R. (3d) 92 (Q.B.).

16. Bank of Nova Scotia v. International Harvester Credit Corp. of Canada Ltd., (1990) 74 O.R. (2d) 738 (C.A.).

17. S.S. 1993, c. P-6.2, s. 9(2).

18. Supra note 14, Appendix B.

19. Under provincial law, registration of a security interest in goods is generally effected in the location of the collateral (although an exception is made in the case of certain types of highly mobile goods). Under the Bank Act, the registration must be effected in the jurisdiction where the debtor is located.

20. Bank Act, s. 428(7)–(11).

21. Bank of Montreal v. Hal, [ 1990] 1 S.C.R. 121; Kovlaske v. Canadian Imperial Bank of Commerce (2002), 39 C.B.R. (4^th) 43 (Sask. Q.B.).

22. Civil Enforcement Act, R.S.A. 2000, c-15, s. 9(3).

23. See Canadian Imperial Bank of Commerce v. Sledz, [1991] 1 W.W.R. 42 (Alta. Q.B.).