Federal Security Interests Research Study and Report 2000

IX. BANKRUPTCY ISSUES

The provincial PPSA ensures that secured creditors enjoy two important advantages over unsecured creditors:; (1); Secured creditors can seize and sell collateral without having to seek judicial or other third party assistance and (2); secured creditors, provided they follow the appropriate registration procedure, are given priority in the distribution of proceeds from the forced sale of collateral.; The federal Bankruptcy and Insolvency Act ("BIA") does not change this basic structure.; The BIA does, however, impact on secured creditors in a multitude of different ways, with the result that the provisions of the BIA represent an important factor in the decision-making process of secured creditors faced with a defaulting debtor.; For the most part, the impact of the BIA actually enhances the position of secured creditors, thereby encouraging them to petition insolvent debtors into bankruptcy.; A summary of the relevant legislative and regulatory provisions is provided in Appendix I.

A. The Impact of the BIA on Priorities

Sections 136 to 147 of the BIA sets out a scheme for determining priorities among creditors in the event of bankruptcy.; The list of priorities set out in s. 136 is made "Subject to the rights of secured creditors".; In other words, the priority scheme that prevails under the PPSA, which gives secured creditors who have properly registered their security first priority, after only statutory Crown trusts and liens, remains intact under the BIA:; Secured creditors are permitted to realize their security as if there were no bankruptcy. In fact, in respect of statutory Crown trusts and liens, the priority position of secured creditors may even be better under the scheme established by the BIA.;

1. Crown Claims and Secured Creditors under the BIA

The relative priorities of statutory claims and secured creditors are significantly affected, and in many cases reversed, if the debtor becomes bankrupt.; Section 86(1) of the BIA provides that all claims of the federal and provincial Crown, including secured claims, and all claims of a workers' compensation body rank as unsecured claims in a bankruptcy, unless the claims have been registered in the manner contemplated by s. 87.; Section 87 requires that Crown securities be registered in a general system of registration of securities that is available to any creditor and is open for public inspection.; In provinces with PPSA legislation, this would mean that Crown securities would have to be registered under the PPSA.; Section 87(2) ensures that Crown securities registered under the PPSA will not have any super-priority over other secured claims.; Crown securities are subject to the same "first to register" formula for determining priority as are other secured creditors.

Section 67(2) of the BIA provides that, notwithstanding any provision in federal or provincial legislation that has the effect of deeming property to be held in trust for Her Majesty, property of a bankrupt shall not be regarded as held in trust for Her Majesty unless it would be so regarded in the absence of that statutory provision.; Accordingly, in order to take priority the deemed trust must be valid at common law.; The only exception to this rule is made for the claims of Revenue Canada for income tax source deductions and for Employment Insurance and Canada Pension Plan remittances [s. 67(3)].

2. Landlord's Right of Distraint under the Commercial Tenancies Act

The Commercial Tenancies Act gives landlords the right to seize and sell the assets of tenants in order to satisfy arrears of rent.; The right of distraint applies to all goods on the premises that are owned by the tenant, regardless of whether they are subject to a security interest.; Furthermore, case law has held that the right of distraint is not limited to the extent of the tenant's equity in the goods:; Commercial Credit Corp. Ltd. v. Harry D. Shields Ltd. (1980), 29 O.R. (2d) 106, aff'd 32 O.R. (2d) 703.; It is also worth noting that a landlord can seek to distrain even after a receiver takes possession of the premises.

A landlord's right to distrain is significantly affected where a bankruptcy intervenes.; Section 136(1)(f) of the BIA provides that upon the bankruptcy of the tenant, the landlord's right to distrain is replaced by a preferred claim for up to three months arrears of rent and three months accelerated rent.; As preferred claims are subject to the rights of secured creditors, the practical effect of s. 136(1)(f) is to give secured creditors priority over landlords seeking to distrain.; The result is often a race between landlord and secured creditor to see which party will move more promptly to exercise its rights.

The above-noted examples illustrate how the position of secured creditors in respect of priority can be strengthened considerably in the event of bankruptcy.; This strengthening of position should be kept in mind by a secured creditor planning its strategy in a situation where a possibly insolvent debtor has defaulted.; The courts have ruled that there is nothing wrong with a secured creditor petitioning the debtor into bankruptcy in order to obtain priority over a preferred creditor:; Re Fresh Air Fireplaces of Canada Ltd. (1986), 62 C.B.R. (N.S.) 39, aff'd 65 C.B.R. (N.S.) 21 (Alta. C.A.).; This ruling makes the BIA a potentially useful strategic tool in the hands of secured creditors.

B. Notice Requirements under the PPSA and the BIA

1. Notice Requirements under the PPSA and at Common Law

Section 63(4) of the PPSA requires secured creditors to give not less than fifteen days notice to the debtor and other interested parties before disposing of the collateral.; Section 63(7) describes circumstances in which such notice is not required.; For example, notice is not required where the the collateral is perishable or where the secured party believes on reasonable grounds that the collateral will decline speedily in value.; "Reasonable grounds" is determined in accordance with the case law.; The common law imposes its own notice requirement on secured creditors.; The leading case of Lister v. Dunlop (1982), 135 D.L.R. (3d) 1 established that secured creditors must provide reasonable notice, to be determined in light of all of the surrounding circumstances, before enforcing their security. The courts have recognized that in certain circumstances it may be reasonable for a creditor to give little or no notice before taking steps to enforce its security.; For example, the creditor may have a justifiable apprehension of dishonesty on the part of the debtor or that the collateral will be dissipated.

The common law requirement to give reasonable notice places the secured creditor in the difficult position of having to determine, typically armed with imperfect information, what constitutes reasonable notice in the circumstances.; The decision is one that must be made with care, as the result of insufficient notice may be a substantial claim for damages against the enforcing creditor.; As compared with the common law requirement, the fifteeen day notice period prescribed by the PPSA actually represents a welcome measure of certainty for secured creditors.

2. The Notice Requirement under the BIA

Section 244(1) of the BIA provides that secured creditors intending to enforce a security on all or substantially all of (a) the inventory, (b) the accounts receivable or (c) the other property of an insolvent person that was acquired for , or is used in relation to, a business carried on by the insolvent person shall send to that insolvent person, in the prescribed form and manner, notice of that intention. The section 244 notice requirement prevails over security agreements which provide for immediate enforcement upon default.; Service of the section 244 notice triggers a ten day statutory freeze during which secured creditors are prohibited from enforcing their security.; The ten day freeze is designed to allow the debtor time to attempt to put its financial affairs in order.; It applies only to insolvent, as opposed to bankrupt debtors, as presumably the extra time would be of no use to the latter.

While at first impression s. 244 might seem to impose a burden on secured creditors, the ten day notice requirement actually provides some welcome certainty to secured creditors trying to determine what constitutes reasonable notice.; As long as the debtor is insolvent and no special circumstances exist, secured creditors can be confident that the ten day notice will be sufficient to satisfy the common law demand to provide reasonable notice.; This is preferable to having to guess at what a court might consider to be reasonable notice under the circumstances.; The fact that the notice period is shorter than that provided for under the Ontario PPSA is also to the benefit of secured creditors.

The risk that debtors might dispose of the collateral during the ten day notice period is dealt with in s. 47 of the BIA.; Section 47 allows the court to appoint a trustee as interim receiver of all or any part of the debtor's property that is subject to the security to which the s. 244 notice relates.; The court has the authority to bestow broad powers on the interim receiver, including the power to take possession of the debtor's property or exercise control over the debtor's business.; In order to obtain the appointment of an interim receiver, the onus is on the applicant creditor to show that the appointment is necessary for the protection of (a) the debtor's estate or (b) the interests of the creditor.; To come within (b), the creditor must show that there is an actual and immediate danger of dissipation of the debtor company's assets to the detriment of the creditor's security:; Royal Bank v. Zutphen Brothers Construction Ltd. (1993), 17 C.B.R. (3d) 314 (N.S.T.D.).

Similar to s. 244, s. 47 creates a statute-sanctioned procedure for what would otherwise be a "self-help" decision on the part of the creditor.; Obtaining the court's sanction may be preferable to taking immediate enforcement steps based on the belief that assets are about to be squandered.; The latter action exposes creditors to the risk of liability, a risk that is often difficult to assess beforehand.

In terms of the requirement to give notice, the BIA helps both creditors and debtors by adding certainty to an otherwise uncertain process.; The procedures established under ss. 244 and 47 improves the lot of the secured creditor as compared to a situation involving a non-insolvent debtor.

C. The Interplay Between the BIA and the Customs Act

The Customs Act provides that the Crown is entitled to a lien against all goods imported into Canada for which duty has not been paid.; Typically the duty is paid by a customs broker on behalf of the importer.; The customs broker adds the cost of the duty to its account for reimbursement by the importer.; Case law has established that, as the sole purpose of this lien is to secure a claim of the Crown, the customs broker is entitled to step into the shoes of the Crown.

A problem arises where a customs broker acquires possession of goods against which the Crown has a lien for unpaid customs duties, and the importer subsequently becomes insolvent or goes bankrupt.; Section 87 of the BIA provides that a statutory lien whose sole purpose is to secure a claim of the Crown is only valid in relation to a bankruptcy if it is registered.; Section 87 is silent as to security interests perfected by possession.; As custom brokers' liens are not usually registered, the effect of s. 87 is to invalidate the lien.; As the customs broker is thus not considered to be a secured creditor, s. 69 of the BIA ensures that upon the filing of a notice of intention or of a proposal the customs broker will be unable to take any enforcement remedy against the property it holds, including disposing of same.; At the same time, if the customs broker releases the property to the importer, it loses its status as a perfected secured creditor pursuant to provincial PPSA legislation.; The result is that the customs broker may end up retaining possession of the goods indefinitely, with no right to enforce its security.; In terms of commercial realities this creates a lose-lose situation.; Goods retained by the customs broker for an extended period of time are likely to lose much of their value.; Not having access to its inventory puts an insolvent debtor in an impossible position in terms of staying afloat and putting forth a realistic proposal.; Other creditors also stand to lose if the value of the collateral decreases.

The legal stalemate created by the interplay between the Customs Act and the BIA has been the subject of judicial criticism.; The case of Solemate Calderone Corp. v. Peace Bridge Brokerage Ltd. (July 21, 1998), Toronto 31-346242 (Ont. Gen. Div., per Farley J.) [hereinafter "Solemate Calderone"] involved a shoe store chain ("Solemate") that had filed a Notice of Intention to File a Proposal and was in the process of trying to put together a reasonable proposal.; Solemate's efforts in this regard were thwarted by the fact that Peace Bridge, a customs broker to which Solemate owed some $300,000, had seized a large shipment of goods.; The goods in question were seasonal shoes, the value of which would quickly diminish if left to languish in storage. ;Solemate argued Peace Bridge should be forced to relinqish the goods, as possession of the goods was crucial to the success of its proposal.; Peace Bridge argued that giving up the goods would cause it to lose its possessory lien pursuant to the PPSA.; Peace Bridge also relied on the contract between itself and Solemate, which provided that Peace Bridge was entitled to retain possession of goods until it had been paid in full.; Farley J. held that as a matter of contract Peace Bridge was not required to give up possession of the goods.; However, the court also held that pursuant to s. 69 of the BIA, Peace Bridge was not entitled to sell or dispose of the goods.; The court went on to criticize "the awkwardness of the BIA and meshing it with the Customs Act", but refused to grant Peace Bridge a stay under s. 69(4) of the BIA to allow it to dispose of the goods.

The problems canvassed in Solemate Calderone could be solved if the BIA were amended to recognize both registration and possession as benchmarks for determining the validity of Crown secured claims.; In the alternative, the BIA could be amended to force an unregistered secured creditor in possession of goods to release the goods to the debtor where the debtor can show that the goods are required to enable it to put forward a viable proposal.; This approach would be in keeping with the line of case law that recognizes that the promotion of reorganizations is an "underlying fundamental" of the BIA.; In any event, reform of some kind would be welcome.; A large number of Canadian companies are involved with the importation of goods, and it is inevitable that some of these companies will become insolvent each year.

D. Conclusion

For the most part, the BIA does not alter the regime for dealing with secured creditors established by the provincial PPSA.; The BIA allows secured creditors to retain their priority and enforcement rights.; In fact, the BIA in some circumstances serves to enhance the rights of secured creditors. This in turn makes the BIA a potentially useful weapon for secured creditors seeking to enforce their security.

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