ADVANCED ASSET BASED LENDING

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1 INSIGHT CONFERENCE ADVANCED ASSET BASED LENDING SECURING AND ENFORCING ON ABL RECEIVABLES Tuesday, May 10, 2011 Jason Arbuck Telephone: (416) Cassels Brock & Blackwell LLP Barristers & Solicitors Scotia Plaza, Suite King Street West Toronto, Ontario M5H 3C2 Joe Bellissimo Telephone: (416) Cassels Brock & Blackwell LLP Barristers & Solicitors Scotia Plaza, Suite King Street West Toronto, Ontario M5H 3C2 Admin*

2 Legal Issues in Receivables Financing One way for a business to raise money is to leverage its accounts receivables. The term receivables financing is often used to describe this general concept, though there are a number of specific ways that accounts receivables may be leveraged. Most notably are factoring arrangements and asset based lending arrangements. This paper will outline some of the basic legal issues relating to receivables financing. Part I: Receivables Financing Basics First, a note on terminology. Throughout this paper, the terms used in the personal property security legislation throughout the common law Provinces of Canada will be used wherever possible. Following is a quick summary of those terms. The term accounts is used when referring to accounts receivables. Asset based lending arrangements will involve a debtor granting a security interest in its accounts to secure obligations for a loan made by a lender. Factoring arrangements involve an absolute assignment or true sale of accounts by a debtor to a factor. The party borrowing money or selling receivables is a debtor. The customers of the debtor who owe money to the debtor are account debtors. A secured party may be either a factor or a lender. While all types of debtors may seek financing by assigning their accounts, the following are some of the more typical debtor profiles: 1. Debtors who need additional working capital as a result of recent growth, especially where purchase orders significantly larger than past purchase orders are being placed. 2. Debtors with accounts from foreign customers that cannot be leveraged by the debtor s bank lender. 3. Debtors who are in the start up phase and cannot yet secure sufficient financing for working capital. 4. Debtors completing a poor year of financial results who are being pushed to payout or pay down a bank until their financial situation improves. A debtor can assign its accounts to a lender or factor in a range of different transactions. The effect of the assignment is that the lender or factor is assigned the right to receive payment from the account debtor. The lender or factor essentially assumes the position of the debtor prior to the assignment. The following are examples of the most common receivables financing structures: 1. Factoring vs. Asset Based Lending. The debtor can absolutely assign accounts to a factor. This may be accomplished by transferring a single account to the factor or by entering into a financing agreement pursuant to which accounts are sold to a factor on a regular basis, subject to a set of continuing covenants. Alternatively, a lender can lend funds to a debtor based on the value of the debtor s accounts and take a security interest in such accounts. All else being

3 equal, a factor who takes an absolute assignment of an account will have more protection than a lender with a security interest in an account. 2. Recourse. A factoring arrangement may be with recourse or without recourse. An arrangement with recourse will require the debtor to buy back or otherwise be responsible for those accounts that the factor is unable to collect. An arrangement without recourse requires the factor to bear the risk of noncollection. All other things being equal, an arrangement without recourse carries greater risk for the factor and, accordingly, will be more expensive for the debtor. Where an arrangement is with recourse, often additional security is taken from the debtor in order to support the debtor s recourse obligations. Although security given to support recourse obligations may be against specific assets, it is typically against all assets of the debtor (i.e. general security ). 3. Notice. Some factoring arrangements are with notice and some are without notice. Factoring arrangements with notice require the account debtors to be notified of the assignment of the account at the time the account arises. In arrangements without notice, the account debtors have no knowledge that the accounts have been assigned. Arrangements with notice provide the factor with greater control over the accounts, but allow the debtor s customers to gain insight as to the debtor s financing arrangements. Many debtors prefer that their customers not know about their financing arrangements and, accordingly, would prefer arrangements without notice. While providing notice to account debtors is not legally required, providing notice may be useful or necessary to (i) require the account debtor to directly pay the secured party as opposed to paying the debtor, and (ii) cut off an account debtor s right to set off against the accounts in respect of obligations arising subsequent to the delivery of notice. A compromise between the control that the secured party seeks and the confidentiality that the debtor seeks involves the proceeds of the accounts being delivered by the account debtors directly to a lockbox and then deposited into a bank account by a third party bank. No notice is provided to the account debtor as the bank account remains in the name of the debtor. However, by entering into a three-way control agreement between the debtor, the secured party and the bank that maintains the accounts, the bank agrees to take instructions regarding the lockbox and the bank account only from the secured party. Part II: Key Legal Issues There are number of key legal issues and/or pitfalls that a factor or secured party should be aware of when taking an assignment of accounts. 1. True Sale vs. Security Interest If a factor intends to take an absolute assignment of accounts (as opposed to a security interest), then the factor must be sure the assignment is a true sale. In order for a

4 true sale of an account to be effective against the debtor and its other creditors, the factoring agreement must be absolutely clear and consistent in stating that the transaction is an absolute transfer of accounts and not merely a security interest. 2. Anti-assignment Clauses in Customer Contracts Section 40(4) of the Personal Property Security Act ( PPSA ) helps facilitate the assignment of whole accounts even where a customer contract contains terms restricting such assignment by rendering such a restriction unenforceable against the secured party. The section reads as follows: A term in the contract between the account debtor and the assignor that prohibits or restricts the assignment of, or the giving of a security interest in, the whole of the account or that requires the account debtor s consent to such assignment or such giving of a security interest, (a) is binding on the assignor only to the extent of making the assignor liable to the account debtor for breach of their contract; and (b) is unenforceable against third parties. Note that Section 40(4) only applies to the assignment of the whole of an account. The validity of an anti-assignment clause preventing the assignment of partial accounts will not be rendered automatically unenforceable under the PPSA. Accordingly, Lenders and factors should review contracts between the debtor and its account debtors (i.e. customer contracts) for provisions that limit the assignment of partial accounts. 3. Crown Account Debtors Requirements regarding notice of assignment may differ depending on the identity of the account debtor. Most importantly, if the Crown is the account debtor, there is a process for providing notice to the Crown under the Financial Administration Act that must be followed in order for the assignment to be effective against the Crown. Obviously, having the assignment effective against the Crown is critical to the secured party if it needs to enforce its rights. Section 67 of the Financial Administration Act generally prohibits the assignment of Crown debts. Section 68, however, permits absolute assignment, in writing and under the hand of the assignor, not purporting to be by way of charge only, of Crown debts due under a contract, as well as prescribed class Crown debts. The absolute assignments of Crown debts are valid only if notice is given according to Section 69. Notice is given to the Crown by serving the Receiver General or paying officer the notice of the assignment with a copy of the assignment. Notice is deemed served when the paying officer sends acknowledgement of the notice to the assignee by mail. Thus, the secured party should be aware of notice requirements contained in other legislation that would be applicable to the account debtor.

5 4. Representations, Warranties, and Due Diligence The secured party can require the debtor to make certain representations and warranties regarding the accounts. Some of the key representations are: 1. The accounts are bona fide; 2. Existing obligations of the debtor s customers arising from and created in the ordinary course of business and owing to the debtor are not subject to defence, set-off, or counterclaim and not contingent upon the fulfilment of any obligation or condition; 3. Each account is an accurate and undisputed statement of indebtedness by the customer to the debtor; and 4. The debtor has supplied the goods or services that make up the approved account. The secured party should review the invoices issued in respect of the accounts to determine the amounts owed. The secured party should also confirm that the goods or services were actually delivered to the account debtor, thus establishing the account. The secured party can review shipping papers if goods were delivered and obtain confirmation from the account debtor that it received the goods or services in full and, for the goods, in good order and condition. It is not unusual for a secured party to confirm these matters directly with the account debtors prior to advancing funds. 5. Notice to the Account Debtor As referenced above, providing notice to an account debtor may be useful or necessary to (i) require the account debtor to pay the secured party directly as opposed to paying the debtor, and (ii) cut off an account debtor s right to set off against the accounts in respect of obligations arising subsequent to the delivery of notice. Section 40(2) of the PPSA states that an account debtor may pay the debtor until the account debtor receives notice that reasonably identif[ies] the relevant rights [and] that the account has been assigned. What is reasonable will depend on all the circumstances. For instance, a notice to a small account debtor will require less information than notice to a government department or a large corporation handling hundreds of accounts. If the account debtor requests proof of the assignment, the lender or factor must provide such proof within a reasonable time. If the lender or factor does not provide the proof, the account debtor may continue to pay the debtor. Section 68(2) of the PPSA provides the requirements for service to account debtors. The following is a summary of the key rules relating to service: 1. Individuals may be served by personal service, courier, or mail to the individual s residence or business, fax, and .

6 2. Partnerships may be served by personal service, , or fax upon a partner or a person having control or management of the partnership business at the principal place of business of the partnership and by courier or mail to the partnership, one of the partners, or person controlling or managing the business. 3. Corporations may be served by personal service upon, fax or to any officer, director or agent of the corporation or manager of the office where the corporation carries on business and courier or mail to its registered or head office, or fax or to its head of council or chief administrative officer at its principal office. 4. Out-of-province individuals, partnerships, or corporations may be served by personal service upon the individual, partnership or body corporate carrying on the business in Ontario, or in the case of a corporation incorporated or continued under the laws of a jurisdiction outside of Canada or an extraprovincial limited partnership under the Limited Partnerships Act, upon the agent or attorney for service in Ontario ; courier, fax, , or mail to the address of the individual, partnership, body corporate, agent or attorney. 5. Notice sent by mail is deemed to have been served on the earlier of the addressee s actual receipt of the notice or expiry of 10 days after the registration of the security interest. 6. Notice sent by fax or is deemed to have been served on the earlier of addressee s actual receipt of the notice or the first business day after the day of transmission. 7. Section 69 of the PPSA states that a person is notified when service is effected in accordance with section 68 or the regulations or in the following circumstances: (a) In the case of an individual, when information comes to his or her attention under circumstances in which a reasonable person would take cognizance of it ; (b) (c) In the case of a partnership, when information has come to the attention of one or more of the general partners or of a person having control or management of the partnership business under circumstances in which a reasonable person would take cognizance of it ; or In the case of a corporation, when information has come to the attention of a senior employee of the corporation with responsibility for matters to which the information relates under circumstances in which a reasonable person would take cognizance of it. The Ontario Superior Court of Justice case RPG Receivables Purchase Group Inc. v. Krones Machinery Co. exemplifies the circumstances in which an account debtor is given adequate notice of assignment of the account. The court determined notice was adequate for several reasons. The debtor was clear in conveying to the account debtor

7 the fact that it had assigned the account to the factor, RPG, and that payments should be made to RPG. The debtor faxed the account debtor a notification that the debtor had assigned to RPG its right, title and interest in all currently outstanding as well as all future accounts receivable from the account debtor. The debtor also requested that the account debtor make its payments directly to RPG. The notification also stated that RPG s receipt of payment was the only valid discharge of the debt and that RPG s interest was registered under the PPSA. Additionally, all the invoices the account debtor received from the assignor had a stamp stating in bold and capital font the notice of assignment to RPG, that payments should be made directly to RPG, and the address of RPG. The account debtor also signed an acknowledgement of the notification and entered into a payment agreement with the factor. The notification required the account debtor to sign and send to RPG a copy of the notification letter to acknowledge the notification and form a separate agreement with RPG concerning payment of the invoices. The account debtor returned the executed copy of the notification of assignment to RPG. Absolute assignments are subject to certain requirements in the Conveyancing and Law of Property Act. According to Section 53(1) of the Act, absolute assignments by writing under the hand of the assignor, not purporting to be by way of charge only must be unequivocal and express to be effective. The notice of assignment, therefore, should not be just a direction to the account debtor to pay the factor. The notice should indicate that the direction to pay results from an assignment of the debt. The form of notice should not only comply with the relevant legislation, but it also must comply with the requirements stated in the customer contract between the debtor and the account debtor. In the Ontario Superior Court of Justice case Centurion Capital Corp. v. Wal-Mart Canada Inc., for instance, the customer contract between the debtor and its account debtor expressly excused the account debtor from honouring an assignment where notice was not given pursuant to the terms of the agreement. The court in Centurion Capital Corp. confirmed the following principle: In an assignment, the assignee steps into the shoes of the debtor and takes subject to any equities between the debtor and the account debtor as of the date at which notice is given of the assignment. The judge stated the account debtor had a right to impose contractual obligations on the debtor and to be able to rely on those terms because if an assignee were allowed to ignore the equities such as an existing contract between the assignor and the debtor it could place the assignee in a better position than the assignor, simply by failing to make due enquiry... In Centurion Capital Corp., the court only required the customer to pay the outstanding amounts on invoices that arose after the date notice was given to the account debtor in the manner required by the customer contract. 6. Proceeds The PPSA defines proceeds as identifiable or traceable personal property in any form derived directly or indirectly from any dealing with collateral or the proceeds therefrom, and includes:

8 ... (b) any payment made in total or partial discharge or redemption of an intangible, chattel paper, an instrument or investment property, and (c) rights arising out of, or property collected on, or distributed on account of, collateral that is investment property. In other words, where the debtor assigns an account to a factor, a lender s security interest in that account will continue to be a security interest in the account and enforceable against the factor. As well, when the account is collected by either the debtor or the factor, the security interest of the lender will continue to be a security interest in the cash received provided such cash continues to be identifiable and traceable. Understanding how a lender s security interest extends to proceeds is critical to factors and lenders who engage in receivables financing of any nature. In March 2010, the Superior Court of Justice in Ontario heard Bank of Nova Scotia v. IPS Invoice Payment System Corporations, which is an important Ontario case on the subject of proceeds and receivables financing. In short, Blooming Rose granted a first priority security interest in all its property to Bank of Nova Scotia ( BNS ) to support certain credit facilities. Blooming Rose subsequently entered into a factoring agreement with IPS, with recourse. It was clear that the IPS arrangement was subordinate to the BNS security interest and that BNS had not consented to the IPS factoring arrangement. During the relevant time period, IPS paid (all numbers are approximate) $1.7M to Blooming Rose for accounts it purchased with a face value of $1.85M. This $1.7M was used to pay down BNS s credit facility. $1.6M was collected by IPS from account debtors. BNS was not repaid in full and claimed against IPS for the $1.6M that IPS had collected from account debtors since according to the PPSA, BNS s security interest extended to such proceeds. While the court was satisfied that BNS s security interest extended to both sets of proceeds (i.e the $1.7M it had received, as well as the $1.6M that IPS was holding), BNS was not entitled to recover both $1.7M and $1.6M. The court decided that BNS s recovery was limited to the face value of the accounts that were factored which was approximately $1.85M. In its reasoning, the court cited the following (i) this result struck a balance between the interests of the parties, (ii) the result provided greater certainty for parties engaging in these types of transactions going forward, (iii) BNS should not have been entitled to a windfall since it knew only of the original receivables amounting to $1.85M when it advanced funds to Blooming Rose, and (iv) the result brought Ontario law into conformity with all other provinces governed by PPSA legislation. The key lesson for factors from this case is to obtain consent from prior secured parties and to enter into appropriate intercreditor agreements at the outset.

9 Part III: Special Issues to Consider in Enforcing Against Accounts Receivable There are a number of important matters to consider when seeking to enforce on accounts, some of which are addressed in the balance of this paper. 1. Enforcement Notice Requirements Not Just for General Secured Creditors Pursuant to the Bankruptcy and Insolvency Act (Canada) ( BIA ), a secured creditor must give the debtor 10-days advance notice of intended enforcement on security, including where the enforcement may be against all or substantially all of the business s accounts. In particular, section 244(1) of the BIA provides that: A secured creditor who intends 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 used in relation to, a business carried on by the insolvent person shall send to that insolvent person, on the prescribed form and manner, a notice of that intention. Thus, the requirement applies where the secured party is intending to enforce against all or substantially all of the accounts of an insolvent person where the accounts were acquired for or used in relation to a business. The term insolvent person is defined in the BIA as: A person who is not bankrupt and who resides, carries on business or has property in Canada, whose liabilities to creditors provable as claims under this Act amount to one thousand dollars, and (a) who is for any reason unable to meet his current obligations as they generally become due, (b) who has ceased paying his current obligations in the ordinary course of business as they generally become due, or (c) the aggregate of whose property is not, at a fair market valuation, sufficient, or, if disposed of at a fairly conducted sale under legal process, would not be sufficient to enable payment of all his obligations, due and accruing due. Where notice is required under section 244(1) of the BIA, the secured party is not entitled to enforce on the security until the expiry of 10 days after sending the notice, unless the debtor consents to an earlier enforcement. However, under section 244(3) of the BIA, advance consent to early enforcement is not permitted.

10 2. Direct Collection of Accounts Receivables Other than in situations in which all ordinary course payments by an account debtor are to be paid to the secured party (as discussed earlier in this paper), the most important enforcement right when dealing with security against accounts is the ability to collect on the accounts directly from the account debtor to bypass the debtor or its estate. The PPSA specifically addresses that enforcement/collection right. In particular, section 61(1) of the PPSA provides that: Where so agreed and in any event upon default under a security agreement, a secured party is entitled: (a) to notify any person obligated on an account or on chattel paper or any obligor on an instrument to make payment to the secured party whether or not the assignor was theretofore making collections on the collateral; and (b) to take control of any proceeds to which the secured party is entitled under section 25. Therefore, section 61(1) recognizes and acknowledges that the secured party may have the right to pursue the account debtor directly under the security agreement and contemplates the exercise of that right even before default. But, it also goes on to provide that such right is available post-default irrespective of whether the right is provided in the security agreement. However, section 61(2) creates certain protections for the debtor. It requires that that the secured party proceed in a commercially reasonable manner when exercising its collection rights. As explained by Professor Richard McLaren: For example, a secured party may have an interest in an account of the debtor which itself has an account debtor. This account debtor may be insolvent and the secured party may have the right to settle or compromise that debt. By providing that the secured party must proceed in a commercially reasonable manner, s. 61(2) may prevent the secured party from dumping the account. 1 However, the protection only applies where the secured party is by agreement entitled to charge back uncollected collateral or otherwise to full or limited recourse against the debtor. If there is no recourse back to the debtor, then the debtor is considered to have no legal interest affected by the secured party s conduct and, accordingly, the secured party is not required to proceed in a commercial reasonable manner when exercising the collection rights. 2 Section 61(2) also provides that in these situations, the secured party may deduct reasonable expenses of realization from the collection. 1 R.H. McLaren, The 2010 Annotated Personal Property Security Act (Toronto: Carswell, 2010), pp R.H. McLaren, The 2010 Annotated Personal Property Security Act (Toronto: Carswell, 2010), p. 415.

11 Where collection rights under section 61 have been taken by the secured party, the PPSA also governs how any surplus collection are to be handled if there are any after realizing proceeds sufficient to satisfy the security interest and the expenses of the secured party. In particular, section 64 of the PPSA provides that where the secured party has dealt with collateral under section 61, the secured party must account for and pay over any surpluses to the next entitled parties, as stipulated in the section. The section also provides for mechanisms to require proof of an interest in the surplus (s. 64(2)) and to pay the surplus into court where there is a question as to who is entitled to payment of the surplus (s. 64(4)). 3. Collection on Crown Accounts Enforcing on federal Crown accounts creates additional difficulties and considerations in light of the general prohibitions against and restrictions on the assignment of federal Crown debts under Sections 67 to 69 of the Financial Administration Act ( FAA ), as discussed earlier. It is clear that an attempt to take a security interest in a Crown receivable is completely ineffective. As noted by the Supreme Court of Canada in Marzetti v Marzetti, 1994 Carswell Alta 246 (SCC): [Section 67(b) of the FAA] amplifies the broad prohibition apparent in section 67(a), so that a purported assignment of a Crown debt is rendered absolutely ineffective, as between debtor and creditor, and as between assignor and assignee. Thus, any attempt by a secured party to pursue collection of a Crown account upon default by the debtor will be ineffective and the security interest will be unenforceable against a trustee in bankruptcy in the event of a bankruptcy of the debtor. However, there may be some situations in which recovery on security over Crown accounts may be possible notwithstanding the provisions of the FAA. Although the FAA renders ineffective any attempt to assign a Crown debt by way of security, the FAA does not nullify the actual security agreement granting security over the funds received by the debtor. There is therefore still valid and subsisting security over the proceeds of the Crown debts once paid by the Crown to the borrower. For example, in the case of Cargill Ltd. v. Ronald (Trustee of), 2008 CarswellMan 470 (C.A.), the Manitoba Court of Appeal found that the ineffectiveness of an assignment of the Crown debt ends once the debt is paid and the funds attributable to the Crown debt are received by the payee. At that point the funds are captured by the security agreement, and any related instruments or responsibilities. In addition, the Supreme Court of Canada has suggested that the appointment of a Court-appointed receiver is simply the substitution of the person entitled to receive and administer the benefits of the debtor and may not therefore itself engage the restriction contained in the FAA.

12 Thus, arguably, post-default recovery of the proceeds of Crown debts may still be possible in situations where the payments on account of the Crown debts are being collected by a Court-appointed receiver or a debtor-in-possession in restructuring proceedings under the Companies Creditors Arrangement Act or the BIA. In those situations, the security may still be enforceable against the funds receiver notwithstanding that the direct assignment of the Crown debt is ineffective. 4. Super-Priority Issues to Consider In addition to priority issues that must be addressed vis-a-vis other secured parties (discussed earlier in this paper), there are also a number of potential interests and claims that may take priority over a secured party, some of which may not even be known or in existence at the time that the security is put in place. Super-priority charge or deemed trust claims may, for example, exist in an insolvency of a debtor, which take priority over previously registered security for a number of potential claims, including: unremitted employee source deductions, unpaid employee wages and vacation pay, unremitted GST/HST and PST, and unremitted pension and benefit plan contribution. 3 One of those super-priorities, which has only come into existence in the last few years, may have a particular impact on security over accounts, as compared to general ALLPAP lenders. The BIA creates a super-priority charge, which takes effect in a bankruptcy or receivership, against the current assets of the debtor for amounts owing in respect of unpaid wages and accrued vacation pay for 6 months prebankruptcy/receivership up to a maximum of $2,000 per employee. Wages has been interpreted fairly broadly to include amounts paid from the employee s earnings to a third party for employee benefits. Current assets is defined as cash, cash equivalents including negotiable instruments and demand deposits inventory or accounts receivable or the proceeds from any dealing with those assets. Thus, where applicable, these employee claims will constitute a super-priority charge on accounts (and other current assets) but not fixed assets. Thus the claims may disproportionately impact receivables lenders compared to other general secured creditors. 5. Select Causes of Action Relating to Accounts While claims against a debtor for the short-fall following realization on the collateral are often simply paper-victories, there are some noteworthy cases in which causes of action have been successfully advanced by secured parties in relation to security on accounts to obtain additional recovery or to pursue claims against third parties to enhance overall recovery. Two such claims are discussed below. (i) Breach of Trust 3 Such claims may have priority status in certain situations but not others. However, a fulsome discussion of the claims and status of co-called super-priority charges and deemed trusts is outside the scope of this paper.

13 In some loan transactions, the lender and debtor may agree that the debtor holds the payments from accounts in trust for the lender. The debtor is, therefore, subject to a fiduciary obligation. If the debtor diverts these funds from the lender, the debtor is in breach of trust. Any other person who assists in the breach of trust or is put on notice that a breach of trust is being committed and does nothing may also be found liable. In the Ontario High Court of Justice case of Bank of Nova Scotia v. Bank of Montreal (1982), 43 C.B.R. (N.S.) 269, for instance, the debtor had absolutely assigned all of its present and future accounts debts to the Bank of Nova Scotia. The security documents also provided that the debtor held the proceeds of the sale of its inventory in trust for Bank of Nova Scotia. The Bank of Nova Scotia registered the security interest under the PPSA. The Bank of Nova Scotia also perfected its security interest under the Bank Act. The debtor later deposited a cheque from an account receivable in a newly opened account at Bank of Montreal and, at the request of the debtor, Bank of Montreal immediately sent a large portion of the funds to the lawyers of the debtor to pay off a mechanics lien. The Bank of Nova Scotia sued the Bank of Montreal for participating in a breach of trust. The Bank of Nova Scotia was successful in its action in claiming that the cheque deposited in the account was its property pursuant to the general assignment of book debts and to its security under the Bank Act. The Court determined that the debtor was under a fiduciary obligation and was in breach of trust for diverting accounts receivable through Bank of Montreal. The Court also determined that the Bank of Montreal was subject to a fiduciary obligation. Because the Bank of Montreal had the degree of knowledge required to indicate a breach of trust was being committed by the debtor, it could become a trustee by construction and liable to account to Bank of Nova Scotia. The manager of the Bank of Montreal branch was aware of the debtor s financial troubles, that the debtor was indebted to Bank of Nova Scotia, that Bank of Nova Scotia held an assignment of accounts and Bank Act security, that the provisions of such securities imposed fiduciary obligations, and that the contract manager of the debtor in dropping off funds and picking up the cheque for the debtor s lawyers was not working in the ordinary course of business. The bank manager knew that Bank of Nova Scotia held prior security and that the only way the debtor could pay off the mechanics lien was through a bank other than Bank of Nova Scotia. The Court concluded that the bank manager should have asked questions when the debtor deposited the funds with the branch. The circumstances were sufficient to alert a prudent banker to the likelihood that it was the absolute property of Bank of Nova Scotia... The Court held that Bank of Montreal was liable to account to Bank of Nova Scotia as a constructive trustee as it assisted the debtor in breach of trust with constructive knowledge of the breach. The bank manager had knowledge of circumstances that would have put him or any honest, reasonable banker on inquiry whether a breach of trust was being committed and also, that even the slightest inquiry would have elicited the truth. (ii) Fraudulent Misrepresentation and Deceit

14 The lender may be able to sue the debtor and the account debtor for making fraudulent misrepresentations regarding the accounts to induce the secured party to advance funds. A fraudulent misrepresentation is a false representation of fact, made with the knowledge that it is false, or without an honest belief in its truth, or recklessly without caring whether it is true or false, with the intent that it be relied upon. The Ontario Superior Court of Justice decision in v. Mantella (1 February 2002), 00-CV CM (On. Sup. Ct.) provides an example in which the factor successfully sued the debtor for making fraudulent misrepresentations on its receivables and committing the tort of deceit. To succeed in an action for deceit, the plaintiff must prove that it relied to its detriment on a false misrepresentation and that the misrepresentation was made to the plaintiff with an intention that the plaintiff would rely, and act upon it to its detriment. In Mantella, the debtor made fraudulent misrepresentations that the goods referred to in the invoices had been supplied to the account debtors. The Court determined that the debtor knew from the outset that her misrepresentations with respect to the genuineness of the invoices would be acted upon by the [factor], which would advance funds to her. The Court also found that the account debtor was liable in that it took part in the fraudulent scheme by signing acknowledgements for the factor even though the products referred to in the invoices were not delivered. The account debtor knew that the debtor did not intend to make such delivery and was using false invoices. The combination of the false invoices and the account debtor s acknowledgements misled the factor into advancing funds.