FACTORING AND FINANCING IN CANADA WHAT EVERY U.S. FACTOR AND LAWYER WANTS TO KNOW ABOUT PURCHASING AND TAKING SECURITY ON CANADIAN RECEIVABLES

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1 FACTORING AND FINANCING IN CANADA WHAT EVERY U.S. FACTOR AND LAWYER WANTS TO KNOW ABOUT PURCHASING AND TAKING SECURITY ON CANADIAN RECEIVABLES Cross-border transactions involving U.S. and Canadian parties are increasing at an ever growing pace. Much of this activity involves purchasing Canadian-based unsecured trade receivables which originate in Canada, or acquiring security interests in such receivables. It therefore seems timely to discuss a number of issues which are frequently raised, from a Canadian legal standpoint, when a U.S. factor or lender purchases or takes security on receivables owing by Canadian obligors. 1. Common Factoring/Financing Scenarios Questions regarding Canadian dollar receivables most usually arise when a U.S. factor or lender (which I ll refer to as a secured party ) is dealing with a U.S. or Canadian customer (a debtor ) which has Canadian dollar receivables owing to it by its Canadian customers. In either case, the secured party needs to know whether its rights or obligations will differ materially because the receivables it is purchasing or taking security on arise in Canada rather than the U.S. 2. Canadian Personal Property Security Regime The basic legal framework that regulates perfection and priority in Canada is somewhat complicated by the existence of two separate legal systems. The basic summary: Most Canadian jurisdictions - nine provinces and three territories - have enacted a personal property security act ( PPSA ) which is modelled on Article 9 of the UCC. Quebec s rules are derived from the civil law of France, but have recently been amended to provide for an Article 9-type notice filing system. Security must be taken under a unique security instrument (a hypothec ) and is subject to a special set of rules and principles. 3. Perfection is Necessary and Relatively Straightforward PPSA jurisdictions: An interest in receivables is perfected by filing a financing statement in the jurisdiction (e.g. a Canadian province or U.S. state) where the debtor has its chief place of business or chief executive office. Thus, if the debtor is located in the U.S. and has receivables which originate only in a PPSA jurisdiction, it should not be necessary to file in Canada. Quebec: The procedure to be followed differs for security interests and absolute sales. Security must be perfected where the debtor is domiciled. Purchases are more complicated. If the receivables form a universality (a not perfectly understood concept relating to classes of receivables), the

2 Notification purchaser perfects by either registering in Quebec or notifying the account debtor, although giving prior notice to the account debtor may be necessary to achieve priority. Where the receivables do not form a universality (e.g. a single receivable or a group of receivables that clearly form part of a larger class of receivables), registration is not possible, and priority can be achieved only by notifying the account debtor. Notification to account debtors is not relevant to the legality or validity of a sale or security interest affecting Canadian receivables. However, notification may be useful or necessary for other purposes: notification is generally necessary to bind the account debtor - the account debtor will be entitled to pay its creditor until receipt of notice of the assignment. notification also generally cuts off an obligor s right to set off in respect of unrelated obligations arising subsequent to notification. in Quebec, notification may be necessary to achieve priority against other purchasers or secured parties. 5. Completing Financing Statements in PPSA Jurisdictions A few simple rules: a check-the-box approach is followed in Ontario; a detailed collateral description is required in the other PPSA jurisdictions. the financing statement is usually signed only by the secured party or its agent (e.g. its Canadian attorney); for this to apply in Manitoba, the debtor must sign the security agreement or appoint an agent of the secured party as its own registering agent. the financing statement may usually be signed and registered before the transaction is closed, and before the security agreement is executed; these flexible rules do not apply in Manitoba or Quebec, and may not apply elsewhere if the collateral consists of consumer goods. 6. Canadianizing U.S. Security and Factoring Agreements Relatively few modifications are necessary to adapt these agreements for use in PPSA jurisdictions. Some points to keep in mind: certain enforcement procedures may not be waived; e.g., the requirement to give 15 or 20 days notice prior to disposing of most collateral.

3 - 3 - except where references to insolvency legislation are sufficiently broad, consider adding applicable Canadian insolvency statutes and proceedings. consider adding receivership provisions which are usually absent from U.S. security agreements (these provisions enable the secured party to appoint a receiver to take over and manage the debtor s business). revise interest provisions to comply with Canadian usury laws and other related principles (see item 9 below). true sale terminology: Canada is more form conscious than the U.S., and factoring agreements should contain absolute sale terminology rather than language that suggests the agreement may constitute security. add references to provinces and territories where applicable. collateral description - it is generally possible to obtain security in all of a debtor s present and future personal property. registration documents: in PPSA provinces, perfection is effected or continued by filing financing statements or financing change statements. add references to personal property security legislation to accompany references to the Uniform Commercial Code. references to liens should be expanded to include security interests, hypothecs or other charges or encumbrances. note that Canadian financing statements do not create a security interest; security interests are created only by a separate security agreement. the ACH System does not exist in Canada - agreements should add generic electronic transfer terminology (e.g. such authorizations and other documents as may be required to enable the purchaser to make electronic debit and credit entries to the seller s bank account ). certain PPSA jurisdictions require that a financing statement set out an individual s date of birth and middle initial, while others require the debtor s second given name; if a corporate debtor has both an English and French name, each must be set out on the financing statement. 7. French Language Requirements It is not necessary to translate agreements into French. In Quebec, a standard form agreement should state, in both English and French, that the parties have required the agreement to be drawn up in English only.

4 Secret Liens Perfected purchase or security interests may be subordinate to various types of unregistered liens or trusts. The majority of these prior interests relate to obligations to pay vacation pay, and unremitted employee tax withholdings, pension plan contributions and sales taxes. Certain of these liens lose their priority in the debtor s bankruptcy. 9. Interest Apart from generally inapplicable consumer protection legislation, Canada s usury legislation is federal and renders it a crime to agree to receive, or to actually receive, interest at an effective annual rate that exceeds 60%. While primarily aimed at loan sharks, the legislation nevertheless applies to all commercial and consumer transactions. When calculating interest for the purpose of this legislation, one must include all charges and expenses payable in respect of the advancing of credit, including any fees, fines, penalties and commissions. There is as yet no case law as to whether the legislation applies to factoring arrangements. It is common for lending agreements to contain a somewhat elaborate provision disclaiming any intention to charge or collect interest at a criminal rate and dealing with the allocation of excess interest payments. It should also be noted that the Interest Act, federal legislation applicable throughout Canada, requires interest to be expressed at an annual rate, e.g. 12% per annum rather than 1% per month. This legislation may also require that a 360-day interest rate clause be revised to include a formula which permits calculation of the equivalent annual rate. 10. Government Obligors Accounts receivable owing by the Canadian federal government, federal Crown corporations and certain provincial and territorial governments are not assignable without the applicable government s written consent. 11. Anti-Assignment Clauses Ontario does not have legislation similar to UCC Article If the underlying contract clearly prohibits its assignment, any purported assignment will be void as against the obligor, although it may bind the assignor. 12. Currency Issues Three matters to keep in mind: Consider revising the amount of any dollar-denominated limitations or events set out in the applicable agreement so as to take into account the differing value of the Canadian dollar (e.g. any maximum program amount, the amount of any permitted judgements, and the dollar amount specified in any cross default provisions).

5 - 5 - Canadian courts are able to give judgement only in Canadian currency. If an obligation is denominated in U.S. dollars, consider a provision rendering the debtor liable for losses which may result from the conversion of payments under a Canadian dollar judgement into U.S. funds. If Canadian-based receivables are to be securitized, U.S. rating agencies commonly require that the exchange risk be hedged. Consider whether the factoring or loan agreement should make the debtor liable for the cost of any hedging arrangements. 13. Canadian Withholding Tax The Income Tax Act of Canada generally imposes a withholding tax on payments of interest or rent by a Canadian resident to a non-resident of Canada. Note the following: Subject to applicable exceptions, withholding tax will apply if a loan is made by a U.S. lender to a Canadian borrower, or if a U.S. factor purchases Canadian-based receivables which include interest or rent. Most trade receivables do not bear interest and are therefore not subject to withholding tax (other than for default charges). The statutory withholding tax rate is 25%, which is often reduced by treaty. The treaty rate for payments to U.S. residents is 10%. The U.S. secured party may be able to utilize foreign tax credits to offset the effect of any withholding tax. If the Canadian debtor is to be responsible for any withholding tax, the agreement should contain a gross-up clause to allocate this risk. Certain withholding tax exemptions apply; e.g. there is generally no withholding tax if an arm s length loan to a Canadian corporate borrower does not require more than 25% of the principal to be repaid during the first five years of the loan term (except in the case of certain events of default). Voluntary repayments will generally not affect this exception. 14. Thin Capitalization Rules In order for a Canadian borrower to deduct its interest expense for tax purposes, its debt to equity ratio in respect of the borrowing must not exceed 3:1 if the non-resident lender is a 25% shareholder or does not deal at arm s length with the Canadian borrower. This limitation does not apply where the shareholder guarantees a loan made by a third party U.S. lender to the Canadian subsidiary. 15. Guarantees Certain Canadian principles applicable to guarantees:

6 - 6 - The Guarantees Acknowledgement Act of the Province of Alberta will invalidate a guarantee given by an individual guarantor who does not complete a prescribed form in the presence of a notary public. It is questionable whether this requirement can be avoided by simply using coborrower terminology where the facts dictate otherwise. Canadian courts interpret guarantees quite strictly in favour of the guarantor. Guarantees should therefore clearly and specifically waive numerous possible defences that a guarantor might otherwise have. Consider adding a gross-up clause to the guarantee to cover withholding tax on interest or rent payments by the guarantor, as well as a currency clause rendering the guarantor liable for the exchange rate risk in respect of U.S. dollar liabilities which are paid in Canadian funds or are subject to a Canadian dollar judgment. A guarantee given by the debtor s affiliate may be subject to financial assistance restrictions, which are statutory and more formalistic than U.S. fraudulent conveyance limitations. Guarantees are usually valid if given by a parent or wholly-owned subsidiary, or if the guarantor satisfies certain statutory solvency tests. The financial assistance rules vary from province to province, and may be quite liberal depending on the guarantor s jurisdiction of incorporation. 16. Litigating in Canada A number of fundamental issues should be borne in mind when suing or being sued in Canada: A foreign litigant which does not have significant Canadian assets may be required to post security for costs. Canadian courts will generally enforce arbitration agreements, choice of law clauses and choice of venue clauses. Foreign judgements will generally be enforced if the defendant was accorded procedural fairness and the foreign court properly took jurisdiction. A commercial dispute will almost always be decided by a judge alone, rather than by judge and jury. The unsuccessful party will normally be required to pay a portion of the successful party s legal costs of the proceedings. Punitive damages are rarely awarded by Canadian courts. Litigation is not particularly expeditious; e.g. an Ontario action which is diligently prosecuted may take two years or more to reach trial.

7 - 7 - Some provinces do not permit pre-judgement execution without evidence of an intention to dispose of assets for the purpose of avoiding creditors. 17. Regulatory Issues Certain statutory requirements may apply depending on the nature and location of the U.S. secured party s activities: Foreign banks (which term is broadly defined) require regulatory approval to carry on a banking business in Canada. However, it is possible to structure a lending transaction or program under which the U.S. party is not carrying on business in Canada although it is dealing with Canadians. Finance companies may require a license to carry on a finance company business in a particular province and/or an actual place of business. It may also be necessary to register as an extra-provincial corporation whether or not a special finance company license is required. 18. Taxation Depending on the circumstances, the U.S.-based secured party may wish to avoid becoming subject to Canadian taxation. In addition to the usual considerations in this regard: Factoring arrangements often provide for the Canadian seller to act as the U.S. purchaser s agent for the purpose of collecting the purchased receivables. Unless the applicable agreement makes it clear that the seller does not have general authority to contract on behalf of the purchaser, the seller may be deemed to have a Canadian permanent establishment which could subject it to Canadian taxation on its Canadian-based income. Note as well that other activities may lead to a finding that the seller has a permanent establishment, such as opening a Canadian office. The whole arrangement, including all of the U.S. purchaser s Canadian-related activities, should be carefully reviewed in evaluating the permanent establishment issue. February 21, 2005 Martin Fingerhut Blake, Cassels & Graydon LLP Toronto, Ontario, Canada martin.fingerhut@blakes.com