July 2010

You are a financial institution and you have decided to advance credit to someone (the "Borrower").  In addition to the Borrower's undertaking to pay you back (with interest), and, in addition to whatever real and/or personal property security the Borrower gives you to secure performance of its obligations, you also require the Borrower to get someone else (the "Third Party") to mortgage/charge/grant a security interest in some of the Third Party's realty and/or personalty.  The understanding between you and the Third Party is that if the Borrower fails to repay its debt, then you can realize upon the Third Party's assets charged to you (typically, by way of your selling or foreclosing upon, that is, becoming the owner of, the Third Party's charged assets).

You decide - or are convinced by the Borrower and/or the Third Party - to accept the Third Party's charge of its assets without the Third Party, in any way whatsoever, undertaking responsibility for the satisfaction of the Borrower's obligations owed to you.  That is, you take the charge from the Third Party on its assets without also obtaining a (more or less concurrently granted) guarantee, indemnification or other obligation from the Third Party to "stand good" for the Borrower's debt.  You make this decision because:

(i)            the Third Party is closely related and/or controlled by the Borrower (for example, the Third Party is a close friend or relative of the Borrower, or the Third Party is a corporation, all of whose issued capital stock is held by the Borrower and all of whose directors and officers are nominees of the Borrower); and/or

(ii)           the Third Party holds the assets charged to you as a bare trustee only, for and on behalf of the Borrower (here, the Borrower would probably argue that because the Third Party is merely the "alter ego" of the Borrower, they are essentially one and the same person, so that no separate obligation undertaking personal responsibility by the Third Party is required, as any charging of its assets by the Third Party should be considered to be a charging of the same assets by the Borrower).

After having taken security from the Third Party without obtaining a concurrent obligation by the Third Party and after advancing funds to the credit of the Borrower, one or both of the following occur:

(a)          the Borrower fails to repay its debt and you decide to realize your security against the Third Party's charged assets; and/or

(b)          the Borrower fails to repay its debt and when you go to proceed against the Third Party's charged assets, the Third Party has become bankrupt under the Canada Bankruptcy and Insolvency Act.

As a further "twist" in the above-described fact scenario, also assume that some time after taking security from the Third Party and advancing credit to the Borrower, you agree with the Borrower to certain variations in the terms of your arrangements with the Borrower. You agree to release some of the security given to you by the Borrower and/or you and the Borrower agree to an increase in the rate of interest payable by the Borrower and/or you and the Borrower agree to one or more other variations of your arrangements, any and all of which increase the risk to the Third Party that you will have to proceed against the Third Party's assets - without, in any of these instances, either notifying or seeking and obtaining the consent in writing of the Third Party.

What are your rights vis-à-vis the Third Party, and in particular, the Third Party's assets charged to you?  The answer or answers to these question(s) are of considerably more than mere academic interest.  Two frequently encountered instances of the occurrence of the above-described arrangements are:

(1)          where a financial institution obtains a "pledge" from a third party of "collateral" to secure payment of indebtedness owed by someone other than the pledgor (ie, the Third Party).  The standard forms of "hypothecation and/or pledge of collateral" utilized by many financial institutions make it clear that the Third Party is pledging collateral whether or not the Third Party then or subsequently provides any form of guarantee to the financial institution.  In this context, "pledge" almost always implies the actual physical delivery of some sort of personal property to the financial institution, and, "collateral" typically implies personal property such as certificated securities, documents of title/bills of lading which entitle the holder to claim goods, either generically or specific goods, and precious metals such as gold bars, valuable gemstones, etc.

(2)          one or more "investors" buy a revenue generating property (perhaps an apartment building or small commercial development) and for various reasons, put title to the property in the name of a corporation which they create for the sole purpose of holding title, with the corporation undertaking to hold the asset in trust, as a bare trustee only, for the investors.  They then approach a lender requesting that a loan be made to them on the security of the property.

It is the writer's understanding that in theUnited States, grants of security without any underlying obligation are quite common.  Thus in a multi-jurisdictional transaction involving bothU.S.and Canadian jurisdictions,U.S.counsel may expect to implement such arrangements as a matter of course, and consequently expect Canadian counsel to opine on the enforceability of them. 

When acting for a lender, it has always been the writer's approach to require the Third Party to undertake some sort of an obligation to the creditor to "stand good" for the borrower's debt.  I say "some sort" because the Third Party could be made a co-borrower or could be made an unlimited guarantor or indemnifier (meaning that if the Third Party fails to pay, then the creditor can proceed, not only against the assets charged by the Third Party to the creditor, but also against the Third Party's other properties and assets by way of post-judgment execution and/or realization under a judgment lien filed against (other) real property belonging to the Third Party).  Depending upon how negotiations "go", and at the very least, the writer would require the Third Party to provide a "non-recourse" guarantee to the creditor (meaning that the creditor would agree that the only way it can enforce the Third Party's guarantee obligation is to proceed against the charged assets put up by the Third Party).

While the writer still believes that it is prudent for a creditor to obtain at least a non-recourse guarantee from the Third Party (which then, in effect, "supports" the granting of security on the Third Party's assets), there is certain case law and certain wording in the Personal Property Security Acts which indicate that a Third Party can, at least in some instances, grant security without undertaking any underlying obligation.  This is pointed out and discussed by Mr. Robert M. Scavone (of McMillan LLP) in a paper he presented at a meeting of the Ontario Bar Association (Professional Development) dated April 21, 2010.

The concept was enunciated in Re Conley (1938) 2 All ER 127(CA), and a review of the judgments in this case clearly indicate that the principle was accepted by English Courts much earlier than 1938.  Additionally, most, if not all, Canadian Personal Property Security Acts define and contemplate that a "debtor" can mean someone who owns (or has interests in) secured collateral without also being obligated to the secured party for payment/performance of the secured obligation.

However, and as noted above, it would be prudent for a creditor to nevertheless acquire some sort of an obligation from a Third Party to support its granting of security even if only on a "non-recourse" basis.  The reasons for this are as follows:

1. As Mr. Scavone points out, although a Court may uphold a grant of security by a Third Party without the necessity of the creditor requiring the Third Party to undertake an obligation for the debtor's debt, or, a Court may imply the existence of a guarantee or guarantee-like obligation on the part of the Third Party, the creditor will not - or at least not necessarily - have the benefit of the various creditor exculpatory provisions traditionally contained in guarantees.  In particular, the creditor may be in a position where virtually any move it makes vis-à-vis the debtor or security provided to the creditor by the debtor (or by any other person) will release the Third Party's security.  It is possible that a Court will treat the Third Party as being in the same position as a guarantor who is thus entitled to the various equitable defences available to guarantors.
2. As also pointed out by Mr. Scavone, if the Third Party has no underlying obligation whatsoever - other than its grant of security - to the creditor, and the Third Party becomes bankrupt under the (Canada) Bankruptcy and Insolvency Act, it is very likely that the Third Party's security grant will not constitute the creditor as a secured creditor in the bankruptcy.  This is because currently, a "secured party" in a bankruptcy must have some sort of obligation due or accruing due to the creditor which underlies the grant of security.
3. Although the Personal Property Security Acts contemplate that a "debtor" and a person owning or having interests in secured personalty can be two different persons, the writer is unaware of any legislation which would allow the mortgaging of real property interests in the absence of an underlying obligation, at the very least, a contingent guarantee obligation.  There is in fact a difference of opinion amongst lawyers advising lenders taking security in real estate interests as to whether or not such security can validly exist without an underlying obligation.

It is thus the writer's view that a guarantee (or as the case requires, an indemnity or some other obligation) must be issued by a Third Party in conjunction with the Third Party's grant of security to the debtor's creditor.  This may be on a non-recourse basis, although in the case of bare trustee corporations whose sole raison d'être is and will always be to hold legal title to specific realty and/or personalty, the non-recourse feature is probably meaningless.

The one situation where the writer would consider taking security without any supporting obligation is where the holder of the collateral is legally prohibited from giving any guarantee, even on a non-recourse basis, but is not prohibited from granting security in its assets.  Such a situation would no doubt be infrequently encountered, but where it is, it behooves counsel to think long and hard about the viability and enforceability of any security so given.