Jason Bryk 

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THE BROWN PAPERS

Can one take advantage of another's mistake?

February 2011


The answer to the question posed in the heading of this paper is “sometimes”.  As unsatisfactory as such answer may be (from the point of view that predictability of the outcomes of legal questions should be an important feature of our legal system), it is necessary to keep in mind three rules found in the Personal Property Security Act (the “PPSA”):


(i)            the principles of common law, equity and the law merchant, except insofar as they are inconsistent with the provisions of (the PPSA), supplement (the PPSA) and continue to apply;


(ii)           the rights, duties and obligations arising under a security agreement, under (the PPSA) or under any other applicable law shall be exercised or discharged in good faith and in a commercially reasonable manner; and


(iii)          a persondoes not act in bad faith merely because the person acts with knowledge of the interest of some other person.


Generally, the PPSAs are intended to establish a regime where the priority of competing security interests can be clearly and easily determined. Thus, the general rule is that if you have a security interest and you want to come out ahead of any competitors, you had better register promptly (before a competitor registers) and, you had better register properly (in accordance with the rules for registration under the Act and its Regulations).


But what if a security interest is acquired by a creditor (“Creditor # 1”) who knows that another pre-existing secured creditor (“Creditor # 2”) has not registered, or has improperly/erroneously registered, with the result that Creditor # 1 ends up with an unexpected benefit, advantage or windfall?


Clearly, the third of the above quoted rules would appear to give Creditor # 1 an unexpected benefit where Creditor # 1 knew of the existence of Creditor # 2’s security interest and Creditor # 1 took advantage of Creditor # 2’s failure to register knowing that Creditor # 1’s registration would – in the absence of Creditor #2 properly registering – rank ahead of Creditor # 2’s interest.  Something more than mere knowledge on the part of Creditor # 1 (of the pre-existing security interest held by Creditor # 2) is required in order to subordinate Creditor # 1 to Creditor # 2.  In essence, that “something more” must comprise one or both of:


(a)          inequitable conduct (in the eyes of a Court) on the part of Creditor # 1; and/or

(b)          bad faith (in the eyes of a Court) on the part of Creditor # 1.


The application of these rules is illustrated in these three cases:

  1. The Furmanek v Community Futures case (The “Furmanek Case”), British Columbia Court of Appeal.  In the Furmanek Case, the vendor of a business “took back” a security interest in the purchaser’s assets and made a proper registration of its security interest in the Personal Property Registry.  The purchaser paid part of the purchase price in cash which it borrowed from Community Futures Development Corporation of Howe Sound (“Development”) and Development also registered its security interest in the Personal Property Registry, but in so registering, Development erroneously omitted to refer to the purchaser’s inventory in its financing statement.  When the purchaser failed to pay what it owed, a contest arose between the vendor and Development as to who had priority over the purchaser’s inventory.  The vendor (for obvious reasons) argued that the PPSA required that a secured party strictly comply with the applicable registration rules, failing which it should not be considered to have perfected its security interest, or, in other words, it should not be entitled to priority as against the vendor’s proper registration.  Development argued that it was always understood by all parties concerned that Development was to have a first charge on inventory.  The Court noted the following facts:

(a)          the vendor knew that without Development’s financing, the sale and purchase transaction would not have been completed;


(b)          the vendor was actively involved in the negotiations between the purchaser and the Development leading to provision of the Development financing, and the vendor represented to Development that the assets being acquired by the purchaser from the vendor were “free and clear” and that accordingly, Development expected to obtain a first charge on the inventory;


(c)          the vendor knew that if Development did not obtain a first position on the purchaser’s inventory, Development would not provide financing; and


(d)          in the sale and purchase agreement between the vendor and the purchaser, the security interest granted by the purchaser back to the vendor for part of the purchase and sale price was referred to as a “second mortgage”.

The Court held in favour of Development. On the basis of the facts in the Furmanek Case, justice was done as it was manifestly unfair to allow the vendor to take advantage of Development’s registration omission.  However, the Court based its decision on more than just what seemed fair or unfair.  In particular, the Court held that:


(i)            while generally speaking, registration of a security interest with knowledge of a prior unregistered security interest will not of itself constitute bad faith or operate as an estoppel against the registering party, the circumstances in the Furmanek Case went “beyond mere knowledge of the fact that Development was asserting a prior interest”;


(ii)           although the vendor did not expressly agree to subordinate its security interest in favour of Development’s security, the PPSA makes it clear that a secured party may subordinate its interest in ways other than inclusion of a subordination provision in a security agreement.  The statute provides that “Any secured party may, in a security agreement or otherwise, subordinate his or her security interest to any other interest…”; and


(iii)          in light of the first of the above stated rules, PPSA priorities may be determined by the application of equitable principles.


            The Court held that on the basis of the vendor’s knowledge and its conduct, the vendor’s security interest in the purchaser’s inventory was equitably subordinated to Development’s interest.


                        Note:


(A)          the Court pointed out that its decision in the Furmanek Case was simply another in that long line of cases where the Courts have held that an act of a legislature will not be permitted to be utilized as an instrument of fraud.  In doing so, a Court does not hold invalid the legislature’s legislation, rather, on the basis of equity, it imposes an obligation on the individual who is seeking to take what the Court believes to be an inequitable advantage against one or more others on the basis of the strict operation/application of the legislation;


(B)          the vendor’s knowledge and unfair conduct would not have protected Development if an innocent third party was involved.  Thus if the vendor had sold its debt claim and security interest to a bona fide assignee, that assignee would almost certainly be entitled to hold priority over Development (some might argue that an assignee would and should acquire its interest "warts and all", no doubt on the basis that the PPSA provides that an assignee of a security interest takes the assigned security interest, essentially, "as is", as to the matter of perfection, but in this scenario, there was nothing wrong with the vendor's perfection, the problem being the vendor's inequitable conduct vis-a-vis Development, something that an assignee would not be "guilty" of); and


(C)         the Court of Appeal observed that another possible rationale for holding that Development had priority over the vendor would be on the basis of an implied agreement or undertaking by the vendor to subordinate its security position to that of the Developer.  In this regard, remember the above-noted factual holding that in the purchase and sale agreement, the vendor referred to its security interest as a “second mortgage”.


  1. The Canadian Imperial Bank of Commerce v. A.K. Construction (1988) Ltd. Case (the “CIBC Case”), Alberta Court of Queen’s Bench.

In the CIBC Case, CIBC and RoyNat both loaned money to two debtor corporations related to each other (collectively, the “Debtor”) for the purpose of enabling the Debtor to acquire certain heavy construction equipment.  The equipment was “serial numbered goods” under the PPSA and its Regulations, but only CIBC properly registered its security interest against the serial numbers, RoyNat omitting to register against the serial numbers.  The Debtor became insolvent, the equipment was sold and a contest arose between CIBC and RoyNat as to who was entitled to the proceeds of sale.  CIBC argued that it had done what it was supposed to do under the legislation and RoyNat had failed to do what it was supposed to do, with the result that CIBC should be entitled to the proceeds of sale, not RoyNat.  RoyNat argued that there was an underlying understanding between CIBC and RoyNat to the effect that RoyNat was to have a first charge on the Debtor’s equipment and CIBC was to have a first charge on the Debtor’s accounts receivable and inventory.  There was at least one meeting between representatives of CIBC and RoyNat at which they discussed their respective security positions. However, the Court held that CIBC did not undertake to subordinate its security interest in favour of RoyNat (or treat RoyNat’s security interest as holding priority over CIBC’s security interest) so as to bar itself from relying on its (CIBC’s) rights under the legislation. The Court observed that knowledge held by CIBC of the existence of RoyNat’s security interest and its knowledge that if RoyNat had properly registered its security interest, it would have held priority over CIBC’s security interest (which had not been properly registered) was not sufficient to constitute “bad faith”.  For CIBC to have been subordinated to RoyNat, RoyNat would have had to have established something more which would constitute a waiver or an estoppel argument or involve CIBC in some nefarious conduct such as misleading RoyNat or hindering it in the perfection of its security interest. None of these could be “fastened” on CIBC in this case.

  1. The Carson Restaurants International Ltd. v. A-1 United Restaurant Supply Ltd. (the “Carson Case”), Saskatchewan Court of Queen’s Bench

In the Carson Case, the priority contest was between:


(a)          the debtor Yorkton Restaurant as franchisee (being a corporation controlled by a Mr. Dennis A. Skuter, hereinafter, “Skuter”), the secured party, Carson as franchisor (also a corporation controlled by Skuter), the secured party Shonavan (also a corporation controlled by Skuter) and Mr. Dennis Skuter himself (collectively, the “Skuter Group”); and


(b)          A-1, being a secured party of the debtor with no connection to Mr. Skuter.

The sequence of events involving these parties was as follows:


(i)            In September of 1986,Carsonacquired a security interest in Yorkton Restaurant’s present and after acquired personal property;


(ii)           In April of 1987, A-1 acquired a security interest from Yorkton Restaurant covering goods provided by A-1 to Yorkton Restaurant on credit;


(iii)          In June of 1987, with Yorkton Restaurant being in default in the payment of its obligations owed to A-1, A-1 demanded payment and following that demand, there was a meeting between representatives of A-1 and Dennis Skuter.  Mr. Skuter assured A-1’s representative that Yorkton Restaurant would pay its debt to A-1;


(iv)         In July of 1987, A-1 registered its security interest but misdescribed Yorkton Restaurant’s name in its registered financing statement;


(v)          On October 1, 1987, Shonavan, in anticipation of selling certain equipment to Yorkton Restaurant on credit and taking a security interest therein, obtained a PPR search of Yorkton Restaurant’s correct name, which of course did not reveal A-1’s security interest which had been registered against Yorkton Restaurant’s incorrect name;


(vi)         On October 26, 1987, Carsonregistered its security interest against Yorkton Restaurant’s correct name, and on the same day, Shonavan also registered its security interest against Yorkton Restaurant’s correct name;


(vii)        In November of 1987, Mr. Skuter registered his own security interest against Yorkton Restaurant’s correct name;


(viii)       On January 20, 1988, with Yorkton Restaurant being in default of its obligations owed to Carson, Carson seized all of Yorkton Restaurant’s assets; and


(ix)         On January 26, 1988, A-1 amended its PPR registration to correct the name of Yorkton Restaurant.

The Court held that as between A-1 and the Skuter Group, A-1 should prevail.  The Court noted that fraud was not alleged against Mr. Skuter or the Skuter Group.  Nevertheless, the Court observed that “…in (these) circumstances…, to permit (the Skuter Group) through Skuter, to use (the PPSA and its registry system) has an instrument to defeat a claim of which (Skuter) was not only aware, but which he deceitfully delayed by his representations to A-1 when it was pursuing its security interest against Yorkton Restaurant on or about June 18, 1987 (emphasis being the writer’s here), would be inequitable. Accordingly, the priorities which would otherwise result from a strict application of the legislation should not hold and should be overturned by the application of equitable principles. 


What is interesting about the Carson Case is that the facts as spelled out in the decision do not themselves indicate that Mr. Skuter made deceitful representations to A-1 at the time of the June 18, 1987 meeting.  However, we can only assume that such deceitful representations were in fact made and that they were made by Mr. Skuter with the objective of inducing A-1 to not take the steps necessary to achieve PPSA priority for A-1’s security interest.

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