Set-off & security interests.
~ Aristotle, The Nicomachean Ethics (1)
In the 2009 decision Caisse populaire Desjardins de l'Est de Drummond v Canada, (2) Rothstein J, on behalf of a majority of the Supreme Court of Canada (SCC), acknowledged, by extension, (3) that a transaction incorporating or prominently featuring a right of set-off may create a security interest under the Personal Property Security Act (4) ("PPSA"). In this article, I approximate an answer to an important threshold question that flows from that acknowledgment, and pose and address a further series of derivative questions.
At what point, along the continuum of transactions incorporating or featuring the right of set-off, (5) is a PPSA security interest created? To what extent can this transactional threshold be defined? And what, precisely, are the implications of crossing the threshold? Does it spell disaster for the set-off claimant under the PPSA priority structure, as commonly intimated by bank industry representatives in the aftermath of Drummond?. Or, are the implications more benign?
Answering these questions is important because commercial players crave certainty. (6) They must understand whether, in any particular circumstance, they have crossed the transactional threshold and created a PPSA security interest. Moreover, they must appreciate the implications of crossing that threshold, even if unwittingly. For instance, it is essential that they understand whether, once the transactional threshold has been crossed, registration is a prerequisite for effective protection vis-a-vis third parties. In short, commercial players must understand, in any given situation, the procedural and substantive niceties that flow from crossing the transactional threshold and creating a PPSA security interest. Relative comfort in this knowledge is important for any depository institution, like a bank or credit union, that regularly uses set-off as part of its lending and realization strategy. Indeed, depository institutions are specially impacted in this arena since reciprocal debt obligations are endemic to the bank-customer relationship. (7) The issues discussed in this article bear relevance to the question of whether Canadian common law provinces and territories ought to adopt, under the PPSA, a "control" paradigm for deposit account perfection and priority ordering. (8) To adopt a bank-friendly control paradigm for deposit accounts is arguably unnecessary since set-off rights occupy a superior position to security rights in the PPSA priority structure.
Part II of this article furnishes a basic doctrinal account of Canadian set-off--legal, equitable and contractual. Of the third variety, account combination--the implied contractual right of a depository bank to set off a current customer debt balance against a reciprocal deposit account balance--is introduced as a contractual set-off prototype, and becomes a key focus of the analytical exercise undertaken in Part IV. Part III examines the PPSA's concept and definition of the term "security interest", revealing a functional approach for identifying transactions that create, or fall short of creating, such an interest. A basic introductory discussion of the PPSA's "substance over form" mantra segues into, and facilitates, the analytical exercise in Part IV. Part IV examines four scenarios--representing distinct points along the transaction continuum--that assist in developing and elucidating an answer to the threshold question. It then identifies and discusses the implications that potentially flow from this answer. Part V both closes and opens the discussion.
A. Concept & Terminology
Before divining an answer to the threshold question, I must furnish a brief synopsis of the conceptualization of set-off and its basic doctrinal framework. "Set-off" is broadly defined as the "discharge of reciprocal [monetary] (9) obligations to the extent of the smaller obligation." (10) Suppose that Ai owes Bo $100, and that Bo owes Al $60 in a related or unrelated transaction. Bo's claim against Al is property in the hands of Bo; an "account" (11) (a species of "intangible" (12)) under the PPSA taxonomy (13) or a "chose in action" under the common law taxonomy. (14) So too is Al's claim against Bo. Pursuant to set-off principles, Bo is entitled to extinguish his indebtedness to Al; he does so by using his property (i.e., his monetary claim against Al) to reduce or retire Al's reciprocal monetary claim. (15) In technical set-off parlance, Bo may "set off" (16) his property against (or assert his right of set-off against) Al's property. (17)
It does not necessarily follow, however, that Bo has a proprietary right in Al's property; instead, Al's claim against Bo is merely reduced or retired by operation of law. Bo's set-off right can be conceptualized as an "entitlement to pay with Bo's property" as opposed to an "entitlement to seize and liquidate Al's property " (18) In this sense, the right of set-off is distinguishable from a scenario in which Al specifically grants Bo a security interest in Al's property to secure repayment of Al's indebtedness to Bo. But this distinction is tenuous, and unhelpful to some degree, since both scenarios produce the same substantive outcome. So we confront the threshold question: At what point, along the continuum of transactions incorporating or featuring a right of set-off, is a PPSA security interest created? Before launching into the analytical exercise required to answer this question, I will furnish a basic account of the law of set-off.
B. CANADIAN SET-OFF
1. LEGAL SET-OFF
In Canada, set-off is generally subdivided into three categories: legal, equitable and contractual. Legal set-off requires (i) mutuality between the party asserting set-off and the party against whom set-off is asserted (meaning that two parties must hold reciprocal debts against each other), and (ii) that the cross-obligations constitute debts both existing and payable at the time set-off is asserted. (19) Legal set-off only arises between two parties holding reciprocal cross-debts whether or not such debts arose under connected contracts.
2. EQUITABLE SET-OFF
Equitable set-off can be conceptualized as a relaxation of the strict rules of legal set-off. (20) Unlike legal set-off, equitable set-off does not require mutuality (i.e. an account debtor may assert equitable set-off against an assignee of the claim on which he is liable), but may require a close connection between the obligations being set off. (21) Additionally, equitable set-off does not necessarily require that the cross-obligations constitute liquidated debts; unliquidated claims may be the subject of equitable set-off. (22)
3. CONTRACTUAL SET-OFF
The principles of legal and equitable set-off may be varied under contract. (23) The usual purpose of such contractual clauses is to expand set-off rights, (24) not narrow or negate them. (25) In the bank industry, the unique relationship between a bank and its customer gives the bank an implied contractual right of "account combination." (26) Account combination is a form of implied contractual set-off (27) which permits the bank, with or without notice to the customer, (28) to set off the customer s current debit balances against reciprocal deposit account balances. (29) P Wood concisely describes the basic elements of account combination, which he refers to as "blending".
The classic example is a bank current account. The chief characteristics of reciprocal claims on current account available for blending appear to include the following:
(a) There is a continuous relationship between the parties, notably the relationship between banker and customer.
(b) Both debit and credit balances are currently payable, in the sense that each must be paid on reasonable notice.
(c) Both claims are liquidated. (30)
Account combination can be conceptualized as a reaffirmation of existing legal set-off principles, with a self-help component. (31) As noted above, account combination can also be understood as an implied contractual term under which the bank is entitled to set off its customer s current debit balances against reciprocal deposit account balances. (32) In any event, as noted by P Wood, account combination is an extraordinarily powerful tool for banks, stacking up favourably against the competing claims of various interveners.
It is probably true to say that in no case can an intervener defeat a debtors current account set-off. For example, an assignee of an assigned claim takes subject to an independent cross-claim owing by the assignor to the debtor which was incurred before the notice of assignment to the debtor if the cross-claim is a simple debt (not contingencies or future rent) and is due and payable before the assignee commences his action for the assigned claim. (33)
One notable qualification to P Wood's broad statement regarding the power of account combination presents itself where the bank receives actual notice of an intervener's interest in specific funds (34) prior to their deposit in the customer's deposit account. In such an instance, the bank's right of account combination is defeated by the intervener's proprietary interest in the funds. (35) To suggest otherwise is to assert that banks have a license to knowingly convert others' property, which clearly cannot be the case. (36)
III. SECURITY INTERESTS
Having synopsized the fundamental principles of set-off, and presented account combination as a contractual set-off prototype, I now turn my attention to the basic concept of a security interest. Consider the PPSA's definition of the term:
"security interest" means (i) an interest in personal property that secures payment or performance of an obligation ... (37)
The PPSA adopts a "substance over form" mantra, (38) employing a functional approach for classifying transactions that create a security interest or fall short of that threshold. (39) Subsection 3(1) of the PPSA governs the scope of the statute:
3(1) Subject to section 4, this Act applies:
(a) to every transaction that in substance creates a security interest, without regard to its form and without regard to the person who has tide to the collateral; and
(b) without limiting the generality of clause (a), to a chattel mortgage, conditional sale, floating charge, pledge, trust indenture, trust receipt, or to an assignment, consignment, lease, trust or transfer of chattel paper that secures payment or performance of an obligation.
Pursuant to subsection 3(1), but subject to section 4, the PPSA applies to every transaction that in substance creates a security interest without regard to the form of the transaction or the intention of the parties. (40) The PPSA is concerned with the economic effect of the transaction, not its label or form. (41) The PPSA cannot be effective in fulfilling its function and mandate if one can simply circumvent its application by using clever and well-placed contractual language. (42) In their treatise on Canadian personal property security law, Cuming, Walsh & Wood articulate the essential elements for the creation of a PPSA security interest.
A transaction will give rise to a security interest within the meaning of the Act if the following four requirements are satisfied:
1. The transaction creates or evidences a proprietary interest in an asset in favour of a creditor.
2. The asset is personal property.
3. The creditor's proprietary interest functions to secure payment or performance of an obligation.
4. The interest arises out of an agreement between the parties. (43)
Cuming, Walsh & Wood pose the central question:
[D]oes the transaction involve the contractual recognition or creation of an interest in the personal property of one person that secures an obligation owing to another person? (44)
Based on the foregoing, it is clear that a security interest can only be created with the consent of the debtor by agreement. Cuming, Walsh & Wood continue:
The "interest" involved must be a real right in personal property in the sense that it is exercisable against not only the obligor but also against third parties with subsequent interests in the property. Often, whether or not a security interest has been created will depend upon the wording of a contract between the parties. (45)
Therefore, the answer to the threshold question, of whether a security interest has been created, depends on the specific contents of the contract defining the various rights and obligations of the parties vis-a-vis each other and any attributable personal property. With the above points in mind, I now turn to the central threshold question: At what precise point, along the continuum of transactions incorporating or featuring the right of set-off, is a PPSA security interest created?
IV. SET-OFF & SECURITY INTERESTS
A. Conventional View
Though set-off is often credited with performing a security function, (46) the conventional view is that a bare right of set-off does not create a PPSA "security interest." (47) In the following account, Cuming, Walsh & Wood describe the conventional view of the relationship and interaction between set-off and security interests.
Legal or equitable set-off does not involve a security interest because it exists without agreement between the parties and neither party to the set-off acquires a property interest. Similarly a contractual right of set-off by itself, does not involve a security interest. However, a right of set-off may be a method through which a creditor may enforce its security interest otherwise created in the obligation it owes to the counter-party. (48)
In the ensuing discussion, the conventional view is examined, challenged
(in certain instances), and elaborated upon. The discussion unfolds through testing, along the transaction continuum, of the threshold question. I ask, in relation to a series of transaction scenarios featuring set-off rights, whether each such arrangement creates, as a matter of substance over form, a PPSA security interest.
B. THRESHOLD TESTING ALONG THE TRANSACTION CONTINUUM
1. Scenario A--Non-Contractual Set-Off
Let us revisit the scenario involving Al and Bo. Al owes Bo $100, and Bo owes Al $60 ("Scenario A"). Does Bo, simply by virtue of having the right of legal set-off against Al, acquire a proprietary interest in Al's intangible property that secures payment of an obligation (i.e., Bo's $100 claim against Al)? Posed more concisely, does Bo acquire a PPSA security interest in Al's property?
No. As detailed in Part III, the PPSA governs the creation, enforcement, and priority ordering of consensual security interests in personal property. (49) The key word is consensual. This word implies a contract. In order to create a security interest in property, there must be, at minimum, some form of agreement with reference to the subject property. (50) As between Al and Bo, there is no such agreement. (51) Specifically, there is no contractual term, express or implied, furnishing either party with the right of set-off. For each of Al and Bo, this right of legal set-off simply exists, independent of the presence or absence of contractual set-off provisions. No PPSA security interest has been created in Scenario A; the transactional threshold has not been crossed. To this extent, I fully agree with Gilmore that "a right of set-off is not a security interest and has never been confused with one: the statute might as appropriately exclude fan dancing." (52) Beyond Scenario A, I am not as sanguine.
2. SCENARIO B--CONTRACTUAL SET-OFF
Consider a variation of the original scenario involving Al and Bo; replace Bo with a Bank. Al has a $60 balance in his deposit account at the Bank, but also has a $ 100 balance on his unsecured revolving demand operating line of credit ("Scenario B"). In Scenario B, does the Bank acquire a PPSA security interest in Al's deposit account? The answer, according to the conventional view, is no. However, defending the conventional view requires much more elaborate reasoning than that employed in Scenario A.
(b) Dismissing the Analogy Argument
One might attempt to defend the conventional view with an analogy. Specifically, one might assert that since Bo does not acquire a security interest in Al's reciprocal claim in Scenario A, the Bank does not acquire a security interest in Al's deposit account balance in Scenario B. If all we have done, in Scenario B, is replace Bo with the Bank, then surely our answer to the basic question--of whether a PPSA security interest has been created--must be the same. This conclusion is appealing, but is it sound? Specifically, is Scenario B (involving the Bank and Al) sufficiently analogous to Scenario A (involving Bo and Al) to support the conclusion that no security interest has been created?
No. There is one critical difference between the two scenarios. In Scenario B, the Bank's right of set-off arises under contract. The relationship between Al and the Bank is a unique contractual relationship, (53) under which the Bank has an implied contractual right of account combination buttressed by an express set-off clause in the customer account agreement and, most likely, the loan documentation governing the operating line (collectively, "contractual set-off").
The Bank's right of contractual set-off entitles it to set off the operating line balance against Al's deposit account balance: that is, by contractual arrangement, extinguish Al's deposit account balance in satisfaction of the operating line balance. One might observe, without jumping to any hasty conclusions, that this looks an awful lot like a PPSA security interest! At this stage, however, I resist that conclusion. I merely note that Bo's argument that no PPSA security interest is created because there was no form of agreement with reference to the subject property, is unavailable to the Bank. Unlike Bo's right of set-off in Scenario A--which simply exists, at law or in equity--the Bank's right of set-off against the deposit account balance in Scenario B arises under contract, in addition to whatever legal and/or equitable set-off rights the Bank may have had in the absence of contractual set-off. The analogy argument, therefore, must be dismissed.
(c) Dismissing the Intent Argument
Along another line of reasoning, the Bank might assert that the parties did not intend to create a PPSA security interest in Al's deposit account by virtue of the contractual set-off right. Since no security interest was intended, no security interest was created. (54)
This argument must also be dismissed. As noted in Part III, the PPSA prefers substance to form. (55) Pursuant to subsection 3(1), but subject to section 4 (a provision in which there is no mention of set-off), the PPSA applies to every transaction that in substance creates a security interest without regard to the form of the transaction or the intention of the parties. As noted above, the Bank's right of contractual set-off entitles it to extinguish Al's deposit account balance by setting off the operating line balance against it. In this sense, the Bank's exercise of its right of contractual set-off is a perfect analogue to secured realization, in which the Bank notionally seizes the deposit account balance and applies it against the operating line balance. (56) It does not matter that the contractual set-off right employs different conceptual mechanics than conventional security, and may not be defined with specific reference to the deposit account (the purported collateral). Under the PPSA, what matters is effect. To invoke a "sleight of hand" argument, and draw on the conceptualization of the Bank's right of set-off as a mere "payment right" against Al's deposit account balance, as opposed to a property interest in Al's deposit account balance, (57) is to embrace a "form over substance" approach that the PPSA explicitly rejects.
The same argument is advanced, but rejected, in the leasing context. A lease that exhibits certain attributes may be characterized as creating a security interest because, as a matter of economic substance over form, the leasing arrangement secures payment or performance of an obligation. Such a lease does not create a security interest because the parties intended it to. Indeed, they likely intended the very opposite. Through the form of a lease, they may have intended, very deliberately, to avoid the creation of a security interest in the leased item. Nonetheless, the PPSA looks beyond the form of the transaction, at its economic substance, and determines that a security interest has been created. (58)
Corresponding logic should apply in the context of deposit account set-off; namely, that the Bank does indeed acquire a PPSA security interest in Al's deposit account by virtue of its contractual set-off right against the deposit account balance. This is because the Bank's contractual set-off right arises under a consensual transaction that in substance secures payment of an obligation. (59) This contrary argument seems especially strong in light of subsection 3(1)'s opening words (i.e., "Subject to section 4 ..."), which suggest that the provision is subject only to section 4 of the PPSA and to no other PPSA provisions. Yet the conventional view is to the opposite effect. Under the conventional view, the Bank does not acquire a PPSA security interest in Al's deposit account by virtue of its right of contractual set-off against the account. How can this be?
(d) Dismissing the Non-Preservation Argument
Next, one might advance a non-preservation argument in defence of the conventional view. In the context of Scenario B, the non-preservation argument takes the following form: though the Bank may have the contractual right to extinguish Al's deposit account balance by setting off the operating line against it, this fact alone does not transform such right into a security interest in Al's deposit account. This is because the Bank has not taken any proactive measure to preserve the deposit account balance. In other words, since Al is entitled, at his discretion, to withdraw funds from the deposit account and deprive the Bank of an asset to assert set-off against, (60) no security interest has been created. (61) Does this argument withstand scrutiny?
No. The non-preservation argument must be rejected. It is true that, in Scenario B, the Bank has not contractually fettered Al's ability to access funds from the deposit account. Al can deprive the Bank of its set-off remedy by drawing down the balance to nil. But this is quite beside the point. Consider a basic inventory-financing scenario. A supplier grants purchase money inventory financing to its customer, and takes a security interest in the inventory to secure payment of the purchase price. No one seriously argues that the supplier does not have a security interest in the inventory because the debtor may deplete such inventory in the ordinary course of business. Why, then, should this same line of reasoning be embraced in respect of a deposit account and the Bank's right of contractual set-off? An arrangement that creates a security interest need not exhibit an element of preservation. On this basis, the non-preservation argument must be dismissed. A more persuasive explanation for the conventional view must be furnished.
(e) Embracing the Purposive Interpretation Argument
While we have seen that the conventional view fails on grounds of analogy, intent and non-preservation, it appears to survive under a purposive interpretation of subsection 41(2), paragraph 2(1)(qq), and subsections 3(1) and 65(2) of the PPSA. (62) The earlier provisions--paragraph 2(1)(qq) and subsection 3(1)--were reproduced above. The later provisions--subsections 41(2) and 65(2)--are reproduced below:
41(2) Unless the account debtor on an intangible or chattel paper has made an enforceable agreement not to assert defences to claims arising out of a contract, the rights of an assignee of the intangible or chattel paper are subject to:
(a) the terms of the contract between the account debtor and the assignor and any defence or claim arising from the contract or a closely connected contract, and
(b) any other defence or claim of the account debtor against the assignor that accrues before the account debtor acquires knowledge of the assignment....
65(2) The principles of the common law, equity and the law merchant, except to the extent that they are inconsistent with this Act, supplement this Act and continue to apply.
Paragraph 41(2)(a), read in conjunction with subsection 65(2), can be interpreted as a codification of the bank's right of contractual set-off: an assignee (whether transferee, secured party, etc. (63)) of a deposit account takes subject to the depository bank's contractual rights as account debtor, including its right of contractual set-off. Section 41 of the PPSA therefore recognizes the supremacy of contractual set-off vis-a-vis an assignee. The implication, under this purposive interpretation, is that contractual set-off is something different than, or distinguishable from, a PPSA security interest; (64) that the Bank's right of contractual set-off does not, ipso facto, create a PPSA security interest. Common law and equitable principles, of the contractual set-off variety, are not inconsistent with the PPSA. To the contrary, contractual set-off principles are enshrined in the PPSA, albeit rather obliquely. (65) Since paragraph 41(2)(a) appears later in the PPSA than the definitional and scope provisions supporting the contrary view (i.e., paragraph 2(l)(qq) and subsection 3(1)), it overrules or modifies the earlier provisions. (66) On this purposive interpretation, contractual set-off is an attenuated form of security right that falls short of constituting a PPSA security interest. (67)
Embracing this purposive interpretation and the conventional view is consonant with the notion that a contractual set-off right does not extend to proceeds of the disbursed account balance. A contractual set-off claimants expectation is that funds he actually pays on the account and proceeds thereof cannot later be pursued under a contractual set-off claim. Whereas the conventional view satisfies this expectation, the contrary view exceeds it. To conclude that a bare right of contractual set-off creates a security interest is also to conclude, by implication, that a contractual set-off claimant does acquire the right to pursue proceeds. Embracing the purposive interpretation theory and the conventional view avoids this anomaly, instead promoting statutory coherency and congruity with the reasonable expectations of commercial parties. The Bank's right of contractual set-off does not extend to proceeds, nor is it intended to. (68) It is therefore readily distinguishable from the type of transaction PPSA subsection 3(1) is meant to capture.
The reasoning employed in the previous paragraph buttresses the conventional view, to be sure, but it can be criticized for its circularity. Once it has been determined that a security interest has been created in original collateral, the PPSA automatically confers on the secured party a right to pursue proceeds. (69) If a proceeds claim flows from a claim to original collateral, it seems strange that the question of whether a security interest has been created in the original collateral (e.g., the deposit account in Scenario B) should hinge on the parties' intentions with respect to proceeds (e.g., funds disbursed from that deposit account). In other words, the chief focus in ascertaining whether a security interest has been created in Al's deposit account by virtue of the Bank's right of contractual set-off, should be on the deposit account itself, not its proceeds. Still, to conclude that a right of contractual set-off creates a security interest is to include, by implication, proceeds within the scope of its protection. And this goes well beyond what any person holding a right of contractual set-off reasonably expects. The better view thus appears to be that the right of contractual set-off is a form of attenuated security right, but does not create a PPSA security interest.
Another weakness in the purposive interpretation argument is that it completely disregards the introductory words of subsection 3(1) which state that subsection 3(1) is subject only to section 4, a provision which, again, makes no reference to set-off. (70) But this weakness is arguably counteracted by a pragmatic counterpoint. As we have seen, a bank's right of contractual set-off can be conceptualized as a contractual reaffirmation of principles that would nonetheless exist (to the same extent, more or less) in the absence of their contractual embodiment. (71) In other words, contractual set-off gives the bank approximately equivalent set-off rights to those it would ordinarily enjoy at law and in equity (rights of "non-contractual set-off"); the bank gains nothing, or very little, by specifically contracting for them. In Scenario A, non-contractual set-off rights did not create a security interest in favour of Bo. (72) To conclude that contractual set-off rights--the substantive equivalent of non-contractual set-off rights, more or less--create a security interest in favour of the Bank in Scenario B is to create asymmetry in the interaction between set-off and PPSA principles. Therefore, to ensure symmetry and consistency in the interaction between set-off and PPSA principles (i.e. to afford identical treatment to Bo in Scenario A and the Bank in Scenario B), the purposive interpretation argument should be adopted. (73)
Ultimately, though the purposive interpretation argument is assailable, it provides a coherent path to the conclusion that, in Scenario B, the Bank's right of contractual set-off does not create a PPSA security interest in Al's deposit account. I will proceed on the basis that it is correct. In Scenario B, the Bank does not create a PPSA security interest in Al's deposit account simply by virtue of its contracting for the right of set-off.
3. SCENARIOS C & D--FLAWED ASSET ARRANGEMENT
(a) Scenario C--Adding a Preservation Element
i. On Down the Transaction Continuum
In Part IV.B.2.d, a non-preservation argument was advanced in support of the conventional view that contractual set-off does not create a PPSA security interest. Though the non-preservation argument was ultimately dismissed as a stand-alone justification for the conventional view, this still leaves the converse of the non-preservation argument to be contemplated. What if an element of preservation is introduced into Scenario B? (74) Does the Bank acquire a PPSA security interest in Al's deposit account if Al is prohibited from accessing the deposit account until such time as the Bank's loan to Al is retired ("Scenario C")?
In the bank industry, the transaction described in Scenario C is known as a "flawed asset arrangement", (75) and is commonly employed by banks as part of a comprehensive lending strategy called a "triple cocktail". (76) A triple cocktail consists of "(1) a contractual right of set-off; (2) a charge back or security interest in the account; and (3) a flawed asset arrangement." (77) We already know, from the above discussion, that the first element of a triple cocktail does not, in itself, create a security interest. We also know that the second element is achievable as it is possible to create a conventional security interest in a deposit account with specific charging language. (78) What about the third? Does the final element of the triple cocktail--the flawed asset arrangement--create a security interest in the debtor's deposit account?
In Drummond, the SCC answered the above question in the affirmative. Note that the decision in Drummond was rendered not pursuant to set-off principles in the common law tradition, but rather in the context of Quebec's civil law compensation principles; "compensation" is the civil law equivalent of common law "set-off." (79) Also note that the SCC was specifically concerned with the term "security interest", not as defined in the PPSA, but as defined in subsection 224(1.3) of the Income Tax Act. Notwithstanding these distinguishing features, the Drummond decision has significant import in the PPSA context, particularly since the term "security interest" is defined similarly in the Income Tax Act and the PPSA. (80)
The dispute in Drummond concerned a term deposit maintained with a depository bank (a caisse populaire, the functional equivalent of a credit union). The competition was between the depository bank with which the deposit account was maintained and a federal Crown tax agency asserting a deemed trust in respect of unremitted source deductions. The federal Crown tax agency prevailed in a majority decision penned by Rothstein J. The outcome hinged on his conclusion that, pursuant to the transaction documentation, a security interest in the term deposit had been created in favour of the depository bank. Accordingly, the term deposit fell subject to the federal Crown tax agency's trust-based claim.
On behalf of the majority of the SCC, Rothstein J adopted the PPSA's standard functional approach, preferring substance to form in the determination of whether a flawed asset arrangement creates a security interest. (81) While Rothstein J accepted the conventional view that a bare right of contractual set-off does not create a security interest, he was of the view that the addition of a series of contractual encumbrances designed to maintain or preserve the deposit account balance for an effective set-off, pushes the transaction, as a matter of substance, over the threshold: (82)
It was the five-year term and the maintenance and retention of the $200,000 deposit, as well as Camvrac's agreement not to transfer or negotiate the deposit and that the deposit could only be used as security with the Caisse, that created the Caisse's interest in Camvrac's property for the purposes of s. 224(1.3) ITA. In the absence of these encumbrances on Camvrac's deposit, Camvrac could have withdrawn the deposit at any time. Should it have done so and still been indebted to the Caisse, the Caisse's right to compensation would be ineffective because it would not be indebted to Camvrac at the time the Caisse had to resort to the remedy of compensation. However, in this case the terms of the agreements provided that Camvrac agreed to the encumbrances on its deposit of $200,000 so that the Caisse would continuously be indebted to Camvrac and that on default there would be effective compensation. It is the fact that the agreements secured the Caisse's right to effective compensation by conferring on the Caisse an interest in Camvrac's property that created a "security interest" for the purposes of s. 224(1.3) ITA. (83)
Justice Rothstein's conclusion, that a flawed asset arrangement creates a security interest, tends to follow as a matter of logical necessity. In Scenario B, the absence of a preservation element was cited (unsuccessfully) in support of the conventional view that a security interest was not created. (84) If, from the conventionalist's perspective, the absence of a preservation element validates the conclusion that no security interest is created (i.e., saves the arrangement from crossing the transactional threshold), then surely the addition of a preservation element, in Scenario C, must put the arrangement over the transactional threshold, implying the creation of a security interest in the deposit account.
In the realm of intangible personal property, the flawed asset arrangement is the functional equivalent of the tangible realm's possessory security interest. Indeed, it can be directly analogized to a pawn shop deal--one of the most paradigmatic examples of a security interest--whereby a debtor leaves his Rolex with the pawn shop pending repayment of his debt. Unlike a bare right of contractual set-off, the flawed asset arrangement is not a "truncated" form of security. For this reason, the purposive interpretation theory, which is at least palatable in the context of bare contractual set-off, is totally unpalatable in the flawed asset arrangement context. It is difficult to see how the conventionalist can escape this logic. In any case, the SCC has spoken, and its reasoning applies equally in the PPSA context. (85) In Scenario C, the transactional threshold has been crossed and the Bank has acquired a PPSA security interest in Al's deposit account.
(b) Scenario D--Examining the "No Property Theory"
In the previous subpart, I described the flawed asset arrangement as the contractual preservation of an account through a restriction on withdrawal, coupled with the remedial mechanism of set-off. Consider the following two excerpts in which P Wood furnishes an alternate account of the flawed asset arrangement, which he refers to as a "conditional debt":
In the case of a conditional debt, the creditor has no claim at all and there is no discharge: the creditor must pay the cross-claim to the protected debtor. The customer has no claim for the deposit unless the customer pays the loan. (86) A conditional debt is a debt which is not payable at all until an event happens. The creditor does not have an asset at all until that event occurs. The asset is therefore "flawed." The depositors claim for its deposit is conditional on the depositor paying its loan. This is not a setoff since, if the event has not happened, the debtor has no liability against which the debtor can set off its cross-claim. Nor is it a charge-back because the creditor-depositor does not assign its property in the conditional debt-deposit. (87)
Under this strict conceptualization of the flawed asset arrangement, Al has no claim to his deposit account unless and until he fully retires his indebtedness to the Bank. (88) The implication is that the Bank does not acquire a PPSA security interest simply because Al has no property to grant a security interest in (the "No Property Theory"). (89) Can the Bank avoid characterization of the flawed asset arrangement as creating a PPSA security interest simply by framing its contractual relationship with Al in a manner consistent with the No Property Theory? (90) In Canada, this is doubtful.
Consider an exaggerated variation of Scenario C. Suppose that Al's deposit account balance is $1,000, and that the Bank grants Al a $100 term loan on contractual terms consistent with the No Property Theory, providing that Al has no claim to the $1,000 until the $100 term loan is repaid. Further imagine that Al eventually ceases having access to assets, outside the notional deposit account balance, to satisfy the $100 loan balance. His only asset, the $1,000 deposit account balance, is flawed ("Scenario D").
In Scenario D, does the Bank have the right to retain the entire $1,000 deposit account balance without an accounting to Al? (91) Moreover, is the Bank additionally entitled to judgment against Al for $100, the amount outstanding under the term loan? A strict application of the No Property Theory suggests an affirmative answer to both questions; the Banks obligation to pay Al the deposit account balance does not arise since the condition precedent for payment remains unfulfilled. I suspect, however, that a Canadian court, faced with the above questions, would force a pro tanto set-off of the Bank's loan balance against the notional deposit account balance on the basis that Al has some equitable or reversionary entitlement to the latter. In other words, the court would acknowledge that Al does indeed have a property interest in the "flawed asset". P Wood is similarly skeptical of the efficacy of such arrangements. (92)
Loxton, a proponent of the No Property Theory, rejects the explicit language of Australia's Personal Property Securities Act 2009, (93) which specifically names the flawed asset arrangement as a transaction that may, in substance, create a security interest under that statute. (94) In support of his position, Loxton offers a simple example:
Suppose a depositor owes a bank $500 and places $300 on deposit with the bank on flawed asset terms, that is, the obligation of the bank to repay the deposit is conditional upon the depositor repaying its debt. If the depositor does not repay its debt, then the bank's obligation is simply not payable. It remains a contingent or conditional obligation. No setoff is necessary to protect the bank's position. While it is still owed $500, it is (using loose language) able to 'retain' $300. It is not liable to pay that sum. It can pursue the depositor for the $500 without reference to the amount on deposit (as occurred in BCCI (No 8)). (95)
Loxton then promptly betrays the No Property Theory by acknowledging the depositor's residual property right in the $300 deposit:
Without set-off, then each debt would continue to accrue interest. Because the bank is not obliged to repay the $300 deposit, its maximum net principal loss is the $500 it may lose in recovery from the depositor, less $300, giving a net $200. At some stage, presumably, the accountants of a party would make suitable adjustments to its balance sheets. This is effective, but somewhat untidy. (96)
In a display of cognitive dissonance, Loxton steadfastly maintains--notwithstanding his last three sentences--that the flawed asset arrangement does not involve or require set-off. (97) Meanwhile, Derham states without hesitation or qualification that in Australia a flawed asset arrangement, papered in a manner consistent with the No Property Theory, creates a security interest. (98) Indeed, as noted above, the AUSPPSA specifically says so. (99)
Duggan and Brown note that the economic effect of the transaction, not its form or label as a "flawed asset arrangement", ultimately guides the determination of whether a security interest has been created. (100) This is true, but it is difficult to conceive of a flawed asset arrangement that does not, in substance, secure payment or performance of an obligation. Indeed, the very essence of the flawed asset arrangement is the assurance it provides to the account debtor (under the flawed asset) that he or she will be paid on his or her reciprocal account via the remedial mechanism of set-off.
In the English legal tradition, P Wood might endorse adherence to the No Property Theory. (101) However, it is doubtful whether he would endorse this view of the law in Canada, particularly given that all Canadian common law jurisdictions have enacted the PPSA, a statute that prefers substance to form and explicitly disregards contractual language designed to avoid its purview. In any event, if the No Property Theory is tempered or rejected by Canadian courts, it follows that the Bank does indeed acquire a PPSA security interest in Scenario D; again, the transactional threshold has been crossed.
C. THE DRUMMOND LEGACY
1. Threshold approximation: in defence of drummond
The analytical exercise undertaken in Part IV.B establishes that the security interest threshold is not crossed via non-contractual set-off (Scenario A) or bare contractual set-off (Scenario B). Something more, beyond a right of bare legal or contractual set-off, is required in order to create a PPSA security interest. Testing has also established that a right of contractual set-off, coupled with a preservation element (or a conditional obligation), does cross the definitional threshold, and creates a PPSA security interest (Scenarios C & D). These observations are helpful: they enable one to "straddle" the dividing line--representing the security interest transactional threshold--with both a left and right foot planted reasonably firmly on either side. (102)
The above exercise, however, does not precisely define the transactional threshold. Nor does Rothstein J furnish such a definition in Drummond. For instance, it is not entirely clear from Justice Rothstein's reasons whether a right of contractual set-off, coupled with a negative pledge clause but absent a preservation element, crosses the transactional threshold. (103) Of course, an infinite number of contractual variations could be introduced to the facts to affect one's conclusions. (104) As such, we must live with the limits of Justice Rothstein's guidance.
Some have argued that Justice Rothstein's decision in Drummond is incorrect or unhelpful, or both. (105) I disagree. For me, the Drummond decision confirms a rather obvious point. When one takes proactive steps to preserve a corpus of property against which he or she is to have prioritized realization rights, he or she has created a PPSA security interest. The bank industry may not consider this answer desirable, (106) but it is a straightforward answer, and a sensible one at that. True--the decision in Drummond does not delineate, in painstaking detail or exhaustive fashion, the transactional threshold for the creation of a security interest. But that is because such task is nigh impossible. In Drummond, Rothstein J considered the transaction before him and, based on its features, concluded that a security interest had been created. (107) This is the function of the judiciary. In my view, Rothstein J ably fulfilled his judicial function in Drummond.
2. BOTHERSOME IMPLICATIONS?
(a) Responding to the Bank Industry's Concerns
In the aftermath of the Drummond decision, bank industry representatives were quick to identify the troubling implications that flowed from Justice Rothstein's conclusion that a flawed asset arrangement creates a security interest. (108) The general apprehension can be articulated as follows: A depository bank cannot use a flawed asset arrangement with absolute confidence that it will maintain priority over competing secured creditors. Since a flawed asset arrangement creates a PPSA security interest, the bank must be the first registrant, or procure subordination agreements from prior registrants, in order to assure itself priority to the deposit account balance under the PPSA's "first to register" rule. (109)
The above apprehension is well-founded to the extent that a depository bank must rely on the PPSA's residual priority rule. However, fortunately for the bank it need not rely on the PPSA's residual priority rule in order to enjoy supremacy over competing secured creditors. First, if the bank can establish a purchase money security interest in the account and registration within 15 days of attachment, it enjoys priority over any secured party with a prior registration pursuant to the purchase money super-priority rule. (110)
Additionally, and in any event, a depository bank may assert an even more potent priority rule that does not hinge on or even require registration. As detailed above, the depository bank as account debtor on the deposit account may assert its contractual rights in priority to a competing security interest in the deposit account balance. (111) Indeed, whether flawed asset provisions or bare contractual set-off provisions, such provisions constitute "terms of the contract between the account debtor (the depository bank) and the assignor (customer)" which, pursuant to PPSA paragraph 41(2)(a), supersede a competing security interest. As such, the decision in Drummond does not spell catastrophe for depository banks under the PPSA. Indeed, to conclude that a flawed asset arrangement creates a PPSA security interest is to say precisely nothing about the bank's independent and freestanding contractual rights as account debtor, including its right of contractual set-off, which prevail in a priority competition. (112)
The PPSA does not treat set-off and security interests as mutually exclusive. (113) Nor is a right of contractual set-off "consumed by" the secured transaction of which it is part, whether in the form of a flawed asset arrangement or conventional security agreement. (114) Instead the better view is that a right of contractual set-off is extricable from the secured transaction of which it is part. Subsection 41(2) effectually dissociates the contractual set-off component from the larger secured transaction, thereby allowing the account debtor's contractual set-off right to stand on its own terms against competing PPSA security interests. (115)
One could argue that, by virtue of putting a flawed asset arrangement in place, a depository bank elects to relinquish, or forfeit, its freestanding contractual set-off rights. (116) However, the explicit language of the PPSA does not support this view. (117) To bring this "relinquishment theory" to fruition, provincial and territorial legislators would need to go out of their way to specifically overrule the superiority of the depository bank's contractual rights, amending the statutory language of PPSA subsection 41(2) accordingly. Therefore, provided a bank's independent and freestanding right of contractual set-off remains intact and extricable from the secured transaction of which it is part, no dire consequences flow from the conclusion that a flawed asset arrangement creates a PPSA security interest.
In my view, the bank lobby's criticism of the Drummond decision is unnecessarily alarmist, and involves a misreading, or over-reading, of the decision and its potential impact on secured transactions law. (118) At most, the Drummond decision typifies the overextension of the federal Crowns reach under the Income Tax Act and Employment Insurance Act, and could be dealt with, if necessary, with amendments to those federal statutes, not the PPSA. Those who seize on the Drummond decision as justification for PPSA deposit account reform--the adoption of a control paradigm--draw irrational connections.
(b) Responding to Anti-Bank Concerns
Now consider the flipside. Those who as a matter of principle or reflex oppose policies that benefit the bank industry will be bothered by my assertion that a banks unregistered right of contractual set-off prevails over a registered PPSA security interest. They will say: "Doesn't this go too far? Sure, a bank's right of deposit account set-off is powerful, but should it be that powerful?" I think it should. I ground my position on the principle of universality: a depository bank should be entitled to the same rights and privileges as everyone else, including you and me.
Let us revisit Scenario B, where Al and the Bank entered into a contractual arrangement providing for set-off. Suppose that you step into the shoes of the Bank; Al and you enter into a contractual arrangement generating reciprocal accounts and providing for set-off. Now imagine that Cy, an assignee of Al's claim, shows up at your door with evidence of his first registered security interest in the account debt on which you are liable. On the basis of lack of registration, or later registration, should you be deprived of your right of set-off against Cy's claim? My guess is that your answer is no. My answer is the same. And since that is so, corresponding logic must apply, mutatis mutandis, in favour of the Bank. Just as you should not be deprived of your right of contractual set-off vis-a-vis Cy, nor should the Bank.
In this article, I have approximated the point, along the transaction continuum incorporating or featuring the right of set-off, at which a PPSA security interest is created. Although I have not defined the transactional threshold, my hope is that this article contributes, in some positive way, to the attainment of that legal certainty so desired by commercial players. Perhaps it will also allay some lingering concerns in the ongoing aftermath of Drummond. The subject matter of this piece is important for depository institutions, like banks and credit unions, that regularly use set-off as part of their lending and realization strategies. It is also material to derivatives industry participants, for instance, since set-off rights are inherent in over-the-counter arrangements.
This article is provocative. The observations and conclusions set out herein will no doubt be unsettling. Some will be troubled by my conclusion that a flawed asset arrangement (however framed or structured) creates a PPSA security interest, and disturbed by my suggestion that bare contractual set-off does the same. Meanwhile, others will be bothered by my bank-friendly position on the deposit account set-off rights of a depository bank. Aristotle's final remarks in The Nicomachean Ethics seem apposite as I bring this article to a close ...
"Let us then begin our discussion." (119)
(1) Aristotle, The Nicomachean Ethics, translated by Harris Rackham (Ware: Wordsworth, 1996) at 5, Book I, iii, 4.
(2) 2009 SCC 29,  2 SCR. 94 ["Drummond"], Deschamps and LeBel JJ dissenting.
(3) The statutes actually interpreted in Drummond were the Income Tax Act, RSC 1985, c 1 (5th Supp) and Employment Insurance Act, SC 1996, c 23. Both s 227(4.1) of the Income Tax Act and s 86(2.1) of the Employment Insurance Act incorporate, by reference, the definition of "security interest" from s 224(1.3) of the Income Tax Act.
(4) Personal Property Security Act, 1993, SS 1993, c P-6.2 [PPSA], In this article, Saskatchewan's PPSA acts as a general proxy for the PPSA. Ontario's version of the statute is cited later in this piece. See RSO 1990, c P.10 [OPPSA],
(5) It is not a perfect analogy. Transactions incorporating or featuring the right of set-off do not lie on a neat linear continuum, but rather contain unique provisions and exhibit distinctive features and characteristics. Nor is the continuum analogy inapt, however. It is helpful because it correctly suggests that there exists a transactional threshold--a point beyond the bare right of set-off--that, if surpassed, results in the creation of a security interest.
(6) See Clayton Bangsund, "PPSL Values" (2015) 57:2 Can Bus LJ 184 at 197.
(7) Because over-the-counter derivatives transactions prominently feature set-off rights, the derivatives industry is also specially affected. Indeed, this subject matter bears materially on any commercial relationship in which reciprocal indebtedness is inherent or probable.
(8) See e.g. Ontario Bar Association, Personal Property Security Law Subcommittee, Perfecting Security Interests in Cash Collateral (6 February 2012), online: <www.oba.org/Advocacy/Submissions>; Robert M Scavone, "Cash Collateral Under the PPSA: The Case for Control" (2012) 53 Can Bus LJ 263; Jennifer Babeet al, Business Law Agenda: Priority Findings & Recommendations Report (June 2015), online: <www.ontariocanada.com>; Margaret Grottenthaler, "Cash Collateral Amendments for Ontario Recommended by Expert Panel", Canadian Structured Finance Law (4 August 2015), online: <www.canadianstructuredfinancelaw.com>; Bangsund, "PPSL Values", supra note 6.
(9) Philip R Wood, English and International Set-Off (London: Sweet & Maxwell, 1989) at para 1-91 [P Wood, International Set-Off].
(10) Ibid at para 1-1.
(11) PPSA, supra note 4, s 2(1)(b).
(12) Ibid, s 2(1)(w).
(13) For a detailed account of personal property taxonomy under the PPSA, see Clayton Bangsund, "The Deposit Account & Chose in Action at Common Law & Under the PPSA-. A Historical Review" (2014) 30:1 BFLR 1 at 11.
(14) For a detailed account of the common law taxonomy, see ibid at 7.
(15) See P Wood, International Set-Off, supra note 9 (where the author describes the proper conceptualization of set-off: "Note that the debtor uses his asset to pay his liability. He sets off the cross-claim owed to him to pay the creditors claim. The debtor does not apply the creditor's claim to pay the cross-claim. It is vital at the very outset to get the property in the debts the right way round." at para 1-3).
(16) The term "set off" (i.e., absent a hyphen) is used as a verb. See ibid at para 1-4.
(17) There is a noticeable lack of adherence to P Wood's technical conceptualization in both case law and academic commentary. His "order of operations" is regularly reversed, but outcomes are rarely affected or in any way tainted by non-observance. Nonetheless, I prefer his conceptualization, and endeavour to adhere to it.
(18) See Philip R Wood, Set-Off and Netting, Derivatives, Clearing Systems, 2nd ed (London: Sweet & Maxwell, 2007) at para 1-022 [P Wood, Set-Off & Netting]:
Set-off uses the loan to knock out the deposit, like skittles. Set-off is the discharge of both reciprocal claims. Thus a bank applies a loan owed to it to pay a deposit owed by it--its asset to pay its liability. The bank does not retain a deposit as a lien because it has no property over the deposit: the property of the deposit is held by the depositor. Note that in set-off the debtor uses its asset to pay its liability: it pays with its asset.
(19) Telford v Holt,  2 SCR 193 at para 25, 41 DLR (4th) 385 [Telford v Holt}-, Benjamin Geva, "Rights in Bank Deposits and Account Balances in Common Law Canada" (2012) 3 BFLR 28:1 at 6, 41.
(20) Telford v Holt, supra note 19. For a detailed account of the strictures of equitable set-off, see Clayton Bangsund & Jasmine Lothian, "Inequity in Equitable Set-Off: Telford v Holt Revisited", online: (2016) 94:1 Can Bar Rev 149 <www.cba.org /Publications-Resources/CBA-Journals/Canadian-Bar-Review>.
(21) A & E Capital Funding Inc v Maplex General Insurance Co (1999), 122 OAC 53, 10 CBR (4th) 225 (CA) [A&E v Maplex]. See also Cam-Net Communications v Vancouver Telephone Co, 1999 BCCA 751, 182 DLR (4th) 436 ("[t]he interrelatedness of the obligations giving rise to the two claims may give rise to the possibility of unfairness to the appellant if set-off is not allowed" at para 30).
(22) See e.g. Coopers & Lybrand Ltd v Lumberland Building Materials Ltd (1983), 49 BCLR 239, 150 DLR (3d) 411 at paras 16-17 (SC).
(23) Telford v Holt, supra note 19 at para 22; Teneycke v Saskatchewan Wheat Pool, 2000 SKQB 191, 97 ACWS (3d) 81; Drummond, supra note 2 at para 22.
(24) See Ewan McKendrick, ed, Goode on Commercial Law, 4th ed (London: Penguin Books, 2010) at 650. See also Louise Gullifer, ed, Goode on Legal Problems of Credit and Security, 4th ed (London: Sweet & Maxwell, 2009) at para 7.26 [Gullifer, Goode on Legal Problems].
(25) MH Ogilvie, Bank and Customer Law in Canada (Toronto: Irwin Law, 2007) ("[f]inally, there can be no exercise of the right of set-off where it has been expressly excluded by agreement or by a course of dealings between the bank and the customer" at 249); National Westminster Bank Ltd v Halesowen Presswork and Assemblies Ltd,  AC 785,  2 WLR 455 [Westminster Bank v Halesowen]; New Brunswick (Minister of Commerce & Development) v Bank of NS (1988), 95 NBR (2d) 330,  CLD 364 (QB).
(26) Ogilvie, supra note 25 ("[a] bank's right to combine accounts in order to discharge an overdraft is based on the fundamental bank and customer contractual relationship entered into when the first account is opened" at 247). See also Geva, supra note 19 at 16:
It is noteworthy that the existence of the common law right to combine accounts presupposes that the mere existence of separate accounts does not amount to an agreement precluding the combination. Rather, as indicated, 'as between banker and customer, whatever number of accounts are kept in the [bankers] books, the whole is really but one account.' While contractual set-off is premised on the existence of an agreement permitting it, a bankers set-off is premised on the lack of an agreement precluding it.
(27) Some hold the view that account combination, properly conceptualized, is not set-off at all. See e.g. Rory Derham, Derham on the Law of Set-Off, 4th ed (Oxford: Oxford University Press, 2010) at para 15.04.
(28) O'Hearn v Bank of Nova Scotia,  SCR 341,10 DLR (3d) 1.
(29) See Sutcliffe & Sons Ltd, Re,  OR 120 at para 22,  1 DLR 562 (CA); O'Hearn v Bank of Nova Scotia, supra note 28; National Westminster Bank v Halesowen, supra note 25. See also Geva, supra note 19 at 14. See e.g. Ogilvie, supra note 25 (where the author comments on the decision in Re European Bank, Agra Bank Claims (1872), LR 8 Ch 41 (CA): "The English Court of Appeal found that the securities could be applied to the indebtedness in the third account on the ground that there was essentially one account(ing) between the bank and its customer, although there may have been several accounts." at 247).
(30) P Wood, International Set-Off, supra note 9 at para 3-2.
(31) See Geva, supra note 19 at 14-16.
(32) Ibid at 19:
Rather, in my view, the bank's right to combine accounts is an implied term in the overarching banking as well as in each account contract. Under that contractual term, the bank is allowed to transfer to an overdrawn account, or in fact any account in a debit position which is in breach of the banking contract, funds available to the credit of the customer in another account. The bank may do so for its own protection as well as for the protection of the customer. See also Bradley Crawford, The Law of Banking and Payment in Canada, vol 2 (Toronto: Canada Law Book, 2008) (loose-leaf updated 2008), [section]9:60.20(3)(b); Gullifer, Goode on Legal Problems, supra note 24 at para 7-01.
(33) P Wood, International Set-Off, supra note 9 at para 3-28.
(34) Such funds must be "identifiable" and "traceable", and the intervener's claim to them is subject to the lowest intermediate balance rule. In other words, the intervener's proprietary claim in the deposit account balance may dissipate. For detailed discussion of tracing principles, see Ronald CC Cuming, Catherine Walsh & Roderick J Wood, Personal Property Security Law, 2nd ed (Toronto: Irwin Law, 2012) at 567-73.
(35) For application of this principle in the context of trust property, see Fonthill Lumber Ltd v Bank of Montreal,  OR451 at para 17, 19 DLR(2d) 618 (CA).
(36) See Ronald CC Cuming, "Security Interests in Accounts and the Right of Set-Off" (1990) 6:1 Business & Finance L Rev 299 at 309 [Cuming, "Security and Set-Off"]; NW Caldwell, "Security Interests in Proceeds: Account Consolidation and the PPSA" (1995) 59:1 Sask L Rev 165 ("[t]here is, however, a further condition on the exercise of the right to consolidate accounts: the account debtor must lack knowledge of the security interest before the right to consolidate accounts exists" at 176).
(37) PPSA, supra note 4, s 2(1)(qq) [emphasis in original].
(38) Michael G Bridge et al, "Formalism, Functionalism, and Understanding the Law of Secured Transactions" (1999) 44:3 McGill LJ 567 at 572.
(39) See Tamara M Buckwold, "The Rights of Account and Inventory Financers Under the P.P.S.A.: Transamerica Commercial Finance Corp., Canada v. Royal Bank of Canada" (1991) 55:1 SaskL Rev 171 at 178.
(40) Bank of Montreal v Innovation Credit Union, 2010 SCC 47,  3 SCR 3 ("[t]hese provisions have the effect of extending the provisions of the PPSA to almost anything which serves the function of a security interest" at para 18). See also i Trade Finance Inc v Bank of Montreal, 2011 SCC 26,  2 SCR 360 at para 26.
(41) Louise Gullifer, "Flawed Assets" in Sarah Worthington & Graham Virgo, eds, Commercial Remedies: Resolving Controversies (Cambridge, UK: Cambridge University Press) [forthcoming in 2017].
(42) In this light, consider the following advice from Margaret Grottenthaler, "Supreme Court of Canada Decision Reveals Risk of Characterization of Cash Collateral Arrangements as Creating Security Interests", Structured Finance Update (24 September 2009), online: <www.stikeman.com/cps/rde/xchg/se-en/hs.xsl /13044.htm> at 4 ["SCC Decision Reveals Risk"]:
It would therefore be advisable to take special care to avoid 'security interest language' in relevant documentation and even to specifically disclaim the intention to create a security interest. The Transfer Annex and the cash collateral language were carefully drafted in this respect. However, if you are putting together a bespoke arrangement it is very important to be rigorous in maintaining the distinction between set-off and security interests.
(43) Cuming, Walsh & Wood, supra note 34 at 12 [citations omitted].
(44) Cuming, Walsh & Wood, supra note 34 at 146.
(45) Ibid at 146.
(46) See Drummond, supra note 2 at para 102 (Deschamps J); P Wood, Set-Off & Netting, note 18 at para 1-008; Kelly R Palmer, The Law of Set-Off in Canada (Aurora, Ont: Canada Law Book, 1993) at 1; John AM Judge and Margaret E Grottenthaler, "Legal and Equitable Set-Offs" (1991) 70:1 Can Bar Rev 91 at 92; Gullifer, "Flawed Assets", supra note 40 ("[i]n a loose sense, this can be said to 'secure' the repayment of the loan").
(47) See Drummond, note 2 at para 102; P Wood, Set-Off & Netting, supra note 18; Cuming, Walsh & Wood, supra note 34 at 148.
(48) Cuming, Walsh & Wood, supra note 34 at 148.
(49) Ibid at 12.
(50) i Trade Finance Inc v Bank of Montreal, supra note 40 at para 30. See also Cuming, Walsh & Wood, supra note 34 at 12, 146.
(51) In Scenario A, AI and Bo are two individuals who happen to have claims against each other, created by contract. Perhaps each purchased an item at the other's garage sale, and furnished a simple "demand IOU" instead of cash. One could argue that, in such a circumstance, there exists an implied contractual right of set-off between Al and Bo. This is a question of fact, just as it was in Telford v Holt, where the court concluded that there was no contractual set-off available. For the purposes of Scenario A, we can assume that there is no implied contractual right of set-off, and hence no contractual set-off at all.
(52) Grant Gilmore, Security Interests in Personal Property, vol 1 (Boston: Little, Brown and Company, 1965) at 315-16.
(53) See Part II.B.3.b. For more information on the nature of the bank-customer relationship, see Geva, supra note 19; Ogilvie, supra note 25 at 247; Bangsund, "Deposit Account & Chose in Action", supra note 13.
(54) This argument was raised in Drummond, supra note 2 at para 26.
(55) See Buckwold, supra note 39 ("[t]he type of interest contemplated by the legislation is a generic one determined not by the form of its creation, but by its function (i.e., to secure payment or performance of an obligation)" at 178).
(56) Cuming, Walsh & Wood, supra note 34 at 661-62.
(57) This argument is palatable where one of the cross-claims generates transaction documentation furnishing a right of contractual set-off, and where that right of contractual set-off cannot be specifically attributed to any particular item of the debtors intangible personal property (i.e. the property that is ultimately set off against). This argument, however, is unavailable to the Bank in Scenario B since, in the terms governing Al's deposit account, the Bank specifically claims a right of contractual set-off against the deposit account balance.
(58) See Cuming, Walsh & Wood, supra note 34 at 12, 125-33.
(59) Binnie embraces the inverted "form over substance" mantra. See Ian J Binnie, "Comment on Caisse populaire Desjardins de l'Est de Drummond v Canada", Case Comment (2011) 26:2 BFLR 327 at 331-32:
Without doubt, this conclusion would come as a surprise to whomever prepared the standard-form agreements that the Caisse required Camvrac to sign. The Caisse clearly did intend to take effective "security" from Camvrac, but common sense (at least of the kind possessed by commercial lawyers) suggests that the Caisse did not mean to create a "security interest" within the meaning of section 224(1.3). Instead, its use of a compensation-based structure gives strong indication that the Caisse had precisely the opposite intention. At the time that the Camvrac credit facility was established, the prevailing view among commercial lawyers was that a right of compensation (set-off) could provide effective protection from the claims of other creditors (including Her Majesty) or a trustee in bankruptcy.
(60) If there is a nil balance in the deposit account, the Bank has nothing against which to set off its claim.
(61) This idea was discussed by Rothstein J in Drummond, supra note 2 at para 33:
The situation in this case is in contrast to one in which a bank has what may be a standard term in a deposit agreement that any credit in the customer's account may be appropriated by the bank in discharge of the customer's potential indebtedness to the bank. In that case, there is no obligation on the customer to maintain a specific sum or, indeed, any amount deposited in the account at all as security for a loan that may or may not exist. There is no continuous right in the customer's property to protect the bank against default. The customer may withdraw any or all of the amounts in the account at any time. No specific property secures repayment. In these circumstances, based on this type of deposit agreement, the customer's property--its right to claim a deposit--cannot be said to secure its indebtedness to the bank. Unlike the case before this Court, this is a simple contractual right to set-off or compensation without attendant security.
(62) See Royal Bank of Canada v Agricultural Credit Corp of Saskatchewan (1994), 115 DLR (4th) 569, ("[t]he applicable canons of interpretation dictate that the section be interpreted contextually and be read in relation to the whole Act" at 578), 7 WWR 305 (Sask CA).
(63) PPSA, supra note 4 ("'assignee' includes a secured party and a receiver" at s 41(1)(b)).
(64) Drummond, supra note 2 at para 106 (Deschamps J).
(65) See Bangsund, "PPSL Values", supra note 6 at 215.
(66) Pierre-Andre Cote, The Interpretation of Legislation in Canada, 4th ed (Toronto: Thomson Reuters, 2011) ("A special provision in conflict with a general one will be interpreted as an exception to the general one: specialia generalibus derogant. In the event of conflict, the specific provision takes precedence" at 331). "See also Stevenson v GMAC Leaseco Ltd, 2003 NBCA 26 ("[a]s a matter of statutory interpretation, the general must make way for the specific" at para 54), 257 NBR (2d) 141.
(67) Along another line of reasoning, one might conclude that the right of contractual set-off creates a security interest, but that the PPSA additionally recognizes, under section 41(2), contractual set-off (i.e., the terms of the contract between account debtor and assignor) as an independent, free-standing, and superior right vis-a-vis competing security interests. The law commonly allows for both "belt and suspenders".
(68) But see Part IV.B.2.C.
(69) PPSA, supra note 4, paras 28(l)(b), 28(2)(b).
(70) Drummond, supra note 2 at para 42 (Rothstein J).
(71) See Part II.B.3.
(72) See Part IV.B.1.
(73) See Cuming, "Security and Set-Off", supra note 36 at 321 (where the author employs similar reasoning in a slightly different context).
(74) Diccon Loxton, "One Flaw Over the Cuckoos Nest--Making Sense of the 'Flawed Asset Arrangement' Example, Security Interest Definition and Set-Off Exclusion in the PPSA" (2011) 34:2 UNSWLJ 472 at 476:
Occasionally some practitioners may describe the feature of a Deposit Flawed Asset as being a restriction on withdrawal. One may see arrangements drafted with a deposit and a restriction on the right to withdrawal rather than the standard approach of making the obligation to repay the deposit expressly conditional....
(75) The term "flawed asset arrangement" is of recent vintage. See Loxton, ibid at 477, where the author traces the origin of the term to a 1981 law review article: FW Neate, "Set Off" (1981) 9:6 Int'l Bus Law 247.
(76) P Wood, Set-Off & Netting, supra note 18 at para 1-025.
(77) Roderick J Wood, "Journey to the Outer Limits of Secured Transactions Law: Caisse Populaire Desjardins De I'est De Drummond' (2009) 48:3 Can Bus LJ 482 at 491 [R Wood, "Journey to the Outer Limits"].
(78) PPSA, supra note 4 ("[a]n account debtor as defined in clause 41(l)(a) may take a security interest in the account or chattel paper under which the account debtor is obligated" at s 9(4)).
(79) Drummond, supra note 2 at para 18. See also R Wood, "Journey to the Outer Limits", supra note 77 at 484.
(80) R Wood, "Journey to the Outer Limits", supra note 76 at 487.
(81) Drummond, supra note 2 at paras 24-25, per Rothstein J. In dissent, Deschamps J adopted a form over substance approach which is captured in the following excerpt: "The fact that a legal mechanism enables a creditor to obtain an effect similar to that of a 'security interest' in the generic sense of the term does not make that mechanism a security interest": at para 109.
(82) Ibid at para 55.
(83) Drummond, supra note 2 at para 30.
(84) See Part IV.B.2.d.
(85) R Wood, "Journey to the Outer Limits", supra note 77 at 487.
(86) P Wood, International Set-Off, supra note 9 at para 1-60 [emphasis added]. For similar accounts of the flawed asset arrangement, see R Wood, "Journey to the Outer Limits", supra note 76 ("[a] flawed asset arrangement is a transaction in which the payment of a debt is conditioned on some other event, such as payment of a different claim owed to the debtor by the creditor" at 491-92 [citation omitted]); Gullifer, Flawed Assets, supra note 41 ("[a] flawed asset is a contractual obligation which only has to be performed if a contingency arises").
(87) P Wood, Set-Off & Netting, supra note 18 at para 1-023 [emphasis added], H
(88) Loxton, supra note 74 at 484-85 [citations omitted], adopts this strict H conceptualization of the flawed asset arrangement:
It is important to note that in no sense is a simple flawed asset enforced or exercised. If the obligor is relying on the relevant condition not to perform the relevant conditional obligation, it is merely reflecting the fact that it is not under an obligation to do anything. It H is not 'refusing' to honour the conditional obligation nor is it taking any step. Of course, if H the Extras which accompany a flawed asset include a right of set-off or a right to appropriate H an obligation, the conditional obligor could exercise that right, but it is not necessary for it to H do so to be able to rely on the flawed asset.
(89) Ibid at 506:
In relation to a simple flawed asset without any Extras, it might be said that as well as creating no interest for the obligor that could be described as a security interest for the purposes of the PPSA, there is nothing that secures any obligation in the sense described above. If the obligee or other party defaults, then the obligor is simply not obliged to perform the obligation that otherwise it might have had. It can also be said that it does not 'in substance secure' payment or performance in that case, as there is no resort to any particular asset or fund.
(90) Note that, as a matter of fact, the actual terms of the contractual documents in Drummond were not consistent with P Wood's strict conditional obligation conceptualization. See R Wood, "Journey to the Outer Limits", supra note 77 at 493.
(91) Leave aside the fact that, in reality, this is a highly improbable eventuality for a number of practical reasons including, without limitation, the prospect of a negotiated compromise between the Bank and A1 (i.e., a subsequent agreement to set off), bridge financing availability, etc.
(92) P Wood, International Set-Off, supra note 9 at paras 5-1, 5-216.
(93) 2009 (Cth) [AUSPPSA], Under the AUSPPSA, a bank that acquires a security interest in a deposit account via flawed asset arrangement (consistent with the No Property Theory) automatically perfects its security interest by control. In the words of Stumbles, this leaves the Australian bank in an "especially privileged position": John GH Stumbles, "Personal Property Security Law in Australia and Canada: A Comparison" (2011) 51:3 Can Bus LJ 425 at 436.
(94) AUSPPSA, supra note 93, s 12(2)(1).
(95) Loiaon, supra note 74 at 481 [citation omitted].
(96) Ibid at 482.
(97) Ibid at 485.
(98) Derham, supra note 27 at para 16.108, n 431.
(99) AUSPPSA, supra note 93, s 12(2)(1).
(100) Anthony Duggan & David Brown, Australian Personal Property Securities Law, 2nd I ed (Australia: LexisNexis, 2016) at para 3.14.
(101) P Wood, International Set-Off, supra note 9 at paras 5-209, 5-216.
(102) See Cuming, Walsh & Wood, supra note 34 at 146.
(103) Drummond, supra note 2 at para 54. It is clear that a negative pledge clause, standing alone, does not create a PPSA security interest.
(104) Anthony Duggan, "Some Canadian PPSA Cases and their Implications for Australia and New Zealand" (2010) 38:3 Austl Bus L Rev 161 at 165.
(105) See e.g. Binnie, supra note 59; Scavone, supra note 8 at 275; Loxton, supra note 74 at 509-16.
(106) See e.g. Grottenthaler, "SCC Decision Reveals Risk", supra note 42 at 1; Binnie, supra note 59.
(107) Cuming, Walsh & Wood, supra note 34 at 143-45.
(108) See Grottenthaler, "SCC Decision Reveals Risk", supra note 42; Binnie, supra note 59 at 334; Scavone, supra note 8 at 275-77.
(109) PPSA, supra note 4, s 35(1).
(110) Ibid, s 34(2) (b).
(111) PPSA, supra note 4, s 41 (2)(a).
(112) See Grottenthaler, "SCC Decision Reveals Risk", supra note 42 at 2, where the author employs the same reasoning, correctly in my view:
The argument against set-off being a security interest is that the party seeking to set-off does not by virtue of a set-off right itself have a proprietary claim in property belonging to the other party. The party setting off itself has an obligation (in this case the term deposit obligation) and is entitled to satisfy that obligation by setting off an obligation owed to it by the other party (in this case the loan obligation). Set-off does not have anything to do with realizing on a property interest in one's own obligation. Even if there is a security interest in one's own obligation (as there was in this case), the set-off right can exist quite independently of that (and in a properly drafted agreement that would be clear).
(113) Drummond, supra note 2 at paras 38-41.
(114) Article 9 of the Uniform Commercial Code (UCC) explicitly embraces this view. See UCC [section]9-340(b), Official Comment 3: "Subsection (b) makes clear that a bank may hold both a right of set-off against, and an Article 9 security interest in, the same deposit account. By holding a security interest in a deposit account, a bank does not impair any right of set-off it would otherwise enjoy." See UCC [section]9-340(b): "Except as otherwise provided in subsection (c), the application of this article to a security interest in a deposit account does not affect a right of recoupment or set-off of the secured party as to a deposit account maintained with the secured party."
(115) For a contrary view, see Anthony Duggan, "The Australian PPSA from a Canadian Perspective: Some Comparative Reflections" (2014) 40:1 Monash UL Rev 59 at 68; "Set-Off, Flawed Assets and Security Interests in Cash Deposits" (2016) 31:4 Butterworths J IntI Banking & Financial L 201 at 202.
(116) See Binnie, supra note 59 at 334-35; Scavone, supra note 8 at 272.
(117) For a like interpretation of s 40(1.1) of the OPPSA, Ontario's concordant provision of the SPPSA's s 41(2), see Grottenthaler, "SCC Decision Reveals Risk", supra note 42 at 4.
(118) Ibid at 3:
While there is much to criticize in the judgment, this decision is now a part of Canadian law and may require adjustments to practices. In particular, it is important to note that while the case dealt with the deemed trust provisions of the ITA and EIA, its implications could extend further into the realm of personal property security law.
See also Scavone, supra note 8 at 265-66:
Rothstein J.'s majority judgment in that case called into question the legal and practical efficacy of relying on contractual rights of set-off coupled with limitations on the debtors rights to the offsetting obligation in lieu of registering a security interest. As discussed at greater length below, if the court's reasoning with respect to security interests under federal tax legislation is extended to provincial personal property security law, the rights of set-off often used as an alternative to perfection by registration could be re-characterized as security interests requiring such registration.
(119) Supra note 1 at 284, Book X, ix, 23; other translations of Aristotle's famous work adopt slightly different wording. See e.g. Aristotle, The Nicomachean Ethics of Aristotle, translated by David Ross (London: Oxford University Press, 1961) ("[l]et us make a beginning of our discussion" at 276, Book X, ix, 23). This concluding statement links Aristotle's work on ethics to his work on politics.
CLAYTON BANGSUND, Assistant Professor, University of Saskatchewan--College of Law. Special thanks to Professors Ronald CC Cuming, Anthony Duggan, Roderick J Wood and Tamara M Buckwold, and to all other members of the Canadian Conference on Personal Property Security Law in attendance at the June 2016 meeting in Charlottetown, Prince Edward Island, for your valuable feedback. Thanks, also, to Professor Michael Plaxton and, of course, my anonymous peer reviewers.
|Printer friendly Cite/link Email Feedback|
|Publication:||University of British Columbia Law Review|
|Date:||Feb 1, 2017|
|Previous Article:||On pardons and miscarriages of justice: extracting and dissecting institutional bias from the conviction review framework in Canada.|
|Next Article:||Case comment on Goodwin v British Columbia (superintendent of motor vehicles): reviewing the consequences of a search or seizure in administrative...|