The corporate lending market in Canada was very active in 2016, particularly in the merger and acquisitions area, and, overall, activity levels and the average deal size were higher than in 2015. Syndicated loans are frequently used by Canadian borrowers to fund a number of activities, including acquisitions, capital expenditures, dividend recapitalisations, refinancing of existing debt and ongoing operations. Continuing low interest rates, substantial liquidity in the North American market and reasonable credit terms have contributed to the attractiveness of leveraged loans for Canadian borrowers in 2016. However, the prospect of increased interest rates, uncertainty as to the direction of oil and other commodity prices, together with a tightening of credit terms, may negatively affect the level of Canadian lending activity in 2017.
ii Standardised terms
The Canadian Bankers Association has published Model Credit Agreement Provisions to be used in syndicated loan transactions in Canada. The goal of the Provisions was to standardise selected provisions of loan agreements to more easily facilitate secondary market trading and include standard provisions relating to assignments and loan trading. The Provisions are based on provisions prepared by the Loan Syndication and Trading Association, Inc. Use of the Provisions is not mandatory, but they are commonly used in syndicated loan transactions where the administration agent is a major Canadian bank.
iii Recent Canadian deal activity
Deal volume in the Canadian merger and acquisition market in 2016 increased by 2.4 per cent from 2015, with a total of 2,685 deals announced.2 These transactions totalled C$331.5 billion, a nine-year high for the Canadian market and a 20 per cent increase from 2015.3 Deal volume in 2016 peaked in the second quarter (with 709 announced deals), declined in the third quarter (with 681 announced deals) and increased again in the fourth quarter and into the first quarter of 2017 (with 693 and 771 announced deals, respectively).4 Deal value remained strong on the back of a number of mega deals, but increases in mid-market transactions were the driving force behind the surge in activity.5 There were 55 mega deal transactions in 2016, with a total value of C$255.4 billion.6 While the real estate sector was the most active industry by deal volume in the second and fourth quarters of 2016, information technology was the most active industry in the first quarter, with 82 transactions announced, and metals and mining was the most active industry in the third quarter, with 94 transactions announced. Energy was the industry with the highest deal value in 2016 (representing 31 per cent of a total Canadian deal value of C$331.5 billion).7 Overall, 2016 was a strong year for Canadian merger and acquisition activity, with deal value hitting record levels. The market was driven by a record string of pipeline deals by energy firms making foreign acquisitions, including Enbridge Inc's acquisition of Texas-based Spectra Energy Corp for $61 billion.8 While experts predict that the overall value of outbound transactions will likely fall in 2017,9 push for growth by shareholders, a weak currency, strong equity markets, low interest rates, healthy corporate balance sheets and an increase in appetite for cross-border transactions are all expected to support an active Canadian mergers and acquisitions market for 2017.10
iv Canadian financing sources
Canadian companies continue to finance their operations in a variety of ways. Day-to-day operations and cash management are generally financed with operating loans or liens of credit that are entered into with a company's primary financial institution. Asset-based loans, financed on the security of a company's working capital assets, also continues to be a frequently used source of financing for many Canadian companies, particularly in the manufacturing, distribution and retail sectors. In many cases, a significant portion of the consideration for acquisitions was funded through various types of debt obtained from a variety of sources. Sources include senior secured credit facilities provided by domestic and foreign financial institutions, second lien credit facilities, unsecured credit facilities, streaming arrangements, high-yield notes and mezzanine debt.
II LEGAL AND REGULATORY MATTERS
i Lender-related regulatory requirements
Canadian borrowers regularly obtain financing and leveraged finance products from a broad range of lenders including domestic and foreign financial institutions, private equity and hedge funds and through the issuance of public debt, including high-yield debt. Canadian and foreign banks are very active in this area and provide a wide variety of debt products to Canadian borrowers. The key regulatory issue for lenders dealing with Canadian borrowers is whether the lender would be considered a bank for Canadian regulatory purposes. The activities of Canadian banks and foreign lenders affiliated with foreign banks that are carrying on banking business in Canada are subject to regulation under the federal Bank Act. Lenders that are banks or affiliated with foreign banks must obtain the necessary approvals under the Bank Act to establish a presence in Canada, and must comply with certain operational requirements of the Bank Act on an ongoing basis.
Foreign lenders affiliated with foreign banks that do not have a presence in Canada may lend to Canadian borrowers without obtaining regulatory approvals from federal banking regulators if the lending relationship is established in a way that would not involve the lender being viewed as carrying on business in Canada. Generally speaking, a loan that is made by a lender located outside Canada, and that is approved, negotiated and documented outside Canada with payments being made to an entity outside Canada, should satisfy this test.
Without connection to a bank, foreign and other lenders that are not otherwise regulated as financial institutions in Canada (e.g., insurance companies, trust companies and credit unions) do not require any special licences or regulatory approvals to make a loan to a Canadian borrower. Such lenders will, however, be subject to laws of general application that apply to the taking and enforcement of security in certain provinces. For example, a lender may require an extra-provincial licence under provincial legislation to hold and enforce a mortgage on real estate in that province. Lenders that lend on the security of real property may also need to obtain a mortgage brokerage licence under provincial legislation if it is not a financial institution exempted from compliance.
Although not a Canadian regulatory issue per se, foreign lenders entering the Canadian market will also need to consider their ability to fund loans in Canadian dollars as many Canadian borrowers require Canadian dollar borrowings.
ii Borrower-related regulatory requirements
The activities of many Canada borrowers are subject to some degree of government regulation, and often a particular government licence or approval is a key component of the borrower's business operations. Lenders to such borrowers should ensure that the borrower obtains all necessary governmental consents required to grant security on its assets to secure the proposed financing and to permit the lender to realise on its security. In addition, any transfer of a regulated borrower's assets (including any applicable licences) as part of the realisation process may well require further governmental approvals, including approval of the proposed acquirer.
iii Canadian anti-money laundering legislation
The Proceeds of Crime (Money Laundering) and Terrorist Financing Act makes it mandatory for certain entities (including lenders) to ascertain the identity of Canadian borrowers and related parties before accepting them as clients, to report a variety of transactions to the Financial Transactions and Reports Analysis Centre of Canada and to maintain certain client and transaction records. These requirements are designed to assist in the detection and deterrence of money laundering and the financing of terrorist activity in Canada and around the world. Lenders should ensure that their due diligence requirements include a request for the information necessary to ensure compliance with this legislation.
iv Basel III
In 2015, the Basel III liquidity rules started to be phased in as part of Canada's commitment to have the rules progressively phased in by 2019. There are two minimum rules for liquidity: the liquidity coverage ratio that has a 30-day horizon, and the net stable funding ratio that has a one-year horizon. Both rules are designed to ensure adequate liquidity for banks during periods of stress. Canada's banks remain among the best-capitalised in the world in terms of quality and quantity of capital.
III TAX CONSIDERATIONS
Canadian tax issues also need to be considered when structuring financing and leveraged finance products.
i Withholding tax
Under the Income Tax Act (Canada) (the Tax Act), interest paid by a Canadian resident debtor to an arm's-length non-resident creditor will not generally be subject to the Canadian withholding tax, provided that the interest is not participating (e.g., contingent or dependent on the use of or production from property in Canada or computed with reference to revenue, profit, cash flow, commodity price or similar criterion or by reference to dividends paid). Where interest is subject to withholding tax under the provisions of the Tax Act (either because it is paid to a non-arm's length creditor or is participating), the terms of an applicable bilateral tax treaty may apply to reduce the rate of withholding tax from the Canadian domestic rate of 25 per cent. Under the provisions of the Canada-US Income Tax Treaty, the rate is reduced to 15 per cent if the interest is participating, or otherwise to zero per cent. Most other treaties reduce the rate of withholding tax on interest to 10 per cent.
Under Canada's ‘back to back' rules, additional withholding tax may apply where an intermediary is interposed between a foreign lender and a Canadian borrower, and a high rate of Canadian withholding tax would otherwise apply in respect of payments to the foreign lender.
ii Interest deductibility
Interest is only deductible to a Canadian resident debtor where it meets certain technical requirements set out in the Tax Act. In particular, interest (not in excess of a reasonable amount) is generally deductible on:
- a borrowed money used for the purpose of earning income from a business or property; or
- b an amount payable for property that is acquired for the purpose of gaining or producing income from a business or property.
Interest payable on financing incurred to fund the acquisition of an asset to be used in the debtor's business should generally be deductible. Similarly, interest payable on financing incurred to fund the acquisition of shares of a company (where there is a reasonable expectation of income from the shares) should also generally be deductible. Where the Canadian resident debtor incurs debt to finance the acquisition of shares, and it then amalgamates with, or winds up, the target company, the interest payable on that debt will generally continue to be deductible (on the basis that the income-producing shares are now replaced with income-producing assets).
iii Thin capitalisation rules
Under the Tax Act, interest payable by a Canadian resident debtor may not be deductible to the debtor, and also may be subject to Canadian withholding tax on an accrual basis, if the Canadian thin capitalisation rules are applicable. These rules generally apply where:
- a a non-resident creditor owns or has a right to acquire (or is non-arm's length with a person who owns or has the right to acquire) shares of the debtor representing 25 per cent or more of the votes or value of the debtor's capital stock; and
- b the debt-equity ratio of the debtor is in excess of 1.5:1.
The thin capitalisation rules may apply in a situation where financing is undertaken by a non-resident parent corporation that then on-lends the funds to its Canadian subsidiary.
iv Consolidation issues
Canadian resident corporations do not file consolidated tax returns (unlike in certain other jurisdictions, such as the United States). As a result, interest payable by a Canadian resident corporation is only deductible by that particular corporation and can only offset income earned by that particular corporation. Where the taxable income of the debtor corporation is not sufficient to offset the interest deductions, other transactions may need to be undertaken to efficiently use the interest deductions in the corporate group. In particular, when an acquirer incurs debt to finance the acquisition of a target corporation, additional steps (such as the amalgamation of the acquirer with the target) may need to be undertaken to facilitate the deduction of the interest on the acquisition financing against the target's operating income.
v Stamp and documentary taxes
There are no stamp or other documentary taxes in Canada to which loan or securitisation documentation or loan trading documentation might be subject.
vi Foreign Account Tax Compliance Act
Under the US Foreign Account Tax Compliance Act (FATCA), payments made to foreign creditors under Canadian financing or leveraged finance arrangements may, in certain circumstances, be subject to a 30 per cent US withholding tax. Where there is a risk of FATCA withholding, the applicable loan or debt financing instrument will typically require the foreign creditor to provide such documentation as may be necessary for the debtor to comply with its obligations under FATCA and to determine whether the creditor has complied with its obligations under FATCA, or to determine the amount of FATCA withholding tax that will be deductible from payments made under the instrument. A Canadian debtor will typically not provide a gross up to the foreign creditor for amounts deducted on account of FATCA withholding tax.
IV CREDIT SUPPORT AND SUBORDINATION
Secured loans are commonly used in the Canadian debt market to finance working capital, acquisitions and longer-term borrowing needs. The forms of security and quasi-security (such as guarantees) most commonly used in the Canadian market to secure personal and real property assets, as well as the regime for taking security under the Civil Code of Quebec (CCQ) and the common law applicable in the other provinces and territories are discussed below.11
Personal property - tangible moveable property - common law provinces
Each of the common law provinces and territories in Canada has a personal property security statute (collectively, the PPSAs) that is modelled on Article 9 of the Uniform Commercial Code in the United States. Under the PPSAs, tangible moveable property consists of goods, chattel paper, documents of title and investment property. In secured financings in the Canadian market, tangible moveable property normally means goods that are equipment or inventory.
Security in this type of property is created when a debtor grants to the creditor a security interest in that property. The granting clause in the security agreement will expressly describe the collateral that the security interest attaches to. Quite often, secured creditors are given a general security interest that secures all of the debtor's existing and after-acquired personal property, both tangible and intangible.
A security interest in tangible property must be perfected if a creditor is to have priority over the interests of other creditors and third parties. Registration of a financing statement in the province or territory where tangible assets are physically located is necessary to perfect a security interest in those assets. The PPSAs are publicly accessible, searchable databases and a registered financing statement serves as a public notice that a debtor's assets have been encumbered in favour of a secured creditor. The cost to file a financing statement under the various PPSAs is nominal and varies slightly with the length of the filing term. Secured parties must file under the PPSAs in every province or territory where the debtor's assets are located if they wish to be perfected against all of those assets. Certain types of tangible personal property such as chattel paper, instruments, money, documents of title and large goods can also be perfected by possession.
Personal property - tangible moveable property - Quebec
Security over tangible moveable property in Quebec is created by a hypothec. Registration at the Register of Personal and Moveable Real Rights (RPMRR) perfects the hypothec. The cost to register at the RPMRR is nominal and varies slightly with the length of the filing term. No written agreement is needed where a hypothec is taken with delivery (i.e., a pledge). Perfection occurs when the pledged collateral is physically delivered to the pledgee.
Personal property - tangible moveable property - federal jurisdiction
Security in aircraft, ships and most railways is governed in Canada by federal legislation. While security interests in these types of assets can be taken under the PPSAs or the CCQ, secured parties are well advised to consider any applicable federal legislation and to take any additional steps prescribed therein to establish a first-ranking claims on such assets.
Personal property - intangible property (general) - common law provinces
Intangible personal property includes claims and receivables, contractual rights, intellectual property rights (IP rights) and investment property.12 Generally, creditors secure intangibles similarly to tangibles, by way of a security agreement and perfection by registration under the PPSAs.13 The law of the jurisdiction where the debtor is located14 at the time the security interest attaches governs the validity, perfection and priority of a security interest in intangible personal property.
IP rights are governed by federal legislation in Canada, but these rights are personal property under the PPSAs and are considered intangibles. A security interest is created in IP rights through a grant of security under a security agreement, and is perfected by registration. In addition, it is common practice for secured creditors with a security interest in Canadian trademarks, copyright or patents to file a copy of or notice of the security agreement with the Canadian Intellectual Property Office.
Personal property - intangible property (general) - Quebec
Under the CCQ, the law of the jurisdiction where the grantor is domiciled (i.e., where its registered office is located) governs the validity and perfection of security over intangibles. Intangibles (incorporeal moveable property) such as claims, receivables, contractual rights and IP rights owned by a debtor domiciled in Quebec are secured under the CCQ by way of a hypothec that is perfected by filing in the RPMRR. For monetary claims relating to the credit balance of a financial account, the security thereon may be perfected as a prior ranking security by entering into a control agreement with the bank or other financial entity that maintains the financial account.
Personal property - intangible property (investment property)
Financial assets such as shares and other securities are considered investment property under the PPSAs. Almost all of the common law provinces and territories have a Securities Transfer Act or similar legislation (STAs) that is based on revised Article 8 of the Uniform Commercial Code. The STAs work together with the PPSAs to govern the creation and perfection of security interests in investment property. The CCQ also contains provisions specific to investment property.
Investment property under the PPSAs and STAs includes securities (uncertificated and certificated), securities entitlements, securities accounts, futures contracts and futures accounts. In secured financings in Canada, the type of investment property seen most commonly is certificated securities. A borrower or guarantor would typically pledge the certificated shares it holds directly in a subsidiary to a lender to secure its obligations owing to that lender.
In addition to execution of a security agreement and filing under the PPSAs to perfect an interest in investment property as an intangible, secured creditors can also establish ‘control' or possession over such property. Control is the best method for perfecting such an interest as it gives the secured party a higher priority than a security interest perfected by registration alone.
Where investment property is held directly by a debtor, a secured party obtains control of certificated securities by taking possession of the certificates and either taking an endorsement or having the securities registered in its name. For uncertificated securities, control is achieved by either registering the securities in the name of the secured party or by obtaining a control agreement from the issuer of the securities. A control agreement is a tripartite agreement among the issuer, the debtor and the secured party and provides that the issuer agrees to comply with instructions from the secured party with respect to the securities without the debtor's further consent.
Where the investment property consists of securities entitlements held indirectly by the debtor through a securities intermediary, the secured party obtains control by:
- a arranging for the securities intermediary15 to record the secured party as the entitlement holder;
- b obtaining a control agreement from the securities intermediary; or
- c having a third party obtain control on its behalf.
The most common forms of security over real estate in the Canadian market are mortgages, debentures, hypothecs and trust deeds. Real estate in the common law provinces and territories includes land (together with buildings and fixtures), airspace above land, crops, forests, non-navigable waters, easements, subsurface land rights, rental income and other profits derived from land and leasehold interests. Real estate under the CCQ includes land; any constructions and works of a permanent nature located on the land and anything forming an integral part of the land; plants and minerals that are not separated or extracted from the land; personal property that is permanently physically attached and joined to an immoveable and that ensures its utility and real rights in immoveable property; as well as actions to assert such rights or to obtain possession of immoveables. Each province and territory in Canada has a real property title registration system. Secured creditors perfect interests in real property by filing a mortgage, debenture, hypothec or trust deed against the title to the debtor's real property. Generally, registration fees for real property mortgages in Canada are nominal. However, in several provinces and territories (Alberta, Newfoundland, Northwest Territories, Yukon Territories and Nunavut) registration costs can be higher as they are calculated based on varying formulas that take into account the principal amount of the mortgage that is being registered. Lastly, it is worth noting that there are several special statutes in Canada that govern most federally regulated facilities such as airports, prisons and major shipping ports, and these should be assessed when taking security involving such facilities.
Security over all or substantially all of the debtor's assets
Security over all of a debtor's present and after-acquired property is commonly taken in Canada by secured parties. To do so, standard practice is generally to take separate security agreements, some for personal property (for example, general security agreements, stock pledge agreements and sometimes intellectual property security agreements) and another for real property (for example, a hypothec or debenture) that together, encumber all of the debtor's property. While it is possible to secure both real and personal property in single documents such as a debenture, the practice is seen less often in the Canadian market and primarily on real-estate based transactions.
ii Guarantees and other forms of credit support
Guarantees are a common feature of secured lending structures for financings in the Canadian market. Typically, a guarantor (e.g., a parent or corporate affiliate of the borrower) will enter into a stand-alone guarantee with a lender that guarantees the obligations of the borrower to the lender. In the acquisition context it is not uncommon for the obligations of a sole-purpose acquisition entity to be guaranteed by an equity sponsor or controlling parent company. In Quebec, suretyships are used frequently in secured lending.
Corporate legislation in Canada has eliminated outright restrictions on financial assistance. It is permitted without restrictions of any kind in several provinces, including Ontario, Nova Scotia and Quebec. In other provinces and territories, financial assistance is also permitted generally but is subject to a solvency test or disclosure requirements. This more relaxed regime has provided increased flexibility to lenders in Canada when structuring security packages that include guarantees.
There is no corporate benefit requirement under Canadian corporate law statutes. However, a financing transaction that does not provide any apparent benefit to a corporation may be challenged as oppressive by creditors or minority shareholders or may result in an allegation that the fiduciary duties of the corporate directors approving the transaction have been breached. Guarantees supporting the debt of affiliated entities are generally enforceable and valid in Canada as long as the debt is of benefit to the corporate group as a whole.
The concept of agency is recognised in all Canadian jurisdictions and is commonly used in secured loan structures in Canada. Agents are often used to represent lenders in a syndicate or to hold collateral on behalf of lenders.
In Quebec, the agent must be formally appointed as the hypothecary representative for all present and future creditors of the obligations. The deed of hypothec must be executed before a Quebec notary. As the party holding the hypothec, the agent, in its capacity as hypothecary representative, can enforce all of the rights under the hypothec.
Challenging security under Canadian law
Under Canadian law, there are several ways that a creditor or court-appointed officer could challenge security both before or after the commencement of insolvency or restructuring proceedings. Remedies for ‘reviewable transactions' are available under federal insolvency legislation and provincial legislation.
In the context of insolvency proceedings, a trustee in bankruptcy16 can challenge preferences and other transactions at undervalue under the federal Bankruptcy and Insolvency Act (BIA). Under Section 95 of the BIA, a trustee in bankruptcy can challenge a preference - namely a transaction with a debtor or payment made by a debtor that has the effect of preferring one creditor over another and that was entered into within prescribed time periods before insolvency proceedings in respect of the debtor were commenced. If the preference is proven, the transaction or payment is void against the trustee in bankruptcy. Under Section 96 of the BIA, a trustee in bankruptcy can attack transactions between the debtor and persons who gave inadequate consideration for assets, goods or services provided by the debtor within prescribed time periods before insolvency proceedings in respect of the debtor were commenced. Courts can order that transfers at undervalue are void against the trustee in bankruptcy or, alternatively, that the parties to the transfer pay to the debtor's estate the difference between the consideration received by the debtor and the consideration given by the debtor. To the extent that transactions are rendered void as against a trustee in bankruptcy and the property in question has been further transferred, the BIA provides that the proceeds from the transfer of the property shall be deemed to be the property of the trustee. These sections of the BIA also apply (with any necessary modifications) to proceedings under Canada's other major insolvency and restructuring statute, the Companies' Creditors Arrangement Act (CCAA).17
Provincial legislation is also available to creditors or trustees to attack preferential transactions. While there are differences among the various provincial statutes, most provinces allow a creditor to attack fraudulent conveyances and unjust preferences.18 In general terms, fraudulent conveyances are transactions where conveyances of real or personal property are made with the intent to defeat, hinder, delay or defraud creditors or others. Unjust preferences are preferential payments or transactions made when the debtor was in insolvent circumstances, unable to pay its debts or knew it was on the eve of insolvency. Transactions found to be fraudulent conveyances or unjust preferences can be voided as against creditors.
Finally, in almost all Canadian provinces and territories, creditors may use the oppression remedy under provincial corporate law to challenge security given by a corporation. This would involve a transaction where the corporation or its directors effected a result or acted in a manner that was oppressive, unfairly prejudicial to or unfairly disregarded the interests of certain parties (including creditors). Where oppressive conduct is found, Canadian courts have broad discretion to grant any remedy they deem appropriate in the circumstances.
iii Priorities and subordination
In Canada, the priority of a claim of a creditor of an insolvent corporation will depend upon the nature of the claim and the insolvency proceedings applicable to the borrower. The enforcement of security may occur in the context of a proceeding under the CCAA or the BIA. An insolvent corporate borrower may reorganise itself under the CCAA or BIA or petition itself into bankruptcy under the BIA.
In a Canadian insolvency proceeding, certain claims may be afforded priority over a secured lender in a court order and the priority of these claims will be determined by the court based on the facts of each case. In addition, certain statutory charges will continue to have priority over a secured lender's claim in a bankruptcy, including claims for unremitted employee source deductions, certain employee claims that are paid by the Canadian federal government under the Wage Earner Protection Act and certain employee and employer pension plan contributions that are due and unpaid. It should also be noted that a number of the Canadian federal and provincial statutory-deemed trust and charges that can prime a lender's security outside a bankruptcy for unpaid amounts, such as vacation pay and sale taxes, will be reversed in a bankruptcy of the insolvent borrower.
In a CCAA restructuring or BIA proposal, generally speaking, the restructuring plan or proposal for the insolvent borrower must provide for the payment of certain employee and other claims unless otherwise agreed by the relevant parties. In addition, the court may grant a charge in priority to the security of existing lenders in the assets of the debtor to secure, among other things, claims of critical suppliers, debtor-in-possession lenders, corporate directors' indemnities, key employee retention payments and professional administration fees.
As noted above, certain pension claims may rank in priority to a lender's security in the event of a borrower's insolvency. The Supreme Court of Canada decision in Indalex Limited (Re),19 however, has created some doubt as to the priority afforded to the amount of any funding deficiency arising in connection with the wind-up (a wind-up deficiency) of a borrower's defined benefit pension plan. Prior to this decision, it was generally thought that the deemed trust provisions of the applicable pension legislation would not apply to a wind-up deficiency. Although the Supreme Court made it clear that a deemed trust could apply to a wind-up deficiency and that the claim for that amount would be subordinate to a court-ordered charge securing debtor-in-possession financing for the insolvent borrower, the Court did not opine on the relative priority of liens on the accounts receivable and inventory securing indebtedness in existence at the time that a CCAA order is made. Lenders providing financing to a Canadian borrower that has a defined benefit plan registered in Canada or to acquire a target with such a plan should determine whether a deemed trust could apply to a wind-up deficiency under the applicable pension legislation and consider the impact on their security position in the event of an insolvency.
Under the US Bankruptcy Code, the doctrine of equitable subordination allows courts to subordinate creditor claims to those of lower-ranking creditors. This extraordinary remedy is typically reserved for situations of egregious conduct on the part of creditors, because it supplants negotiated contractual arrangements between parties. For a claimant to succeed in subordinating a creditor claim, it must demonstrate that the creditor engaged in inequitable conduct, that the conduct harmed other creditors of the bankrupt company or conferred upon the creditor an unfair advantage, and that the subordination is consistent with the remainder of the US Bankruptcy Code.20
Although there is no equivalent legislative provision in Canada, recent decisions by Canadian courts have suggested that the doctrine of equitable subordination could potentially be adopted in certain circumstances. In Indalex, the Supreme Court of Canada affirmed the ‘wait and see' approach it espoused in Canada Deposit Insurance Corp v. Canadian Commercial Bank,21 whereby rather than ruling one way on the doctrine's applicability, it declared that the facts at hand did not give rise to a claim for equitable subordination and left its determination for a later date.22 Subsequently, in its recent decision in US Steel Canada Inc (Re)23 (US Steel), the Ontario Court of Appeal ruled that the CCAA court does not have the jurisdiction under the CCAA to grant the remedy of equitable subordination. The Ontario Court of Appeal, however, left the door open for equitable subordination to apply in a BIA context on the basis that the BIA provides the court with express jurisdiction in equity. Leave to appeal to the Supreme Court of Canada has been granted in respect of the Ontario Court of Appeal's decision in US Steel, the appeal for which is expected to be heard in November 2017. In the meantime, there remains uncertainty as to whether and in what circumstances the doctrine of equitable subordination applies in Canada.
Second lien financings
As noted above, a Canadian borrower may incorporate several different types of indebtedness (including second lien loans) in its capital structure. Second lien loans (also known as term B loans) are an increasingly popular source of financing in Canada for acquisitions, recapitalisations and restructurings. Non-bank entities such as hedge funds, private equity funds and distressed debt funds, particularly those based in the United States, are typically the providers of second lien loans to Canadian borrowers. As second lien loans are secured by a lien on all or a portion of the borrower's assets, these loans are generally considered to be a lower risk alternative to mezzanine loans and, accordingly, are less costly than mezzanine or other junior unsecured debt. In addition, as a result of investor demand for the enhanced yields available through leveraged products, second lien loan terms have become more debtor-friendly and a number of borrowers have been able to obtain covenant-lite loans. Often these loans are provided in US dollars so are particularly attractive to Canadian borrowers with significant US-dollar cash flows that provide a natural hedge to currency exchange fluctuations that could otherwise affect their ability to make loan payments in US dollars.
The respective rights of the first-lien lenders and the second lien lenders will be set forth in an intercreditor agreement. A first lien-second lien intercreditor agreement will certainly include a contractual subordination of the second lien lender's claim to the rights of the first lien lender and restrictions on the ability of the second lien lender to enforce its lien against the common collateral for the loans. The intercreditor agreement may also include provisions addressing the issues set out directly below.
Lenders have made a broad variety of debt products available to borrowers to finance their operations, acquisitions and other activities. As a result, many borrowers have complex capital structures with several layers of debt secured by liens on the same collateral. For example, a borrower may have a senior term and operating credit facility, hedging obligations, cash management obligations and a second lien term loan secured by liens on the borrower's assets. Lenders in these circumstances will typically enter into an intercreditor agreement that delineates their respective rights, remedies and priorities particularly in a default situation. Canadian courts will generally treat an intercreditor agreement as an enforceable contract between the lenders and uphold its provisions. However, if the borrower in question is subject to an insolvency proceeding, it is possible that the court supervising the proceeding may make an order that is not consistent with the provisions of the applicable intercreditor agreement in exercising its jurisdiction over the matter.
The terms of any particular intercreditor agreement will be influenced by the borrower's creditworthiness and capital structure, the type and terms of the relevant debt, the lender's preferred exit strategies and the general economic environment. The primary purpose of an intercreditor agreement from a senior lender's perspective is to ensure that it is in a position to control the enforcement proceedings with respect to a defaulting borrower until the senior lender is repaid in full or is no longer prepared to continue. Intercreditor agreements also typically include provisions that deal with:
- a the relative priority of liens on the collateral;
- b the application and turnover of proceeds derived from the collateral, payment restrictions or blockage periods with respect to junior debt payments;
- c restrictions on the type and amount of senior debt that ranks prior to more junior debt;
- d standstill periods and other restrictions on enforcement proceedings by holders of junior debt;
- e access rights to certain collateral;
- f restrictions on certain modifications to the terms of each lender's credit documentation;
- g refinancing rights; and
- h the right of junior debtholders to purchase the senior debt.
Triggers for junior debt payment blockages, the frequency and length of payment blockage periods as well as the right to make catch-up payments once a payment blockage has ceased are often heavily negotiated. The elements and amount of senior debt (including interest rate and fee increases, over-advances, prepayment premiums and hedging obligations) that ranks in priority to the junior secured debt are also frequently the subject of much discussion.
V LEGAL RESERVATIONS AND OPINIONS PRACTICE
In syndicated lending transactions in Canada, legal opinions are generally delivered by counsel to the borrower and, where necessary, local counsel in each relevant province or territory. Such opinions typically include corporate opinions; non-contravention and no breach opinions; regulatory approval opinions; share capital opinions; enforceability opinions; and creation and registration of security opinions.
It is not uncommon for lending transactions in Canada to be financed by foreign lenders based in financial centres such as New York or London. This occurs most often when the borrower is foreign or part of a larger cross-border or international corporate structure or where the transaction being financed is a cross-border transaction. Foreign lenders often expressly choose to have their principal financing agreement governed by the law of their home jurisdiction, and to stipulate that any resulting disputes will be governed by that law. In these circumstances, foreign lenders need to understand how choice of law and foreign judgments are treated in Canada and whether consent to jurisdiction clauses are enforceable.
i Choice of law
Generally speaking, in a proceeding in Canada to enforce a foreign law-governed document, Canadian courts will, with limited exceptions, apply the law expressly chosen by the parties, so long as the choice of the foreign law in the agreement is bona fide, legal and not contrary to public policy. Canadian courts will apply local law to procedural matters and apply local laws that have overriding effect. In addition, Canadian courts will not apply foreign law if to do so would have the effect of enforcing a foreign revenue, expropriation or penal law.
In the unlikely event that the parties do not expressly choose a system of law to govern the primary financing agreement, Canadian courts will apply the law that has the closest and most real and substantial connection to the agreement.
ii Enforcement of foreign judgments
Without reconsidering the merits, and subject to certain defences, Canadian courts generally will issue judgments in Canadian dollars based on final and conclusive foreign judgments rendered against the person for a specified amount if the action in Canada is brought within any applicable limitation period. Under certain circumstances, our courts have the discretion to stay or decline to hear an action based on a foreign judgment. Such actions may also be impacted in our courts by bankruptcy, insolvency or other similar laws affecting creditors' rights.
Certain defences are available to debtors in Canada to prevent recognition and enforcement of a foreign judgment against them. The foreign judgment cannot have been obtained by fraud or in a manner contrary to natural justice. In addition, the foreign judgment cannot be for a claim that under Canadian law would be characterised as being based on a revenue, expropriation or penal law, nor can the foreign judgment be contrary to public policy. Finally, our courts will not enforce the foreign judgment if it has already been satisfied or is void or voidable under the foreign law.
iii Submission to jurisdiction clauses
Agreements to submit all disputes related to the financing transaction to a specified jurisdiction are common in commercial financing agreements, and can be exclusive or non-exclusive. Under Canadian law, non-exclusive jurisdiction clauses have historically been held to be enforceable. Recent Canadian case law, including decisions from the Supreme Court of Canada, has strongly supported enforcement of exclusive jurisdiction clauses to increase predictability and certainty in the Canadian market.
VI LOAN TRADING
In Canada, the market for syndicated loans continues to be the primary means for borrowers to access financing. Syndication continues to be the avenue used by lenders to allocate and distribute exposure to certain borrowers or industry sectors. However, unlike the US loan market, the use of secondary trading in loans is limited and there is no significant market for loan participations. Syndication or assignments of loans and lending commitment are the most common methods of transferring loan exposure in Canada. Assignment by a lender of its loan position is usually permitted, subject in some cases to the borrower's consent or only to a permitted list of assignees and to the general requirement that the assignment must not result in increased costs to the borrower. Because of the lack of a significant secondary market for trading loans that limits term B loan availability in Canada as stated above, many large Canadian companies have instead chosen to access the term B loan market or the second lien loan market available in the United States.
Loan participants in Canada, as in most other markets, do not have a direct contractual relationship with the borrower. While a participant assumes the risks associated with the loan transaction in which it is participating, it has no direct interest or rights under any credit documents, including the security, if any, related to the loan. In addition to the credit risk associated with a borrower, a participant also faces the risk related to the solvency of the grantor of a participation in a loan. In the event the grantor of a participation files for bankruptcy, for example, a participant's right to receive payment on its underlying loan will continue to depend upon and flow through the grantor and not the borrower. The terms of the particular participation agreement will determine the rights available to the participant in a grantor's bankruptcy as a secured or unsecured creditor.
VII OUTLOOK AND CONCLUSIONS
We expect that leveraged financing in Canada will be negatively impacted in the coming year to a certain extent by expected increases in interest rates, slow economic growth, continuing weakness in the oil and commodities sectors and a general tightening of credit terms. Having said that, we also expect that Canadian borrowers will continue to take advantage of interest rates that continue to be low by historical standards, where appropriate, by securing debt financing to fund acquisitions, dividend recapitalisations and other balance sheet restructurings and to refinance existing debt with more onerous terms. In addition, we expect that the trend of Canadian borrowers amending (including repricing) and extending their credit facilities prior to maturity will continue given the relatively favourable pricing conditions in the Canadian debt market, particularly in light of the fact that interest rates generally are expected to increase later in 2017.
The high-yield market in Canada has seen increased volume year over year, with eight issuances in 2016 and six issuances to date in 2017.24
As US sponsors become more active in Canada and seek financing from Canadian lenders for their Canadian acquisitions, covenant-lite loans are becoming more common in Canada. Covenant-lite loans generally do not include financial maintenance covenants or include them only on a springing basis based on certain leverage levels. Equity cures of financial covenant breaches are generally permitted. As financial covenant breach is often an early indicator of financial difficulty, the downside for lenders is that they may not be able to trigger a default based on a financial covenant breach and initiate restructuring discussions at an early stage when more options are available to address the borrower's financial issues.
Unitranche lending has also gained some popularity with Canadian borrowers, particularly those exposed to US lenders through their US affiliates. Unitranche facilities combine senior and junior debt into one credit facility, with the lenders addressing their respective priorities with a first-in, last-out mechanism under an agreement among lenders.
Another trend is the increased activity level of foreign lenders in Canada, particularly those based in the United States. The increasing level and size of cross-border transactions has created new lending opportunities for foreign lenders in Canada. Many foreign lenders are also seeking to expand their relationship with clients in their home jurisdictions to affiliates of those clients located in Canada. In this connection, a number of foreign lenders have established a local presence in Canada such as a foreign bank branch, and are offering a wide variety of financial products to Canadian clients. The increased competition in the Canadian financial market resulting from entry of additional foreign lenders should be beneficial to Canadian borrowers.
1 Jean E Anderson, David Nadler, Carrie B E Smit, Caroline Descours, David Wiseman are partners at Goodmans LLP. The authors would like to thank Ti-Anna Wang of Goodmans for her invaluable assistance during the writing of this chapter.
2 Crosbie & Company, Canadian M&A Publications, online: www.crosbieco.com/who-we-are/m-a-publications. Figures provided were compiled from the 2016 and 2017 quarterly reports, Note: Crosbie & Company sets a minimum deal value of $5 million for inclusion in its data.
3 Crosbie & Company, footnote 2, supra.
4 Crosbie & Company, footnote 2, supra.
5 Crosbie & Company, footnote 2, supra.
6 Crosbie & Company, footnote 2, supra.
7 Crosbie & Company, footnote 2, supra.
8 Bloomberg, ‘Pipeline Deals Help Push Canadian Takeovers Abroad to Record', 19 December 2016, online: https://www.bloomberg.com/news/articles/2016-12-19/pipeline-deals-help-push-canadian-dealmaking-to-
9 Bloomberg, footnote 8, supra.
10 Citi and MergerMarket, ‘Navigating Changes: Canadian M&A in a period of global upheaval', 31 January 2017, online: https://www.acuris.com/citi-canadian-ma-outlook-2017.
11 The common law provinces and territories in Canada are: British Columbia, Alberta, Saskatchewan, Manitoba, Ontario, New Brunswick, Nova Scotia, Prince Edward Island, Newfoundland, Nunavut, the Yukon Territories and the Northwest Territories.
12 The PPSAs expressly exclude an interest in or claim under any insurance policy or annuity contract from their scope. Secured debtors must take steps outside the PPSAs to secure an interest in an insurance policy. The PPSAs do, however, provide that a previous security interest in other secured personal property assets extends to the proceeds of insurance on such assets. In Quebec, insurance policies can be charged by a hypothec.
13 Certain government receivables payable by the federal government of Canada and the provincial and territorial governments cannot be assigned or transferred as security unless secured parties comply with certain conditions prescribed by statute.
14 Generally, under the PPSAs, a debtor is located at its place of business or if a debtor has more than one place of business, where it has its chief executive office. In Ontario, however, new deeming rules for determining a debtor's location under the Personal Property Security Act (Ontario) became effective on 31 December 2015. The new rules determine a debtor's location based on what type of entity the debtor is. For example, provincial corporations are deemed to be located in the province or territory of incorporation or organisation.
15 For example, a clearing house, retail investment broker or bank.
16 Where a trustee refuses or neglects to take proceedings after being requested to do so by a creditor, that creditor may make an application to the court for an order authorising it to take the proceedings in question in its own name and at its own expense and risk.
17 In which case, a monitor could challenge preferences and other transactions at undervalue. See Section 36.1(1) of the CCAA.
18 Court-appointed officers and other parties seeking to challenge a transaction or grant of security may rely on these provincial statutes both within insolvency proceedings under the BIA or CCAA and outside such proceedings.
19 2013 SCC 6 [Indalex].
20 See also Grant Forest Products Inc. v. The Toronto-Dominion Bank, 2015 ONCA 570 (Grant Forest). In Grant Forest, the Ontario Court of Appeal confirmed that a judge presiding over CCAA proceedings has the discretion to permit a creditor to petition the debtor company into bankruptcy, even when the transition to bankruptcy results in a loss of the pension deemed trust and an altering of priorities in favour of a secured creditor. In addition, the Ontario Court of Appeal, although not explicitly upholding the ruling of the lower court that a wind-up deemed trust does not prevail when a wind-up is ordered after the commencement of CCAA proceedings, did distinguish the facts from the Indalex case (the wind-up deemed trust under consideration in Indalex arose before the CCAA proceedings commenced, whereas in Grant Forest, neither of the pension plans were wound up until after the CCAA proceedings commenced).
21  3 SCR 558, paragraph 44.
22 Indalex, footnote 17, supra, paragraph 77.
23 2016 ONCA 662
24 Retrieved from Bloomberg database under Fixed Income Search, with criteria of Canadian dollar-denominated and high-yield based on S&P Issuer Ratings or Moody's.