Under the Ppsa and Sta

PERFECTION BY CONTROL OPINIONS

UNDER THE PPSA AND STA

The Toronto Opinions Group

November, 2013

LEGAL_20607809.6

Table of Contents

1. Introduction 2

2. Basic Concepts of the STA Relevant to Control Opinions 3

(a) Two Systems for Holding Securities 3

(b) The Concept of Control 5

(d) Priorities 6

(i) Basic Rules 6

(ii) Protected Purchaser Status 7

(e) Conflict of Laws Issues 8

3. Typical Opinions on Investment Property 10

(a) Perfection by Registration Opinion 10

(b) Preliminary Considerations 11

(i) Threshold Issues 11

(ii) Conflict of Laws Jurisdictional Scope Limitation 12

(iii) Priority Opinions 13

4. Opinions on the Direct Holding System: Certificated Securities 14

(a) Certificated Securities: Suggested Opinion Language for Perfection by Control 14

(b) Due Diligence and Statutory Basis 15

(i) Conflict of Laws Issues 15

(ii) Is it a Security? 16

(iii) “The security interest has been perfected by control”. 17

(iv) “By virtue of such control, such security interest has priority over any other security interest in the Certificated Pledged Securities to which the PPSA applies”. 22

(d) Protected Purchaser/No Adverse Claim Opinion 25

5. Opinions on the Direct Holding System: Uncertificated Securities 26

(a) Uncertificated Securities: Suggested Opinion Language 26

(b) Due Diligence and Statutory Basis 28

(i) Conflict of Laws Issues 28

(ii) Is it a Security? 28

(iii) “The security interest has been perfected by control”. 28

(1) Delivery of an Uncertificated Security 29

(2) Control Agreement with the Issuer 29

(iv) By virtue of such control, such security interest has priority over any other security interest in the Uncertificated Pledged Securities to which the PPSA applies. 31

(d) Protected Purchaser/ No Adverse Claim Opinions 33

6. Opinions on the Indirect Holding System: Security Entitlements 33

(a) Security Entitlements and Securities Accounts: Proposed Opinion Language 33

(b) Due Diligence and Statutory Basis 35

(i) Conflict of Laws Issues 35

(ii) Description and Composition of Collateral 37

(1) Securities Account vs. Security Entitlements 37

(2) Cash 38

(3) Certificated Securities Held by Intermediary 39

(iii) Perfection by Control 40

(iv) Secured Party as Entitlement Holder 41

(v) Control Agreement 42

(vi) Dual Capacity Issues 43

(vii) Priority 44

(1) Control Agreements 44

(2) Super-Priority of Securities Intermediaries 45

(3) Clearing Agency Rules 46

(d) No Adverse Claims Opinion 48

LEGAL_20607809.6

Perfection by Control Opinions
under the PPSA and STA

Memorandum

From: / TOROG[1] / Date: / November, 2013
Subject: / Investment Property Perfection and Priority Opinions under the Securities Transfer Act, 2006 and the Personal Property Security Act

Ontario’s Securities Transfer Act, 2006[2] (“STA”), with conforming amendments to the Personal Property Security Act[3] (“PPSA”), came into force on January 1, 2007, and almost identical uniform legislation is now in effect in every common law province and territory in Canada except P.E.I., and a civil law variant has been in force in Québec since January 1, 2009. [4] This memorandum sets out some considerations and suggested language for giving perfection and priority opinions in secured transactions involving investment property.

1. Introduction

Based closely on Revised Article 8 of the U.S. Uniform Commercial Code, the STA marked a major reform in the law of securities transfers and has cleared up many of the uncertainties in this area of the law that made it difficult to give “transaction level” opinions on perfecting security interests in “book- based” or indirectly held securities through “constructive possession” and it lets us speak a common language with our colleagues to the south.

The generic concept of “control” replaced possession (constructive or otherwise) as the preferred means of perfecting security interests in shares or other “investment property”, and lenders and other secured creditors taking such security interest now routinely ask for opinion comfort that the security interest has been perfected by control and as a result has priority over other security interests in the same property. Over the last six years opinion language in this area has become more uniform but there is still considerable divergence among the larger firms as to what assumptions and qualifications are required or appropriate.

This memorandum presents a brief overview of the principal concepts of the STA relevant to control opinions and then a discussion of the opinions that will typically be requested, the due diligence required to give them and suggested appropriate qualifications and assumptions. This discussion represents a consensus of members of the Toronto Opinion Group (or TOROG) but does not purport to be binding on any firms that have representatives in that group.

Attached as Appendix A is a document setting out sample annotated PPSA opinion paragraphs that incorporate the language discussed in this memorandum.

2. Basic Concepts of the STA Relevant to Control Opinions

A detailed discussion of the STA legislation is beyond the scope of this memorandum. However, a basic grasp of STA concepts is essential for understanding why certain opinions are requested and what language is appropriate to formulate those opinions and the relevant assumptions and qualifications. What follows is a simplified and schematic overview of the STA legislation intended to provide a basic frame of reference. More detailed discussions of particular provisions are provided below in connection with specific opinion language.

(a) Two Systems for Holding Securities

The STA deals with both the direct and the indirect holding systems for holding financial assets such as securities. The direct holding system involves a direct relationship between the issuer of the security and the investor. A common example is a share issued by a non-offering corporation registered in the name of the investor where the investor receives a physical certificate issued in the name of the investor. Direct holding gives the investor a direct right of action against the issuer. In certain circumstances securities are considered to be held directly if held by an agent. Directly held securities may also be uncertificated. Parts III, IV and V of the STA deal principally with the direct holding system.

In contrast, in the indirect holding system, the investor holds the underlying financial asset indirectly through an account with a “securities intermediary” such as an investment dealer, bank or trust company, which in turn typically holds an account with a clearing agency such as CDS Clearing and Depository Services Inc. (“CDS”) or another intermediary. Typically in this system it is only the clearing agency, at the top of the pyramid, that holds the security directly. The lower tier holders, referred to as “entitlement holders”, own what the STA terms “security entitlements”.

The security entitlement is a sui generis form of property that defines the property interest of an indirect holder essentially as a bundle of rights that can be exercised only against the securities intermediary, as specified in Part VI of the STA. While a security entitlement does represent a proportionate property interest in the underlying financial assets held by the securities intermediary[5] and person acquires a security if the person acquires a security entitlement to the security[6], the legislation does not deem the indirect holder to be constructively in possession of the security certificate itself (as was the case with the former section 85 of the Ontario Business Corporations Act, now repealed).

A person acquires a security entitlement to a financial asset when a securities intermediary indicates by book entry that the financial asset has been credited to the person’s securities account, receives the financial asset from or acquires it for the person and accepts it for credit to a securities account, or becomes obligated by law to credit the asset to the securities account.[7] In effect, the security entitlement arises when the trade is “booked” with the intermediary, regardless of whether the intermediary actually holds the asset.[8] A security entitlement is not transferable as such. Instead, it arises when the financial asset is credited to the securities account and is extinguished when the asset is debited from the account.

It is important to bear in mind that the method of holding a security (direct or direct) is distinct from the form in which the security is evidenced (certificated or uncertificated). “Uncertificated security” is not a synonym for “book-based” or indirectly held security and the two should not be confused.

(b) The Concept of Control

The key concept for understanding perfection of security interests in securities and other “investment property” under the PPSA is “control”. Control is not defined except by reference to the actions that will achieve control in respect of specific forms of investment property, which are set out in sections 23-26 of the STA. In essence, a “purchaser”[9] (which includes a secured party) that attains control of investment property has done whatever is necessary, given the type of property, to be in a position to dispose of the property without the consent of the original owner.

The specific methods of control applicable to each type of financial asset are discussed in more detail below. Basically, a purchaser obtains control of a certificated security in registered form by acquiring possession of the certificate that is either endorsed to or registered in the name of the purchaser.[10] Control of an uncertificated security is obtained through registration as the owner by the issuer or by a “control agreement” with the issuer in which the issuer agrees to comply with instructions originated by the secured party.[11] Control of a security entitlement is obtained through a control agreement with the securities intermediary in which the intermediary agrees to comply with “entitlement orders” originated by the secured party, or by becoming the entitlement holder.[12] When an entitlement holder grants a security interest in a security entitlement to the entitlement holder’s own securities intermediary, the securities intermediary automatically has control.[13]

Security interests in investment property may be perfected under the PPSA by registration of a financing statement[14]; in the case of certificated securities, by simple delivery of the security certificate;[15] and for all investment property, by control[16]. Control will generally be the preferred method for secured parties because of the special priority afforded to a control party discussed in the next section.

(d) Priorities

(i) Basic Rules

In general, a secured party having control of investment property has priority over a secured party that does not have control, without regard to the control party’s knowledge of the prior security interest or the temporal order of attachment or perfection.[17] Accordingly, if SP 1 perfects its security interest in investment property only by registration on Day 1 and then SP 2 perfects its security interest in the same investment property through control on Day 2, SP 2 will have priority over SP 1. Perfection of a security interest in a certificated security by simple delivery of an unendorsed certificate will rank ahead of a security interest perfected by registration, but behind one perfected by control.[18] Conflicting security interests in the same investment property between two or more secured parties, each of which has control, rank according to priority in time.[19] A security interest held by a securities intermediary in a security entitlement or securities account automatically takes priority over any other conflicting security interest.[20]

(ii) Protected Purchaser Status

A secured party that is a “protected purchaser” of a directly held security acquires the security interest free of any adverse claims[21] and takes priority over an earlier security interest, even if perfected.[22] A “protected purchaser” (which replaced the concept of “good faith purchaser for value without notice” in the predecessor legislation) is defined as a purchaser (which would include a secured party) of a certificated or uncertificated security, or of an interest in the security, who gives value, does not have notice of any adverse claim to the security and obtains control of the security.[23] “Adverse claim” is both broader and narrower than a security interest. It means “a claim that (a) the claimant has a property interest in a financial asset, and (b) it is a violation of the rights of the claimant for another person to hold, transfer or deal with the financial asset”.[24] Accordingly, being a protected purchaser confers special advantages on a secured party in addition to priority over other PPSA security interests. For example if the debtor purported to sell a security to X on Day 1 but did not deliver the certificate and then on Day 2 granted a security interest in the same security to Secured Party and delivered the certificate to Secured Party with an effective endorsement, Secured Party would take the security interest free of X’s ownership interest. Similar protections are accorded to purchasers of security entitlements.[25]

(e) Conflict of Laws Issues

Section 7.1 of the PPSA sets out the conflict of laws principles that govern the validity and perfection of security interests in investment property. The validity of a security interest in investment property is governed by the law, at the time of attachment, of the location of the certificate, in the case of a certificated security; of the “issuer’s jurisdiction”, in the case of an uncertificated security; and of the “securities intermediary’s jurisdiction”, in the case of a security entitlement or securities account.[26] These same factors determine the law governing perfection, nonperfection and priority, except that no point in time is specified, which would suggest that the relevant tests are to be applied at the time the issue in question is to be determined. Perfection of a security interest in investment property by registration of a financing statement is governed by the law of the location of the debtor as determined under PPSA s. 7(3).[27] Accordingly, where the security interest in investment property is perfected by both control and registration the laws of two jurisdictions may govern perfection, and yet a third jurisdiction may be involved for the law governing validity. For example, assume that a certificated share of an Alberta corporation is to be pledged by a Manitoba debtor to a Toronto bank. When the security agreement is signed, the share certificate is still located in Alberta but is owned by the debtor; the next day the endorsed certificate is couriered to Toronto for closing. A PPSA financing statement will also be registered. The validity of the security interest will be governed by Alberta law, perfection by registration by Manitoba law and perfection by control by Ontario law.[28] The STA sets out specific rules for determining the “issuer’s jurisdiction”[29] and the “securities intermediary’s jurisdiction”[30]. These terms do not refer to the physical location of the issuer or the intermediary or their common law situs. Instead, the “issuer’s jurisdiction” depends on the type of entity and to some extent, the jurisdiction specified by the issuer.[31] The “securities intermediary’s jurisdiction” is determined by a “waterfall” of criteria in STA s. 45(2), each of which is tested against the fact situation sequentially until the applicable criterion is reached: if the first test does not apply, one goes to the second; if the second does not apply, one goes to the third, and so on. The five criteria are as follows: