Hypothecation of investment assets: digression from general principles

1. Hypothecation of investment assets: digression from general principles Catherine Walsh Formation Continue McGill University 30 November 2010

2. New Regime • The Act Respecting the Transfer of Securitiesand the Establishment of Security Entitlements (Loi sur le transfert de valeurs mobilières et l’obtention de titres intermédiés) entered into force on 1 January 2009. • Complementary amendments were concurrently effected to the Civil Code hypothecary regime.

3. Objectives of new regime • To modernize the law governing the transfer and hypothecation of investment property to accommodate market realities and practices • To harmonize Quebec law with equivalent legislation in the common law provinces (Securities Transfer Acts) • Canadian legislation in turn rooted in Articles 8 and 9 of the Uniform Commercial Code in the United States

4. Directly held securities Directlyheldsecurity = direct legalrelationshipbetweenholder and issuer • Certificatedsecurities: holderholdscertificateissued by the issuerrepresenting the security • Uncertificatedsecurities: holderisregistered in the issuer’sshareregister but does not possess a certificaterepresenting the security

5. Indirectly held securities • no legal relationship between the holder and the issuer; • investor holds a securities account with a securities intermediary (e.g. a broker) and the security is credited to this account • investor exercises its rights in the security through the intermediary • Intermediary in turn holds securities in an account with an upper tier intermediary and so on up to a central securities depository

6. Security versus security entitlement • Security = a directly held security, whether certificated or uncertificated • Security entitlement = the right of the holder of a securities account against his intermediary in respect of the securities and other intangible property credited to his account (“financial asset”).

7. Creation & third party effectivenessGeneral Principles • For creation, a written agreement or physical dispossession is required • For third party effectiveness, publication by registration or physical dispossession is required

8. Creation & Third Party Effectiveness:security entitlements • A hypothec with delivery may be constituted and made effective against third parties by the creditor obtaining “control”; physical dispossession is not required (and not possible); • A hypothec without delivery granted by an intermediary is deemed published upon its creation without the need for registration.

9. Modes of control: security entitlements A person acquires control by: • becoming the account holder • concluding a control agreement with the intermediary with whom the grantor maintains the securities account (for example, a broker) • By virtue of status if the secured creditor is the intermediary with whom the grantor has his securities accounts

10. Priority of Hypothecs:General Principle Priority among the holders of hypothecs granted by the same grantor rank according to the date on which each becomes effective against third parties regardless of the method of publication (registration or dispossession).

11. Priority of hypothecs:security entitlements • A “control” hypothecary creditor trumps all other creditors including creditors who registered their hypothecs prior to the obtaining of control • Among control creditors, priority is accorded to the creditor who obtained control by becoming the named holder on the securities account • Otherwise, control creditors rank according to when they obtained control.

12. Special priority rules for intermediaries • If the holder of a securities account grants to the intermediary with whom he has his account a hypothec on the assets credited to the account, the intermediary’s hypothec has a super priority over any other hypothec on those assets, regardless of when that other hypothec was granted; • Multiple hypothecs without delivery granted by an intermediary rank concurrently.

13. Priority among hypothecs granted by different grantors: general principle • Suppose A grants to B a hypothec on certain assets, and B subsequently grants to C a hypothec on those same assets. • General principle: Nemo datquod non habet: a hypothec on the asset of another is ineffective.

14. Exception to nemodat: security entitlements • Rehypothecation generally permissible; • Rehypothecation by intermediary/secured creditor permissible if authorized by client/grantor • Even if reyhpothecation not authorized by law or by an agreement, generally C prevails against A if C obtains control and gives value.

15. Priority of intermediary’s secured creditor against account holders • If an intermediary is bankrupt and there is a shortfall in the securities accounts held for its customers, a secured creditor of the intermediary who has obtained control has priority over the claims of the intermediary's customers. • The secured creditor takes precedence even if the intermediary violated its customers’ rights in granting security. • To defeat the secured creditor, the entitlement holders must show that the secured creditor acted in collusion with the securities intermediary in violating the intermediary's obligations (knowledge or imputed knowledge insufficient.

16. Conflict of laws • General principle: validity, third party effectiveness and priority are governed by the law of the location of either the encumbered asset (tangibles) or the grantor (intangibles); • Exception: If the encumbered asset is a security entitlement, the applicable law is the law designated by the parties to the securities account agreement as the law governing the account.

17. Policy rationales • Finality in securities transfer transactions • Reduction of transaction costs for purchasers and secured creditors • Facilitation of access to low cost financing for brokers and other intermediaries

18. Do costs outweigh benefits?

19. Acknowledgements/References • J.M. Deschamps, «Sûretés et ventes portant surdes valeurs mobilières » 2010 Cours de perfectionnement du notariat no 1, p. 179 (Édition Yvon Blais) • J.M. Deschamps «Le nouveau régime québécois des sûretés sur les valeurs mobilières» (2009) 68, Revue du Barreau du Québec, p. 541 • Mohamed F. Khimji,Annotated Securities Transfer Act (Ontario) (Toronto: Butterworths • Steven L. Schwarcz, “Distorting legal principles” (2010) 35 J. Corp. L. 697