CHAPTER 11
THE DEBTOR - CREDITOR RELATIONSHIP
to creditors to secure the payment of debt.
of a debtors assets.
CHAPTER COMMENTARY
In addition to the land mortgage, this chapter explains a number of other commonly used legal instruments to secure debt. Most of these instruments use chattels as the subject matter of the security interest, and are in widespread use to finance consumer and business purchases. One of the most common forms of security, and one of the oldest, is the chattel mortgage, which is often employed by finance companies and banks to secure personal loans. Any discussion of the instrument, however, should emphasize the importance of registration in accordance with the provincial registration procedures in order to protect the mortgagee and maintain mortgage priority over subsequent encumbrances or purchasers of the chattels.
The conditional sale agreement is also worth examination in class, as it is a common method of selling goods on an installment basis. The simplicity of this form should be noted, but again, the importance of adherence to the provincial registration requirements should be stressed, as these establish the seller's rights on default, or on disposal of the goods by the buyer. The assignment of book debts, represents a form of security that is used to secure debt, but to a lesser degree than the chattel mortgage or conditional sale agreement. The assignment of book debts naturally has a use limited to business organizations with accounts receivable. The instrument is not used to secure consumer debt.
The registration requirements for personal property security vary from province to province, a point that should be explained. Particular emphasis should be placed upon personal property security legislation in each province and its application to the various forms of underlying security.
The general trend toward a simplified personal property security registration system should be examined carefully. It employs a single registry for most security interests, and a single document to register all types of personal property security. It should be noted, however, that not all forms of security are covered by these systems. Some are quite specialized in nature, and, as a result, require special procedures for registration and enforcement. The Bank Act and the Construction Lien Acts are examples of legislation that cover special types of security interests. The Bank Act provides a different system for the securing of bank security interests under the Bank Act. The use of this security interest is, however, limited to the types of security specified in the Act.
Bankruptcy for the most part is a federal matter, and the principal legislation is the Bankruptcy and Insolvency Act, which governs bankruptcies in general. The purpose and intent of the legislation is explained on p. 302. However, students should note that the legislation places emphasis on the opportunity for a debtor to make a proposal to creditors in order to save viable businesses, and time is allowed for the debtor to do this before bankruptcy proceedings may be taken against the debtor's assets. The Act sets out the rights of the receiver, trustee, debtor, creditor, etc., and the method for the distribution of the debtors' assets amongst the creditors. From a procedural point of view the steps are more or less straight forward. The priorities are set out on p. 307 of the text.
Case 5 of the Discussion Cases may be used as a class exercise to review the priorities and the distribution of assets to a variety of creditors.
Students should note that the Bankruptcy and Insolvency Act provides for a proposal and three kinds of bankruptcy proceedings: voluntary, summary, and creditor‑initiated (by way of a petition). Regardless of how the proceedings begin, the general thrust is the same, because the purpose of the law is to have a trustee collect the debtor's assets and dispose of them, then distribute the proceeds from the sale to the creditors. The distribution, however, recognizes certain priorities amongst the creditors, as the text indicates on page 307, and subject to certain initial restraints gives secured creditors the right to realize on their security outside the bankruptcy proceedings.
Another point to emphasize is that the bankruptcy legislation is also designed to prevent fraud, and to this end, penalties are included in the Act for a number of specified activities known as bankruptcy offences. A debtor that commits any of these offences is normally not given a prompt discharge, and depending upon the seriousness of the offence, may be subject to fines or penalties.
In class discussion, it should be pointed out that the primary purpose of the legislation is to permit the honest but unfortunate debtor to make a new start, free of debt, by surrendering his existing assets to his creditors. The Act also gives the debtor a greater opportunity to make a proposal in order to save the business if restructuring of the debt would render the business viable.
1. How does a conditional sale agreement differ from a chattel mortgage?
Answer:
A debtor pledges only the title to the goods as security for the debt under a chattel mortgage, and retains possession. Under a conditional sale agreement, the seller retains title, but gives the buyer possession of the goods.
2. Describe the effect of personal property security legislation on chattel mortgages and conditional sales agreements.
Answer:
Personal Property Security legislation provides a standardized registration for both types of security instruments using a central computerized registry that may be checked from anywhere in the province.
3. What is the purpose and effect of an assignment of book debts ? Identify the circumstances where registration must take place.
Answer:
An assignment of book debts is a means by which a creditor takes the debts owing to the debtor as security for payment of a debt and permits the creditor to collect the accounts and apply them to the merchant's indebtedness. Registration is necessary to protect the assignee's right to the debts.
4. Outline the special types of security instruments that may be issued by corporations as security for debt.
Answer:
Corporations may issue bonds or debentures as security for debt.
5. Define: bond, floating charge, debenture.
Answer:
A bond is a debt instrument which pledges the assets of the corporation as security for the debt. A floating charge is an equitable charge that does not attach to any specific asset until and unless default occurs in the debt. A debenture is usually an unsecured subordinate security issued by a corporation.
6. What types of assets may be used as security by chartered banks for loans made under section 427 of the Bank Act?
Answer:
A bank may make loans under s. 427 to manufacturers, wholesalers, retailers, shippers and dealers in products of agriculture, of the forest, sea, lakes, quarry or mine, and on goods and merchandise manufactured or otherwise.
7. Describe the procedure that a bank must follow to secure a loan under section 427 of the Bank Act.
Answer:
To secure a loan under s. 427 the borrower must sign a form and deliver it to the bank to vest the lien in the bank. The bank must also file a notice of intention to receive the security with the Bank of Canada.
8. What is a bank credit card? In what way does it secure a debt?
Answer:
In most cases, the bank makes payment to the merchant or service supplier for the goods or services supplied to the credit card holder, then looks to the card holder for payment.
9. Outline why legislation for a mechanics' lien (sometimes referred to as construction lien) was necessary?
Answer:
Legislation was necessary to give contractors and sub‑ contractors some means of protection for the labour and materials they apply to property. No protection was available under contract law, and a security interest was created by statute to protect their interests.
10. Why is an insolvent person not necessarily a bankrupt?
Answer:
To be a bankrupt, a person must commit an act of bankruptcy.
11. Under what circumstances could a person have assets in excess of liabilities, yet be bankrupt?
Answer:
If a person has debts in excess of $1,000 and commits an act of bankruptcy, a creditor may commence bankruptcy proceedings against the debtor.
12. What should a person do who finds it impossible to carry on business any longer without incurring further losses?
Answer:
If the business cannot be made viable by restructuring the debt, the person should advise his creditors of his financial condition, and cease any business activity that would result in greater losses.
13. Describe the acts of bankruptcy that would entitle a creditor to institute bankruptcy proceedings.
Answer:
The acts of bankruptcy as found in s. 42 (1) of the Act. See text pp. 303-304.
14. Outline the requirements a creditor must satisfy in order to institute bankruptcy proceedings against a debtor.
Answer:
To institute bankruptcy proceedings, a creditor must satisfy the court that the debtor has debts of at least $1,000 and has committed an act of bankruptcy within the past six months.
15. If a debtor makes a proposal to his or her creditors, then fails to comply with the proposal at a later date, what steps may be taken by the creditors?
Answer:
If a debtor fails to comply with the terms of an approved proposal, the default constitutes an act of bankruptcy (s. 42 (1) (i)), and a creditor may then proceed to petition the court for a receiving order.
16. Under what circumstances would a debtor be permitted to make a voluntary assignment for the benefit of his or her creditors?
Answer:
A voluntary assignment may be made where the debtor wishes to make an assignment of his assets for the benefit of his creditors. The assets are assigned to an official receiver who then proceeds as if the matter is an ordinary bankruptcy.
17. Why are "inspectors" appointed by creditors at their first meeting in bankruptcy proceedings?
Answer:
Inspectors are expected to give instructions and supervise the trustee in the collection and distribution of assets of a bankrupt estate.
18. What is a "preferred" creditor, and how does this status affect the right to payment?
Answer:
A preferred creditor is entitled to payment according to a list of priorities in the Act.
(s. 136) (1).
19. Outline the order of priority to payment of preferred creditors in a bankruptcy.
Answer:
The order of priority is set out in s. 136 (1) of the Act. The list is described on pp. 306-307 of the text.
20. Explain the duties of an undischarged bankrupt.
Answer:
An undischarged bankrupt must not engage in any business without disclosing that he or she is an undischarged bankrupt. An undischarged bankrupt must not purchase goods on credit except for necessaries (and then only for amounts under $500), and may not become a director of a corporation.
21. What is the effect of a discharge on a bankrupt debtor's obligation to pay his or her creditors?
Answer:
A discharge releases the bankrupt person from all debts except those arising from wrongdoing or from martial obligation.
22. Describe the role of the Superintendent of Bankruptcy in, bankruptcy proceedings.
Answer:
The Superintendent administers the Act, and has the power to investigate alleged offences under the Act.
1. Ask A Lawyer requires an assessment of two distinct issues: (1) the type of credit security to use to enable buyers to purchase the new product line, and (2) to determine the best way to finance the purchase of its larger building. For issue (1) What are the advantages and disadvantages of each credit instrument that you might consider? Which approach might give the corporation the easiest access to the credit monies? For issue (2) which security instrument might be best for raising the money necessary to build the new building?
Comment:
Ask A Lawyer looks for answers to two distinct questions. The first question deals with the type of security instrument the business should offer to customers to finance their purchases. Since the corporation does not wish to carry the credit itself, it should select an instrument that would not only secure payment, but allow the corporation to sell it to a financial institution (or perhaps arrange with the financial institution to handle the financing itself on a direct basis with the customer). The lawyer in this case might suggest a conditional sale contract for the sale, registered under the PPSA of the province. This would allow repossession of the goods if default occurs.
As to the financing of the new building, a land mortgage or charge would probably be suggested as the property could be used to secure the financing.
2. Chartered banks are in the business of lending money. In what ways might a bank provide financial assistance to a merchant?
Comment:
As noted in the Ask A Lawyer scenario above, a bank may assist a merchant by lending it money to finance its business. It might also agree to assist in the financing of its sales to customers.
3. In what way (or ways) does bankruptcy affect the rights of secured creditors? How would they recover their debts if the security they held was insufficient to cover the amount owing?
Comment:
In a bankruptcy, secured creditors are entitled to look first to their security for payment, but if the proceeds from the sale of the asset are insufficient to cover the debt owing, they are entitled to claim the balance as an unsecured creditor.
4. If a corporation finds itself in financial difficulty, consider the approaches that it might take in order to restructure its operations.
Comment:
COMMENTS RE: DISCUSSION CASES
CASE 1
Amelia, a B.C. resident, was the owner of a small yacht that was subject to an unregistered chattel mortgage to Ace Finance in the amount of $20,000. She sold the yacht to her friend Donald, who resided in Vancouver, B.C. The friend purchased the yacht for $50,000. Some time later, Donald purchased a larger yacht from a dealer and used the small yacht as a trade-in to cover part of the purchase price. The dealer made a search of security interests under the provincial Personal Property Security Act and found no claims against the yacht. The boat dealer later sold the yacht to Martin, under a conditional sale agreement for $55,000, and registered the security interest. Martin later sold the yacht to Wray for $50,000, and moved to the province of Alberta. Wray did not search for claims against the yacht at the time of the purchase, and paid over the money unaware that the boat dealer had a registered security interest in the property.
The conditional sale agreement went into default when Martin neglected to make a payment to the boat dealer. The ownership of the yacht was traced to Wray, and the yacht was seized by the boat dealer.
Discuss the rights of the parties in this case.
The first point to note in the case is that the yacht was subject to an unregistered chattel mortgage. Ace Finance would lose its security in the yacht when it was sold to Donald. However, Amelia would be liable for payment on her personal covenant to pay in the chattel mortgage. Ace Finance could not claim against Donald or the yacht. The dealer that purchased the yacht as a trade-in would also acquire good title, clear of the Ace Finance chattel mortgage, and could sell to Martin under a conditional sale agreement. The registered conditional sale agreement would permit the boat dealer to repossess the yacht when default occurred under the conditional sale agreement. Wray in this case would have the right to sue Martin for the purchase money paid (if he can find him).
CASE 2
Victor owned a block of land that fronted on a large lake, On May 1st , he entered into a contract with Ace Construction Company to have a custom designed cottage constructed on the site.
Ace Construction Company fixed the contract price at $80,000, payable
$10,000 on the signing of the agreement, and the balance on the completion of the contract. Victor signed the contract and urged the building contractor to begin construction immediately. On May 1st, he gave the contractor a cheque in the amount of $10,000.
Ace Construction Company entered into the following subcontracts for the construction work:
on June 1st.
to be delivered by July 1st.
only to erect and close in the cottage by July 20th.
shingle the building roof by July 20th.
equipment, the work to be completed by August 1st.
Ace Construction Company was to have the cottage completed and ready for occupancy by August 6th. Work progressed on schedule, and each subcontractor was expected to complete the subcontract on time. By August 1st, the cottage was almost ready for occupancy, and only the front door and eavestroughing remained unfinished.
On August 1st, the proprietor of Ace Construction Company approached Victor and asked him if he might receive the balance of the contract price, as he wished to use the funds to pay his subcontractors. Victor gave him a cheque for the remaining
$70,000, confident that the contract would be competed.
On August 2nd, a dispute arose between Ace Construction Company and Baker Framing Contractors over the terms of the contract between them, and Ace Construction Company refused to make payment. Baker Framing Contractors registered a construction lien against the cottage lot later the same day. All of the other subcontractors immediately became aware of the lien claim, and registered liens on August 3rd.
The next day, Ace Construction Company was found to be insolvent without having paid the subcontractors.
Discuss the legal rights of the various subcontractors, Victor, and Ace Construction Company. Indicate the probable outcome of the case.
Comment:
This case concerns the application of the mechanics' or construction lien legislation to a construction situation. The first matter to be determined is the validity of the various lien claims. Were all liens registered within the time period specified in the Act? For example, in Ontario, the lien must be registered within forty‑five days of the day on which the last work was done. Using Ontario as an example, the contract of Able Excavation is outside the time period for filing a lien, if the last work was done on June 1st.
The remaining liens would be in time. This would entitle the subcontractors to claim against the holdback, but Victor, in error, did not holdback the required 10%. He would, as a result, be obliged to pay the amount over again in order to free the property of liens. Since the amount of the liens would exceed the amount of the holdback, the subcontractors would be obliged to claim for the balance as creditors in the bankruptcy of Ace Construction Company.
It should be noted that under the legislation in some provinces, Ace Construction Company would be expected to hold the money received as trust money until the subcontractors were paid. The failure to do so, would be a breach of the Act. (Ontario for example).
CASE 3
The Luxury Housing Corporation required capital in order to finance certain land acquisitions for its proposed housing project. The corporation made a $l,000,000 bond issue to acquire the funds necessary for working capital and to cover a down payment on the purchase of a large block of land that it purchased for $5,000,000. The balance of the land transaction was in the form of a first mortgage back to the vendor for $4,000,000.
Once the land was acquired, Luxury Housing Corporation entered into a building contract with High Rise Construction Company to construct a large apartment building on the site. The contract was for the sum of $15,000,000, which Luxury Housing Corporation expected to finance by a construction loan of $19,000,000 from Apartment Finance Limited. The money was to be advanced as construction of the building progressed. The building mortgage was registered as a second mortgage, on the understanding that the part of the funds remaining after the building was constructed (plus the corporation's working capital) would be used to discharge the first mortgage.
After the contractor had completed $1,000,000 worth of work on the building, and after Luxury Housing Corporation received a $l,000,000 advance on the building mortgage, Luxury Housing Corporation decided to stop construction due to a sudden decline in demand for apartment units in the City.
Assuming that the bonds issued contain a floating charge, and assuming that the contractor files a construction lien against the property for $1,000,000, discuss the rights of the various creditors if Luxury Housing Corporation decides to abandon the project and allow its bonds and mortgage obligations to go into default, even though it has cash in the amount of $1,000,000 and other assets (excluding land) in the amount of $500,000.
The land is subject to a first mortgage in the amount of $4,000,000, and a second mortgage in the amount $19,000,000, of which only $1,000,000 was advanced. The lien registered against the property is in the amount of $1,000,000. If the corporation allows the mortgages to go into default, and does not pay the lien claimant, the lands may be foreclosed by the first mortgagee (or the second mortgagee), or sold by the courts to settle the claims of the lien claimant.
Assuming the land is sold for $5,000,000 the first mortgagee would receive $4,000,000 and be paid in full as first claimant to the money. The second mortgagee may be able to claim the remaining $1,000,000 in priority over the lien claimant, (depending upon the province).
The bond holders would have a secured claim against the assets under the floating charge, and would be entitled to the $500,000 in assets. The bond holders may also be entitled to $500,000 of the cash, leaving $500,000. This would leave the lien claimants as the only parties partially satisfied in their claims.
Motor Repair Ltd. carried on business as a service station operator. In addition to repairing automobiles, the business maintained a small dealer franchise for the sale of a line of new automobiles. It also sold gasoline and the usual lines of goods for the servicing of vehicles. Business was poor, however, and the company made a voluntary assignment in bankruptcy in which it listed as assets:
Land and building $150,000
New automobile (3) 62,000
Gasoline & oil 3,000
Parts, supplies, and equipment 13,000
Accounts receivable 12,000
Bank loan 100
Misc. assets (furniture, tools, etc.) 1,900
$242,000
Its creditors' claims were as follows:
1st registered mortgage on land and building $120,000
2nd registered mortgage on land and building 19,000
Registered conditional sale agreements on automobiles 62,000
Due and owing to fuel supplier 25,000
Due and owing to other trade creditors 33,000
Municipal taxes owing 6,000
$265,000
When the trustee went to the place of business he discovered that: (a) the new cars had been taken by the manufacturer; (2) the fuel tanks had been emptied by the fuel supplier; and (3) Smith, an employee, was on the premises and in the process of removing an expensive set of tools that he maintained had been given to him by the company in lieu of wages for his previous weeks work.
Discuss the steps that the trustee might take as a result of the discoveries.
Comment:
The facts in this case illustrate a situation where some of the creditors have taken upon themselves to seize assets of the debtor before bankruptcy proceedings have begun. It should be noted, however, that some creditors have this right. For example, secured creditors may realize upon their security outside the Bankruptcy and Insolvency Act. While the case does not so indicate, the first and second mortgagees might look to the land and building for the satisfaction of their mortgages, rather than proceed through the bankruptcy action.
From the facts, the manufacturer of the new cars apparently sold them under a conditional sale agreement to Motor Repair Ltd., and on default, would be entitled to recover them, as title had not passed. The fuel oil dealer, however, would probably not be entitled to take back his fuel, but must rely on his claim as a creditor for payment. The trustee might recover the value of the fuel oil from the supplier under the circumstances.
The employee, Smith, was caught in the process of taking a set of tools, which he explained had been given to him by Motor Repair Ltd. in lieu of wages. If the tools had been given to him in full satisfaction of his wages prior to the assignment in bankruptcy, the payment "in kind" to the employee might be beyond the reach of the trustee. This would likely depend upon a number of factors, the most important being whether the wages owing and the value of the tools were approximately the same. The unusual method of payment may nevertheless, be open to challenge.
For many years, the Specialty Mfg. Company carried on business as a manufacturer of consumer products. In 2001, it embarked on an ambitious program of expansion that involved the acquisition of a new plant and equipment. Financing was carried out by way of real property mortgages, chattel mortgages, and conditional sale agreements, with very few internally generated funds used for the expansion.
By 2003, a general decline in demand for its product line due to a poor economic climate placed the company in a serious financial situation. As a result of a failure to pay a trade account to one creditor, bankruptcy proceedings were instituted. Specialty Mfg. did not object to the proceedings, and did not make a proposal to its creditors.
The trustee disposed of the assets of the company and drew up a list of creditors entitled to share in the proceeds. His preliminary calculations were as follows:
Sale of assets, etc.
Sale of land and buildings $350,000
Sale of production equipment 35,000
Sale of trucks & automobiles 25,000
Sale of inventory of finished goods, etc. 30,000
Accounts receivable 48,000 $488,000
(all secured claims properly registered)
1st mortgage on land and buildings $290,000
2nd mortgage on land and buildings 45,000
3rd mortgage on land and buildings 40,000
1st chattel mortgage on trucks & automobiles 22,000
2nd chattel mortgage on trucks &automobiles 40,000
Bank claim under s. 427 of Bank Act 25,000
Unsecured trade creditors 60,000
Unpaid wages (10 employees@ $300 each) 3,000
Unpaid commissions to salespeople 1 @ $1,500 1,500
Bankruptcy expenses, fees& levy 39,000
Unpaid municipal taxes 9,000
Production equipment conditional sale agreement 10,000
$584,500
Calculate the distribution of the funds to the various creditors and calculate the cents per dollar amount that the unsecured trade creditors would receive.
Comment:
The purpose of this case is to illustrate a distribution of assets to the creditors in a bankruptcy. The first point to note here is that the secured creditors may realize on their security outside the bankruptcy proceedings. The first, second and third mortgagees may satisfy their claims in the following manner:
Value of land and buildings ‑ $350,000
less lst mortgage amount ‑ 290,000
balance 60,000
less 2nd mortgage amount ‑ 45,000
balance $ 15,000
3rd mortgagee gets the $15,000 balance, and may claim as an unsecured creditor for the remaining, $25,000.
The chattel mortgagees with claims against the trucks and automobiles may exercise their rights in a similar manner. Viz:
Value of trucks and automobiles ‑ $25,000
less lst mortgagee's claim 22,000
balance $ 3,000
The second chattel mortgagee would get the $3,000 balance and claim as an unsecured creditor for the remaining $37,000. The claim of the conditional seller ($10,000) would be satisfied from the proceeds of the sale of the production equipment, leaving a balance of $25,000.
The claim of the bank ($25,000) against, say, the inventory ($30,000) would be fully satisfied, leaving a $5,000 balance for other creditors, etc. The remaining claims would fall within the priorities under the Bankruptcy Act.
To satisfy the priorities, the following funds would be available:
balance from sale of inventory - $ 5,000
balance from sale of production equipment ‑ 25,000
accounts receivable - 48,000
$78,000
The preferred creditors, in order of preference (or right to the funds) would be:
Bankruptcy expenses and levy - $39,000
unpaid wages - 3,000
salesman's commission - 1,500
municipal taxes - 9,000
$52,500
The remaining $25,500 would be divided between the unsecured creditors using the formula and each creditor would receive:
total funds available x creditor's claim
total unsecured creditors' claims
The amount owing to unsecured creditors would be:
unsecured trade creditors ‑ $ 60,000
balance of 3rd mortgagee's claim ‑ 25,000
balance of 2nd chattel mortgagee's claim ‑ $ 37,000
Total $122,000
The cents on the dollar would be: 25,500 or about 21 cents.
122,000
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