Credit Laws
Factoring Agreement: Security or Sale of Assets?
by Domenico Magisano
Lenders and other members of the factoring community should be aware of the potential impact of a recent ruling on a priority fight over the accounts receivable of a bankrupt company. One of the issues that the court had to consider was the application of a factoring agreement. Canadian courts have always struggled with factoring agreements. Are they security agreements, or are they merely a sale of accounts receivable?
The latest chapter in this debate occurred in 2811472 Canada Inc. (C.O.B. Acorn Partners) v. Royal Bank of Canada. In this case, the Royal Bank of Canada (“RBC”) lent money to Molnar Industrial Maintenance Ltd. (“Molnar”) and took security by way of General Security Agreement (the “RBC Security”). Prior to Molnar’s bankruptcy, and after the Bank had demanded payment of its loans, Molnar entered into factoring agreements with 2811472 Canada
Inc. (“Acorn Partners”) under which Molnar purported to assign its accounts receivable to Acorn Partners. Acorn Partners never sought, and RBC never agreed, to subordinate the RBC Security to that of Acorn Partners. Once Molnar became bankrupt, a priority dispute arose between RBC and Acorn Partners with respect to Molnar’s accounts receivable.
First Acorn Partners argued that its factoring agreements were merely a purchase of Molnar’s accounts receivable. But Acorn Partners subsequently argued that its factoring agreements constituted security arrangements, pursuant to which Acorn Partners acquired a Purchase Money Security Interest (“PMSI”) in Molnar’s accounts receivable. The court was skeptical about Acorn Partners position that it either entered into an agreement of purchase and sale or, alternatively, had a PMSI in Molnar’s account receivable. But the court gave an opinion on Acorn Partners’ argument that it had a properly perfected PMSI in the accounts receivable. In dismissing Acorn Partners’ motion, the Honourable Justice Forget made the following findings:
• Acorn Partners could not have a properly perfected PMSI, since the funds advanced by Acorn Partners to Molnar were not used to acquire or create the collateral over which Acorn Partners claimed its PMSI; and
• irrespective of point (1), the pre-existing RBC Security already encumbered all of Molnar’s “accounts and book debts”. Absent a subordination agreement with RBC, Molnar was therefore not in a position to assign its accounts receivable to Acorn Partners.
Acorn Partners appealed the Honourable Justice Forget’s decision to the Ontario Court of Appeal. In a unanimous decision, the appeal was dismissed and the Court of Appeal confirmed that RBC had priority over Molnar’s accounts receivable.
When considered in conjunction with the Supreme Court of Canada decision in First Vancouver Finance v. Minister of National Revenue, it appears that this decision has clarified the nature of factoring agreements under the Personal Property Security Act (Ontario). Specifically, factoring companies must recognize:
• when an existing creditor has security in the present and after acquired accounts receivable of the debtor, then absent a subordination agreement, the courts will find that the factoring agreement does not have priority to the pre-existing security;
• it is difficult for a factoring company to prove that its factoring arrangement and by extension, the security taken in the debtor’s accounts receivable, forms a PMSI, since the factoring company first must prove that its proceeds were used to create or acquire the collateral that is subject to the PMSI; and
• should a factoring company attempt to purchase accounts receivable that have previously been encumbered by the debtor, it does so at its peril, since a pre-existing secured creditor with a properly perfected security interest has priority to these proceeds. Factoring agreements have a role to play in corporate finance (particularly with companies facing a liquidity crisis), however, their priority will be subject to pre-existing creditor rights in that same security.
Domenico practices both business law litigation and insolvency law with the firm of Blaney McMurtry LLP. Domenico has acted for all types of creditors in both litigation and insolvency proceedings, including acting for factoring companies in priority disputes with other creditors. Domenico is committed to achieving practical business solutions to complex legal problems and may be reached directly at 416-593-2996 or by e-mail at dmagisano@blaney.com
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