Catherine WalshFormation Continue

McGill University30 November 2010

Hypothecation of investment assets: digression from general

principles

New RegimeThe Act Respecting the Transfer of

Securities and 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.

Objectives of new regimeTo 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

Directly held securitiesDirectly held security = direct legal relationship between holder and issuer

Certificated securities: holder holds certificate issued by the issuer representing the security

Uncertificated securities: holder is registered in the issuer’s share register but does not possess a certificate representing the security

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

Security versus security entitlementSecurity = a directly held security, whether

certificated or uncertificatedSecurity 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”).

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

Creation & Third Party Effectiveness:security entitlementsA 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.

Modes of control: security entitlements

A person acquires control by:becoming the account holderconcluding 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

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).

Priority of hypothecs:security entitlementsA “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.

Special priority rules for intermediariesIf 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.

Priority among hypothecs granted by different grantors: general principleSuppose A grants to B a hypothec on

certain assets, and B subsequently grants to C a hypothec on those same assets.

General principle: Nemo dat quod non habet: a hypothec on the asset of another is ineffective.

Exception to nemo dat: security entitlementsRehypothecation 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.

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.

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.

Policy rationalesFinality in securities transfer transactionsReduction of transaction costs for

purchasers and secured creditorsFacilitation of access to low cost financing

for brokers and other intermediaries

Do costs outweigh benefits?

Acknowledgements/ReferencesJ.M. Deschamps, «Sûretés et ventes portant sur

des 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