Canadian Business and the Law - Second Edition

Canadian Standards Association also provides testing and certification of products under its brand name CSA International.
The international standards-setting body is the International Organization for Standardization (ISO).
23. SC 1993, c 16.
24. Food and Drugs Act, RSC 1985, c F-27 (FDA).
25. Canadian Standards Association International, A Guideline on Children's Playspaces and Equipment, Doc No CSA
Z614–98 (Toronto: CSA International, 1998).
26. See Canadian Food Inspection Agency, “The Use of Trade-Marks in Labelling of Foods Sold in Canada” (27 April
2012), online: Canadian Food Inspection Agency <http://inspection.gc.ca/food/labelling/other-requirements/trade-
marks/eng/1335544176482/1335544253720>.
27. The principal exception to this is the Quebec language legislation, most importantly that found in s 51 of the Charter of
the French Language, RSQ c C-11. Otherwise, provincial legislation tends to apply to specialized industries such as alcohol,
milk, and margarine.
28. RSC 1985, c T-10. See Competition Bureau of Canada, Guide to the Textile Labelling and Advertising Regulations
(September 2000), online: <http://www.competitionbureau.gc.ca/eic/site/cb-bc.nsf/eng/01249.html>.
29. SC 1997, c 13.
30. RSC 1985, c C-38. See also Competition Bureau of Canada, Guide to the Consumer Products Labelling Act and
Regulations: Enforcement Guidelines (October 1999), online: Competition Bureau Canada
<http://www.competitionbureau.gc.ca/eic/site/cb-bc.nsf/eng/01248.html>.
31. These requirements were recently tightened. New guidelines for food products came into effect on 31 December 2008.
See Canadian Food Inspection Agency, Guidelines for Product of Canada and Made in Canada Claims, online: Canadian
Food Inspection Agency <http://www.inspection.gc.ca/food/labelling/other-requirements/origin-claims/product-of-
canada/guidelines/eng/1333457811817/13334 58040733l>. For non-food products, see Competition Bureau of Canada,
“Competition Bureau confirms enforcement approach to new guidelines on “Made in Canada” and “Product of Canada”
claims” (14 May 2010), online: Competition Bureau Canada <http://www.competitionbureau.gc.ca/eic/site/cb-
bc.nsf/eng/03230.html>.
32. 2nd Session, 39th Parliament.
33. Canada Consumer Product Safety Act, SC 2010, c 21.
34. LE Boone et al, Contemporary Marketing, 3rd Can ed (Toronto: Nelson, 2013) at 45.
35. Supra note 21.
36. Advertising Standards Council, “Recent Complaint Case Summaries”, online: Advertising Standards Canada
<http://www.adstandards.com/en/standards/adComplaintsreportscurrent.asp>.
37. RSC 1985, c C-34.
38. Ibid, ss 52, 74.01. Other legislation tends to focus on specific issues. For example, the Consumer Packaging and
Labelling Act, supra note 30, prohibits misleading advertising, specifically in the context of prepackaged goods; it would be
misleading to describe the product box as “full” or “large” if this is not the case.
39. For example, a Vancouver career management company made representations to prospective clients that created the
false impression that they had an extensive network of personal contacts in the corporate world. See Competition Bureau of
Canada, “Federal Court of Appeal rules that career management firm misled vulnerable job seekers” (16 October 2009),
online: Competition Bureau Canada <http://www.competitionbureau.gc.ca/eic/site/cb-bc.nsf/eng/03144.html>.
40. Competition Bureau of Canada, “Premier Fitness undisclosed fees investigation successfully concluded” (27 November
2007), online: Competition Bureau Canada <http://www.competitionbureau.gc.ca/eic/site/cb-bc.nsf/eng/02518.html>.
42. Competition Bureau of Canada, “Competition Bureau reaches agreement with Bell Canada” (28 June 2011) online:
Competition Bureau Canada <http://www.competitionbureau.gc.ca/eic/site/cb-bc.nsf/eng/03388.html>.
43. R v Sault Ste Marie (City), [1978] 2 SCR 1299 at para 60.
44. Supra note 37 at s 74.01(1)(b).
45. Supra note 37 at s 36.
46. Go Travel Direct.Com Inc v Maritime Travel Inc, 2009 NSCA 42.
47. See Iain Marlow, “Bell Aliant sues Rogers over Internet ads”, The Globe and Mail (15 February 2010), online: Globe
and Mail <http://www.theglobeandmail.com/news/technology/bell-aliant-sues-rogers-over-internet-ads/article1468899/>;
Simon Houpt, “Rogers ditching ‘most-reliable’ claim”, The Globe and Mail (30 November 2009), online: Globe and Mail
<http://www.theglobeandmail.com/globe-investor/rogers-ditching-most-reliable-claim/article1383253/>; and Bertrand
Marotte and Simon Houpt, “Bell takes Videotron to court over ‘fastest’ claim”, The Globe and Mail (30 April 2010), online:
Globe and Mail <http://www.theglobeandmail.com/report-on-business/bell-takes-vidotron-to-court-over-fastest-
claim/article1552315/>.
48. Supra note 37 at s 74.10.
49. Richard v Time Inc, 2012 SCC 8 and see Cristin Schmitz, “Caveat venditor for advertisers”, The Lawyers Weekly (9
March 2012) 2.
41. Competition Bureau of Canada, (25 June 2008), online: Competition Bureau Canada
<http://www.competitionbureau.gc.ca/eic/site/cb-bc.nsf/eng/02701.html>.
50. Supra note 41.
51. Based on McAsphalt Industries Ltd v Chapman Bros Ltd, 2008 NSSC 324.

52. Based in part on a Health Canada recall notice – Health Canada, “Consumer Product Recalls” (9 December 2011),
online: Health Canada <http://cpsr-rspc.hc-sc.gc.ca/PR-RP/recall-retraiteng.jsp?re_id=1480>.
53. Based on Prebushewski v Dodge City Auto (1984) Ltd, 2005 SCC 28.
54. Based in part on Paul Taylor, “BPA being absorbed from canned food: study”, The Globe and Mail (24 November
2011), online: Globe and Mail <http://www.theglobeandmail.com/life/health/new-health/paul-taylor/bpa-being-absorbed-
from-canned-food-study/article2248262/>.

P. 598

© 2007 Cengage Learning Inc. All rights reserved. No part of this work may by reproduced or used in any form or
by any means - graphic, electronic, or mechanical, or in any other manner - without the written permission of the
copyright holder.

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copyright holder.

Chapter 24 : Sales and Marketing: Price, Distribution,
and Risk Management : Chapter Overview
(p. 599)

Sales and Marketing: Price, Distribution, and Risk Management: Chapter Objectives

Objectives

After studying this chapter, you should have an understanding of

the legal obligations associated with the price component of marketing
the legal obligations associated with the distribution (place) component of marketing
the role of ethics, risk management, and corporate compliance in marketing

Sales and Marketing: Price, Distribution, and Risk Management: Chapter Overview

GLOW IMAGES, INC./GETTY IMAGES

Business Law in Practice

Pacific Play Centres Inc. (PPC), introduced in the previous chapter, is continuing to develop its marketing strategy for its
new line of wooden backyard play centres for children. The preliminary marketing plan included a premium pricing strategy
of selling to affluent parents who want attractive and high-quality play equipment for their children. The plan also included
distribution through national hardware and toy retail chains, and directly by PPC online. Steve Martin, the head of sales, has
concerns about several aspects of pricing and distribution of the new product line. Some retailers are aggressive in
negotiations, and he is worried that PPC is being urged to engage in legally suspect practices. In particular, there is a new
market participant insisting on preferential terms (higher discounts and longer payment terms) that would give it a distinct
advantage over other competitors.

To support the premium pricing strategy, Steve is exploring ways of discouraging distributors and retailers from selling PPC
products at discount prices and proposes to place a “recommended retail price” sticker on the packaging. Steve thinks that
arranging for exclusive dealerships in different regions of the country might be the best way to promote the high-quality
image of the new products. Steve is interested in promoting and selling the new products through PPC's website, but he
wants to proceed cautiously. In general, Steve and Lisa Patel, the CEO, wish to develop and implement a marketing plan
that incorporates management of legal risks.

1. How does the law affect PPC's pricing strategy?
2. How does the law affect PPC's distribution strategy?
3. How can PPC effectively manage its exposure to legal risk in the context of marketing?

P. 599

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email Id: [email protected]
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by any means - graphic, electronic, or mechanical, or in any other manner - without the written permission of the
copyright holder.

Chapter 25 : Business and Banking
(pp. 622-643)

Business and Banking: Chapter Objectives

Objectives

After studying this chapter, you should have an understanding of

the relationship between a business and its bank
the legal issues involved in electronic banking
the legal challenges involved in the various methods of payment
the legal framework of negotiable instruments
the rights and obligations of those connected with negotiable instruments

Business and Banking: Chapter Overview

COURTESY

OF DARCY SAGE

Business Law in Practice

Bill Ikeda and Martha Wong operate a building supply outlet in Timmins, Ontario. They also sell hardware, plumbing, and
electrical supplies. Their customers are retail and commercial. They operate the business through a corporation, Hometown
Hardware Ltd. (Hometown). Bill is the CEO and majority owner. He conducts most of the business apart from the operation
of the store. Martha is the vice president and owns the remaining shares. She manages the store. The business has dealt with
the local branch of the same bank for many years—the Full Service Bank (FSB). Both Bill and Martha have signing
authority.
Bill and Martha have recently begun to reconsider their relationship with FSB. The branch has a new manager. There have
been other personnel changes, as well, so that Hometown's accounts and loans are now handled by unfamiliar employees
who seem uninterested in Hometown's business and have recently been unhelpful. Bill is also not sure that he has the
appropriate types of accounts. He is concerned about high service fees on his accounts and rising interest rates on his loans.
He wonders whether he should consider moving his business to another bank. Martha has been advised by business
acquaintances that banks are offering a vast array of financial services and that Hometown's banking can be done more
easily and cheaper online.
Bill is also concerned about the growing number of cheques being returned to him by the bank because customers have
insufficient funds in their accounts to cover them. He currently accepts payment by cash, cheque, debit card, and credit card.
Hometown also extends credit to some commercial customers. Bill is interested in the cost and risk of various payment
options.

1. What do Bill and Martha need to know about the legal aspects of the relationship between their business and a bank?
2. What are the risks and benefits of various payment options and doing banking electronically?
3. What are the risks and benefits of using cheques to pay bills and allowing customers to pay by cheque?

P. 622

When operating a
building supply store, what financial decisions with legal consequences must the owners make? BORIS
SPREMO/THE CANADIAN PRESS

Business and Banking

This chapter describes the relationship that a business has with its bank, including the financial services the bank provides
and the agreements and duties involved in the relationship. Various forms of payment and the related risks are explored—
traditional paper-based payments and the growing number of electronic options. The chapter begins with a brief look at the
banking system.

The Regulation of Banks

Traditionally, the Canadian financial services industry had four distinct sectors: banks, trust companies, stockbrokerages,
and insurance companies. To ensure stability within each sector and to avoid conflicts of interest resulting from institutions
providing services from several sectors, each was separately regulated, and institutions in one sector were prohibited from
conducting business beyond that sector.

The internationalization of the financial services industry in the 1980s placed pressure on governments to deregulate and
relax the strict separation of the four sectors. In 1987, Canadian legislation1 allowed banks to go beyond traditional banking
and participate in other sectors in their branches or through subsidiary firms. Banks have become financial marketplaces,
offering services in cash management, payment services, investment advice, and business financing. Subsequent legislation2
further blurred the distinctions between different types of financial institutions by allowing greater structural flexibility.
Among many other changes, it provided for liberalized ownership rules for banks. The key

P. 623

remaining limit on banks' business is the prohibition against selling or promoting insurance products in their branches.
Banks have responded by opening separate insurance branches and attempting to conduct insurance business online.3 The
financial sector legislation is reviewed every five years.4 Bank regulation has become a topic of great interest since the
world financial crisis began in 2008.

Banks are increasingly offering international banking services, such as letters of credit, cross-border transfers, and accounts
in different currencies. These services are governed largely by voluntary rules created by international bodies, such as the
Bank for International Settlements and the International Chamber of Commerce. Parties involved in international
transactions frequently incorporate these rules into their agreements.

In Canada, banks are under federal jurisdiction and are regulated through the federal Bank Act.5 The main purposes of the
Act are to ensure the stability and liquidity of banks and to identify and regulate the types of business they are permitted to
conduct. The relationship between a bank and its individual customers is not a primary concern of the Act. The terms and
conditions of that relationship are, instead, found primarily in the agreements made between the bank and its customers,
which are influenced by banking practice and common law rules. Contract law is the prime source of guidance in
interpreting and enforcing the rights and obligations of the parties in this relationship.

The Bank–Customer Relationship

In its simplest form, the relationship between a business and its bank consists of one bank account into which the business
deposits its cash receipts from customers and from which it makes payments to suppliers, employees, government, and
owners. As a result of regulatory changes and decisions by banks to broaden their range of services, the relationship is now
more comprehensive. It is a challenge for businesspeople like Bill and Martha to decide what banking services they need,
which services they can afford, and who will do the best job of providing them.

The legal nature of the relationship is clear. In terms of the customer's money on deposit with the bank, the relationship is
that of the bank as debtor and the customer as creditor. Normally, the bank is not obligated to give advice or to look out for
the best interest of the customer, unless, for example, the bank provides services such as financial advice, which are outside
the normal scope of traditional banking services. In that situation, a fiduciary relationship may exist, and the bank has
several additional onerous duties, including

to provide advice with care and skill
to disclose any actual or potential conflicts of interest
to consider the interests of the customer ahead of those of the bank6

P. 624

For example, if Bill has sought and received advice from his banker as to the amount and structure of the financing he needs
for Hometown, he can expect to receive competent advice from the bank and should be encouraged to seek an independent
opinion before agreeing to a financing arrangement operating heavily in the bank's favour.

The practical advice for customers is to appreciate the basic nature of the relationship and to understand that banks generally
have no obligation to look beyond their own self-interest. However, banks are beginning to broaden their roles to remain
competitive.7 They are also under pressure to deal fairly with customers and to refrain from strict enforcement of
agreements that are onerous for their customers. For example, financial services legislation8 established the Financial
Consumer Agency of Canada (FCAC)9 to protect and educate consumers through the monitoring of institutions' business
practices regarding such matters as account fees and credit card rates. In addition, the financial services industry, in
cooperation with the federal government, has created the Centre for the Financial Services OmbudsNetwork (CFSON)10 to
provide a one-stop complaint procedure covering brokers, banks, insurance companies, and sellers of mutual funds in order
to ensure fair and impartial complaint resolution for consumers.

Duties of the Bank and the Customer

The common law and banking practice imply legal duties on both parties in the banking relationship. For example, the bank
must

honour payment instructions and repay deposits
collect payments for the customer
provide account information to the customer on a regular basis
maintain secrecy of the customer's affairs.11 This duty is qualified by legislation.

P. 625

Customers also have implied duties to the bank. They must

take reasonable steps to provide documentation as to who is authorized to give instructions to the bank, in order to
prevent fraud and forgery
keep authorizations current
notify the bank of any suspected problems
provide safeguards for electronic communications14

The Bank–Customer Agreement

Standard banking documents are designed primarily to protect the bank, not the customer. Large customers may have some
bargaining power, but small businesses such as Hometown have little. Understanding the terms and conditions in the
agreement will enable Bill to identify risks arising from the banking aspects of his business. He can then establish practices
to avoid incidents resulting in loss for which the banking agreement would make him responsible.

The purpose of the banking contract is twofold:

to specify who has the authority to issue instructions to the bank on behalf of the customer
to allocate the risk of loss resulting from problems with verifying the customer's authority and carrying out the
customer's instructions

The customer designates those with authority to issue instructions to the bank through such means as signing cheques. At
this time, Bill and Martha are the only persons with that authority at Hometown.

The second focus of the banking contract—namely, the allocation of loss—is of greater significance. Bill must be cautious
in his dealings because the bank–customer contract is drafted by the bank to limit its duties and liabilities. For example, a
verification clause commonly found in banking contracts gives the customer 30 days to detect and report any

P. 626

unauthorized payments that the bank makes from the customer's account. Beyond that period, the customer absorbs the loss.
Normally, the bank also has flexibility in dealing with all of the customer's accounts. For example, the bank can transfer
funds from an account with a positive balance to one that is overdrawn.

The key document involved in a banking contract is the account agreement, sometimes broadened into a financial services

agreement. It includes provisions dealing with issues such as

the bank's ability to apply charges to the customer's accounts (commonly known as service charges)
arrangements concerning instructions for payment by the customer, especially the issue of cheques
confirmations and stop payments on cheques
release of information by the bank about the customer.

Traditional banking transactions are increasingly done online.

P. 627

Business Application of the Law: Client Information and Money Laundering

The bank's duty to maintain secrecy of customer information is subject to the law concerning money laundering —that is,
the false reporting of income obtained through criminal activity as income gained through legitimate business enterprises.
Since 1991, banks have been urged to verify the identity of individual and corporate customers and the validity of their
business activities, and to determine the source of transfers exceeding $10 000.12

Legislation passed in 200013 was meant to enable Canada to meet its international obligations in combating money
laundering. The legislation created a mandatory reporting system in which banks, trust companies, insurance companies,
and professionals must report to a new independent body—the Financial Transactions and Reports Analysis Centre
(FINTRAC)—suspicious financial transactions and large cross-border currency transfers. Suspicious transactions are not
defined in the act, but FINTRAC provides guidelines under headings such

P. 625

as “economic purpose” of the transaction. For example, if a transaction seems to be inconsistent with the client's apparent
financial standing or usual pattern of activities, does not appear to be driven by normal commercial considerations, or is
unnecessarily complex for its stated purpose, it should be considered suspicious.

FINTRAC is responsible for managing the information reported by the various organizations affected by the Act and
deciding which transactions to refer to law enforcement agencies for investigation.

Subsequent regulatory changes have tightened the requirements by broadening the applicability and expanding the
obligations of record keeping, reporting, and registration; increasing client identification requirements; requiring compliance
regimes, employee training, and education; and establishing federal registration for money service and foreign exchange
businesses. The legislation is undergoing its five-year mandatory review.

Critical Analysis

To what extent should the confidentiality of individual client accounts be compromised to combat money laundering by a
minority of clients? How is the effectiveness of this regime measured? Is the regulatory burden justified?

Sources: Department of Finance Canada, “Minister of Finance launches consultation to update anti-money laundering and
anti-terrorist financing regime” (21 December 2011), online: Department of Finance Canada <http://www.fin.gc.ca/n11/11-
142-eng.asp >; and Christine Duhaime, “Push to expand money laundering law”, The Lawyers Weekly (9 March 2012) 11.

P. 626

Electronic Banking

Electronic banking includes a growing range and variety of transactions that previously required formal documentation. A
wide variety of technological developments are changing the ways that businesses deal with banks, customers, and other
businesses. Banks are encouraging customers to conduct their banking business through ATMs, telephone, or online, rather
than through in-person transactions in bank branches. These methods can be more convenient for customers and
significantly less expensive for the banks. Some new banks have no physical branches at all and conduct all their business

online.

There are several legal issues arising from electronic transactions. Electronic storage means that data are subject to system
crashes or hackers. Fraud has become a significant concern. Other potential problems are transmission failures or system
crashes. As business comes to rely increasingly on instant payments, possibly at the last minute, the potential loss from a
failed or delayed transfer is significant.

Most of the legal uncertainty surrounding electronic banking is the result of the irrelevance of existing legislation to a
paperless environment. The process and timing of electronic transactions do not fit with existing rules related to risk
allocation for authentication, verification, and finalization of payments in paper-based transactions.

The gap in the rules governing electronic banking is being filled in several ways. First, banking contracts now include an
agreement for electronic financial services and access. Banks may be tempted to limit their liability through their
agreements with customers, but they are also interested in reassuring customers by assuming responsibility themselves.
Agreements make provision for risks that specify the customer's duties to report problems to the bank and the bank's
responsibility for electronic failures. Customers are also required to choose personal identification numbers (PINs) that are
not obvious, to change PINs regularly, and to safeguard those PINs from unauthorized use. If they fail to meet these
requirements, customers are liable for any losses that result. Banks are also placing daily and weekly monetary limits on
transactions in order to control the losses in the event of

P. 627

fraud. Second, industry codes have been created to provide guidance. The Code of Conduct for Credit and Debit Card
Industry was revised in 201015 and the Minister of Finance has formed a working group to develop a voluntary code for
electronic funds transfers and electronic banking. Third, there are international rules, such as the UNCITRAL Model Law on
International Credit Transfers,16 since electronic transfers are completed as easily across the world as within the local
community. If the sending and receiving banks are in different countries, these international rules deal with the obligations
of the parties, timing for payment, consequences for technical problems, and liability and damages.

What rules govern Atm transactions? EDYTA

PAWLOWSKA/SHUTTERSTOCK

P. 628

Although fraud and data security breaches are matters of concern, there is little evidence yet of significant legal problems
arising from electronic transfers. Business customers of banks are interested in security, convenience, and low costs in terms
of banking services. As long as banks can demonstrate to customers that their needs are being met without significant risks,
the volume of electronic banking will increase.

P. 629

Business and Legislation: Identity Theft

The Internet has increased the potential for fraudulent activities. In particular, identity theft has become a serious problem.
Identity theft involves obtaining others' personal information through various means and using that information for
fraudulent purposes such as accessing bank accounts or obtaining credit cards, loans, mortgages, or title to property. The
victims can be individuals or businesses. Their entire financial situation is compromised. One method for initiating identity
theft is through “phishing,” whereby fraudsters send email messages that appear to be from reputable companies, such as
banks, and direct recipients to websites that appear genuine, where victims are urged to disclose personal information in
order to verify their accounts and ensure their continued access. Simply visiting one of these websites may enable fraudsters
to extract valuable information. The information is then used to steal the victim's identity. The danger of identity theft has
increased with the advent of wireless technology, to the extent that identity theft has become an organized criminal activity.

To combat this increase in identity theft, the federal government passed legislation17 to create several new criminal
offences, including

P. 628

obtaining or possessing identity information with the intent to commit certain crimes
trafficking in identity information with knowledge of or recklessness as to its intended use, and
unlawfully possessing or trafficking in government-issued identity documents.

Identity information is broadly defined to include anything that is commonly used alone or in combination with other
information to identify an individual, such as name, address, fingerprints, date of birth, signature, bank account number, and
passport number. Penalties for violation of the law include imprisonment for five years. The challenge with such a law is to
address the criminal activity without unduly restricting legitimate business.

Sources: Sharda Prashad, “Identity theft strikes small businesses”, The Globe and Mail (18 January 2010), online: Globe
and Mail<http://www.theglobeandmail.com/report-on-business/small-business/start/legal/identity-theft-strikes-small-
businesses/article1433204/ >; Christopher Guly, “Identity theft may target innocent acts”, The Lawyers Weekly (18
December 2009) 17; and Eva Hoare, “Bank staff thwart identity thefts”, The Chronicle Herald (20 March 2010) A3.

Methods of Payment

When Bill and Martha pay an account with one of Hometown's suppliers, they have several options. They can use cash,
with the inconvenience and risk of keeping adequate cash on hand to pay bills. Other options are to pay by cheque (a
written order to the bank) or by electronic funds transfer (a paperless transaction). Electronic payments are expanding in
terms of scope and volume.

P. 629

Do the same rules apply to various payment choices?
IGOR VLADIMIROVICH ZHOROV/SHUTTERSTOCK RYAN MCVAY/GETTY IMAGES/JUPITER IMAGES

P. 630

The rules governing payment by cheque are well defined and are part of the law of negotiable instruments.

Negotiable Instruments

A cheque is the most common example of a negotiable instrument , but the rules also apply to other documents, such as
promissory notes and bills of exchange. A promissory note is a written promise by one person to pay a specified amount on
a certain date or on demand to another person. A bill of exchange is an order to someone else to pay funds to another
person. A cheque is a special type of bill of exchange, which is payable on demand and where the party instructed to pay is
a bank. These instruments are federally regulated by the Bills of Exchange Act.18 The rules in this legislation focus on the
attributes and transferability of pieces of paper called negotiable instruments.

There are several technical requirements for an instrument (a document) to become negotiable or transferable without the
need to investigate its validity through reference to the circumstances of its creation or other documents. The essence of the
requirements is that the instrument must be a self-contained obligation. It must be in written form and signed by the person
making the promise or authorizing the payment. It must specify an amount of money to be paid on a specified date or on
demand, and the obligation must be unconditional. For example, if a promise is made to pay “the balance due” on a
construction contract, the promise cannot be a negotiable instrument because the balance can be determined only by
consulting the original contract and investigating the work done and payments already made. A negotiable instrument must
be for a specific sum without conditions. When Bill issues a cheque (on behalf of Hometown) to a supplier of goods or
services, he gives a written order to his bank to pay a specified sum to the supplier. The cheque is a negotiable instrument.

As indicated in Figure 25.1 below, Bill is the creator of the instrument. The supplier is the payee (the business entitled to
payment). Bill is formally known as the drawer because

Annotated Cheque Figure 25.1 An

P. 631

he is ordering his bank (“drawing an order”) to pay the supplier. The bank, as the recipient of Bill's instructions, is known as
the drawee.

Bill's instructions to his bank in the form of a cheque and the bank's actions to carry out his instructions by paying money
from the Hometown account to the designated supplier are at the centre of the bank–customer contract. The written
agreement addresses these transactions in some detail and a number of duties are imposed through the common law. For
example, the customer must keep adequate funds in his accounts to pay any cheques that are issued, and he must provide
clear and unambiguous instructions to the bank concerning payment. The bank must take reasonable care in honouring
instructions to pay out the money.19

Bill's supplier will likely take the cheque to its own bank for deposit. Through the centralized clearing process, the cheque
will find its way from the supplier's bank to Hometown's bank, and the specified sum will be taken from Hometown's
account (see Figure 25.2 below).

As long as there are adequate funds in Hometown's account and there is no defect in the cheque, it will proceed smoothly
through the steps. If Bill accepts cheques as payment from his customers, the customer is the drawer and Hometown is the
payee, in relation to the steps in Figure 25.2. The following sections describe the potential problems and risks for the
participants if difficulties arise in the circulation or cashing of the cheque.

Implications of Creating a Cheque

When Bill chooses to pay a supplier by cheque, he is discharging a debt that Hometown owes as debtor to the supplier as
creditor. That debt has arisen through the contract between Hometown and the supplier for the provision of goods or
services. Assuming

Cheque Circulation Process FIGURE 25.2 Steps in the

P. 632

that Bill buys his building supplies from a number of suppliers, he will have regular payment obligations arising from his
contractual arrangements with those suppliers. If he encounters problems with the supplies, he will have a valid complaint
against the supplier (subject to their contract). He can pursue that complaint as he would any breach of contract.

However, his claim on the contract is a totally different matter from his obligation to pay the cheque. By issuing the cheque,
he has made an unconditional promise to pay the specified sum not just to the supplier, but potentially to anyone (known as
a holder ) who presents the cheque to Hometown's bank for payment. The special status of the cheque and the holder are
created by legislation20 that deliberately places the holder in a strong position in terms of collecting on the cheque. If the
holder has acted in good faith (meaning she has no reason to doubt the validity of the cheque), that person acquires the
status of a holder in due course . There are limited arguments (for example, a forged signature or an alteration of the
cheque) that Hometown can use to justify refusing payment to a holder in due course.The rights of such a holder are not
affected by any terms of Hometown's contract with the supplier. Hometown's bank will pay out the cheque to the holder.
Hometown can then seek compensation separately from the supplier.

A cheque involves a markedly different situation from an ordinary assignment of contractual rights, where there can be any
number of defences against paying. For example, if Hometown owes money to a supplier, that supplier can assign the right
to collect to someone else (known as an assignee). In the absence of a negotiable instrument, the assignee's right to collect
from Hometown is subject to any problems with the contract between Hometown and the supplier. Thus, if Bill has a valid
reason for refusing to pay the supplier's claim, he can use the same reason to avoid paying the assignee. In law, this idea is
captured in the expression “an assignee can have no better rights than the assignor.”21

This important distinction between an assignment and a negotiable instrument is illustrated by the former practice in some
consumer sales (in which the buyer is the final user of the goods for a non-commercial purpose) where the separation of
obligations arising from the negotiable instrument and the contract of sale was abused. If a consumer bought something on
credit and signed a negotiable instrument such as a promissory note in favour of the seller, that seller could sell the note to
another party (such as a finance company). The legal result of the transfer of the note was that the financier became a holder
in due course. The buyer's obligation to pay the financier was then nearly absolute and independent of problems with the
quality and performance of the purchased goods. Such problems could be pursued against the seller based on the contract of
sale, but they did not affect the consumer's continuing obligation to make payments to the holder of the note. These rules
enabled collusion between unscrupulous sellers and financiers to sell substandard goods to consumers and require them to
make all payments, even when the goods were defective or worthless.

P. 633

Legislation now22 classifies promissory notes arising from consumer credit sales as consumer notes . The holder of a
consumer note is not accorded the special status of a holder in due course and is subject to claims arising from the original
contract of sale. The consumer's obligation to pay the note is subject to remedies against the seller if the goods are defective.
Note that the special status of promissory notes is preserved in such transactions that are commercial in nature.

FIGURE 25.3 Comparison of Payment and Collection Arrangements

Type of arrangement Parties Enforcement rights
involved

Contract Buyer Seller can collect subject to performance of its obligations.
(debtor)
Seller
(creditor)

Assignment of contractual Debtor Assignee's right to collect is subject to the debtor's obligation to pay the assignor.
right Creditor

(assignor)
Assignee

Negotiable instrument Drawer Holder in due course's right to collect is not tied to the original contract.
(e.g., a cheque) (debtor)
Payee
(creditor)
Holder

Consumer note Consumer Financier does not have the status of a holder in due course—consumer's

Seller obligation depends on the original contract.

Financier

FIGURE 25.3 Comparison of Payment and Collection Arrangements

The essential point for the creator of a cheque is that the cheque is a self-contained obligation, the validity of which does not
depend on any circumstances outside the cheque. The creator has issued instructions to the bank to pay the designated payee
or a holder in due course. As long as the cheque contains the necessary endorsements (signatures) to confirm the holder's
right to possession of the cheque, the bank will pay it. Despite the strong position of a holder in due course, there are certain
risks, described below.

Implications of Accepting a Cheque

The major risk involved in accepting a cheque relates to the financial health of the cheque's creator, more than any legal
rules. The strong and secure legal position of a holder in due course is of no value if the drawer's account does not contain
enough money to cover the cheque when it is presented for payment. The likelihood of that happening is the key
consideration in Bill's decision about whether to accept any payments by cheque from customers. Deciding to accept
cheques is equivalent to extending credit, since there are several days between handing over goods and receiving payment
from a cheque.

In major transactions, the method of payment that overcomes the above risk is the certified cheque. Certification is a
process in which the drawer (or sometimes the payee) takes the cheque to the drawer's bank and has the bank certify it for
payment. The bank immediately removes the money from the customer's account and holds it in reserve until

P. 634

the cheque is presented for payment. This process removes the risk of there being insufficient funds in the drawer's account
when the cheque is cashed.

Certification usually prevents the drawer from putting a stop payment on the cheque. A stop payment means that the drawer
(as the bank's customer) countermands (or cancels) its instructions to pay the cheque and orders the bank to refuse payment

when the cheque is presented. These instructions can be issued at any time before a cheque has been charged against the
drawer's account. However, the banking contract will likely absolve the bank from responsibility if the cheque is cashed
accidentally, despite the stop payment order. The drawer of a cheque may also postdate it, which makes it payable on the
future specified date and not on the date of creation. Since the bank must follow the drawer's instructions, it cannot cash the
cheque until that future date.

Despite the secure position of holders in due course, those who are called upon to accept the transfer of a cheque may be
reluctant to do so without verification of the various endorsements on the cheque and some means of recovering funds
advanced on a cheque that turns out to be invalid. Thus, banks are reluctant to cash cheques for those who are not their
customers with significant balances on deposit with them. If the cheque comes back to the bank due to a lack of funds in the
drawer's account, the amount can be deducted from the customer's account (likely in accordance with the bank–customer
contract). The bank, therefore, will not suffer the ultimate loss on the cheque. If the bank cashes a cheque for someone who
is not a customer, it will be more difficult to recover the funds if the cheque turns out to be worthless. If Bill accepts cheques
from customers in his store, he bears the risk that his bank will deduct the value of worthless cheques from his account.

Endorsement and Transfer of Negotiable Instruments

A cheque normally follows a relatively short route, as shown in Figure 25.2 on page 632, but it may also be transferred
many times. Eventually, it is presented by a holder to the drawer's bank for payment. The transfer process is known as
negotiation —hence the name “negotiable instrument.” However, negotiation in this context has a distinct meaning from its
more common use as a process for resolving disputes. All that is needed for the negotiation of an instrument is for the
current holder to endorse , or sign, the instrument over to a new holder, who then becomes entitled to either present the
instrument for payment or transfer it to yet another holder.

Although a bank or anyone else who gives money in return for a cheque runs the risk that the drawer is not able or obligated
to honour it, anyone who has endorsed the cheque is potentially liable for the amount. This liability is a significant risk for
anyone who endorses a negotiable instrument.

A bank's responsibility to carry out the instructions of its customers includes verifying a customer's signature on a cheque.
The bank and its customers both have obligations when forgery is involved. The bank has a duty to detect unauthorized
instructions (such as a forged signature), and customers must take reasonable steps to prevent forgeries and immediately
report any potential problems to the bank (see the case on the next page). If a bank is left with liability for a forged cheque,
it can look to prior endorsers of the cheque to recover its money. Therefore, anyone accepting a cheque should verify the
authenticity of the endorsements on it.

P. 635

Those in possession of cheques should take steps to safeguard them and transfer them by endorsing in a way that minimizes
the risk that others may illegally obtain and cash them. Simply signing a cheque on the back is known as an endorsement in
blank . This means that the signatures are complete and that anyone who acquires the cheque can cash it (subject to a bank's
willingness to do so). Holders should therefore take care with the form of endorsements. Businesses commonly endorse
cheques “for deposit only.” These are known as restrictive endorsements and mean that the cheques can be deposited only
in the account of that business. Restrictive endorsements stop the circulation of cheques and remove the risk of anyone else
acquiring and cashing them. If Bill accepts cheques from customers, he should routinely endorse them in this manner as
soon as possible. If a cheque received by a payee is to be transferred to someone other than a bank, it is wise to endorse it
directly to that person (for example, “Pay to Desmond Chu/signed Bill Ikeda”). This is known as a special endorsement ; it
ensures that only the designated person is able to deal with the cheque further.

P. 636

Those accepting cheques should realize that there are financial and legal reasons why collection may be a problem. Apart
from a certified cheque, there is no guaranteed payment. Bill must understand that if a customer's cheque is returned to him
by Hometown's bank because of insufficient funds in the customer's account, he will recover the funds only if he can collect
from the customer. If the customer cannot be located or is unable to pay the amount, Bill will ultimately bear the loss.
However, if he can locate the customer, the cheque is valuable evidence of the customer's contractual obligation.

The Future of Payments

A negotiable instrument has a life of its own, quite separate from the contract that produced it. Liability for payment is
independent of the original debtor–creditor relationship. The result is convenience and dependability in the commercial
environment. The tradeoff is that a relatively small but significant number of the instruments must be honoured by their
creators in situations where there is a good reason for liability to be borne by another party, such as someone who breached
the originating contract through failure to deliver goods or services.

The basis of the well-established and comprehensive set of rules governing negotiable instruments is the instrument itself—
the piece of paper. The information it contains and where it goes are the key features of any dispute. Electronic transfers
present several challenges in relation to this set of rules. First, since there is no key piece of paper that circulates through the
system, there is no paper trail in the event of a dispute. Second, electronic transfers are instantaneous, so there is no
opportunity to change the instructions for payment (for example, by issuing a stop payment). There is no need for the
certification process because the transfer is unlikely to be effective unless the account from which the transfer is made has
sufficient funds. Electronic deposits may result in problems if no one verifies the validity of the instruments being deposited.
For example, if there is a serious defect in a cheque deposited electronically, the amount will initially be added to the
customer's balance, but it will be deducted later when the defect is discovered. By this time, the customer may have already
spent the money.

Electronic transfers are cheap and efficient. There is no paper to track or store. Instructions can be issued by the customer to
the bank instantly, and the funds are transferred to the recipient immediately. However, safeguarding the authority for such
transfers becomes a major challenge for customers. Rather than verifying signatures on cheques, banks are looking for the
necessary authorization codes in electronic messages. Potential methods for forgery and fraud are changed and expanded.
Tracing the cause of an electronic loss may be difficult. Someone must bear that loss, but in terms of the public good, the
reliability and convenience of the transfer system may be more important than identifying the one responsible. The
convenience and volume of electronic transactions outweigh the occasional injustice resulting from a defective transaction.

Commercial and consumer transactions are increasingly being conducted online. The volume of cheques is declining.
Traditional paper cheques are converted to digital images for processing. In practical and legal terms, the focus is shifting to
electronic banking, although not without challenges in the transition.24

P. 637

Technology and the Law: Developments in Electronic Payments Systems

Customers are offered a range of electronic options by their banks. Some examples are automatic payments from chequing
accounts, direct deposit of cheques, automatic teller machines (ATMs), payment by telephone or computer, and point-of-
sale transfers. Banks now offer smart phone apps for access to their accounts. ATMs are available for deposits, withdrawals,
transfers between accounts, and bill payments. Telephone banking and online banking can be used for everything other than
cash transactions, including applications for mortgages and loans.

There are many models for cashless transactions. Debit cards allow buyers to purchase goods and services and to transfer
payment directly from a bank account to the seller. Money cards carry a computer chip that enables virtual money to be
loaded on the card and transferred directly from the card to the seller. Electronic money or digital cash takes no physical
form, but instead is loaded onto computer hard drives or electronic wallets, enabling payment to be made as easily as
sending email. “Smart cards” can now combine all of the above features.

Cellphones are gaining wide use in online banking. They can also be used as virtual wallets by those without bank accounts,
who can have cash loaded onto them for transfer by cellphone. This practice is growing for transfers to other countries.
Phones with virtual embedded credit cards can also be used to make contactless payments. Customers can now use their
cellphone cameras to photograph cheques to be cashed and send the digital image to the bank. Payments can also be made
through secure online commercial intermediaries such as PayPal.

Credit card transactions are processed electronically as well. Credit cards have evolved from manual processing to networks
accessed with magnetic stripes, then to embedded microchips and PINs, and now to contactless payments using microchips
and radio frequencies where the card is simply waved at a reader. They involve three contracts—one between the card issuer
and the user, the second between the credit card company and the merchant, and the basic contract of sale between the user
(buyer)

P. 629

and the merchant. The second contract has become contentious since merchants are largely at the mercy of card companies
in terms of acceptance of cards from buyers and the associated fees. This imbalance of power has attracted the attention of
the Competition Bureau.

Critical Analysis

The range of electronic payment mechanisms is continually expanding. Are the risks associated with these methods
outweighed by the low cost, convenience, and customer demand? Can the developers of such methods and the lawmakers
stay ahead of those who seek to breach security?

Sources: Ivor Tossell, “Enter the digital wallet”, The Globe and Mail (7 November 2011), online: Globe and Mail
<http://www.theglobeandmail.com/report-on-business/small-business/enter-the-digital-wallet/article2226181/ >; Tara S
Bernard and Claire C Miller, “Swiping is the easy part”, The New York Times (23 March 2011), online: New York Times
<http://www.nytimes.com/2011/03/24/technology/24wallet.html >; Grant Robertson, “Say cheese! Photo chequing on its
way to Canada”, The Globe and Mail (26 March 2012), online: Globe and Mail <http://www.theglobeandmail.com/globe-
investor/say-cheese-photo-chequing-on-its-way-to-canada/article2381965/ >; and Competition Bureau of Canada,
“Competition Bureau challenges Visa and Mastercard's Anti-competitive rules” (15 December 2010), online: Competition
Bureau Canada <http://www.competitionbureau.gc.ca/eic/site/cb-bc.nsf/eng/03325.html >.

P. 630

Case: SNS Industrial Products Limited v Bank of Montreal, 2010 ONCA 500

The Business Context

There are situations where the bank fails to detect forged signatures and the customer does not immediately notice that the
forged cheques have been cashed from its account. In these cases, the courts will look to the legislation and the bank–
customer agreement.

Factual Background

Sanfillippo was the president of SNS Industrial Limited. In 1994, he opened an account at the Bank of Montreal and signed
an agreement which included a verification clause: “Upon receipt of the … statement of account, the Corporation will check
the debit and credit entries, examine the cheques and vouchers and notify the Bank in writing of any errors, irregularities or
omissions. This notice will be provided to the Bank within 30 days …” Over a three-year period from 2003 to 2006, the
office manager of SNS forged Sanfillippo's signature on a number of cheques worth $186 488. In May 2006, Sanfillippo
noticed considerably less money in his account than he expected and inquired at the bank, where he was advised to begin
telephone or online banking so that he could more easily monitor his account balance. At this time he signed a new
agreement whose verification clause made explicit reference to forged cheques. Shortly afterward, Sanfillippo discovered
the forgeries and claimed the value of the cheques from the bank.

The Legal Question

Who was responsible for detecting the forgeries—the customer or the bank?

Resolution

The Court of Appeal relied primarily on the applicable legislation. The Bills of Exchange Act (s 48)23 states: “where a
signature on a bill of exchange is forged, or placed thereon without the authority of the person whose signature it purports to
be, the forged or unauthorized signature is wholly inoperative …” It was open to the bank to transfer the risk to the
customer, but in the 1994 agreement,

the Verification Clause does not refer expressly to forged cheques or otherwise to cheques debited to a
customer's account for improper purposes or by illegal means. Further, the terms “error,” “irregularity,” and
“omission” are not defined in the Verification Clause. Nor is their meaning clear on a plain reading of the
Verification Clause as a whole. Thus, the meaning of these terms is not apparent on the face of the
Verification Clause. Certainly, the scope of these terms would not be self-evident to many, if any, customers

of the Bank without clarification or explanation. It is difficult to conceive, therefore, absent evidence to the
contrary that does not exist in this case, that both parties intended, when the banking agreement was entered
into, that the Verification Clause would extend to forged cheques honoured by the Bank.

Therefore, the bank remained responsible for honouring a forged cheque.

Critical Analysis

Does the specific reference to forgery in the 2006 contract support the court's conclusion regarding the 1994 clause? The
trial judge found that the forger did a good job on Sanfillippo's signature and that Sanfillippo did not have adequate controls
in place. Are these findings relevant to the interpretation of the legislation and the agreement?

P. 636

Risk Management

The factors in Bill's decision about the methods of payment he will accept from his customers relate to marketing and
finance, as well as to legal risks. He must be responsive to the needs and demands of his customers and sensitive to the cost
of various payment options.

Making and accepting payments by cheque involve major risks. Payment by cheque creates an unconditional obligation
independent of the purchase Bill has made. Accepting cheques as payment requires careful endorsement to maximize
security and creates the risk that there will not be sufficient funds in the customers' accounts.

As long as Bill and Martha are the only ones with signing authority at the bank, authorization should not be a problem.
When they reach the point at which they need to share that responsibility, they must make the terms of the arrangement
clear to the persons receiving the authority and to the bank. Bill and Martha must also familiarize themselves with the
practices of their bank related to authorization by phone, fax, or computer if they choose to use them.

Regarding debit cards and credit cards, Bill needs to understand the implications of the agreements he has with those service
providers. By accepting the cards, Bill will pay a portion of the proceeds of those sales to the card providers. In return, he
gets immediate payment for debit card sales and a guarantee of payment on credit card sales, as long as he complies with the
requirements in his agreements, such as verification of signatures.

Bill and Martha need to ask their bank what happens if an electronic transfer does not happen or the bank transfers funds
without proper authorization. They need to ensure that the bank has anticipated potential problems and has a reasonable way
of dealing with them. In risk management terms, they need to evaluate the risks against the potential benefits of electronic
banking.

Figure 25.4 summarizes the comparative risks of the various payment methods. The possibility of extending credit to
customers is the subject of Chapter 26.

FIGURE 25.4 Comparative Risks of Methods of Accepting Payment

Form of Payment Nature of Risk for Person Accepting Payment
Payment

Cash Immediate The money may be counterfeit or the proceeds of a crime.

Cheque Deposited There may be insufficient funds in the account on which the cheque was drawn;
the signature may be forged.

Credit card Guaranteed Risk is borne largely by the card provider.

Debit card Electronic Immediate Risk is borne largely by the payments system.

Transfer transfer

Credit Payment at a The debtor may be unable or unwilling to pay.
later date

FIGURE 25.4 Comparative Risks of Methods of Accepting Payment

P. 638

Business Law in Practice Revisited

1. What do Bill and Martha need to know about the legal aspects of the relationship between their business and a
bank?

Bill and Martha need to appreciate that their basic relationship with the bank is one in which the bank must safeguard their
money and follow their payment instructions, but is otherwise not responsible for their interests, unless the bank is engaged
to provide expert advice. Bill and Martha need to appreciate the importance of the contract with the bank and become
familiar with its basic rights and obligations. They should understand that the contract is written largely to protect the bank
and that their bargaining power is limited. Bill and Martha should, however, seek a level of service and comfort that meets
their needs and allays their concerns with their current bank.

2. What are the risks and benefits of various payment options and doing banking electronically?

If Bill engages in electronic banking, it will be cheaper and faster, but he risks having transmission problems, he cannot
easily cancel e-transactions because they are instantaneous, and he is left with no paper trail to follow the transaction. Bill
needs to thoroughly discuss these risks with his bank so that he feels comfortable with his banking arrangements. Since Bill
accepts payments by credit card and debit card, he needs to negotiate with the providers of those services and be prepared to
pay their fees. Such arrangements are not part of his package of basic banking services.

3. What are the risks and benefits of using cheques to pay bills and allowing customers to pay by cheque?

The risk of paying by cheque is that Bill cannot avoid his obligation to honour the cheque (apart from stopping payment) if
he has a problem with the goods or services for which he paid using the cheque. The risk of allowing customers to pay by
cheque is that they may have insufficient funds in their accounts, they may be engaged in fraud or forgery, they might issue
a stop payment, or there may be a technical defect in the cheque.

The legal benefits of paying by cheque are the relative security compared with cash, the paper trail provided by the cheque,
and the ability to issue a stop payment before the cheque is cashed. Accepting payments by cheque is more risky than taking
only cash, but it is safer than credit.

Business and Banking: Chapter Summary

Customers should be wary of their relationships with their banks, not because banks attempt to take advantage of them, but
because the relationship is a contractual one. The rights and obligations are found in the contract, and because the banks
write the contracts, the language tends to favour the banks' interests more than those of their customers. The major effect of
a banking contract is to transfer risk from the bank to the customer.

The instantaneous nature of electronic transactions greatly improves efficiency, but it also makes the transfers irrevocable.
The absence of paper and the inapplicability of the rules that govern paper transactions create major challenges for security
and liability.

P. 639

The established system for negotiable instruments focuses on the commercial convenience of instruments circulating freely,
with little need for the various holders to be concerned about their validity as long as the requirements for negotiability are
met. It is a paper-based system that places prime importance on the piece of paper and the secure status of those in
possession of it.

The primary right is the ability of a holder in due course to collect from the creator of the instrument—the person whose
promise to pay originated the transaction. The main obligation is that of the creator or drawer of the instrument to pay,
regardless of events that preceded or followed the creation of the instrument.

Business and Banking: Chapter Study: Key Terms and Concepts

banking contract (p. 626)
bill of exchange (p. 631)
certification (p. 634)

cheque (p. 629)
consumer note (p. 634)
electronic banking (p. 627)
endorse (p. 635)
endorsement in blank (p. 636)
holder (p. 633)
holder in due course (p. 633)
identity theft (p. 628)
money laundering (p. 625)
negotiable instrument (p. 631)
negotiation (p. 635)
promissory note (p. 631)
restrictive endorsement (p. 636)
special endorsement (p. 636)
stop payment (p. 635)

P. 640

Business and Banking: Chapter Study: Questions for Review

1. What is the basic nature of the bank–customer relationship?
2. How are banks regulated?
3. What are the key issues addressed in a banking contract?
4. What are the key duties of the customer and the bank?
5. What are the requirements for an instrument to be negotiable?
6. What is a cheque?
7. Why is the volume of cheques declining?
8. Why are electronic transfers not subject to the same regulations as paper transactions?
9. When a business issues a cheque to a supplier, who is the drawer, who is the drawee, and who is the payee of the

cheque?
10. What is an electronic financial services agreement?
11. What are the key risks for a business in creating cheques for suppliers and accepting cheques from customers?
12. Why is the holder in due course in a stronger position to collect on a negotiable instrument than the assignee is to

collect a debt?
13. What are the banks' obligations regarding suspected money laundering?
14. What is identity theft?
15. What are the benefits of electronic banking?
16. What are the legal uncertainties in electronic banking?
17. How can cellphones be used for banking?
18. What is “phishing”?

Business and Banking: Chapter Study: Questions for Critical Thinking

1. In banking relationships, customers are expected to take care of themselves and to negotiate and be aware of their
rights and obligations. In practice, the terms of banking contracts are dictated by the banks and found in standard
form agreements that are not open to negotiation. Should banking contracts be regulated to ensure a basic level of
fairness for customers?

2. Retail merchants are caught between their customers and the credit card companies. Customers want their cards to
be accepted, especially those offering attractive rewards to card users. Meanwhile, the card companies require
merchants to accept all cards and pay whatever fees the companies choose to impose. How can merchants deal with
this dilemma?

3. Electronic banking presents a regulatory challenge in that paper-based rules do not apply and the nature of electronic
transactions produces a new set of potential problems. What are some of those problems? Are the regulations likely
to be outpaced by developments in technology?

4. The regulatory divisions among the four types of financial services (banks, trust companies, insurance companies,
and investment brokerages) have disappeared. Now, banks are able to provide all financial services in some form.
Who benefits most from this relaxation—clients or banks? Can this relaxation

P. 641

contribute to a financial crisis and lead to demand for stricter national and international regulation?
5. Considering the number of negotiable instruments and electronic transfers, there are relatively few legal disputes

arising from them. Does that mean the system is working well? What criteria might be used to measure the
effectiveness of the system?
6. Electronic transactions can result in the creation and combination of databases containing sensitive business and
personal information. Those who provide this information are naturally concerned about its security and their
privacy. One way to deal with such concerns is to enable anonymous transactions through such means as encryption,
which in turn creates concern for illicit activities such as money laundering. Which is more important—providing
security or preventing fraud or crime?

Business and Banking: Chapter Study: Situations for Discussion

1. Grenville agreed to facilitate transfers of funds for a Taiwanese businessman whom he did not know. Grenville was to
deposit cheques in his account and forward the funds to Asian accounts in exchange for a five percent commission. Without
Grenville's knowledge, the first cheque (in the amount of $10 000) that he deposited in his credit union account had been
altered and forged. Several months after the cheque cleared, the defects in the cheque were discovered. Grenville's credit
union took the full balance in Grenville's account ($6000) and sued him for the remaining $4000.25 Is the credit union
entitled to recover the $10 000 from Grenville? What are the relevant rules?

2. Ken needed $100 000 to start his restaurant. He sought advice from W Bank. Pamela, the loans officer at the bank,
suggested a working capital loan on certain specified terms. She assured Ken that he should have no problem being
approved if he decided to apply for a loan. The approval process took longer than usual, but Ken went ahead and signed a
lease for space for his restaurant and a contract for renovation of the space. Eventually, W Bank rejected Ken's application.
Based on recent experience, the bank decided that restaurants are too risky since most do not last beyond six months. Ken
was unable to arrange alternative financing in time and suffered a large loss in his business.26 Is this a typical banking
relationship where Ken must look out for himself, or does the bank have some responsibility for his plight? What should
Ken and the bank have done differently?

3. Ratty Publications wrote a cheque payable to LePage on its account at CIBC in payment for the first month's rent on an
office lease. Ratty changed its mind about the lease and instructed CIBC to stop payment on the cheque. The following day,
LePage got the cheque certified at another branch of CIBC and deposited the cheque in its account at TD Bank. When TD
presented the cheque to CIBC for payment, CIBC refused to honour it.27 Which prevails—the stop payment or the
certification? Does the validity of the cheque depend on the lease agreement between Ratty and LePage? Which of the four
parties should bear the loss?

4. Harvey's Car Lot bought a used car from Luke. When Luke delivered the car, Harvey gave him a cheque for $5000. Luke
cashed the cheque immediately. When Harvey put the car in the garage, he discovered that the bottom was severely rusted
and the engine was shot.28 What can Harvey do about the cheque? How should Harvey change his purchasing practices?
How would the outcome be different if instead of giving Luke a cheque, Harvey had promised to pay Luke when Harvey
resold the car?

5. Ravanello is a computer hacker. He is motivated primarily by the challenge of breaching systems, but he figures he might
as well make some money at the same time. After many months of dedicated effort, he penetrated the electronic customer
files of EZ Bank. Not wanting to appear greedy or be caught, Ravenello devised a system to skim $10 from random
accounts every month. He began to accumulate money in his account faster than he could spend it. It was nine months
before a customer of EZ convinced the bank that his account was short by three $10 withdrawals and the bank was able to
trace the reason.

P. 642

What does this scenario reveal about the perils of electronic banking? Do you think this scenario could really happen? Is
such a risk likely to be prevented by banking practices, contracts, or the law? Who is responsible for the losses?

6. Rubin and Russell were partners in RRP Associates. They did their personal and business banking with Colossal Bank,
where they arranged their accounts so that transfers from one to the other could be made by either partner online, by phone,
or in person. Although the business prospered, Rubin and Russell had difficulty working together. Following a serious
disagreement, Russell went online and transferred $50 000 from the RRP account to his personal account. When Rubin

discovered this transaction, he complained to the bank and was told that the transfer was done in accordance with the
agreement between RRP and the bank. How can partners best balance the risks arising from banking arrangements with the
need for convenient banking? What action can Rubin take now?

7. Bob was the sole officer, director, and shareholder of 545012 Ltd. Bank of Montreal issued a bank card to Bob for the
company's account. Bob entrusted an employee, Paul, with the corporate card and its PIN. Paul forged cheques payable to
the company, deposited them in the corporate account, and then used the corporate card to withdraw cash and make point-
of-sale purchases, creating an overdraft of $60 000 on the corporate account. The bank sued 545012 Ltd. And Bob for the
amount of the overdraft.29 Who is responsible for the overdraft? On what will the answer depend?

8. BMP Global Inc. (BMP) was a distributor of nonstick bake ware in British Columbia. BMP was a customer of the Bank
of Nova Scotia (BNS) in Vancouver. Hashka and Backman were the two owners of BMP and had personal accounts in the
same branch of BNS. BMP received a cheque for $902 563 drawn by First National Financial Corp. on the Royal Bank of
Canada (RBC) in Toronto. Hashka deposited the cheque in the BMP account and informed the manager, Richards, that the
cheque was a down payment on a distributorship contract with an American company. Richards placed a hold on the cheque
for seven days. The cheque cleared and was paid by RBC to BNS and released to BMP. Hashka and Backman paid several
creditors and transferred funds to their personal accounts. Ten days later RBC notified Richards that the signatures on the
$902 563 cheque were forged. Richards froze the three accounts in his branch and returned the combined balance of $776
000 to RBC.30 Was Richards justified in freezing and seizing the accounts of BMP, Hashka, and Backman? Can they take
action against Richards and BNS? Is RBC responsible for accepting the cheque with the forged signatures?

For more study tools, visit http://www.NELSONbrain.com .

Footnotes

1. The Office of the Superintendent of Financial Institutions Act, RSC 1985, c 18 (3rd Supp) Part 1 created a single federal
regulator (OSFI).
2. Financial Consumer Agency of Canada Act, SC 2001, c 9.
3. See Regulations Amending the Insurance Business (Banks and Bank Holding Companies) Regulations, SOR/2011–183,
online: Canada Gazette <http://gazette.gc.ca/rp-pr/p2/2011/2011–10-12/html/sor-dors183-eng.html>.
4. The latest review culminated in the Financial System Review Act, SC 2012, c 5 which contains relatively minor changes.
See Bill Curry and Tara Perkins, “New bill would increase minister's power over banks”, The Globe and Mail (23
November 2011), online: Globe and Mail <http://www.theglobeandmail.com/report-on-business/new-bill-would-increase-
finance-ministers-power-over-banks/article2246925/>.
5. SC 1991, c 46.
6. Alison R Manzer & Jordan S Bernamoff, The Corporate Counsel Guide to Banking and Credit Relationships (Aurora,
ON: Canada Law Book, 1999) at 36.
7. See Tara Perkins, “Bankers evolve into advisory roles”, The Globe and Mail (19 October 2010), online: Globe and Mail
<http://www.theglobeandmail.com/report-on-business/small-business/sb-marketing/customer-service/bankers-evolve-into-
advisory-roles/article1762494/>.
8. Supra note 2.
9. See Financial Consumer Agency of Canada, online: <http://www.fcac-acfc.gc.ca>.
10. See Financial Services OmbudsNetwork, online: <http://www.fson.org> and the Ombudsman for Banking Services and
Investments (OBSI), online: <http://www.obsi.ca>. However, some banks have opted out of the OBSI process. See Grant
Robertson, “TD quits external banking ombudsman”, The Globe and Mail (26 October 2011), online: CTV News
<http://www.ctv.ca/generic/generated/static/business/article2214604.html>. See also Department of Finance Canada,
“Harper government imposes tough new pro-consumer oversight on banking complaints” (6 July 2012), online: Department
of Finance Canada<http://www.fin.gc.ca/n12/12-079-eng.asp>.
11. Supra note 6 at 14.
14. Supra note 6 at 15.
12. Proceeds of Crime (Money Laundering) Act, SC 1991, c 26.
13. Proceeds of Crime (Money Laundering) and Terrorist Financing Act, SC 2000, c 17. See also SC 2006, c 12.
15. (18 May 2010), online: Department of Finance Canada <http://www.fin.gc.ca/n10/data/10–049_1-eng.asp>.
16. UNCITRAL Model Law on International Credit Transfers (1992), 32 ILM 587, online: UNCITRAL
<http://www.uncitral.org/uncitral/en/uncitral_texts/payments/1992Model_credit_transfers.html>.
17. An Act to Amend the Criminal Code (Identity Theft and Related Misconduct), SC 2009, c 28 (in force 8 January 2010).
18. RSC 1985, c B-4.

19. Supra note 6 at 30.
20. Supra note 18 at s 55.
21. See Chapter 9 for a more complete discussion of assignments.
22. Supra note 18 at s 191.
24. See Enza Uda, “Banks lost millions on digital cheque project”, CBC News (24 November 2009), online: The National
<http://www.cbc.ca/thenational/indepthanalysis/gopublic/2009/11/banks-lost-millions-on-digital-cheque-project.html>.
Also Department of Finance Canada, “Minister of Finance welcomes findings of the Task Force for the Payments Review
System” (23 March 2012), online: Department of Finance Canada <http://www.fin.gc.ca/n12/12-030-eng.asp>.
23. Supra note 18.
25. Based on Meridian Credit Union Limited v Grenville-Wood Estate, 2011 ONCA 512 (leave to appeal to SCC dismissed
8 March 2012).
26. Based on Royal Bank of Canada v Woloszyn (1998), 170 NSR (2d) 122 (SC).
27. Based on A.E. LePage Real Estate Services Ltd v Rattray Publications Ltd (1994), 21 OR (3d) 164 (CA).
28. Based on William Ciurluini v Royal Bank of Canada (1972), 26 DLR (3d) 552 (Ont HC).
29. Based on Bank of Montreal v 545012 Ontario Limited, 2009 CanLII 55127 (Ont Sup Ct J).
30. Based on BMP Global Distribution Inc v Bank of Nova Scotia, 2009 SCC 15.

P. 643

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Chapter 26 : The Legal Aspects of Credit
(pp. 644-666)

The Legal Aspects of Credit: Chapter Objectives

Objectives

After studying this chapter, you should have an understanding of

the legal significance of credit transactions in business
methods used by creditors to reduce risk
the difference between secured and unsecured creditors
the ways that lenders and borrowers are protected
the implications of guaranteeing a debt

The Legal Aspects of Credit: Chapter Overview

LIQUIDLIBRARY/JUPITER IMAGES

Business Law in Practice

Hometown Hardware Ltd. (Hometown) and its owners, Bill Ikeda and Martha Wong, were introduced in Chapter 25. They
operate a building supply store in Timmins, Ontario. Bill has become concerned about rumours that a big-box store will
soon be arriving in Timmins. Bill is worried about the impact on Hometown and has decided that the only way Hometown
can remain competitive is to expand and offer a broader range of supplies. Bill is confident that his customers will remain
loyal to Hometown if they can obtain the same range of products from Hometown as will be available from the new big-box
store. At the same time, Bill is concerned about the recent slowdown in housing construction.

In order to finance the planned expansion, Bill figures that Hometown needs $400 000. Two of Bill's business acquaintances
who are now retired have shown interest in investing in Hometown. Bill and Martha have decided to issue new shares of
Hometown to each investor for $100 000. Bill and Martha hope to have Hometown borrow the remaining $200 000 from
the bank.

1. What is the bank likely to require before agreeing to loan money to Hometown?
2. What will the terms of the loan be?
3. What are the risks for Hometown in borrowing the money?
4. Will Bill, Martha, and the two new shareholders be personally liable for the loan?

P. 644

Introduction to Debt and Credit

A business participates on a daily basis in a variety of transactions that involve credit. Some credit arrangements are formal
and deliberate, with carefully negotiated terms, while others are an incidental feature of routine transactions. A business like
Hometown will be both a borrower, or debtor, and a lender, or creditor. When Hometown orders lumber from its suppliers, it
is required to pay the invoice within 30 days, making it a debtor. When Hometown sells the lumber to its commercial

customers, those customers are probably expected to pay on similar terms, making it a creditor. Retail customers are likely
expected to pay immediately, although Hometown may offer financing terms to some retail customers on large purchases.

Credit is a contractual relationship, with the lender agreeing to lend money in exchange for a promise by the borrower to
repay the loan, usually with interest and within a certain time frame. There may be other terms and conditions which are
agreed to by the parties. Since credit is a contractual relationship, all the fundamental principles of contract law apply. As
well, there are legal regulations and principles which are specific to credit. The law of credit forms part of what is known as
debtor and creditor law.

Credit can be either secured or unsecured. Secured credit means the creditor has an interest in all or some of the property of
the debtor in order to secure payment of the debt. If the debtor defaults in repaying the loan, the secured creditor can seize
the secured property and sell it to pay down the debt. Unsecured credit means that the creditor has only a contractual right
to receive payment from the debtor. The unsecured creditor does not have an interest in the property of the debtor that it can
enforce in the event of default by the debtor. If the debtor defaults, a secured creditor is in a much better position than an
unsecured creditor, as will be explained on the next page.

legal risks arise in financing the expansion of a business? COBALT88/SHUTTERSTOCK What

P. 645

When Hometown agrees to pay its suppliers within 30 days, or when Hometown's commercial customers agree to pay
Hometown on similar terms, that is known as trade credit. Trade credit is usually unsecured. In most cases, payment is made
within the designated time period and collection remedies are not needed. However, since these transactions are unsecured,
if a debtor fails to pay on time, the creditor may have to sue the debtor, obtain judgment, and then enforce that judgment. If
the debtor has limited financial resources, the creditor may end up not being paid. For this reason, it is very important for
creditors to exercise good judgment when deciding whether to extend credit. Trade credit can be very risky if the parties
have not dealt with each other before, especially if the supplier and the customer are located in different countries. The
following International Perspective box provides an example.

A business may also decide to raise a significant amount of capital by borrowing. These credit arrangements tend to be more
formal and provide more security to the lender. Borrowing a large amount of money to purchase a major asset or to finance
an expansion, as Hometown is planning to do, is an example of a credit transaction in which the rights and obligations of the

parties are carefully negotiated. When Hometown applies to the bank for a loan of $200 000, the bank will probably require
extensive documentation to support the loan application, such as a business plan and cash-flow projections.

P. 646

The bank will then consider two major criteria in evaluating the loan application. First, the bank will focus on Hometown's
financial health—in particular, the likelihood that the expansion plans will succeed and Hometown will be able to repay the
loan within a reasonable time period. Second, the bank will investigate the security that Hometown can provide—if
Hometown cannot repay the loan, the lender will want to ensure that it can seize Hometown's property and sell it for enough
money to pay the outstanding loan. In this way, the lender ensures that it will be repaid, whether Hometown's business
succeeds or fails.

In addition to the ability of the debtor to repay the loan and the value of the security that the debtor can provide, a lender
will also consider the state of the economy, the particular industry in which the debtor carries on business, whether personal
guarantees are available, and the state of the credit markets generally. Based on all of these considerations, the lender will
decide whether to grant the loan and, if so, on what terms. The lender will set the interest rate at a level that corresponds to
the riskiness of the loan from the lender's perspective.

If the borrower and the lender are able to agree on the terms of the loan, they will enter into a credit or loan agreement. The
terms of this agreement are negotiated by the parties, and may include many different terms and conditions, including
repayment terms, interest, security, fees and events of default . In most cases, however, these terms are largely dictated by
the lender. Normally, both the borrower and the lender will have their own lawyers to advise them on the credit agreement.
In many cases, however, the legal and other fees of the lender must be paid by the borrower.

P. 647

International Perspective: Credit Risk in International Trade

Canadian companies import products from countries around the world to sell in Canada. For example, an international trade
relationship might originate with a visit by representatives of the Canadian government and importers to a country that is
identified as a potential source of trade. Assume that Star Clothing, based in Toronto, participates in such a trip to China and
identifies a manufacturer, Beijing Clothing, which can supply high-quality clothing at a lower cost than Star's current
supplier in Canada. Representatives of Star negotiate with their counterparts in the Chinese company and eventually agree
upon a contract worth $50 000 for clothing to be delivered in time for the spring fashion season in Canada. The contract
includes terms dealing with quantity, price, delivery dates, and terms regarding shipment of the goods from China to
Canada.

Since these companies are dealing with each other for the first time, they are sensitive to the risks involved. Beijing wants
payment before the goods are shipped because there is significant risk for Beijing if it ships the clothing to Canada with no
means of ensuring payment. Beijing appreciates the difficulties involved in suing a Canadian company when they are
located in China. Star, on the other hand, is reluctant to pay for the clothing until it knows that the agreed upon quality and
quantity of clothing has been manufactured and shipped to Canada. Star knows that suing a Chinese company for breach of
contract will be difficult and expensive.

Letters of credit issued by international banks are a common means of dealing with these risks. A letter of credit is a
written promise made by the importer's bank (on the importer's instructions) and given to the exporter's bank to make
payment to the exporter when specified conditions are met. These conditions relate to the exporter's delivery of documents,
such as an invoice, shipping receipt, proof of insurance, and customs declaration. These documents are presented and
payment is made once the goods have been shipped, but before the importer receives the goods. The exporter ships the
goods knowing that payment will be made upon presentation of the documents confirming shipment, and the importer
allows payment to be made knowing the goods have been shipped and with confidence that the goods will arrive. In this
way, both parties reduce some of the risks to which they are exposed.

Critical Analysis

Is the letter of credit a device that could be used to manage risk in domestic as well as international transactions? Can it take
the place of reputation and experience in commercial dealings?

Source: Mary Jo Nicholson, Legal Aspects of International Business: A Canadian Perspective, 2d ed (Toronto: Emond
Montgomery, 2007) at 236.

P. 646

Methods Used to Reduce Risk in Credit Transactions

There are several ways that creditors can reduce the risk of non-payment by debtors.

First, creditors should employ good credit policies and procedures. This involves steps such as having debtors fill out credit
applications and checking debtors' credit references. The easiest way to minimize the risk of default is by not lending money
to people who will not pay it back. Although this is a relatively easy and inexpensive strategy, it is often overlooked.

Second, creditors may be able to change the structure of a transaction so that it is not a credit arrangement at all. For
example, a supplier of equipment may choose to lease the equipment rather than sell it, so that the supplier retains
ownership of the equipment. In the event of default, the lessor can usually repossess the equipment.

Third, creditors may insist on security, or collateral , to back up the borrower's promise to pay. If a creditor is able to seize
property of the debtor and sell it to pay down the debt, the risk to the creditor is reduced.

Fourth, creditors may ask for assurances from other people that the debt will be repaid. If a creditor is able to obtain a
guarantee of the debt from another creditworthy person, then the risk is lessened.

Finally, creditors often include terms in credit agreements which require debtors to carry on business in accordance with
specific requirements. For example, a credit agreement

P. 647

may require the debtor to refrain from making significant capital expenditures or allowing certain financial ratios to fall
below defined limits.

It is important for businesspeople to think of themselves as creditors any time they are extending credit. In many cases,
suppliers will extend credit to customers but fail to take any measures to reduce the risk of not being paid. Banks and other
sophisticated creditors employ the techniques described above in order to reduce their risk—businesspeople who extend
credit would be wise to think along similar lines.

The Credit or Loan Agreement

In the case of trade credit, the agreement between the debtor and the creditor is usually informal and may even be verbal. If
the terms of trade credit are written down, they will often be on a standard form document such as a purchase order or a
standard form set of terms and conditions provided by the supplier.

In the case of a large debt financing, however, the credit agreement is typically called a loan agreement and is much more
comprehensive and carefully negotiated by the parties. The process of applying for a loan and formulating the terms of
credit is much the same as for the negotiation of any other contract. Hometown's need for $200 000 is major in terms of its
expansion plans, but it is a routine transaction for a large commercial lender such as a bank. When Hometown applies for
the loan, the bank will demand whatever information it deems necessary in order to assess the risk and determine how
much, if anything, it is prepared to lend to Hometown and on what terms. If the bank decides to grant the loan, it will
usually provide a letter of commitment to Hometown, which will set out in a summary manner the basic terms on which
the lender is prepared to make the loan. These terms may include

amount of the loan and how it will be disbursed
rate of interest, and whether it is floating or fixed
repayment terms, including the amount and frequency of payments
term of the loan and conditions for renewal (if the entire loan will not be paid out during the term)
conditions that must be satisfied before the loan is made (e.g., guarantees, appraisals)
security or collateral required by the lender
requirements for maintenance of the borrower's financial position

events that constitute default and the lender's remedies
fees to be paid by the borrower

The borrower is free to try and negotiate the terms set out in the letter of commitment, or to try to negotiate with other
potential lenders, but the final say over whether the loan will be made is that of the lender. Once the letter of commitment is
signed by the borrower, the lender will prepare a more formal and comprehensive loan agreement. The loan agreement will
cover all of the terms and conditions set out in the letter of commitment and

P. 648

will often be accompanied by other agreements, such as a mortgage, security agreement or personal guarantee.

Security

In order to reduce the risk of non-payment, a lender may require that the borrower provide security or collateral. Collateral
can be either real property, in which case it is accomplished through a mortgage (as discussed in Chapter 19), or personal
property discussed on the next page. While the loan obligation is evidenced by the credit or loan agreement, the taking of
security is normally covered by a separate security agreement.

Lenders will often try to match their security to the use of the loan proceeds. For example, if Hometown borrows money in
order to buy a new piece of equipment, the security for the loan may be the equipment itself. Similarly, if Hometown
negotiates a line of credit for working capital, the lender may take security in Hometown's inventory and accounts
receivable. Generally, the most attractive collateral to a lender is that which is most liquid (i.e., can most easily be converted
into cash).

If the bank decides to lend money to Hometown to fund its planned expansion, the bank will likely require a general
security agreement , which will include as collateral all the personal property assets currently held by Hometown, as well as
all after-acquired property , which are assets that are acquired by Hometown during the term of the loan. Hometown is free
to carry on business and use its assets as long as it makes the required payments on the loan and complies with its other
obligations under the loan agreement. However, if Hometown defaults on the loan, the bank's security will include all of the
assets held by Hometown at the time of default.

Some assets used as collateral are intended to be retained by the debtor. For example, if Hometown buys a fork lift for use
in its warehouse, the fork lift is available as security for its entire useful life. Other assets, such as inventory and accounts
receivable, are meant to circulate through the business on a regular basis. The security in those assets is their value at any
given time. The security agreement will allow Hometown to sell inventory in the ordinary course of its business, but will
probably prohibit Hometown from selling the fork lift while the loan is outstanding. In addition, the security agreement will
likely require Hometown to maintain adequate insurance on the fork lift and its other assets, in order to protect the value of
those assets as collateral.

The type and extent of security that a lender requires will depend on several factors, including the risk of default and the
market value of the collateral. If Hometown borrows money to buy a piece of equipment and then defaults on the loan, the
lender's security is a used piece of equipment. The lender knows that the proceeds from a quick sale of used equipment are
likely to be much less than the original purchase price or its value to Hometown in its ongoing business. Similarly, if
Hometown gives a general security agreement to the lender, the value of all of Hometown's assets in the event of the
business failing is much less than it may have been when the loan was originally made. For these reasons, the lender will
typically require security in an amount that exceeds the amount borrowed. Credit insurance may be available to lenders as
an additional source of protection against the risk of uncollectible accounts.

P. 649

Environmental Perspective: Credit and Environmental Risk

The value of land as security for credit depends on a variety of factors, including the health of the real estate market and the
nature and location of the specific piece of land. Lenders want to minimize the risk of the land being worth less than the
outstanding loan should the borrower default. In some cases, a lender, especially one who ends up in possession of the land,
may be liable for environmental damage or costs. Financial institutions that engage in commercial lending with real
property as security generally require environmental assurance as part of the credit documentation. This assurance consists

of representations and warranties by the borrower regarding the environmental status of the property, supplemented by
surveys and questionnaires. In addition, lenders are likely to require more detailed environmental reviews and investigations
from the borrower or third parties.
These reviews are known as environmental due diligence or site assessment. This is usually a three-phase process,
consisting of a historical review of the land's past uses, followed by testing on soil, groundwater, and drilled core samples.
The final stage is remediation or cleanup, which may involve considerable expense.

What environmental hazards could affect the value of
the security interest in this property? JOSTEIN HAUGE/SHUTTERSTOCK

Critical Analysis

What previous uses of land would be problematic in the historical assessment stage? What problems might the testing stage
reveal? Are these extensive environmental reviews more appropriate for certain types of land?
Source: Pamela Young, “Caveat developer: What lies beneath”, The Globe and Mail (16 January 2007) at B8.

Personal Property Security Legislation

When considering whether to grant secured credit, lenders must be confident as to their position with respect to the
collateral. Every province and territory has legislation in place to provide an orderly system for recognizing interests in
personal property collateral and setting out rules to determine priority disputes amongst competing claims to the same
collateral. The personal property security systems allow lenders to grant credit, knowing where they will stand with respect
to the collateral in the event of default by the debtor. The legislation in each province and territory (except Quebec) is called
the Personal Property Security Act (PPSA).1 Although the legislation varies somewhat by province and territory, there are a
few basic concepts that are common to all the provinces and territories: attachment, perfection, registration, priorities, and
remedies. These concepts are discussed on the next page.
The PPSA applies to every transaction that in substance creates a security interest . Even if the transaction is called
something else (e.g., a lease or a conditional sale), if its real purpose is to create an interest in personal property to secure
payment or performance of an obligation (normally a debt), the transaction is a security interest and the PPSA applies. The
PPSA also applies to some transactions that are not intended as security, such as leases for a term of more than one year,
commercial consignments (except in Ontario), and absolute assignments (transfers) of accounts.

P. 650

Attachment

Attachment occurs when three conditions are satisfied:
the debtor has rights in the collateral (e.g., ownership)
the secured party has provided value (e.g., granted a loan or extended credit)
the debtor has signed a written security agreement

Once attachment has occurred, the security interest is enforceable against the debtor and third parties. If Hometown grants a
security interest to a lender over a piece of equipment and the three conditions necessary for attachment have been satisfied,
then the lender can seize the equipment and sell it if Hometown defaults on the loan.

Perfection

Perfection is the combination of (a) attachment, and (b) registration or possession of the collateral.2 Once a security
interest has been perfected, the secured party will have priority over security interests that have not been perfected, as well
as judgment creditors and a trustee in bankruptcy. If the security interest in Hometown's equipment is perfected, then on
default by Hometown the lender can seize the equipment, sell it, and apply the proceeds of the sale to the debt owed, even if
Hometown has become bankrupt, a process which is discussed in the next chapter.

Registration involves filing a form called a financing statement . The financing statement discloses the name of the debtor
and the type of collateral secured. The PPSA registration system is computerized and public and can be searched either by
debtor name or, in the case of motor vehicles, by serial number.

Possession, for the purposes of perfection, occurs when the secured party physically takes possession of the collateral for
the purposes of holding it as security. For example, if Hometown wanted to pledge a gold bar as security, the lender might
take physical possession of the gold bar until the loan is repaid. In that case, assuming attachment has occurred, the lender
will have a security interest perfected by possession.

The most common form of perfection is by registration. When a person searches the PPSA register and discovers a
financing statement of interest to them, they can find out the details of the security interest to which that financing statement
relates by making an inquiry to the secured party.

It is important to note that perfection is not “perfect” in the sense that it confers the best possible interest one can have in the
collateral—it does not. The term “perfection” is simply a defined term in the PPSA and it has only the specific meaning
given to it within that legislation.

It is also important to note that perfection may occur even if attachment occurs after registration (except when dealing with
consumer goods). When Hometown applies for the loan, the bank may register a financing statement under the PPSA. If the
loan has not yet been granted, there has been no attachment. However, once the conditions for attachment

P. 651

have been met, the security interest will immediately be perfected, because registration has already occurred. This concept
becomes very important when we discover that, in a contest between two perfected security interests in the same collateral,
the first to register—not the first to perfect—has priority.

Priority among Creditors

One of the most important functions of the PPSA is to determine who has priority when there are competing interests in the
same collateral. The PPSA has rules to resolve such conflicts. The general policy behind the priority rules is that a security
interest that has been made public (e.g., by registration) should have priority over a subsequent interest in the same
collateral, except where specific policy objectives warrant a different outcome. The priority rules produce predictable
outcomes, which promotes the extension of credit generally:

When there are two unperfected security interests that have both attached, the first to attach has priority.
When there is one unperfected security interest and one perfected security interest, the perfected security interest has
priority.
When there are two security interests perfected by registration, the first to register (not the first to perfect) has
priority.

There are other priority rules dealing with specific types of collateral and security interests perfected otherwise than by
registration.

The purchase-money security interest (PMSI) is a special type of security interest that gives the secured party priority over
existing perfected security interests. In order to qualify for this “super priority,” two conditions must be met: first, the credit
advanced must allow the debtor to acquire the assets in which the security interest is taken; and second, the security interest
must be registered within a specific period of time.3 If these conditions are met, the PMSI holder will have priority over an

existing perfected security interest in the collateral that was financed. Suppose Hometown has given a general security
agreement to its bank securing all of its assets including after-acquired property, and the bank registers its security interest.
Then, Hometown borrows $40 000 from a truck dealer to finance the purchase of a truck, and the dealer takes a security
interest in the truck to secure repayment of the loan. If the dealer meets the PMSI conditions, the dealer will have priority
over the bank with respect to the truck, even though the bank registered its security interest first. The purpose of the PMSI
rule is to enable debtors to obtain financing after they have entered into a security agreement which confers an interest in
after-acquired property. Without the PMSI rule, the truck dealer would not have priority over the bank and presumably
would not extend the credit required by Hometown to purchase the truck.

P. 652

Transfers of Collateral

Generally, security interests follow the collateral and take priority over subsequent purchasers of the collateral. Why then is
it not necessary to conduct a PPSA search every time an item is bought in a retail store? The reason is: the exemption for
goods sold in the ordinary course of business. The PPSA contains a provision which gives priority to a buyer who buys
goods in the ordinary course of the seller's business. If Hometown buys a car from a car dealer, it does not have to worry
about a security interest in the car given by the car dealer (e.g., to its supplier). However, if Hometown buys a car from a
person who does not sell cars in the ordinary course of its business, then the onus is on Hometown to conduct a PPSA
search prior to purchasing the car, or Hometown will take the car subject to any existing perfected security interest given by
the seller of the car.

The computerized and centralized system associated with the PPSA is a vast improvement over the earlier patchwork of
different statutes and rules within each province dealing with personal property security interests. However, there remain
inconsistencies among the various provincial statutes, and there is always the practical problem that personal property is
portable and may be moved from one province to another. There are rules in the PPSA to deal with the relocation of
collateral, but they are complicated and vary by jurisdiction. Lenders and borrowers must both be informed of the rules that
apply in the jurisdictions in which they carry on business and in which collateral may be, or end up being, located.

The PPSA system provides potential creditors and buyers with a high level of protection. A lender can search the PPSA
registry before granting credit to determine whether there are existing registrations against the borrower. The creditor can
even register a financing statement in advance of granting credit, to ensure that its priority position will be undisturbed when
it eventually grants the loan. Purchasers of goods can search the PPSA registry to determine whether the goods are subject
to a security interest that would take priority over them. This knowledge allows creditors and buyers to make informed
business decisions with the confidence of knowing where they will stand in the event of default by the debtor. The same
assets can provide security for more than one credit arrangement, but the claims of competing lenders are subject to the
priority rules described above. A lender may decide to grant a loan, even with the knowledge that there is one or more
existing security interests in the same collateral, but presumably the lender will tailor the terms of the loan, and in particular
the interest rate, to suit the particular circumstances.

Other Security Legislation

The federal Bank Act 4 permits banks to take security in the inventory and other assets of certain business borrowers. Bank
Act security is only available to banks that are regulated by the Bank Act. Bank Act security is registered, but the registration
system is quite different than that of the PPSA system. Priority disputes between Bank Act security and PPSA security are
complicated and have resulted in a great deal of litigation. Recently, the federal government introduced legislation which is
intended to resolve some of these priority disputes.

P. 653

Each province and territory has legislation which allows suppliers, building subcontractors, and workers to place liens on
real property if they are not paid for work done, or materials supplied, to the property.5 These liens are called construction
or builders' liens and they remain in place until the supplier, subcontractor, or worker has been paid in full. The legislation
requires property owners who enter into contracts with builders to holdback a portion of the contract price until the lien
period has expired (usually between 30 and 60 days after the contract work is completed). This mechanism provides an
incentive for contractors to pay their suppliers and subcontractors in a timely manner.

Remedies

A creditor's remedies in the event of the borrower's failure to pay are largely determined by whether the creditor is secured
or unsecured. Unsecured creditors have the right to sue the debtor for the unpaid debt and may, at the end of that litigation
process, obtain a judgment against the debtor. In most cases, the unsecured creditor will then be able to enforce its judgment
against the assets of the debtor that are not already claimed by secured creditors. Secured creditors also have the right to sue
the debtor but, in addition, they can immediately seize the collateral and sell it to pay down the debt owed. The ability to
seize the personal property of the debtor without having to commence litigation places the secured creditor in a much better
position than the unsecured creditor. Furthermore, if the debtor ends up bankrupt, the secured creditor will still be able to
claim its collateral, while the unsecured creditor will have no remedy except under the bankruptcy proceedings (see Chapter
27).

Lenders' Remedies

If the borrower defaults on the loan, secured parties have a variety of remedies from two sources: the security agreement
and the PPSA. The remedies provided for in security agreements are often broader than those permitted by the PPSA, in
which case the secured party is generally limited to the remedies permitted by the PPSA.

Credit agreements normally contain an acceleration clause , which permits the creditor to call the entire loan if the debtor
misses one payment. This gives the debtor an incentive to make timely payments and allows the creditor to sue for the entire
debt immediately upon any default by the debtor.

A secured party can enter the borrower's premises and seize the collateral immediately upon default by the debtor, although
the secured party must not break the law and is generally required to provide advance notice to the debtor. The secured party
can then dispose of the collateral (or collect collateral such as accounts receivable). The proceeds are applied first to the
expenses of the secured party in enforcing its security and then to the unpaid debt. The fees and expenses of the secured
party in seizing and selling collateral can often be considerable.

If the amount received by the secured party in disposing of the collateral (less its costs) exceeds the amount owed by the
debtor, the surplus must be paid to the next secured party in line, if there is one, and then to the debtor. If, on the other hand,
the net proceeds are

P. 654

insufficient to pay the outstanding debt, then the secured party becomes an unsecured creditor for the deficiency , which is
the balance still owing, and has the rights only of an unsecured creditor in respect to the deficiency.

If the security agreement permits, the secured party may appoint a receiver or receiver-manager to take possession of the
collateral and manage the business of the debtor while a sale of the collateral can be arranged. If the security agreement is
silent on whether or not a receiver may be appointed, the secured party can apply to a court for an order appointing a
receiver or receiver-manager.

In some cases, the secured party may keep the collateral in satisfaction of the debt owed, however in most provinces doing
so will extinguish any deficiency.

Limits on Lenders' Remedies

When enforcing its security, the secured party must act in a commercially reasonable manner in every respect.6 What is
commercially reasonable will depend on the particular circumstances, but the secured party must take reasonable care of the
collateral and obtain a reasonable price when disposing of the collateral. Creditors are not expected to obtain the highest
possible price, but they must act reasonably. Creditors must also avoid conflicts of interest created by buying collateral
themselves or selling to related businesses at a price less than fair market value. Typically, lenders will have the collateral
valued by an independent appraiser to ensure that the price is reasonable, or they will sell the collateral at public auction,
where the price is set by the highest bidder.

The courts have held that secured parties must generally give the debtor reasonable notice before calling a loan or enforcing
their security, even if the credit agreement does not require notice. What is reasonable will depend on the particular
circumstances, including the type of collateral and whether it is perishable, the relationship between the debtor and the
creditor, and any industry norms or standards. In addition, the PPSA requires that debtors be notified of any intended sale of
collateral and have the opportunity to pay off the debt and reclaim the collateral prior to the sale. This way, the debtor can

monitor any sale and, if possible, bring the debt into good standing and avoid the sale of its assets.

If a secured party is enforcing a security interest against all or substantially all of the inventory, accounts receivable or other
assets of a business debtor, the Bankruptcy and Insolvency Act7 requires that the secured party provide the debtor with 10
days' notice of its intention to enforce it security. The notice is in a prescribed form and is commonly known as a “Section
244 Notice.” During the 10-day period, the secured party cannot take any steps to enforce its security.

The PPSA and other legislation provide special protection for consumer debtors. When dealing with consumer purchases,
secured parties may be prohibited from seizing collateral if the debtor has already paid two-thirds of the loan.8 In some
provinces creditors are limited to the proceeds from the seized assets and may not sue the debtor for any deficiency.9

P. 655

Personal Guarantees

If the bank agrees to lend Hometown the money for its expansion, the bank will likely require personal guarantees from at
least some of Hometown's shareholders. Guarantees reduce the bank's risk because the personal assets of the shareholders
will ultimately be available to the bank if Hometown defaults on the loan. The shareholders of Hometown are not normally
liable for Hometown's debt, because as shareholders they enjoy limited liability. However, if the shareholders personally
agree to guarantee the loan, then they lose their limited liability protection with respect to that debt. In such a case, the
personal liability of the shareholders to the bank arises not from their position as shareholders of Hometown, but because
they have agreed to be personally responsible for the debt. The scope of their personal liability will be determined by the
guarantee contract. The relationship amongst the borrower, the lender, and the guarantor is shown in Figure 26.1.

A guarantee is a contract between a creditor and a guarantor . The terms and conditions of the guarantee are set out in the
guarantee contract. Since a guarantee is a contractual relationship, the fundamental principles of contract law apply. The
essence of the guarantee is a promise by the guarantor to pay the debt if the debtor defaults. The guarantee promise is
conditional or secondary to the primary obligation of the debtor. A guarantee must be distinguished from a contract of
indemnity , in which the indemnifier is primarily and not conditionally liable for the obligation of the debtor.

The implications for those who give personal guarantees are significant. Guarantors lose their limited liability to the extent
of their promises to the creditor and thereby put their personal assets at risk. If the debtor defaults, the creditor can pursue
the guarantors for payment immediately and without the need to take any further legal action.

A continuing guarantee is one where the guarantor is liable for any past, present, and future obligations of the debtor. Bank
guarantees usually apply to the total debt owed to the bank at any given time. When the initial loan is granted by the bank,
Bill and Martha may be confident in Hometown's future and comfortable with the amount of the loan. As time passes,
however, the amount of debt may increase, and Hometown's financial situation may deteriorate. The guarantees, however,
are continuing. If Hometown eventually defaults, the guarantors will be required to pay the balance owing, whatever that
might be at the time of default. If the guarantors are unable to pay, they may be forced into personal bankruptcy.

Personal Guarantees FIGURE 26.1 Relationships in

P. 656

The Guarantee Agreement

A guarantee is one of few contracts that must be in writing and be signed by the guarantor in order to be enforceable.10

The guarantee is normally one component of a larger credit arrangement. The lender will require that the guarantor sign the
lender's standard form guarantee agreement, which is designed to severely limit ways that the guarantors may avoid liability
and provide the lender with maximum flexibility in dealing with the debtor. Guarantees may be required in order for
Hometown to obtain the loan, but the shareholders of Hometown must consider these guarantees as an important factor in
their decision to seek debt financing on behalf of Hometown.

The guarantee agreement is entered into between the guarantor and the creditor—not between guarantor and debtor—
because the creditor wants to be able to enforce the contract without the cooperation of the debtor. If the guarantee contract
was entered into between the guarantor and the debtor, privity of contract would prevent the creditor from enforcing the
contract against the guarantor.

Consideration can be an issue with guarantee contracts. If Bill and Martha promise to guarantee Hometown's debt to the
bank, it is not obvious that they are receiving anything of value in exchange. In order for there to be a valid contract,
consideration must be exchanged. Therefore, guarantee contracts normally include language which describes the benefit that
the guarantors will receive, even if that benefit is indirect.

The following are typical terms in a guarantee contract:

Guarantors are jointly liable for the entire debt. If Bill and Martha guarantee the $200 000 loan, they are each liable
for the full $200 000 and the bank can recover that amount from either of them.
The guarantee applies to all credit extended to the debtor while the guarantee is in force. Any limitation must be
clearly stated in the guarantee contract.
The guarantee is in force for an unlimited period. This may become a problem if one of the guarantors decides to
sell its shares and leave the business—the creditor may not agree to release the guarantor.
Guarantees normally exclude any terms, conditions, statements, or representations that are not in the written
agreement. Guarantors should ensure that any material assurances or assumptions are clearly stated in the guarantee
contract.
Bank guarantees usually provide that the bank may deal with the debtor and the debt without affecting the guarantee
(e.g., increasing the amount of the loan). This is a direct reversal of the common law rule that terminates the
guarantee if the terms of the debt are changed without the guarantors' consent.

If the guarantors are required to honour their guarantees and pay the debt, they have a right of subrogation against the
debtor. If Hometown defaults on its loan and the shareholders are required to pay the bank, they have the right to recover
their payment

P. 657

from Hometown. Of course, if the guarantors are called upon to pay, it is unlikely that Hometown will be able to repay
them. Still, the right of subrogation extends to any rights that the creditor has against the debtor. For example, if the bank
had a security interest or a judgment against Hometown, and the shareholders of Hometown have paid Hometown's debt to
the bank, then the shareholders would become entitled to the benefit of the bank's security interest or judgment against
Hometown.

Defences Available to Guarantors

Guarantors have some common law defences available to them. First, the guarantee obligation is limited to the terms of the
debt guaranteed. If the terms of that debt are changed in a way that increases the risk to the guarantors, the guarantee is
terminated unless the guarantors have agreed to the changes. Such changes may include increasing the amount of the loan or
the interest rate, extending the time for payment, or altering the collateral the debtor has provided. However, standard
guarantee contracts usually eliminate this defence by authorizing the creditor to deal with the debtor and the debt in any
manner the creditor sees fit without the consent of the guarantor.

Guarantors may argue they did not understand the terms of the guarantee contract or the risk of giving the guarantee.
Spouses, friends, or other relatives of the debtor with little or no involvement in the debtor's business may sign guarantees

under pressure. Sometimes, a court will relieve a guarantor from liability if it is satisfied that the guarantor did not
appreciate the nature and consequences of the guarantee. For this reason, when guarantors are individuals who are not
directly involved in the debtor's business, it is customary for them to obtain independent legal advice before signing the
guarantee contract. If the bank requires Bill and Martha's spouses to also sign guarantees, the bank will likely insist that they
receive independent legal advice before the bank will extend the loan. The bank does not want the guarantors to be able to
avoid their obligations using such defences.

The written guarantee contract will normally take precedence over verbal reassurances or statements that contradict or
modify its terms. However, courts tend to interpret guarantee terms strictly against the creditor who is relying on the
guarantee. For example, if the guarantee contract provides a blanket authorization for the creditor to alter the debt contract
without the guarantor's consent, that intention must be clearly stated in the guarantee contract. If there is doubt or ambiguity
about the meaning or scope of language in the guarantee contract, that doubt or ambiguity will generally be resolved in
favour of the guarantor.

Apart from the requirement that guarantees be in writing, the only regulation of guarantees in Canada is in Alberta.11 The
Alberta statute provides that, for a guarantee to be valid, a notary public must certify that the guarantors were aware of and
understood the contents of the guarantee. The statute does not, however, place any limit on the actual content of the
guarantee.

It has been argued that the terms of standard form guarantee contracts are so one-sided that banks should be strongly
encouraged or forced to change the language.

P. 658

Ethical Considerations: Banks' Standard Form Guarantees

Since the language of guarantees is dictated by banks, it includes broad terms intended to give banks maximum discretion in
dealing with the borrower, the security for the loan, and the terms of the lending agreement without affecting the guarantors'
liability to the bank. For example, common terms are “the bank may deal with the security as it sees fit” and “the bank may
vary the terms of the loan as it sees fit.” Banks maintain that these clauses allow them to release other guarantors or sell
security in any way they choose or to raise interest rates or lend more money, all without disturbing the obligation of the
guarantors. Guarantors who wish to challenge the banks' interpretation of such language may do so in the courts; however,
court decisions have been mixed in such cases. Some take a straightforward approach and rely primarily on the written
terms of the guarantee. For example, in a recent case, the judge considered a standard form of guarantee containing complex
language and concluded:

I am in agreement with counsel for [the bank] that the exemption clause is clear. The guarantors have
contracted out of any potential defence relating to the way the bank dealt with its client's credit facility.

Others take a more contextual approach and question whether the meaning of the language would be plain and obvious to
guarantors or whether the language is specific and clear enough for guarantors to understand that the contract gives the bank
such wide powers.

Jan Weir is a civil litigation lawyer who sees the law of guarantees as a real concern for those in small business who are
required to sign such agreements. These people understand interest rates and repayment terms, but not the language of
standard form agreements and its consequences: “It would probably take a law professor with a large magnifying glass
several hours to review and explain the usual bank guarantee form to a layperson.”

He further argues that there is no real competition among banks relating to these terms and therefore no real equality of
bargaining power between banks and guarantors:

In my view, the banks have used a statutorily sanctioned monopoly position to use one-sided agreements that
often deprive unsuspecting and unrepresented small businesspeople of protections and fair principles that
judges have developed.

Weir suggests that we need small business lobby groups to develop fair standard form guarantees.

Critical Analysis

Do you agree with Weir's analysis? Is it ethical for banks to impose these one-sided terms on small businesspeople?

Sources: Jan Weir, “Banks vs. small business: An unequal match”, The Lawyers Weekly (9 February 2001) at 9; and Royal
Bank of Canada v Speight, 2006 NSSC 151.

Regulation of Credit

Government regulation of credit is largely restricted to consumer debt , where the borrower is a consumer rather than a
business. Each province has legislation which attempts to protect consumers from the potentially unfair bargaining
advantage that lenders enjoy. People with poor credit records are especially vulnerable, and their need for credit may be
greater than those on more solid financial footing. However, if consumers are not aware of their legal rights or the legal
processes by which they may enforce those rights, the legislative protection is of little practical value. This is a problem that
some governments have addressed by providing consumer information and debt counselling.12

Within each province and territory, forms of protection are often scattered throughout a number of statutes, but generally
they seek to regulate the provision of credit by licensing certain activities, prohibiting other activities, and requiring
disclosure regarding the terms of credit transactions. As a result, there are many different rules that businesses must follow
when extending credit to consumers.

P. 659

The provincial and territorial legislation

enables the courts to review and reverse transactions where “the cost of the loan is excessive and the transaction is
harsh and unconscionable.” 13
prohibits credit transactions where there is “no reasonable probability of making payment in full” or where there is
no substantial benefit to the consumer.14
prohibits lenders from making misleading statements in advertising dealing with credit transactions and during the
loan application and negotiation process.15
requires lenders to provide detailed disclosure regarding credit transactions, including the true cost of borrowing, the
annual effective interest rate, and any other charges (such as registration fees or insurance) that the borrower must
pay, and the total amount of the loan.16

If a lender fails to comply with these regulations, the borrower can file a complaint against the lender with a regulatory
body, which may lead to fines, licence suspension or revocation, or orders prohibiting further violations. The borrower can
also apply to the courts to have the terms of the loan adjusted or, in some cases, to obtain damages. However, in the case of
consumer disputes, the courts are often not a realistic choice for consumers, due to factors such as cost, inconvenience, and
the length of time it takes the courts to resolve disputes.

Credit bureaus provide a service to lenders by compiling credit information on consumers and reporting on their credit
history. Lenders use this information to evaluate loan applications. There are licensing regulations to ensure the
respectability of credit bureaus, and to ensure the accuracy of the information that is compiled. Consumers have access to
their credit reports and the opportunity to correct errors.17

Collection agencies assist lenders who have difficulty recovering loans. These agencies are subject to licensing regulations
and cannot harass, threaten, or exert undue pressure on defaulting borrowers. They are also prohibited from contacting
anyone other than the borrower (such as a family member or business associate) even when the debtor is bankrupt or
deceased.18 Agencies that go beyond the permitted methods of collection risk the revocation of their operating licences.

In addition to the provincial legislation, there are also federal laws dealing with the regulation of credit.

The federal government recently passed regulations that apply to credit cards issued by federally regulated financial
institutions,19 in order “to make financial products more transparent for consumers” and to “protect Canadians and their
families from unexpected costs and provide clear information to help them make better financial decisions.”20

P. 660

The new regulations require

a summary box on credit applications and contracts clearly indicating key features, such as interest rates and fees
express consent for credit limit increases
restrictions on debt collection practices used by financial institutions
disclosure of the time to pay off the balance by making only minimum payments
notice of any interest rate increases
mandatory 21-day, interest-free grace period for new purchases
allocation of payments to the balance with the highest interest rate first

In addition, the federal Criminal Code21 prohibits lending at a rate of interest above 60 percent on an annual basis, although
this provision has recently been amended to exclude most payday loans . Loans with an interest rate in excess of 60 percent
are illegal and, as such, are generally unenforceable. In addition, lenders who receive such interest may be subject to fines
and imprisonment.

The average payday loan is for $280 and is outstanding for 10 days.22 Payday lenders typically extend credit until the
borrower's next payday. The borrower provides the lender with a post-dated cheque or a pre-authorized withdrawal from a
bank account for the amount of the loan plus interest and fees. In many cases, the annual effective interest rate exceeds 60
percent, and can be as high as 1200 percent!23

Proponents of the payday loan industry argue that the loans fulfill an unmet need for short-term credit and convenience.
Critics argue that the industry is rife with unscrupulous and abusive business practices (such as misleading advertising and
hidden fees) and exploits people who are already financially vulnerable. Until recently, payday loans were largely
unregulated in Canada.

The Criminal Code now excludes payday loans from its limitation on the rate of interest that may be charged, provided the
loan is for $1500 or less, the term of the loan is for 62 days or less, and the province in which the loan is made has
provincial regulations dealing with payday loans. The goal of the new federal legislation is to encourage the provinces to
enact legislation which will protect borrowers and limit the total cost of borrowing. Most provinces have passed, or are in
the process of passing, payday loan legislation.24 Critics of the new regulations argue that delegating responsibility to the
provincial governments will lead to a lack of consistency in the regulations and their enforcement.25

Provincial payday loan legislation generally prohibits a variety of unfair business practices (such as misleading advertising
and “rollover” loans), imposes a limit on the total cost of borrowing, provides the borrower with a two-day “cooling off”
period, and limits various collection practices.26 In Ontario, for example, payday loan borrowers may not be charged

P. 661

more than $21 for each $100 borrowed. In Alberta, British Columbia, and Saskatchewan, the maximum charge is $23 for
each $100 borrowed. Accordingly, in Alberta, a loan of $300 for 14 days, which is a typical payday loan, will require the
borrower to repay a total of $369, for an annual effective interest rate of 599.64 percent.

New

regulations in place for payday loans. © ASHLEY COOPER/CORBIS

Ethical Considerations: The “No Interest” Offer

The local electronics store flyer advertises “No Interest for 24 Months on all Purchases!” The offer is attractive, especially
when the item being considered is a luxury item, such as a giant computer monitor for $299—something Susan would like
to have, but does not really need. In Ontario, Susan would have to pay $337.87 including taxes to buy the monitor if she
pays cash at the time of purchase. Instead, Susan is enticed by the offer of 24 equal payments without interest, or only
$12.46 per month!

The problem is in the fine print. If Susan reads the fine print tucked away inside the flyer, she will see that there are terms
and conditions attached to the “No Interest” offer. First, there is an “administration fee” of $49.95, which must be paid at the
time of purchase. Second, the sales taxes applicable to both the monitor and the administration fee must also be paid at the
time of purchase. Finally, “Interest is charged on all accounts at the annual rate of 28.8 percent. Interest will be waived only
if the customer makes all payments on or before the due date, failing which this offer will not apply.”

Suppose Susan buys the monitor and makes all 24 payments when due. In that case, she pays $95.31 at the time of purchase
(administration fee plus sales taxes on the monitor and the administration fee). She pays $12.46 per month for 24 months for
a total of $299. Accordingly, Susan pays a total of $394.31, compared to the $337.87 that she would have paid if she had
bought the monitor for cash. Some deal!

But things get worse—much worse—if Susan is late making a payment. Suppose now that Susan buys the monitor with the
“No Interest” offer, but because she goes away for a few days during spring break, she is late making one of the 24 monthly
payments. Susan makes the other 23 payments on time. Unfortunately for Susan, the terms of the offer no longer apply
because she did not comply with the conditions of the offer, which were clearly stated. Interest is now charged on the entire
amount for the whole two-year period, even though Susan made 23 out of 24 payments on time. Susan now pays $95.31 at
the time of purchase plus $12.46 per month for 24 months, as before, but now Susan also pays interest at the rate of 28.8
percent for two years, amounting to an additional $130.23. Susan now pays a total of $524.54 for her $299 monitor! The
total cost of borrowing is $186.67, or 62 percent of the original purchase price.

Critical Analysis

Is this type of credit offer fair? Should consumers be bound by such terms and conditions? Should the “administration fee”
be included in the calculation of interest, with the result that the offer would violate the Criminal Code?

P. 662

Business Law in Practice Revisited

1. What is the bank likely to require before agreeing to loan money to Hometown?

Hometown will be asked to provide detailed financial statements and a business plan to justify the expansion and the loan.

2. What will the terms of the loan be?

The bank will require Hometown to provide collateral with sufficient value to cover the loan. The interest rate on the loan
will accord with the risk perceived by the bank. Hometown will be required to maintain minimum levels of accounts
receivable and inventory, to stay within a specified debt/equity ratio, and to provide financial information to the lender at
specified intervals. Hometown will need the lender's permission to deal with secured assets other than inventory, and will be
required to maintain appropriate insurance coverage on the collateral.

3. What are the risks for Hometown in borrowing the money?

The major risk is the possibility that the business will be less profitable than anticipated and that Hometown will be unable
to repay the loan. If Hometown fails to repay the loan, the collateral can be seized and sold by the bank. In many cases, this
will mean the end of the business.

4. Will Bill, Martha, and the two new shareholders be personally liable for the loan?

Bill and Martha will likely be required to personally guarantee the loan. The new shareholders may also be asked to
guarantee the loan. If Hometown defaults, their personal assets will ultimately be available to the bank. Since the guarantees
are probably unlimited in scope, the failure of Hometown to repay the loan could eventually result in personal bankruptcy
for the guarantors.

The Legal Aspects of Credit: Chapter Summary

Credit transactions are an important and normal part of every business. A business can be a debtor or a creditor, depending
on the transaction. Some arrangements are continuous and informal, such as between a customer and supplier. Others are
major individual transactions and involve a formal credit agreement specifying the rights and obligations of the borrower
and the lender. Unsecured creditors have a right to be repaid and can sue the debtor in the event of non-payment. Secured
creditors have, in addition, the right to seize and sell the collateral to pay down the debt owed. When a debtor defaults,
secured creditors are in a much better position than unsecured creditors.

Personal property security is mostly governed by the PPSA in each province. The important concepts of the PPSA are
attachment, perfection, priorities, and lenders' remedies. Lenders and borrowers are protected by credit agreements and by
the PPSA and other legislation.

Guarantors place their personal assets at risk when they provide a guarantee. Guarantors should be aware of the onerous
terms in most guarantees and ensure that they understand their obligations under standard form guarantee contracts.

P. 663

The Legal Aspects of Credit: Chapter Study: Key Terms and Concepts

acceleration clause (p. 654)
after-acquired property (p. 649)
collateral (p. 647)
collection agency (p. 660)
consumer debt (p. 659)
credit bureau (p. 660)
deficiency (p. 655)
events of default (p. 647)
financing statement (p. 651)
general security agreement (p. 649)
guarantee (p. 656)

guarantor (p. 656)
indemnity (p. 656)
letter of commitment (p. 648)
letter of credit (p. 646)
payday loan (p. 661)
purchase-money security interest (PMSI) (p. 652)
receiver (p. 655)
registration (p. 651)
secured credit (p. 645)
security interest (p. 650)
subrogation (p. 657)
unsecured credit (p. 645)

The Legal Aspects of Credit: Chapter Study: Questions for Review

1. What are some examples of credit transactions?
2. What are some of the methods that creditors use to reduce risk in credit transactions?
3. What are the rights of an unsecured creditor on default by the debtor?
4. What are the key aspects of personal property security legislation?
5. What are the disclosure requirements for a consumer loan?
6. What is a criminal rate of interest?
7. What are some problems with payday loans?
8. What is a general security agreement?
9. What is the role of a financing statement?
10. How are lenders' remedies limited by law?
11. What is a purchase-money security interest?
12. What is the difference between a perfected and an unperfected security interest?
13. What is the role of a receiver or receiver-manager?
14. What is a deficiency?
15. Who are the parties in a guarantee contract?
16. What are the issues with standard form guarantee contracts?
17. How does a guarantee affect the limited liability of a shareholder?

The Legal Aspects of Credit: Chapter Study: Questions for Critical Thinking

1. When a business fails, most of the assets may be claimed by secured creditors. Unsecured creditors may receive
very little, if anything, and shareholders may be left with nothing. Is the protection accorded to secured creditors
justified?

2. There is a complex web of rules governing consumer credit. Should commercial credit be regulated the way
consumer credit is now or left to the lender and borrower to negotiate?

3. What factors affect the ability of a borrower to finance their business using debt? How does an economic downturn
or credit freeze affect the ability of a business to borrow? How do these developments affect existing credit
agreements?

4. Creditors holding general security agreements are required to give the borrower reasonable notice before appointing
a receiver to take possession of the assets of the business. How should a secured creditor decide how much time to
give a debtor?

5. The Canadian Constitution gives the provinces control over property and civil rights, which includes the regulation
of credit and registration of property as security for credit. Do the benefits to the provinces of autonomy outweigh
the burden on business of dealing with so many sets of rules?

P. 664

6. In light of this chapter, what factors would you advise Bill and Martha to consider in financing Hometown's
expansion? Did they make the right decision in issuing shares? When Hometown borrows, how should they try to
structure the terms of the loan to minimize the risk to Hometown and to themselves?

The Legal Aspects of Credit: Chapter Study: Situations for Discussion

1. Douglas Pools Inc. operates a pool company in Toronto. In order to finance the business, Douglas Pools negotiated a line
of credit with the Bank of Montreal to a maximum indebtedness of $300 000. The line of credit was secured by a general

security agreement in favour of the bank, in which the collateral is described as “all assets of Douglas Pools, all after-
acquired property and proceeds thereof.” The Bank registered its security interest under the PPSA on 10 January 2011. On
30 March 2011, Douglas Pools bought a 2009 Dodge Ram pick-up truck from London Dodge for $15 000. London Dodge
agreed to accept payment for the truck over three years, with interest at 6 percent per year, and took a security interest in the
truck in order to secure payment of the purchase price. London Dodge registered its security interest under the PPSA on 4
April 2011. On 11 November 2011, Douglas Pools sold the truck to Fisher & Co. (a company owned by the same person
that owns Douglas Pools) for $1.00. Douglas Pools defaulted on its obligations to both the bank and London Dodge and, on
28 November 2011, declared bankruptcy. At the time of the bankruptcy, Douglas Pools owed the Bank $240 000 and
London Dodge $12 000. Now, the bank, London Dodge, the Trustee in Bankruptcy, and Fisher & Co. all claim the truck.
Whose claim to the truck has first priority? Whose claim has second priority?

2. The Weiss Brothers operated a successful business in Montreal for 30 years. They bought a bankrupt hardware business
in Ottawa, even though they had no experience selling hardware. Their bank, TD, got nervous about their financial stability
and suggested they seek financing elsewhere. The brothers contacted a former employee of TD who was with Aetna
Financial Services and negotiated a new line of credit for up to $1 million. Security for the line was a general security
agreement, pledge of accounts receivable, mortgage on land, and guarantees by the brothers. Six months later, the brothers
defaulted on the line. Aetna demanded payment in full and appointed a receiver, who seized all the assets three hours
later.27 What can the Weiss Brothers do to save the business and their personal assets? What could they have done to
prevent this disaster? Why did Aetna grant credit after TD had become reluctant to continue?

3. The bank agreed to lend money to Wilder Enterprises Ltd. and, in order to secure repayment of the loan, the company
granted the bank a security interest in all of its assets. The loan was also personally guaranteed by members of the Wilder
family, who owned the company. Periodically, the bank increased the company's credit limit as the company expanded its
business. When the company experienced financial difficulty, however, the bank dishonoured two of the company's cheques.
That prompted a meeting between the bank and the Wilders, the result of which was that the bank agreed to loan additional
funds to the company, and refrain from demanding payment on its loan, in exchange for additional guarantees from
members of the Wilder family. Despite the agreement, and without warning, the bank stopped honouring the company's
cheques and demanded payment of the loan in full. When the company was unable to pay, the bank appointed a receiver-
manager and took control of the company. The receiver-manager refused the company's request to complete the projects that
the company then had underway and, as a result, the company went bankrupt. The bank sued the Wilders for payment
pursuant to the guarantees that the bank had, all of which permitted the bank to “deal with the customer as the bank may see
fit.”28 Will the Wilders be obligated on their guarantees? How sympathetic are the courts likely to be? Could the Wilders
have structured their affairs differently to avoid high personal risk for the escalating debts of their failing business?

4. Kyle owned and operated a retail sporting goods shop. A new ski resort was built in the area and, to take advantage of
increased activity, Kyle decided to expand his shop. He borrowed money from the bank, who took a security interest in his
present inventory and any after-acquired inventory. One year later, an

P. 665

avalanche destroyed the ski lodge. Kyle's business suffered, and he was left with twice as much inventory as he had when he
first obtained the loan. When he defaulted on the loan payments, the bank seized all his inventory. Kyle claims the bank is
entitled only to the value of the inventory at the time of the loan. How much inventory can the bank claim? Could Kyle have
negotiated better terms at the outset?

5. Nicola applied for a personal loan from ABC Bank. She provided all of the personal and financial information requested
by the bank. When she inquired about her application, the bank's credit officer told her that her application had been denied.
When Nicola sought an explanation for the refusal, she was told that her “credit score” was not high enough. The bank
refused to provide any information concerning her score or the formula used to calculate the score, claiming this was
confidential commercial information. What can Nicola do now?

6. King Tire Shop agreed to buy a vacant building supply outlet to expand its tire business. To finance the purchase, King
negotiated a loan from its bank, with the land and building as security. As part of the loan documentation, the bank required
a report stating that the property was not environmentally contaminated in any way. King engaged a local environmental
consulting firm to investigate and prepare the report for the bank. The firm gave the property a clean bill of health, and the
loan was granted. Two years later, it was discovered that the adjacent property, which was formerly a gas station, had
seriously contaminated the soil, and pollution was leaching into the soil of King's property. The cleanup cost is significant,
and King cannot afford it. As a result, King's property is seriously devalued and the bank is concerned about the value of its
security, especially since King's business is not doing well. Who is responsible for this environmental damage? What are the

bank's options? What are King's options?

7. New Solutions Financial loaned Transport Express, a transport trucking company, $500 000 under a commercial lending
agreement. The interest rate was 4 percent per month calculated daily and payable monthly. This arrangement produced an
effective annual rate of 60.1 percent. Other clauses in the agreement specified other charges, including legal fees, a
monitoring fee, a standby fee, royalty payments, and a commitment fee totalling 30.8 percent for a total effective annual rate
of 90.9 percent. Transport Express found the terms of the agreement too onerous and refused to make the agreed
payments.29 Is this agreement enforceable? Why or why not? Should a commercial arrangement like this be treated
differently from a payday loan?

8. RST Ltd. is an independent printing company in a medium-sized town in Saskatchewan. It was established 15 years ago
by Ron, Sandra, and Tara, who each own one-third of the shares in the company. Last year, RST revenues were $4 million,
mainly from local contracts for such items as customized office stationery, business cards, advertising posters, calendars,
and entertainment programs. Because the business is prospering, the owners are planning to expand their printing and sales
space. They know that significant financing is required for the expanded facilities and the increased business. The current
capital structure of RST is 60 percent owners' equity and 40 percent debt. Rather than issue shares to other investors, the
owners are prepared to put more equity into the business by purchasing additional shares in order to maintain their
debt/equity ratio. The expansion project will cost $1 million, so they need to borrow $400 000. Do you agree with the
owners' financing decisions? What are the risks? How can the owners plan for uncertainty in their industry and the economy
in general?

For more study tools, visit http://www.NELSONbrain.com .

Footnotes

1. See, for example, Personal Property Security Act, RSO 1990, c P-10; and Personal Property Security Act, SNS 1995–96,
c 13.
2. In the case of investment property, a security interest may also be perfected in some provinces by “control.”
3. For example, in Ontario, within 10 days of the debtor obtaining the collateral for non-inventory collateral, and before the
debtor obtains the collateral for collateral which is inventory.
4. SC 1991, c 46, s 427.
5. See, for example, Builders' Lien Act, RSA 2000, c B-7.
6. For example, Personal Property Security Act, SNS 1995–96, c 13, s 66(2).
7. RSC 1985, c B-3.
8. This limitation applies, for example, in British Columbia, New Brunswick, and Nova Scotia.
9. This limitation applies, for example, in British Columbia and Alberta.
10. The in-writing requirement is in place in all provinces except Manitoba, generally in the Statute of Frauds.
11. Guarantees Acknowledgment Act, RSA 2000, c G-11.
12. For example, in Nova Scotia, through Service Nova Scotia and Municipal Relations.
13. Unconscionable Transactions Relief Act, RSNS 1989, c 481, s 3.
14. Consumer Protection Act, 2002, SO 2002, c 30, Schedule A, s 15. See also Chapter 24.
15. Fair Trading Act, RSA 2000, c F-2.
16. Business Practices and Consumer Protection Act, SBC 2004, c 2.
17. See, for example, Consumer Reporting Act, RSO 1990, c C-33, s 12.
18. Collection Agencies Act, RSO 1990, c C-14.
19. Credit Business Practices, SOR/2009-257.
20. Flaherty, Jim (Minister of Finance), News Release, Ottawa, “Regulations Come into Force to Protect Canadian Credit
Card Users” (1 September 2010).
21. RSC 1985, c C-46, s 347.
22. Whitelaw, Bob, “$280 till payday: The short-term loan industry says it provides a service the (average) Canadian needs,
wants and appreciates”, Vancouver Sun (8 June 2005), A21.
23. Kitching, Andrew and Starky, Sheena, “Payday Loan Companies in Canada: Determining the Public Interest”, PRB 05–
81E, Parliamentary Information and Research Service, Library of Parliament, Ottawa (26 January 2006).
24. See, for example, Payday Loans Act, 2008, SO 2008, c 9.
25. Ziegel, Jacob, “Pass the buck: Ottawa has paramount jurisdiction over interest rate regulation”, Financial Post (10
November 2006) online: Financial Post <http://www.canada.com/nationalpost/news/story.html?id=b3efb360-60fc-4c86–
8818-b579b31fcd63>.

26. Supra note 24.
27. Based on Kavcar Investments v Aetna Financial Services (1989), 62 DLR (4th) 277 (Ont CA).
28. Based on Bank of Montreal v Wilder (1986), 32 DLR (4th) 9 (SCC).
29. Based on Transport North American Express Inc v New Solutions Financial Corp, [2004] 1 SCR 249.

P. 666

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Chapter 27 : Bankruptcy and Insolvency
(pp. 667-688)

Bankruptcy and Insolvency: Chapter Objectives

Objectives

After studying this chapter, you should have an understanding of

the legal aspects of business failure
the rights and obligations of debtors and creditors when a business fails
alternatives to bankruptcy
the stages in the bankruptcy process

Bankruptcy and Insolvency: Chapter Overview

©

NAJLAH FEANNY/CORBIS

Business Law in Practice

Hometown Hardware Ltd. (Hometown) and its owners, Bill Ikeda and Martha Wong, were introduced in Chapters 25 and
26. They have successfully operated a building supply outlet in Timmins, Ontario, for the past 35 years. Eighteen months
ago, Bill and Martha became concerned about the imminent arrival of a big-box building supply store. They decided to
expand Hometown's business in order to respond to the competitive threat. To finance the expansion, Hometown issued
$200 000 worth of shares and borrowed another $200 000 from its bank. The loan was structured as a mortgage of $100 000
on Hometown's land and buildings, and a line of credit for up to $100 000 secured by Hometown's inventory and accounts
receivable. Bill and Martha personally guaranteed the line of credit. The expansion strategy failed. Just after the large
competitor opened, the housing market collapsed. Hometown experienced a 30 percent drop in sales and Bill does not
expect the situation to improve.

When the big-box store first opened, Bill reacted with a costly promotional campaign. To cover this extra expense, Bill
borrowed $10 000 from his brother, George. More recently, he was under pressure from a major supplier, Good Lumber, to
pay Hometown's overdue account. Bill sold land that the company owned adjacent to the store. With the proceeds, Bill paid
$20 000 to Good Lumber and repaid George.

Hometown's assets consist of the land and buildings (subject to the mortgage) on which the business is located, inventory,
accounts receivable, and a few pieces of equipment. Hometown's liabilities include the mortgage, the line of credit, accounts
payable, and property taxes. Hometown is also late in remitting its employee source deductions to the government.

Bill wants to keep Hometown in business as long as possible, but he fears that the store may no longer be viable and he is
wondering what he should do.

P. 667

Bill would like to continue to draw his regular salary for as long as possible, and he would also like to continue to pay
Martha, the store manager. He is concerned that if Hometown stops making payments to the bank or suppliers, they will
take some kind of legal action. He is also concerned about the personal guarantees that he and Martha have given to the
bank.

1. What options does Hometown have in dealing with this financial crisis?
2. What rights do Hometown's creditors have?
3. What will happen to Hometown, its owners, its creditors, Bill, and Martha if Hometown goes bankrupt?

Business Failure

Business failure is often overlooked in the study of business, which tends to emphasize success and entrepreneurship. Even
when the economy is strong, businesses fail or falter because of poor management, lack of adequate financing, death or
illness of a principal, fraud, and other reasons. When an industry or the overall economy experiences a downturn, even
strong businesses may run into financial difficulty. Hometown is caught in a declining economy, an industry collapse, and a
changing market in which local stores are threatened by big-box retailers. Hometown must deal with cash-flow problems,
persistent and competing creditors, and possible legal action. The manner in which Hometown responds to these threats
affects many people in addition to the business owners. If Hometown fails, customers, suppliers, and employees will be
harmed, and the local economy may suffer. How the law addresses the respective interests of creditors and others is of
critical importance to a wide and diverse group of stakeholders.

In an attempt to ensure that all stakeholders are treated fairly, a body of law, generically called bankruptcy and insolvency
law, has evolved. The two primary pieces of legislation that govern insolvency law in Canada are the Bankruptcy and
Insolvency Act1 (BIA) and the Companies' Creditors Arrangement Act2 (CCAA). In addition, there are a number of other
statutes and common law rules that affect bankruptcy and insolvency.

If a business such as Hometown is no longer able to cope with a specific debt or its financial obligations in general, there are
several options available, ranging from informal negotiations to bankruptcy.

Informal Steps

Before contemplating bankruptcy, Hometown may first try to solve its financial problems by way of a negotiated settlement.
If Bill can convince Hometown's creditors that the business can be salvaged, they may be willing to make concessions in
terms of payment. Bill can deal with creditors individually or as a group. A settlement can be more or less formal,

P. 668

depending on the circumstances. Creditors may agree to meet with Bill and, possibly using the services of a professional
facilitator (an accountant, a lawyer, or a debt counsellor), they may be able to reach an agreement that is acceptable to all of
them and either allows Hometown to continue operating or wind up its affairs without the need for expensive legal
proceedings. In practice, the more creditors that Hometown has, the less likely it is that they will be able to reach such an
agreement.

The key to negotiated settlements is ensuring that all creditors are in agreement. Creditors will agree to a settlement if they
believe that it will likely produce better results for them in the long run than legal proceedings or bankruptcy. One possible
danger is that some creditors will attempt to push through an agreement that is unfair to others or that simply ignores them.
The value of using facilitators with appropriate expertise is that they are trained to identify these risks and deal with them.
Furthermore, the parties themselves may not recognize alternatives that would result in a better overall outcome. A skilled
facilitator will raise these alternatives for consideration.

In some cases, especially when the business is in serious financial trouble, negotiations may not be a viable option or may
fail after a reasonable attempt. Creditors may refuse to participate in negotiations, or they may decide that it is not in their
best interests to facilitate the debtor continuing to carry on business. In that case, the debtor must look to other options.

Proceedings before Bankruptcy

If informal negotiations fail to produce a settlement with Hometown's creditors, and Hometown's financial situation does
not improve, Bill will likely explore more formal proceedings. He should seek advice from a lawyer or accountant with
insolvency expertise so that he understands all the available options. If Bill decides that bankruptcy is the best or only
option, he will need the services of a trustee in bankruptcy .

Trustees in bankruptcy are professionals who are licensed by the Office of the Superintendent of Bankruptcy and have legal
authority to administer the bankruptcy process. A trustee in bankruptcy will usually agree to take on a matter if there is no
conflict of interest present and the debtor has sufficient assets to pay for the trustee's services. Sometimes the debtor is not
able to pay for the trustee and, in that case, it may be very difficult for the debtor to find a trustee willing to assist.

When Bill and the trustee first meet, the trustee will explain the options available to Hometown, the bankruptcy process, and
the role of the trustee. The trustee will also begin to assess the estate and prepare a preliminary statement of assets and
liabilities. Often, in the case of small businesses, this assessment requires the untangling of business and personal affairs. In
Hometown's case, the pending bankruptcy is that of Hometown Hardware Ltd., since it is the legal entity that carries on the
business. However, it is possible that Bill and Martha may also become bankrupt, or make a proposal to their creditors, as a
result of their personal guarantees.

P. 669

Following consultation with Bill, the trustee will prepare a statement such as the one shown in Figure 27.1.

FIGURE 27.1 Preliminary Statement of Assets and Liabilities for Hometown Hardware Ltd.

From this initial assessment, it is apparent that Hometown is insolvent as that term is defined in the BIA.3 That is,
Hometown owes more than $1000 and

is unable to meet its obligations as they become due, or
has ceased paying its obligations as they become due, or
has assets with a fair market value less than its liabilities

It is important to note that insolvency and bankruptcy are not the same, although the two terms are often, incorrectly, used
interchangeably. Insolvency is a factual matter relating to a person's assets and liabilities or his ability to pay his debts.
Bankruptcy is a legal mechanism whereby the assets of an insolvent person are transferred to a trustee, liquidated, and the
net proceeds are distributed to creditors in a manner determined by the BIA.

Proposals and Arrangements

It may be possible for an insolvent debtor to avoid bankruptcy by making a proposal or entering into an arrangement with
creditors. The general assumption that underlies proposals and arrangements is that a business is worth more to all of its
varied

P. 670

stakeholders (e.g., creditors, employees, suppliers, customers, government, etc.) as a going concern than if it is forced to
liquidate all of its assets. If Bill wants to keep the business of Hometown going, he should consider making a proposal to
Hometown's creditors.

Proposals under the BIA

A proposal is a procedure governed by the BIA that allows a debtor to restructure its debt in order to avoid bankruptcy.
When a debtor makes a proposal, the debtor offers creditors a percentage of what is owed to them, or to extend the time for
payment of debts, or some combination of the two. The goal is to restructure the debts owed by the debtor so that the debtor
is able to pay them. In many cases, creditors prefer that a debtor avoid bankruptcy, especially if it means that the creditor
will receive more money than if the debtor were to become bankrupt.

There are two types of proposal under the BIA:

Division I proposals4 are available to individuals and corporations with no limit on the total amount of debt that is
owed.
Division II proposals5 are available to individuals with total debts less than $250 000 (not including a mortgage on a
principal residence). Division II proposals are known as “consumer proposals.”

In either case, the debtor works with a trustee in bankruptcy to develop a proposal which is first filed with the Office of the
Superintendent of Bankruptcy and is then sent to the creditors of the debtor. Once the proposal is filed, the debtor stops
making payments to its unsecured creditors, salary garnishments stop, and lawsuits against the debtor by creditors are
stayed (stopped). In the case of a Division I proposal, there will be a meeting of creditors to consider and vote on the
proposal, at which time the trustee will provide an estimate to the creditors of the amount they are expected to receive under
the proposal compared to the amount they could expect to receive under a bankruptcy. In the case of a Division II proposal,
there may or may not be a meeting of creditors, depending on whether they request one.

Creditors vote on whether to accept or reject the proposal. With a Division I proposal, the proposal is approved if creditors
representing two-thirds of the total amount owed and a majority in number vote to accept it. In addition, a Division I
proposal must be approved by the court. With a Division II proposal, the proposal is approved if creditors representing a
majority of the total amount owed vote to accept it. If the proposal is approved by the creditors in this manner, then it is
legally binding on all unsecured creditors, whether they voted for or against it.

If the proposal is approved, the debtor will make payments as provided in the proposal and, if the debtor makes all the
payments and complies with any other conditions

P. 671

in the proposal, then the debtor is released from those debts. With Division I proposals, this gives a business the opportunity
to remain in business and ultimately be successful. With Division II proposals, the debtor must also attend two mandatory
financial counselling sessions, and the proposal will be recorded on the debtor's credit record for several years. If the debtor
does not make the payments set out in the proposal, or fails to comply with conditions contained in it, then the trustee or any
creditor can apply to have the proposal annulled.

However, if the proposal is not approved by the creditors, the debtor is deemed to be bankrupt under a Division I proposal
as of the date of the first meeting of creditors.6 In the case of a corporation, this usually means that the corporation will
cease to exist as of that date. In a Division II proposal, the debtor is free to resubmit an amended proposal, consider other
options, or make an assignment into bankruptcy. There is no automatic bankruptcy when a Division II proposal is rejected,
unlike the result when a Division I proposal is rejected.

Generally, secured creditors are not bound by BIA proposals, unless they elect to participate. Secured creditors can realize
on their security before or after the debtor has filed a proposal, even if the unsecured creditors have voted to accept the
proposal. For this reason, it may be very difficult for a business to make a viable Division I proposal if the business has a
large amount of secured debt. In that case, the secured creditors can be expected to appoint a receiver to seize their collateral
and, if the collateral constitutes a majority of the assets used to operate the business, then the business will be effectively
shut down.

Bill and the trustee may meet to discuss the possibility of Hometown submitting a Division I proposal to its creditors. The
trustee will explain to Bill that as soon as the proposal is filed, the bank can be expected to realize on its security, including
the land and buildings, inventory, and accounts receivable. That will leave Hometown with insufficient assets to carry on its
business. For that reason, a proposal under the BIA is not a viable option for Hometown.

Arrangements under the CCAA

Another option for an insolvent business to avoid bankruptcy is an arrangement under the CCAA. The CCAA may be used
by corporations that have total debt exceeding $5 million. The CCAA is a federal statute that allows an insolvent company
to obtain protection from its creditors while it tries to reorganize its financial affairs. Similar to the situation with a proposal
under the BIA, once a company obtains a court order under the CCAA, the company's creditors are prevented from taking
any action to collect money that is owed to them. Unlike the BIA, however, the protection afforded by the CCAA applies to
secured as well as unsecured creditors, and even to lessors and critical suppliers. After the initial court order is obtained, the
company continues to operate while attempting to negotiate an arrangement with its creditors. Canadian companies that