Supreme Court of Canada decision reveals risk of characterization of cash collateral arrangements as creating security interests

September 24, 2009

Collateral arrangement relying on set-off held to create a security interest and therefore subject to federal government's priorities for unremitted income tax and employment insurance at-source deductions

Caisse populaire Desjardins de l'Est de Drummond v. Canada
, 2009 SCC 29

On June 19, 2009 the Supreme Court of Canada released its decision in Caisse populaire Desjardins de l'Est de Drummond v. Canada. The issue was whether an agreement between a lender and borrower with respect to set-off against a term deposit gave rise to a "security interest" within the meaning of s. 224(1.3) of the federal Income Tax Act (ITA). The majority of the court held that it did. Consequently, the lender's right to set-off its term deposit obligation against the borrower's loan obligation was subject to the statutory priority of the federal government with respect to employment insurance (EI) remit¬tances and income tax at-source deductions under s. 227(4.1) of the ITA and s. 86(2.1) of the Employment Insurance Act (EIA).

The majority's reasoning is problematic for commercial set-off arrangements, even those that are deliberately drafted to avoid characterization as security agreements, because it suggests that if a set-off opportunity is created for the purpose of providing "security" for a loan or other obligation it gives rise to a security interest in the asset that is subject to the set-off. Many common title transfer collateral arrangements are arguably designed to do just that (such as the cash collateral arrangements under the ISDA Credit Support Annex New York form if using the Canadian recommended amendments, the ISDA Transfer Annex and other industry agreements such as the Global Master Securities Lending Agreement and the Global Master Repurchase Agree¬ment). So too are margin requirements under many forms of securities loan master agreements and securities repurchase agreements.


Concurrently with its extension of a business line of credit to a company called Camvrac, Caisse populaire Desjardins de l'Est de Drummond (Caisse Drummond) and Camvrac entered into a "term savings agreement" (TSA) requiring Camvrac to deposit $200,000. The deposit matured in five years, was not transferrable and could not be hypothecated or given as security in favour of any person other than Caisse Drummond. They also entered into an inadvisably named "Security Given Through Savings" agreement under which it was agreed that Camvrac would maintain the deposit "to secure the repayment of" the line of credit, among other things. Camvrac also consented to Caisse Drummond withholding the amount of the deposit until the sums due were repaid or the line of credit was in place. In cases of default, Caisse Drummond also had a right to "compensation" (the Quebec equivalent of set-off) between the loan and the amounts deposited. Caisse Drummond kept the certificates of deposit in its possession. In addition as further security, Camvrac hypothecated and pledged to Caisse Drummond the certificates and sums deposited to secure the loan.

The loan went into default in November 2000 but Caisse Drummond did not take any steps as a result until February 21, 2001, two weeks after Camvrac had made an assignment in bankruptcy. Caisse Drummond made a note on its copy of the TSA on February 21: "To be closed on 21/2/2001 to realize on security" (another unfortunate choice of language). In June, the Crown gave notice to Caisse Drummond to pay all of the remittance arrears owing by Camvrac to the Crown. 

Definition of "Security Interest"

The ITA and EIA create deemed trusts in favour of the Crown over property of the employer that has deducted income tax and EI premiums at source. The deemed trust also applies to property of the employer held by any secured creditor of the employer that, but for its security interest, would be property of the employer. "Security interest" is defined as:

any interest in property that secures payment or performance of an obligation and includes an interest created by or arising out of a debenture, mortgage, hypothec, lien, pledge, charge, deemed or actual trust, assignment or encumbrance of any kind whatever, however, or whenever arising, created, deemed to arise or otherwise provided for.

The point of dispute between the majority and minority judgments turned on whether the arrangements created an interest in property of the employer Camvrac.

The majority's reasonsIn a judgment authored by Rothstein J., the majority of the court found that the arrangements between Caisse Drummond and Camvrac created a security interest in the deposit or sums on deposit and that the set-off was the means of realizing on this security interest. Consequently, the Crown claims that arose with respect to remittance arrears prior to the date of the set-off had the benefit of the deemed trust.

The argument against set-off being a security interest is that the party seeking to set-off does not by virtue of a set-off right itself have a proprietary claim in property belonging to the other party. The party setting off itself has an obligation (in this case the term deposit obligation) and is entitled to satisfy that obligation by setting off an obligation owed to it by the other party (in this case the loan obligation). Set-off does not have anything to do with realizing on a property interest in one's own obligation. Even if there is a security interest in one's own obligation (as there was in this case), the set-off right can exist quite independently of that (and in a properly drafted agreement that would be clear).

However, the majority held that the arrangements were such that Caisse Drummond did have a property interest in the term deposit. It adopted a functional analysis. The deposit was put in place to "secure" the loan, there was a security interest in the deposit and the right of set-off was essentially a "remedy" to enforce the security interest in the term deposit. The truly novel aspect of the majority's reasoning is the conclusion that the contractual "encumbrances" placed on the deposit were what created the lender's property interest in Camvrac's deposit, primarily because those encumbrances ensured that the Caisse would be continuously liable to Camvrac. Rothstein J. noted that, had Camvrac been in a position to shift its funds in and out of the term account, there would have been no security interest.

Why This Was A Security Interest

The crux of the court's reasoning is captured in the following passage:

It was the five-year term and the maintenance and retention of the $200,000 deposit, as well as Camvrac's agreement not to transfer or negotiate the deposit and that the deposit could only be used as security with the Caisse, that created the Caisse's interest in Camvrac's property for the purposes of s. 224(1.3) ITA. In the absence of these encumbrances on Camvrac's deposit, Camvrac could have withdrawn the deposit at any time. Should it have done so and still been indebted to the Caisse, the Caisse's right to compensation would be ineffective because it would not be indebted to Camvrac at the time the Caisse had to resort to the remedy of compensation. However, in this case the terms of the agreements provided that Camvrac agreed to the encumbrances on its deposit of $200,000 so that the Caisse would continuously be indebted to Camvrac and that on default there would be effective compensation. It is the fact that the agreements secured the Caisse's right to effective compensation by conferring on the Caisse an interest in Camvrac's property that created a "security interest" for the purposes of s. 224(1.3) ITA.

The majority stressed that they were not saying that a contractual set-off right is per se a species of security interest. Rather, they held that, in light of the way the term deposit was put in place and maintained to be available for set-off as long as the credit line continued, the terms of this particular agreement justified the recharacterization of the transaction as a whole as the grant of a security interest.

The dissent

In dissenting reasons, Deschamps J. strongly disagreed with the majority view. Taking a position reflecting that of many in the financial industry and invoking a rather impressive range of academic commentary, she concluded that security interests can only be derived from "real rights" in property and never from the attenuated type of contractual rights to which the majority referred. Not all interests in property are security interests: in this case, she noted, the Caisse had no right to realize on its interest to secure performance of its obligation. The potential to appropriate the underlying property, she maintained, is one of the distinguishing features of a security interest.


A central problem with the majority's analysis is that it fails to differentiate between a credit support agreement and a security interest. While all security interests provide credit support, the converse is not true: not all credit support arrangements are security interests. For example, guarantees and letters of credit are clearly credit support, but they do not grant an interest in property to secure payment or performance of an obligation. The intention to provide credit support is quite distinct from the intention to confer a security interest. Such distinctions may have been lost on the majority partly because of the drafting of the agreement, which unwisely used "security language". The majority judgment did agree that a property interest must be created in the debtor's property, but its conclusion that there was such a property interest and that the right of set-off was the means to enforce that interest is dubious. One can only hope that this decision will be restricted in any subsequent application to situations where the intention to create a security interest is present on the face of the document and where the set-off rights are not part and parcel of the asset itself (i.e. the terms of the deposit itself do not provide for the set-off).

While there is much to criticize in the judgment, this decision is now a part of Canadian law and may require adjustments to practices. In particular, it is important to note that while the case dealt with the deemed trust provisions of the ITA and EIA, its implications could extend further into the realm of personal property security law. Moreover, it affects not only cash collateral but title transfer arrangements with respect to securities, including industry form agreements such as the GMSLA, the GMRA and the ISDA Transfer Annex. The decision clearly increases recharacterization risk in all of these situations.

Implications for Title Transfer Collateral Arrangements

The Canadian recommended language for cash for the ISDA CSA creates a debtor-creditor relationship with respect to cash and provides for a right of set-off against the cash. Cash is treated as Other Eligible Support and is not subject to the security interest language. On the other hand, there is clearly an obligation to transfer the cash to the collateral taker, there is no right to require repayment except to the extent credit is freed up by changing in exposures, and the purpose of the transfer of the cash is to "secure" the potential obligations under the transactions. The same general analysis applies to credit support transferred pursuant to the Transfer Annex or margin posted for many securities lending and repurchase agreements. While there are certainly features that distinguish these arrangements from the one considered in the Caisse Drummond case, there are also these important similarities.

Federal Crown Claims

Crown claims that benefit from the statutory deemed trusts (particularly those federal ones that prevail in a bankruptcy) may take priority with respect to the cash. (That would also be the case with respect to any collateral which is clearly subject to a security interest). It is also now a more likely result with respect to the Transfer Annex as it applies to securities or cash. Provincial securities transfer laws that provide protection against adverse claims for transfers of securities do not necessarily apply where the adverse claim is a federal deemed trust. On the other hand, there is a strong argument that the Crown would be subject to the right of set-off in the case of an agreement such as the Transfer Annex because the "property" is by its defining terms flawed by the set-off right (as opposed to the term deposit in the Caisse Drummond case, where the set-off was provided for in a separate agreement and the parties treated the term deposit as an autonomous property).

The decision also makes it clear that a non-defaulting party should not sit on its right to effect the set-off. In this case the lender waited several months from the date of default to note in its records that it was effecting the set-off. It became subject to the remittances in arrears that accrued during that period. Effecting the set-off cut off the Crown's claim from the date of the set-off.


The case deals with the definition of "security interest" in the ITA, and the majority decision made a point of saying that it was not considering the definition under provincial Personal Property Security Acts (PPSA). However, the ITA definition is really not materially different from the PPSA definition. Parties who have cash collateral set-off arrangements should discuss with counsel whether a cautionary filing under the provincial personal property security regime would also be advisable with respect to cash collateral. A security interest in an account (unless the cash is held in a securities account) can only be perfected by the filing of a financing statement.

Normally priority with respect to security interests perfected by filing would be determined by order of registration. However, given the contractual right to set-off, the recognition of the paramountcy of defences in section 40 of the Ontario PPSA (and its equivalent in other common law provinces) should ensure priority over other consensual security interests including those of prior registrants. Section 40(1.1) of the Ontario PPSA provides that an account debtor (e.g. the collateral taker) may set up by way of defence against the assignee (e.g. a competing secured party) all defences available to the account debtor against the assignor arising out of the terms of the contract or a related contract (unless it has contractually waived defences). The "account" in this case is the amount owing by the collateral taker with respect to the cash collateral it has received from the assignor and the defence is the right under the agreement to set-off against the net termination amount. Perfection should not be relevant to priority as against other consensual security interests or other assignees. It is somewhat unclear, however, how section 40 would relate to the rights of a trustee in bankruptcy as representative of the unsecured creditors or other non-consensual lien claimants, so it would be advisable to file a financing statement in any event to preclude any argument that there is an unperfected security interest.

Thankfully, perfection is not an issue with respect to the title transfer of securities (or cash in a securities account) because, regardless of characterization and to the extent the laws of an STA, U.C.C. Revised Article 8 or similar jurisdiction apply, the collateral taker should be perfected by control.

Does the decision affect netting?

The case should not affect netting of transaction losses/gains or values. There is no obligation in the normal course to maintain offsetting transactions for the purpose of protecting the other party against particular transaction defaults.

Contractual language

While perhaps not the decisive factor in the Supreme Court's reasons, the security interest language of the agreements between Caisse Drummond and Camvrac definitely did not help. Furthermore, after Camvrac's default, an official of the Caisse wrote " realize on security" on the TSA. To a court applying modern "functional analysis" to the question of whether an agreement create a security interest, the attitude suggested by the use of this type of language was obviously significant.

It would therefore be advisable to take special care to avoid "security interest language" in relevant documentation and even to specifically disclaim the intention to create a security interest. The Transfer Annex and the cash collateral language were carefully drafted in this respect. However, if you are putting together a bespoke arrange¬ment it is very important to be rigorous in maintaining the distinction between set-off and security interests.

Contractual set-off works in Quebec

A positive result of the ruling is to make clear that contractual compensation (set-off) is effective under Quebec law. Whether Bankruptcy and Insolvency Act provisions permitting set-off in a bankruptcy included contractual compensation in Quebec had been unclear as the result of some previous Supreme Court jurisprudence.

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