This Document Contains Chapters 25 to 26 Chapter 25 Business and Banking Instructor’s Manual–Answers by Philip King and Steven Enman V. CHAPTER STUDY Questions for Review, page 654 1. What is the basic nature of the bank–customer relationship? Answer: The usual relationship consists of the bank as debtor and the customer as creditor. 2. How are banks regulated? Answer: The federal government has jurisdiction, which it exercises through the Bank Act. 3. What are the key issues addressed in an account agreement? Answer: The key issues in the account agreement are: signing authority from the customer, service charges, confirmations, stop payments, and confidentiality of information. 4. What are the key duties of the customer and the bank? Answer: The duties of the bank and the customer are listed on textbook page 639. 5. What are the requirements for an instrument to be negotiable? Answer: The instrument must be self-contained: in written form, signed, for a specific amount, and unconditional. 6. What is a cheque? Answer: A cheque is a written order to a bank to pay money to a specified person. 7. Why is the volume of cheques declining? Answer: The volume is declining because more payments are being made electronically. 8. Why are electronic transfers not subject to the same regulations as paper transactions? Answer: Electronic transfers are paperless and do not meet the requirements for negotiable instruments. 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? Answer: The drawer is the person who writes or creates the cheque. The drawee is the bank that is instructed to pay out the money to the payee, who is the intended recipient of the money. 10. What is an electronic financial services agreement? Answer: The electronic financial services agreement is an expansion and adaptation of the basic account agreement, entered into between the customer and the bank, to include terms and conditions applicable to electronic banking transactions. 11. What are the key risks for a business in creating cheques for suppliers and accepting cheques from customers? Answer: The key risk in creating cheques arises from the fact that they are unconditional promises to pay the holders the designated amounts. The key risk in accepting cheques is that the accounts on which they are drawn may not contain sufficient funds to enable the drawee bank to carry out its instructions. 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? Answer: The Bills of Exchange Act contains the rules governing negotiable instruments. If a holder has acted in good faith and met the requirements of the Act, the holder is subject to a limited range of defences to refuse payment. An assignee has only the rights provided by the rules of contract law. 13. What are the banks’ obligations regarding suspected money laundering? Answer: Banks must verify the identity of customers and report large currency transfers and transactions that are deemed suspicious based on specified guidelines. 14. What is identity theft? Answer: Identity theft is the unauthorized and illegal acquisition of someone’s personal information in order to steal that person’s assets or commit fraud in the name of that person. 15. What are the benefits of electronic banking? Answer: Electronic banking can be more convenient for customers and significantly less expensive for the banks. It is more efficient because it uses less time and resources than paper-based banking. 16. What are the legal uncertainties in electronic banking? Answer: The legal uncertainties relate to risk and who is liable in the event of unauthorized or fraudulent transactions. Unlike transactions involving negotiable instruments, there is no clear set of established rules. 17. How can smartphones be used for banking? Answer: Smartphones can be loaded with cash or embedded credit cards. Some large cellphone manufacturers, such as Apple, have recently introduced proprietary pay-by-phone technologies. 18. What is “phishing”? Answer: “Phishing” is a common method for initiating identity theft in which con artists send email messages that appear to be from reputable companies, such as banks, directing recipients to websites that appear genuine, where victims are urged to disclose personal information to verify their accounts and ensure their continued access. The information is then used to steal funds from the accounts. This fraudulent activity has recently migrated to the telephone in the form of “voice phishing.” Questions for Critical Thinking, page 655 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? Answer: This question is meant to address the gap that often exists between the law’s view of the bank–customer relationship and how the customer sees it. Customers sometimes mistakenly assume that the banking agreements are routine aspects of their banking activities. In fact, the agreements are carefully drafted by the banks to manage their risks in the relationship. As with most standard form agreements, they are lengthy and complex and not meant to be understood by customers. As a result, customers find themselves relying on the courts’ interpretation of legislation and contract language, as in the SNS Industrial v Bank of Montreal case on textbook page 649. A refinement on the question regarding regulation could address a distinction between commercial and consumer banking relationships. The question invites an opinion that is likely to be influenced by people’s attitudes toward the banks and whether they have too much power. Recent federal government initiatives are putting pressure on banks to consider the equity of their customer contracts. See, for example, “Government of Canada releases code of conduct for credit and debit card industry” (16 April 2010) at http://www.fin.gc.ca/n10/10-029-eng.asp. 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? Answer: Merchants have few options. They are practically forced to accept the forms of payment preferred by their customers or risk losing sales to competitors. Increasing prices to include the credit card fees involves the same risk. They can attempt to educate their customers regarding the cost of credit card rewards. They can try to increase their bargaining power through cooperation with other merchants. One possible remedy for retailers is the current Competition Bureau proceeding against Visa and MasterCard for alleged price maintenance violations (see textbook page 628 in Chapter 24). 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? Answer: It is not yet clear that there are any aspects of electronic banking that need to be regulated. There are several potential risks, such as the inability to track transactions and the possibility of hacking or system crashes, but there is no public outcry for the government to act. One obvious approach to regulation would be to amend the Bills of Exchange Act to include electronic transactions, along with appropriate changes to deal with the paperless aspect. The major problem with creating regulations for electronic banking is keeping up with technology—formulating rules that could apply to a wide variety of transactions, including those not yet developed. Otherwise, the rules are continually lagging behind what is actually happening. In terms of enforcement, the problems include the tracking of electronic transactions and the challenges in producing and verifying evidence in electronic formats. A broader issue in this regard is the need to create and maintain consumer confidence in the integrity of the electronic banking system. The banks themselves are the prime movers in this direction as they are willing to accept considerable risk in electronic transactions. 4. In 2015 it was discovered that 1859 individuals linked to Canada, including a number of prominent billionaires, had secretly been keeping money in HSBC’s Swiss private bank, presumably in some cases to avoid the payment of Canadian income taxes. Largely through programs which provide leniency in exchange for voluntary disclosure, tax authorities have so far recovered $63 million in unpaid taxes, but no charges have been laid. What is the best way to deal with Canadians who use private banks to hide money for the purpose of evading taxes? [footnote deleted] Answer: Voluntary disclosure and other amnesty programs can be effective because they provide an incentive for violators to come forward on their own, however, they are controversial because they also allow those people to escape penalties for their illegal behaviour. Going forward, a more rigorous regulatory framework and greater transparency on the part of financial institutions will likely be required in order to discourage Canadians from hiding their assets offshore to avoid paying Canadian income taxes. 5. The use of cheques is decreasing while various forms of electronic payments are on the rise. Is there any reason to maintain the paper-based cheque system and the legal framework in which it operates? Answer: Many businesses and consumers still use paper cheques, in part because they have become accustomed to doing business in that manner, but also because they like to have a paper trail to evidence their transactions. If paper cheques are to be eliminated, their electronic replacements must satisfy both of these considerations. In addition, the legal framework governing electronic transactions will have to provide businesses and consumers alike with confidence that their payments will be properly routed and accurately recorded. 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? Answer: As in many such legal dilemmas, the challenge is to create a reasonable balance between the two. Neither goal justifies the exclusion of the other. Legislation on money laundering and privacy rights may be in conflict on some issues. The courts will be the ultimate arbiters as they interpret the various rules and decide individual cases. Situations for Discussion, page 655 1. Grenville agreed to facilitate transfers of funds from a Taiwanese businessman who he did not know. Grenville was to deposit cheques in his account and forward the funds to Asian accounts in exchange for a 5 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. Is the credit union entitled to recover the $10 000 from Grenville? What are the relevant rules? [footnote deleted] Answer: This situation is based on Meridian Credit Union Ltd v Grenville-Wood Estate, 2011 ONCA 512. In that case, the court identified the credit union as the collecting bank who acted as Grenville’s agent in collecting the $10 000 and crediting his account. As the collecting bank and Grenville’s agent, the credit union bore no liability for the cheque and had no duty to warn him of the risk in collecting on the cheque. However, the credit union did have a common law right of charge-back on Grenville’s accounts when the cheque was revealed to be invalid. This right was independent of the banking agreement and made the deposit to Grenville’s account subject to the charge-back right. Furthermore, Grenville was in the best position to identify problems with the cheque. The credit union was not in a position to give assurances or identify any future problems. The relevant rule was found in the common law, which has not been altered by the applicable legislation. It could have been altered in this situation by the banking agreement, but, of course, that would not be in the credit union’s interest. The result of the case presents a challenge for customers. Not only are they subject to banking agreements that may heavily favour the bank, but the common law may also further weaken their position. 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. 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? [footnote deleted] Answer: The question is whether Pamela’s assurance creates any legal obligation on the part of the bank. Does the assurance constitute a misrepresentation on which Ken relied to his detriment? This is the reverse of the classic misrepresentation case in which the customer is seeking to avoid a contract. In this situation, Ken wants a loan agreement to be enforced. Another possibility is promissory estoppel (see Chapter 6), but it is highly unlikely that such an assurance on its own would create an obligation. Ken should not have counted on the loan until it was actually approved and a written commitment received from the bank. Pamela should have cautioned Ken about proceeding to make commitments before the actual approval. In Royal Bank of Canada v Woloszyn (1998), 170 NSR (2d) 122 (SC), the court found the following: Now the relationship, as I have noted, between banker and customer, like that of the relationship between solicitor and client and doctor and patient, incorporates certain understandings and reliances by its very nature. The bank is entitled to rely on the representations by its customer and the customer is entitled to assume the bank will not act to its detriment, for example, by failing to warn the customer of an obvious risk or failing to disclose information within the knowledge of the bank and which would obviously be germane to the position of the customer in dealing with the bank, such as, again for example, at the very least, advising on public information of the insolvency of an account on which the customer is relying and of which the bank is aware. Nevertheless, and absent special circumstances of “reliance”, the relationship is one of a commercial nature, rather than of a fiduciary on whom special duties and obligations rest. In the present circumstances, Woloszyn was seeking to borrow money for purposes of his business venture in Alberta and the Bank, at least through Markell, was anxious to obtain that business. I am satisfied, in this case, there was no special reliance. Certainly the relationship between the Bank, as represented by Markell, and Woloszyn was “arm’s length” and there was nothing in the evidence to sustain the submission the relationship was anything other than a commercial one, albeit involving the special relationship of a banker/customer. I am satisfied that although optimistic, and expressing optimism the loan would be approved, Markell never advised Woloszyn the loan was approved. ... there may have been such a “special relationship” arising out of their roles as banker and borrower as to create a duty of care that could support an action for negligent misrepresentation. Although, as stated by counsel for the plaintiff, it is clear that Woloszyn relied on Markell as the representative of his banker in respect to his financing and borrowings, this did not extend to any reliance in carrying out his business operations.... There was no untrue, inaccurate or misleading representation by Markell to Woloszyn.... Woloszyn was never informed that apart from the small business loan and the small operating line, he had received bank approval for his requested financing. There was no reliance by him since in fact there was no representation and similarly, there was no acting to his detriment, since there was no representation on which he relied. 3. Rattray Publications wrote a cheque payable to LePage on its account at CIBC in payment for the first month’s rent on an office lease. Rattray 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. Which prevails—the stop payment or the certification? Does the validity of the cheque depend on the lease agreement between Rattray and LePage? Which of the four parties should bear the loss? [footnote deleted] Answer: The key issues for discussion are the conflict between the stop payment and the certification, and how the cheque relates to the lease. The first can be resolved by relying on the sequence of events. Since the drawer stopped payment before certification, it could be argued that the cheque was no longer valid and was incapable of being certified. Conversely, the bank made the decision to certify even though payment had been stopped. It could be argued that the bank should suffer the loss accordingly. The second issue relates to the basic nature of a negotiable instrument. It has a life completely separate from the contract that produced it. If the payee (LePage) negotiates it to a holder (such as a bank), the problems with the contract do not affect the holder’s right to collect. In A.E. LePage Real Estate Services Ltd v Rattray Publications (1994), 21 OR (3d) 164 (CA), the legal issue was defined as whether a drawee bank can withdraw certification of a cheque, granted erroneously after a stop payment order by the drawer, where that certification has been granted pursuant to a request by the payee. The court concluded that the distinction between a certification obtained at the request of the payee, and certification obtained at the request of the drawer, is artificial and unsupportable on any theory relating to negotiable instruments. The court also found that if the bank’s arguments were accepted, “there would be little commercial utility in a payee obtaining certification. It would not have a promise to pay from the bank, independent from the drawer’s promise to pay.” In addition, the irrevocability of the bank’s obligation facilitates the acceptability of instruments as cash substitutes, in accordance with commercial expectations. This case is another example of a situation in which the person primarily liable (the maker of the cheque) is not able to respond to the demand for payment. The drawer (Rattray) was insolvent with an outstanding judgment of $1.3 million against it arising from the lease. Therefore, LePage or the bank must bear the loss. 4. Stephen, Eric, and the Kaptor Group were all customers of the same bank. Stephen was involved in a business arrangement with the Kaptor Group, pursuant to which he made regular payments to Kaptor by way of cheques. The bank discovered that Eric and the Kaptor Group were circulating worthless cheques in a fraudulent scheme known as “cheque kiting.” As a result, the bank froze Kaptor’s accounts, and discovered the accounts were overdrawn in the amount of $7 million. However, the bank did not tell Stephen that it had frozen Kaptor’s accounts, nor of its suspicions that Kaptor was engaged in fraudulent behaviour, and continued to process cheques issued by Stephen and payable to Kaptor. In fact, the bank used the funds represented by those cheques to reduce the indebtedness owed by Kaptor to the bank. What obligations does the bank owe to Stephen in this situation? Does the bank owe a duty of confidentiality to Kaptor? If so, how far does that duty extend if it jeopardizes the interests of another customer of the bank? [footnote deleted] Answer: Normally, the bank does not owe a duty to its client to give advice or act in the client’s best interest. However, in this case, the bank profited from failing to disclose pertinent information to Stephen. The bank does owe a duty of confidentiality to its other client, Kaptor, but here the bank failed to disclose not only its concerns about the creditworthiness of Kaptor but also the bank’s own actions in dealing with its concerns. It is not clear how the bank must proceed when it finds itself in a conflict of interest of this type. The bank may argue that it is entitled to act in its own best interests and that Stephen must protect himself. However, Stephen could argue that the bank was the party which placed Stephen in need of protection. 5. Lauren and Peter installed devices on several ATM machines to obtain the debit and credit card information of people using the machines. The devices consisted of an overlay on the card reader which captured the data stored on the magnetic stripe of the card along with a pinhole video camera which secretly recorded PINs as they were entered. The information obtained was used to make counterfeit cards that were then used to make fraudulent purchases and cash withdrawals. In the end, Lauren and Peter committed hundreds of fraudulent transactions over many months using the illegally obtained information. What does this reveal about the perils of electronic banking? Are these risks likely to be prevented by banking practices, contracts, or the law? Who should be responsible for the losses? [footnote deleted] Answer: The scenario is meant to provide an example of the vulnerability of the banking system to those hackers who may be determined to penetrate it. To some extent, the system works on faith and confidence that transactions are processed as intended and without interference. Although examples of hacker triumphs abound in the media, we hope that this scenario wouldn’t happen, mainly because banks are very conscious of such risks and have safeguards in their systems. With regard to prevention, banking practices are the key—the constant battle between custodians of information and the hackers. Contracts will allocate the risk and determine who bears the losses, but they won’t prevent the losses. Banks are willing to absorb many losses to preserve confidence in their system. Hackers, especially those who commit theft, are committing offences under current law. It is not a matter of putting rules in place but the difficulty of detection and enforcement. For the existing law against hacking, see Criminal Code, RSC 1985, c C-34, s342.1. 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? Answer: Banks are willing to accommodate whatever arrangements partners, such as Rubin and Russell, want to make. It is up to the partners to determine the balance between convenience and control. As with the other aspects of a partnership, banking is a matter of trust. Partners must believe that their colleagues will not abuse their access to firm funds. This incident may destroy the partnership or be evidence that their mutual trust has already come to an end. The transfer to Russell’s personal account does not alter the fact that the money belongs to the firm and will form part of the firm assets on dissolution. 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. Who is responsible for the overdraft? On what will the answer depend? [footnote deleted] Answer: The bank’s claim against the corporation was based on the agreement in place, which made the corporation liable for overdrafts, cheques that were deposited and subsequently dishonoured, and all bank card charges. The agreement also required the corporation to monitor its transactions and have a system in place to reduce the occurrence of forgery or fraud. The claim against Bob was based on the confidentiality agreement regarding the bankcard and the PIN, which Bob clearly violated by providing both to Paul. Both defendants argued that the bank failed in its duty owed to them to notice uncharacteristic activity in their account and alert them about it; in addition, the bank should not have accepted the forged cheques for deposit. In Bank of Montreal v 545012 Ontario Ltd, 2009 CanLII 55127 (Ont Sup Ct J), Justice Quinn ruled as follows: [73] It is not sensible to expect the Bank to have done more than it did in the circumstances of this case. The Bank acted reasonably by having a report run off each business-day morning scrutinizing for overdrafts in accounts as of the close of business the day before. No evidence was adduced by the defendants from which I would be justified in concluding that the Bank acted unreasonably and breached its duty to the Corporation. [74] The use of the PIN during a transaction tells the Bank that the transaction has the blessing of the customer. All of the fraudulent activity committed by Patton involved the use of the PIN. The PIN is a security device that is reasonably effective if one abides by the Confidentiality Agreement. If there was a duty on the Bank to notify the Corporation of unusual activity in the Account, the telephone call of December 10th satisfied that duty. [75] The Bank met its common law duty and contractual obligation to the Corporation. However, Batcules and the Corporation breached their contractual responsibility to the Bank (there is no reciprocal common law duty owed to the Bank). [76] The onus that the defendants wish to place upon the Bank would require the continual, if not continuous, monitoring of transactions in customers’ accounts for any change in deposit, withdrawal and spending patterns. Given the volume of transactions in such accounts, I agree with the submission of Mr. Mahoney that such an onus would be unreasonable. Clause 6.8 of the Certificate and Agreement fairly puts the burden on the Corporation to monitor the activities in the Account. The sine qua non here was Batcules having provided his PIN to Patton. [77] Except in an egregious case (and this is not one), I do not see how I could define and apply the duty owed by a bank to its customer in the absence of evidence as to standard, or otherwise accepted, practices in the banking industry. Is a higher or different duty owed to non-corporate customers than to corporate customers? Are the former deemed to be less sophisticated than the latter? Is a telephone call from a bank as to one’s recent spending habits helpful, intrusive or de rigueur? How prevalent is on-line banking, which permits the customer to easily scrutinize account activity daily or even hourly? In the end, who is responsible for the state of an account, the customer or the bank? These are some of the questions that it would be imprudent to answer without the assistance of expert, banking-industry evidence. 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. 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? Answer: BMP sued BNS to recover the seized funds. At trial, the judge found that BNS had violated the service agreement and the law applicable to bank–customer agreements by charging back amounts credited to the accounts. The judge ordered BNS to repay the seized funds as punitive damages and also awarded damages for defamation and wrongful disclosure of information. The Court of Appeal reduced the award of damages to $101. The Supreme Court of Canada dismissed the appeal. RBC was entitled to recover payment made under a mistake of fact—the forged cheque. Nothing in the service agreement or the Bills of Exchange Act precluded the return of the funds. The case demonstrates the importance of the terms of the service agreement between the bank and the customer. The result appears to place the loss from a forged cheque on the customer when the customer has funds that the bank can access. Chapter 26 The Legal Aspects of Credit Instructor’s Manual–Answers by Philip King and Steven Enman V. CHAPTER STUDY Questions for Review, page 677 1. What are some examples of credit transactions? Answer: Some examples of credit transactions are purchases from suppliers, sales to customers, and borrowing to finance an expansion. 2. What are some of the methods that creditors use to reduce risk in credit transactions? Answer: Creditors use the following methods to reduce risk in credit transactions: • maintaining good credit-granting policies and procedures • changing the structure of the transaction so it is not a credit transaction • insisting on security (collateral) • obtaining guarantees from people connected to the business • setting restrictive covenants on credit and loan agreements 3. What are the rights of an unsecured creditor on default by the debtor? Answer: An unsecured creditor has the right to sue the debtor for the unpaid debt and enforce any judgment it obtains, but the unsecured creditor cannot seize specific property of the debtor on default by the debtor. 4. What are the key aspects of personal property security legislation? Answer: The key aspects of personal property security legislation are attachment, perfection, priorities, and remedies. 5. What are the disclosure requirements for a consumer loan? Answer: Lenders must disclose the total amount of the loan, the true cost of borrowing, the annual effective interest rate, and any other charges connected with the loan, such as registration fees or mandatory insurance. In addition, the lender may not make misleading statements about the loan in its advertising or when negotiating or approving the loan. 6. What is a criminal rate of interest? Answer: The Criminal Code prohibits lending at a rate of interest above 60 percent on an annual basis. 7. Why are payday loans regulated differently than other loans? Answer: The key problem is the actual cost of these loans, which can be as high as 1200 percent when the nominal interest rate is calculated on an annual basis and various fees, commissions, and penalties are included. There is also concern that vulnerable borrowers are being exploited by the lenders, in terms of both the cost of credit and their lack of awareness of the actual cost of the loans. The people who rely on payday loans tend to be the very people that can least afford them. 8. Why is after-acquired property included as collateral in a general security agreement? Answer: After-acquired property is included primarily to deal with inventory. This way, a bank or inventory financer can take security in the inventory that the debtor has in its possession, even though the specific inventory that the debtor has will fluctuate over time. 9. What is the role of a financing statement? Answer: A financing statement is the document that is registered pursuant to personal property security legislation as evidence of a security against the personal property of a debtor. 10. How are lenders’ remedies limited by law? Answer: Lenders are required to act in a commercially reasonable manner, which will often require obtaining appraisals and professional advice. In consumer transactions, lenders’ remedies are limited with regard to the seizure of assets after a certain portion of the debt has been repaid and the ability of the lender to sue for a deficiency. The lender must also give reasonable notice to the debtor before seizing collateral. 11. What is a purchase-money security interest? Answer: A purchase-money security interest (PMSI) is a security interest that enables the debtor to acquire assets (e.g., financing the purchase of specific equipment). A PMSI gives the secured party super priority over existing perfected security interests, provided it is registered within a specific period of time. 12. Why is a secured creditor in a better position than an unsecured creditor? Answer: A secured creditor can enforce a debt by looking directly to the property of the debtor. In addition, a secured creditor with a perfected security interest has priority over a wide number of other interests, including unsecured creditors, the interests of some buyers, the interests of a trustee in bankruptcy (if the debtor goes bankrupt), and the interests of judgment creditors who have not enforced their judgments. An unsecured creditor cannot look directly to the assets of the debtor and instead must use the litigation process to obtain a judgment against the debtor and then try to enforce that judgment. 13. What is the role of a receiver? Answer: A receiver or receiver-manager acts on behalf of the lender to seize secured assets and dispose of them to recover the balance on the loan. A receiver-manager may operate the business of the debtor for time to increase the amount of the proceeds received by the lender. 14. What is a deficiency? Answer: A deficiency is the amount still owing after collateral has been disposed of and the net proceeds have been applied to the debt. Normally, the debtor remains liable for any deficiency under contract law. 15. Who are the parties in a guarantee contract? Answer: The parties to a guarantee are the lender, as creditor, and the individual or corporation who signs the guarantee agreement, as guarantor. 16. What are the issues with standard form guarantee contracts? Answer: Banks often use standard form guarantee contracts that are very favourable to the lender and non-negotiable by the debtor. With small and medium-sized business borrowers, the terms of the guarantee contract may not really be voluntary, but rather a non-negotiable condition to borrowing funds. If all the banks adopt similar agreements, then there is really little choice for the borrower who must sign such an agreement, no matter which bank provides the loan. 17. How does a guarantee affect the limited liability of a shareholder? Answer: A shareholder who signs a personal guarantee loses limited liability protection to the extent of the promises in the guarantee. If the borrower defaults on the loan, the creditor may pursue the guarantor directly. Questions for Critical Thinking, page 677 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? Answer: This question is similar to Question for Critical Thinking 4 in Chapter 19 dealing with mortgages on real property. It invites discussion of the whole system of secured credit. Registration is intended to protect the security of creditors and give notice to others that the secured assets are not available to satisfy claims from other creditors. That raises the question as to whether unsecured creditors have any effective means of protecting themselves after their initial decision to extend credit. Shareholders are already protected through their limited liability, unless they sign personal guarantees. The system provides a large and multifaceted illustration of the merits of risk management. To remove or limit the protection for secured creditors would change the nature of the means of financing business. The availability of financing (in the absence of security) might be seriously limited. 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? Answer: The answer depends on whether there are serious problems with commercial credit that need to be addressed. In connection with Question for Critical Thinking 1 above, unsecured creditors might argue that they need protection from secured creditors. Debtors might argue that they need protection from virtually total control of their business by the bank in the event of default. Normally, it is assumed that businesspeople require less protection than consumers, but it is this the case with small businesses and sole proprietorships? 3. What factors affect the ability of a borrower to finance a 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? Answer: An economic downturn generally dampens business prospects and discourages business expansion and the corresponding need for financing. A downturn may place businesses in jeopardy such that they require financing to help them until their situation and the economy recover. In either scenario, a credit crunch is serious for business. Prospective borrowers are faced with a scarcity of credit and a corresponding tightening of the application and approval process. With new credit applications and existing credit agreements, lenders will be more demanding in terms of repayment and security. At the same time, borrowers will have fewer financing options. 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? Answer: The relevant factors are listed on textbook page 655: the amount of the loan, the degree of risk, the length of the relationship, the character and reputation of the debtor, and the likelihood that a period of notice would enable the debtor to acquire alternative financing. The creditor looking to seize collateral should act in a commercially reasonable manner when giving notice to a debtor. However, when a debtor is in default, the secured creditor is likely to be concerned about losing the value of their security as a result of any delay. The prudent secured creditor will seek legal advice as soon as the creditor realizes that the loan is in danger of default. The legal advisor will help the creditor decide on a notice period that is reasonable in the circumstances. Inserting a clause in the loan or credit agreement that allows immediate action in the event of default is of limited use, because the courts insist on reasonable notice regardless. 5. The current legislative framework for payday loans varies from province to province, but essentially allows lenders to loan funds to consumers at interest rates that would otherwise be considered criminal. Do existing payday loan laws adequately balance the interests between lenders, borrowers, and the public? Should payday loans be allowed at all? Answer: The text discusses the controversial payday loans industry, and the various attempts to regulate the industry, on pages 674–675. Many people feel that the current regulations still allow lenders to take advantage of vulnerable borrowers who have nowhere else to turn. On the other hand, some view payday loans as just another contract which people can choose to enter into if they wish to do so. Students can be asked to make the case for and against payday loans, and can be asked how far they feel the regulations on payday loans ought to go. It may be pointed out to students that virtually no business would ever agree to the credit terms which are offered by payday loans and that such terms are unheard of in the world of corporate finance. 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? Answer: The shareholders need the $400 000, so they cannot avoid the unpleasant and risky aspects of debt or equity financing. However, they should understand the credit process, its requirements, and its risks. They should also appreciate the extensive documentation required for a loan application, the all-encompassing nature of the security that the bank is likely to require, the restrictions that may be placed on their ability to deal freely with the assets of the business, and the enormous risk to the business and their personal assets should the business fail to prosper as they expect. If possible, Bill and Martha should restrict the scope of the assets given as security for repayment of the loan. They should definitely, if possible, limit the scope of their personal guarantees. They should be confident that the business can meet the repayment terms before agreeing to these obligations. In their decision to use equity financing and sell shares, the challenge is to find prospective buyers willing to pay the share price that the existing shareholders consider is justified. The major drawback to the equity option is dilution of ownership and loss of control by the original shareholders. Situations for Discussion, page 678 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? Answer: The Bank has a perfected security interest registered on 10 January 2011. London Dodge has a perfected security interest registered on 4 April 2011. Fisher & Co. is a purchaser of the truck, but not a purchase in the ordinary course of business (since Douglas Pools is not in the business of selling trucks). Normally, priority would go to the party who registered first (i.e., the Bank). However, London Dodge has a purchase-money security interest (PMSI) perfected by registration. Accordingly, London Dodge has first priority to the truck. The Bank 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. 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? [footnote deleted] Answer: There is little that the Weiss brothers can do now without alternative financing to pay Aetna and regain control of the business. They can claim that Aetna failed to give them reasonable notice (three hours is less than reasonable by any standard) and, if successful, they will recover damages, but that will not give them control of the business in time to save it. They could have kept in closer contact with Aetna and would perhaps have appreciated the extent of Aetna’s concern and been in a better position to anticipate the appointment of the receiver. There is no way of knowing whether alternative financing could have been obtained which is, of course, the purpose of the reasonable notice requirement. The problem in this situation is a business one rather than a legal difficulty. The Weiss brothers bought a business that had already failed, in which they had no experience, for which they needed extensive financing, in an industry with which they were unfamiliar. They underestimated the risk that TD recognized and Aetna was prepared to take on. In Kavcar Investments v Aetna Financial Services (1989), 62 DLR (4th) 277 (Ont CA), the court focused on the debtors’ ability to raise funds: However, any very short notice period—certainly one of less than a day—is prima facie unreasonable, and in such a case it would be up to the creditor to show why, in the particular circumstances, the period allowed was reasonable. It is important for creditors to keep in mind that while the creditor of a dishonest debtor may well have evidence of that dishonesty available to him, to obtain evidence of a debtor’s inability to raise funds is a much more difficult matter. Even a technically insolvent debtor may have funds available through related individuals or corporations. If a creditor demands payment and gives his debtor no time or a very short time to pay, relying on the debtor’s inability to raise funds, he takes the risk he will be unable later to prove that inability. The court endorsed the findings of the trial judge that a reasonable time to pay was not given and that he was not persuaded that the debtor would have been unable to raise funds had a reasonable time been given. 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 Wilders 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.” 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? [footnote deleted] Answer: The Wilders through their company may have a valid complaint about the bank’s decision to appoint a receiver without notice. The outcome will depend largely on the interpretation of “deal with the customer as the bank may see fit.” If interpreted literally, the Wilders will be obligated. If examined in the context of the arrangement and the assurances given to the Wilders, a court may be more sympathetic. In Bank of Montreal v Wilder (1986), 32 DLR (4th) 9 (SCC), Justice Wilson concluded, There was in this case an umbrella loan agreement, general in nature, under which the Bank agreed to finance the Company’s business. This general agreement was the one guaranteed by the Wilders’ earlier guarantees. The initial loan agreement became very specific, however, when all the interested parties entered into the June agreement. The Bank under the umbrella agreement could have decided to make the business decision to stop financing the Company at any time prior to the June agreement. After that agreement this option was closed to it. It agreed with the Company and with the guarantors that it would continue to finance the Company at least until it had completed the Alberta road projects. It failed to do so despite the fact that the Wilders kept their part of the bargain. The Bank’s breach not only increased the guarantors’ risk in a way which was “not plainly unsubstantial” and impaired their security; it put the principal debtor out of business and into bankruptcy. Such conduct on the part of the Bank cannot, in my opinion, be viewed as within the purview of the clause in the guarantee contracts permitting the Bank to deal with the Company and the guarantors as it “may see fit”. I agree with Lambert J.A. that such a clause must be construed as extending to lawful dealings only. The third question invites the Wilders to consider risk management in terms of the financing of their failing business. They must realize that however accommodating and helpful the bank may be while the business is experiencing financial difficulties, it has the right to call the loans whenever it chooses (subject to reasonable notice). In this situation, the Wilders faced losing their personal assets as well, so the risk of failure was disastrous for both the Wilders and their business. Perhaps the Wilders should have stepped back, looked into the future, and at some point made the decision to “pull the plug” and wind-up the business. If this had been done in a timely fashion, the impact on their personal affairs could have been lessened. 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 his bank, which took a security interest in his present inventory and any after-acquired inventory. One year later, an 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? Answer: This situation is another example of the broad rights that the bank has in credit arrangements. The bank is entitled to seize whatever the agreement describes as the collateral, which, in this case, includes all inventory and after-acquired inventory. Therefore, the bank may claim rights to all Kyle’s inventory. Of course, the bank can recover only what it is owed and must return any surplus to the borrower. The bank must also deal with the collateral in a commercially reasonable manner. The problem for Kyle is that the bank will be much more focused on recovering its money than on generating a surplus for him. It will be a challenge for him to prove that the bank has acted improperly. Kyle could have attempted to negotiate better terms, perhaps by pledging assets other than inventory as security or he could have tried to limit the quantity of inventory that the bank could seize. However, from the bank’s point of view, inventory is risky security because of possible difficulties in disposing of it at market price. The bank also needs to be confident that the inventory on hand at any given time will be enough to cover the loan outstanding. 5. Bruce was employed as a general labourer. With his pay of $1250 every two weeks, Bruce was barely making ends meet. In February of 2014, after making his car payment and paying his utility bills, Bruce did not have enough money left to pay his rent of $750. He had been late paying the rent three times in the previous six months, and his landlord had told him that if he was late one more time his apartment lease would be terminated. Desperate, Bruce went downtown to a payday loan store which was part of a national chain. The loan company did not conduct a credit check against Bruce—all he had to show was that he had a bank account and a job. Bruce borrowed $750 for two weeks and promised to repay the loan from his next paycheque, along with interest of 21% and an administration fee of $39. What is the cost of borrowing in this scenario? What is the annual effective interest rate? Is this a sensible strategy for Bruce given his short-term cash problems? Answer: The actual cost of borrowing for Bruce is $196.50, or 26.2% of the amount borrowed. Since the money was borrowed for only two weeks, the annual effective interest rate of the loan is 681%! This would be a criminal rate of interest for any loan other than a payday loan. What are the chances that Bruce is going to be able to repay $946.50 in two weeks from his paycheque of $1,250? That would leave him very little money for all of his other expenses, including food, clothing, transportation, and entertainment. The likely result is that Bruce will default on the loan, meaning that the interest will continue to run and, in a very short period of time, Bruce will have a crushing debt burden as a result of the loan. Payday loans are not a good strategy for someone like Bruce, who is using the loan to fund his general living expenses. 6. 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, 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. Is this agreement enforceable? Why or why not? Should a commercial arrangement like this be treated differently from a payday loan? [footnote deleted] Answer: It is clear that this agreement violates the Criminal Code, s 347, in that the total cost of lending exceeded the limit of 60 percent. Therefore, the issue before the court was the effect on the credit agreement in terms of enforceability. The court considered two approaches in resolving the issue. One approach is “notional severance,” whereby judges rewrite offending provisions in a contract so as to make them conform to the law. In this case, the court would enforce a total lending cost of interest and fees of 60 percent. In the other approach, judges strike out offending provisions altogether (the “blue pencil” approach). In this case, the lender could collect no interest since the interest clause was illegal. The lender would be entitled only to the various fees totalling 30.8 percent. Choice of interpretative approach is based on what would most appropriately cure the illegality while remaining as close as possible to the original agreement. Application of the doctrine of notional severance required consideration of whether the purpose of s 347 would be subverted by severance, whether the parties entered into the agreement for an illegal purpose, the relative bargaining positions of the parties, and whether the debtor would obtain an unjustified windfall. In this instance, which was not a case of loan-sharking but concerned a credit facility for a sophisticated debtor in financial difficulties that had the benefit of independent legal advice, and where the violation was unintentional, there was no reason to prefer the blue pencil approach. There was no reason to prefer 30.8 percent over 60 percent being the result achieved by the notional severance principle, and the creditor should be repaid the principal together with the highest legal rate of interest in accordance with the contract. The courts tend to treat commercial agreements differently from payday loan arrangements, in part because of the greater bargaining power of the parties. In this scenario, the court wanted to cure the illegality of the contract while not voiding the whole contract. In addition, it wanted to stay as close as possible to the original agreement. Neither party intended to act illegally. If an agreement, though illegal, is not extremely objectionable, a flexible application of notional severance is appropriate. In this case, the agreement was made for ordinary commercial purposes between experienced parties independently advised. 7. 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? Answer: The owners’ approach is reasonable. The equity infusion they will put into the company, although at risk of being lost if the business fails, is limited to the amount invested. There are no personal guarantees, so their personal assets are not at risk. They also have the option in the future of raising additional funds from other outside investors. The planned loan of $400 000 warrants a different risk assessment. To borrow such a large amount from a financial institution will likely require extensive security. The bank will probably demand personal guarantees from each of the three owners. In addition, the bank will typically want a general security agreement covering all the personal property assets of the business, including after-acquired property. If previous debts are already secured and registered, the second lender of $400 000 will want at least second priority. The issue is whether there is enough security (collateral) for the second creditor to be willing to lend $400 000. This will depend on the estimated value of inventory, accounts receivable, and other assets of the borrower. The biggest risk that the owners face is the failure of the business and the enforcement of the personal guarantees. In that case, they would probably lose their entire investment in the business, including their original investment and their recent equity investment. Their risk would be less if more financing were obtained from other investors. However, this would entail dilution of the existing owners’ shares and potentially the loss of some control over the management of the company. In the printing business, technology is crucial. The three owners need extensive strategic planning in terms of the long-term future of publishing and how their business will fare in that environment. Regarding the financing of their business, they should strive for flexibility and perhaps consider an exit strategy. This might be easier with equity financing rather than debt. Solution Manual for Canadian Business and the Law Philip King, Dorothy Duplessis, Shannon O'byrne 9780176570323, 9780176509651, 9780176501624, 9780176795085
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