TSL TRENDING STORY
Staying Covered in Canada
By Lauren Saglamer
When an asset-based lender extends itself across its own borders, it’s imperative that the lender possess a comprehensive understanding of the potential risks involved with adding international exposures to its portfolio.
Asset-based lenders, such as FGI, that are lending against accounts receivable, inventory, or equipment, are subject to a wide range of regulations associated with different industries, legal structures and regional jurisdictions. Therefore, it’s crucial that lenders arm themselves with knowledge of these regulations to mitigate the risks involved with lending in unknown territories. But how can a lender be certain that it took all of the right precautions to protect itself should a default or unfavorable situation arise in a place governed by unfamiliar laws and business practices? The answer is that a lender cannot ever be sure. However, specialized lenders have developed an arsenal of tools to protect themselves against many of the risks associated with lending to Canadian companies and hedging against priority payables. In this article, we will explore a few that may help lenders become better equipped to confidently add Canada to their international portfolios.
A perhaps obvious, but critical, first step in assessing risk and ultimately crafting an appropriate lending structure is quite simply for a lender to get to know its Canadian borrower. Nothing is more worrisome than the unknown. If a lender has the resources, it might choose to perform all of its due diligence in-house, since it is the most cost-effective option. However, lenders should also consider engaging a team of third-parties to bridge any knowledge gaps. These might be asset appraisal and law firms, auditing companies, or industry experts who are trained and likely more well-versed in Canadian laws, business compliance, and commercial lending protection. Another best practice is to ask the third-party team to visit the borrower on-site for a few days to observe the borrower’s daily practices and procedures, and present a detailed report of their findings and recommendations. This simple preventative measure can uncover and address a multitude of lending hazards before even one dollar is advanced.
While engaging Canadian counsel and consultants could prove to be the more costly option for your borrower, their added value might very well outweigh the cost. Legal experts can properly advise a lender on how to structure an agreement at the very beginning of a transaction, maximizing its protection as a secured creditor. For example, in Canada a lender has the option to purchase or have an assignment of the accounts receivable, which creates a bankruptcy-removed vehicle. If there’s an inventory or equipment component, a lender should use a separate and distinct loan agreement. In certain situations it could be useful for a bank to take out a Bank Act security, which has an effect similar to a transfer of title at the time of the grant of security, although there are some limits and restrictions to this. Some of the restrictions include that it can only be used by banks, only against borrowers (not guarantors) and cannot be used in syndicated structures. FGI has found it almost always beneficial to consult with and rely on these professionals to ensure that a transaction in Canada be initiated with a solid foundation for its legal lending structure.
When evaluating a Candian borrower, the lender should also hire a Canadian audit firm to conduct a thorough in-person review of the borrower’s books and records, cash management, and tax compliance. Though they’ll report all of the standard risks applicable to any lender in any country, they can also help with matters that are specific to Canada, such as tax laws. Tax laws are complex and vary greatly from province to province, therefore a tax expert could prove useful in advising in this area. For example, they can provide guidance when it comes to lending against Canada’s provincial taxes, which are tacked onto the invoice amount, or advise if they should be withheld in gross from the borrower’s availability. They can also be of great help in bringing to light things that aren’t even on your radar. For example, a non-Canadian lender might not be aware that the CRA has a deemed trust over other taxes that are collected but not remitted by a business. The Excise Tax Act creates a deemed trust on all collected but unremitted HST/GST (Harmonized Sales Tax/Goods and Services Tax), which attaches to and is impressed upon all real and personal property of the debtor. With this knowledge and advisement, a lender may opt to reserve these amounts.
Asset appraisal firms should be appointed to evaluate, count and assign liquidation values to the borrower’s inventory and equipment to avoid over-advancing against these items. When the lender is considering lending against inventory and equipment, it is not only important to be aware of the potential recovery values and channels, but it is also important to consider Canada’s personal and real property laws. For example, in an orderly liquidation scenario, how can a lender ensure it will be able to access the inventory against which it likely has a first lien? Landlords have a “right of distress,” or the right to seize and sell assets in leased premises for non-payment of rent. Therefore, it is in the lender’s best interest to obtain a “Landlord Lien Waiver,” in which a landlord agrees to waive such rights to the personal property owned by its tenant that is located on its premises. The terms and conditions of this waiver vary from province-to-province and a lender should ensure that their requirements are met, depending on the location of its borrower’s inventory and equipment. If a particular province’s waiver doesn’t quite meet the lender’s standards for a full relinquishment of a landlord’s rights, the lender might choose to reserve three months’ rent from the borrower’s availability so that the lender can pay the rent and ensure access to the premises if needed. Furthermore, if the lender anticipates ever being able to recover on its borrower’s real property, it should certify that the borrower is up to date on its fire and environmental code requirements, so as not to potentially dilute its value by incurring large fines at the time of sale. The borrower’s insurance policies should also be monitored to ensure premiums are up-to-date and coverage is sufficient. This is especially important in asset-based lending when inventory and fixed assets are involved.
Perhaps the area a non-Canadian lender is most vulnerable is related to priority payables. A priority payable is any claim that will, or could, rank ahead of your security on the assets of your borrower. Many priority payables can be avoided if the lender purchases the asset instead of lending against it. This is most commonly done with receivables. This method will also safeguard the lender from the Canada Revenue Agency’s (CRA’s) priorities. However, it is important to make sure you have a true sale, and the economics of achieving a true sale can sometimes be limiting and tend to be related to wages, certain taxes, employee deductions, pensions, and other government priority payments. The laws surrounding these priority payables can be quite dynamic and for that reason FGI has developed its own system for monitoring and updating the reserves related to priority payables when necessary. At the same time, due to FGI’s years of experience lending in Canada, it has developed a list of payables that have become standard exclusions in its borrowing calculations.
The majority of priority payables are all related to employees and wages. Under the Wage Earner Protection Program Act, or WEPPA, employees can claim up to 3,250 Canadian dollars from the federal government for any unpaid wages, vacation pay, severance pay and termination pay that is owed if an employer becomes bankrupt, or is subject to a receivership under the Bankruptcy and Insolvency Act (BIA). The federal government also gets a super-priority claim of up to 2,000 Canadian dollars over the current assets of the employer. Therefore, when planning for priority payables, the appropriate amount to reserve on a borrowing base is 2,000 Canadian dollars per employee. The CRA is entitled to a super-priority interest over employee payroll source deductions that were deducted, but not remitted by an employer. This includes amounts deducted from wages for income tax, employment insurance, and the Canada Pension Plan. Deficiencies in remittances, including employee and employer pension plan contributions, can be classified as a super-priority. Periodic audits of the borrower’s books and records is often the most efficient way to obtain these figures so that they can be accurately reserved.
Another priorities payables group relates to statutory liens. A number of statutes, typically provincial ones, can impose other liens or super priority on the assets of a debtor. For example, most provinces, including Ontario, have a Worker’s Compensation Act that establishes a priority lien in any amount due to the Workers’ Compensation Board (WBC). Customs brokers, warehouses, and repairmen, can have claims by virtue of legislation such as the Ontario Repair and Storage Lien Act. These are not strictly possessory liens, but could extend to non-possessory situations, as the Ontario Act does.
Lastly, the BIA allows creditors in Canada to petition a company into bankruptcy if specific acts of delinquency are demonstrated over a certain period of time. It is mandatory, therefore, for a lender to frequently analyze its borrower’s accounts payable. A lender might establish its own lines of communication with any “stretched” creditors to gauge their commitment to continuing to do business with the borrower and/or uncover any hostility or unfavorable sentiments against the debtor. Severely overdue accounts might prompt the lender to enforce written payment plans between its borrower and its creditors.
Lending in Canada is complex, but certainly not impossible. It takes more time, money and effort than a domestic transaction. However, for specialized asset-based lenders, it opens the door to start lending on a global scale. These carefully curated safeguards discussed in this article should always be kept in mind when lending abroad. And, remember, lenders who are just starting to lend in Canada should sourround themselves with experts who can guide them through the process and help structure facilities that hedge against the risks specific to the region.
Lauren Saglamer is Portfolio Manager at FGI.