Module 3: Purchase of Commercial Real Estate PDF

Module 3: Purchase of Commercial Real 3-2 3.1 LETTERS OF INTENT VS. PURCHASE AND SALE AGREEMENTS We have seen how negotiations may proceed from discussions between the parties with or without lawyers to a letter of intent to a...

Module 3: Purchase of Commercial Real 3-2 3.1 LETTERS OF INTENT VS. PURCHASE AND SALE AGREEMENTS We have seen how negotiations may proceed from discussions between the parties with or without lawyers to a letter of intent to a final form of a purchase and sale agreement. Along that process, the clients and certainly their lawyers will engage in a process of investigation of the circumstances of the clients and the property involved called “due diligence.” Those investigations may reveal issues that may be resolved by representations, warranties or certificates to give assurances to the parties that the transaction may advance without unacceptable risk. The letter of intent may have been signed before some or all of those risks were identified or before the representations and warranties mollified the parties’ apprehensions about the deal. As a result, the formal purchase and sale agreement may be different and is often longer and more detailed than the preceding letter of intent. The representations and warranties may result in adjustments in the price paid for asset purchased. Lawyers have developed a system of credits and debits to account for these adjustments in the transaction process called a statement of adjustments. The Statement of Adjustments reflects credits and debits between the parties to the transaction. We will see how that process operates by doing an assignment to complete Statements of Adjustments. 3.2 ASSUMED AND EXCLUDED LIABILITIES The Statement of Adjustments can also adjust for any assumed liabilities and any excluded liabilities. Often property carries liabilities such as mortgages, security agreements, maintenance agreements, obligations to tenants or to employees or other claimants and other matters that are “adjusted” or accounted for at the closing date. Proper due diligence will reveal these liabilities and the final agreement will reflect how these liabilities will be included (assumed) or excluded in the transaction. 3.3 INCLUDED AND EXCLUDED ASSETS IN THE TRANSACTION Many purchasers wish to “cherry pick” only certain assets instead of buying all of the assets of a business. In this case, they list “included” assets but also list “excluded” assets. The excluded assets are often undesirable because they may have unacceptable costs or liabilities associated with them such as security agreements or are otherwise unneeded by the purchaser. For example, accounts receivable (a right to collect money now and into the future) may or may not be included in the “deal.” To collect money often takes time and is therefore costly Module 3: Purchase of Commercial Real 3-3 and the buyer may not be interested. Perhaps the receivables will be hard to collect and are therefore not worth much to the buyer. Or, by way of another example, some assets may require consent from a third party such as leases of property. The lessor (third party owner of the leased property) may not consent to the buyer taking over (or “assuming”) the lease or the buyer may not be interested in the leased property because it is not needed or is too expensive or is otherwise unneeded. So there may be an “excluded” property list. The property in the “included list” may need adjustments. For example, if leased property is included and that property has a periodic lease payment, then the payments have to be adjusted relative to the closing date. We will see how that works when calculating the Statement of Adjustments. 3.4 PAYMENT OF PURCHASE PRICE The Statement of Adjustments calculates the amount of net purchase price. That is to say, the price is net after calculation of all credits and debits between the buyer and the seller. That payment is also calculated based on a number of payment methods beyond simply payment of cash (meaning an immediate payment in the form of a cheque, usually issued from a lawyer’s trust account). The payment may be financed by a promise to pay in the future (often called vendor financing) usually secured by a mortgage (called vendor take-back security or mortgage), or it may be financed by future business revenues (“earn-outs”) or by cash held in escrow until satisfaction of conditions of the transaction or simply by cash payments at closing or in the future or by some combination of all of these methods. 3.5 FINAL DETERMINATION OF PURCHASE PRICE The purchase of a business or the purchase of business assets often involves valuation issues determined in part by an examination of the financial statements of the business. For example, in the purchase of a business, the price may be agreed as the net worth of the business as disclosed by the financial statements. That may involve an analysis of the effect of taxes, liabilities, accounts receivable, liabilities owed to employees and trade creditors and others. The values are dynamic meaning they fluctuate from day to day and therefore the deal may be subject to an adjustment based on a valuation date, which may or may not be the closing date for the transaction. Again a Statement of Adjustments can take this into account. If it takes time to calculate the valuation amount, there may be an adjustment even after the closing date. Lawyers use a variety of ways to make that post-closing Module 3: Purchase of Commercial Real 3-4 adjustment effective. One way is the parties’ promises to re-adjust after closing. Or the parties may agree to an earn-out where the price is adjusted by future earnings from the business or from the assets that have been purchased. A “reverse earn-out” means that the purchase price is decreased if, for example, the assets did not yield as much as contemplated at the time of the closing. Clearly a buyer prefers an earn-out to a reverse earn-out, since the reverse earn-out creates a credit to refund part of the purchase price after closing. They would prefer to pay part of the purchase price after closing with profits from purchased business assets. To give a concrete example to the above principles, we begin with a relatively straightforward business transaction such as the purchase of commercial real estate. This is not the most complicated business transaction since it focuses on only one type of commercial asset. Many business transactions have a multitude of assets such as real property, personal property (chattels), leases of real or personal property or both; intangible assets such as accounts receivable or intellectual property. 3.6 SIGNIFICANT ISSUES IN THE PURCHASE OF COMMERCIAL REAL PROPERTY The purchase of commercial real property is fairly similar to the purchase of residential property. Much of the legal terminology, documents and registration processes is similar to residential real estate purchases like the Statement of Adjustments, the Transfer of Land and the registration process at the Land Titles Office. Financing is common to both commercial and residential real estate transactions. However, the size of the business transaction typically means commercial financiers have more documentation and other requirements than lenders for residential transactions. Later in the course, we will review the financing of a commercial mortgage. Commercial lenders take many forms. The most common are the chartered banks such as CIBC but other sources of financing include loans from vendors, family and friends. Moreover, the context of the facts will determine what types of searches are needed and what types of documents are prepared. A sample agreement for the purchase/sale of commercial real property is Figure 2.1. The purchasers are listed as Michael and Julie Green. Note that Michael and Julie Green are referred to as the “buyer” or the “buyers.” More commonly, the Module 3: Purchase of Commercial Real 3-5 buyer in a business transaction is referred to as the “purchaser.” The words mean the same thing. Similarly, a seller is often referred to as a “vendor.” 3.7 REVIEWING THE AGREEMENT Begin with a review of the important terms and conditions of the agreement found at figure 2.1. You should note immediately a very important condition, “subject to the lawyer’s approval” in paragraph 8.1(d). This term represents a condition of the agreement. A condition is a significant term of the contract and is often called a “pre-condition” meaning that the agreement is not effective unless the condition is met. In Figure 2.1, the buyers have the right to withdraw from the agreement if their lawyer does not approve the terms of the agreement. Therefore, this condition date is a deadline that has to be addressed before the deal proceeds (paragraph 8.1(b)). 3.8 THE TYPES OF BUSINESS ORGANIZATIONS Here is a quick review of the main considerations for each type of business organization: a) Sole Proprietorship is defined as a business carried on by a single Individual which is not formally organized and for which the individual and the business are indistinguishable in law. In Alberta, a sole proprietor may register a “business name” (also called a Trade Name) at CORES (the Alberta computerized Corporate Registry). Such registrations provide proof of registration of the name but do not result in an exclusive protection of that name by the mere fact of registration. A Trade Name is not a Trademark, which is a form of intellectual property that is registered federally. A Trademark gives significantly greater legal protection to the distinctive presentation of a corporation’s name and brand. However, the registration of a Trademark is expensive and usually beyond the means of a small proprietorship. A search at CORES for a trade name or business name registration may: Confirm identity of business operator (proprietor) Confirm ownership of business asset of the trade name Confirm that there is a proprietor and therefore the applicability of a guarantee made by a third party guarantor Module 3: Purchase of Commercial Real 3-6 b) Partnerships are organizations in which two or more persons carry on a business together with a view to profit. Each partner has certain liabilities that arise out of the partnership. Depending on the type of business undertaken by the partnership, there may or may not be a registration of the partnership at CORES. Considerations include: Confirm legal status of partnership registration and identity of the registered partners. Confirm contractual capacity. If a person is not a registered partner, he or she may not have the contractual capacity to enter into a business transaction on behalf of the partnership. More investigations may be needed such as review of the written partnership agreement. c) A corporation (an “incorporated” business) is a legal entity, created under the authority of a statute, which permits one or more persons as incorporator(s) to submit documents to the government so as to create an independent organization, which then pursues business objectives, and is empowered with certain legal rights such as the right to sue, own property, hire employees or to lend or to borrow money. 3.9 DESCRIPTION OF THE PROPERTY OF THE TRANSACTION The purchase and sale of commercial property usually includes commercial personal property, which lawyers call chattels. Like residential real estate transactions, it is important to know what is included in the transaction. Whether it is a business transaction involving industrial land, farmland or buildings on land in the city, the agreement between the parties should specify what is included in the deal. In that regard, most commercial real estate brokers will list the land by legal description and the chattels usually in appendices in the agreement but it is up to the lawyer and the assistant to understand fully what the deal is about. It is important to distinguish a chattel from a fixture: chattels are items of personal property, which are neither land nor permanently attached to land (the building). For this reason, chattels are sometimes called “movables” because they are property that can be moved around. By contrast, fixtures are items of personal property that have been permanently attached to a building becoming part of the building and, therefore, part of the land on which it is situated. If someone such as a tenant attaches chattels permanently to land, the problem arises when the tenant moves out. Can the tenant remove the fixture? Or when the building is sold—is the chattel a fixture and therefore included in the sale of land or if an unfixed chattel, can the vendor take the personal property? The intention test is used to Module 3: Purchase of Commercial Real 3-7 help us decide if a particular item is permanently attached and therefore a fixture. Ask yourself the following questions: What was the intention when the personal property was brought onto the site? Was it to attach it permanently or to place it there with the intention that it could be relocated? Examples of chattels that are not affixed to the lands/buildings and can be easily removed are snow-blowing equipment, lawnmowers or unattached shelving. Examples of fixtures are shelving attached to the walls, a built-in refrigerator or built-in freezer equipment. When you review an agreement, carefully note the descriptions of each piece of property and think about whether it is a fixture or a chattel. In particular, note any items with serial numbers on personal property as it has special implications related to the Personal Property Registry (PPR) for reasons we will discuss later. Update your search and document checklists to reflect your findings. In other words, you must try to understand the context of the transaction. So, for example, if the transaction involves no chattels but only land then you may not need to order PPR searches but you do need to order Land Title searches. Conversely, if the transaction involves only chattels but no land then no LTO searches are needed. 3.10 THE PRICE It is common practice to apportion the purchase price between the real property and the chattels. For example, the purchase price for a building and the chattels therein is $500,000.00 and may be apportioned as follows: $475,000 for the land and building $25,000 for the chattels The consideration stated in the real property transfer document may be $475,000 or $500,000. If stated as $500,000, the buyer is entitled to declare the value of the land and building as $475,000 and pay the registration fees to the Land Titles Office based on the declared value of the land and building. If the consideration is stated as $475,000, the registration fees will be based on the stated consideration, which will also be the declared value, by the buyer. Furthermore, if the chattels are stated as $25,000.00 then the buyer can claim depreciation for tax purposes for the chattels starting at that amount. Generally speaking, land is treated by the tax system differently than chattels so there may be an advantage to the purchaser in apportioning the overall purchase price between chattels and land, as was done in this case. The better practice is to insert the amount apportioned to the land and building listed in the agreement as the consideration in the real property transfer document. This reflects the value paid for the land and building and avoids any likelihood of the Land Titles Office challenging the declared value. The amount Module 3: Purchase of Commercial Real 3-9 3.11 SEARCHES Identifying risk in business transactions is a key aspect of a lawyer’s work. The lawyer wants to learn everything about the transaction, the parties, and property. It is common to start with the precedent search checklist. Compare the checklist (Figure 1.6) against the agreement to ensure that it is comprehensive. It is time to start applying what you know to this transaction. There are two main categories of searches: the parties and the property. Begin with the business organizations of the various parties involved; do they pose a particular risk to your client or to the transaction? For instance, where the seller is a sole proprietor, is that person properly identified? Does that person have a trade name registration at Corporate Registry (CORES)? Is the name on the agreement also on the land title that is the subject matter of the transaction or has the proprietor used a trade name? Often the property is owned by the family (spouses) rather than the proprietor. Where one or both parties to the transaction are corporate entities, ensure that the subject property is owned by the corporate seller. Confirm the correct legal name of the corporation by conducting a CORES search. Searches related to property fall into two categories, real and personal property. Do we know enough about the property to conduct the appropriate searches? What does the buyer expect to get for the purchase price? Generally speaking, the buyer is concerned about obtaining assets free and clear of a mortgage or security interest. Searches will help you identify how to ensure that the client’s expectations are met. The number and nature of searches will be dictated by the transaction type. It is important to conduct proper searches to ensure that the clients’ interests are protected in a business transaction. Failure to do so is likely to expose the parties and the law firm to substantial claims since most business transactions involve large sums of money. The searches made are primarily intended to verify the status of the business organization involved and the assets affected to ensure that either the financier gets the proper security or the purchaser gets the assets for the price paid. The exact number or nature of the searches will depend on the circumstances of the transaction. In a commercial loan transaction, the following should be considered: 1. Who is the borrower? 2. Who is the lender? 3. What is the nature of the security interest the lender is requesting? Module 3: Purchase of Commercial Real 3-10 4. What and where are the assets being secured? Are the assets land or chattels or both? 5. What is the size of the transaction? 6. What is the relationship between the parties? 7. What is the legal personality of the client; is the client an individual, a partnership or a corporation? 3.12 REGISTRY AND SEARCH SERVICES In the 1990s the Alberta government privatized some functions in the Motor Vehicles Registry, Vital Statistics, Corporate Registry, Land Titles and the Personal Property Registry under the auspices of Alberta Registries, a division of the department of Alberta Government Services, also known as Service Alberta. Access to Alberta Registries data is available through private Registry Agents, or a law firm can apply for direct access through a service called Registries On-line. A legal assistant employed by a law firm with Registries On-line access can search these registries through the following databases: Land Titles—ALTA, or Alberta Land Titles Automation Personal Property Registry—APPRES or the Alberta Personal Property Registry Corporate Registry—CORES, Corporate Registry System The APPRES and CORES registrations can be done at most Registry offices (i.e., the places that issues license plates). Registration in ALTA, however, can only be done through registry agents or at a Land Titles Office. 3.12.1 Typical Searches The following are the usual searches required when a transaction involves a mortgage of commercial real property. These searches should be made by both the lender’s solicitor as well as the borrower’s solicitor. It is useful to use a search checklist (Figure 1.6) to keep track of all searches ordered and received. The results of searches should be immediately given to the supervising solicitor for review. Module 3: Purchase of Commercial Real 3-11 It is important to ask whether a search is necessary based on your understanding of the facts of the transaction. Land Titles Office Title search Plan search Search request (Figure 2.4) to be completed accordingly. Search will be conducted online or through a private registry agent. Corporate Registry Correct name of corporation Status of corporation Directors of corporation Registered office address Shareholders of corporation (the CORES search shows only voting shareholder information) Partnership declaration Trade name (business name) declaration These corporate searches are combined in one search product from Alberta On- line (CORES). The search can be made both for current information and for past historical information. Remember, the CORES registry does not record non- voting shareholder information. Such information will be found in the shareholder register of the Minute Book. The Minute Book must be kept at the Records Address (s. 21 of the Business Corporations Act), which is usually the Registered Office address. Remember that the Registered Office and Records address must be accessible to the public during normal business hours and must be located in Alberta. This search is conducted online or through a private registry operator. You can also search for a Partnership Declaration and Trade Name Declaration if borrower in a partnership or a sole proprietor operating under a trade name. This is normally done if security interest is also being taken in personal property. Municipality Property tax - Annual tax levy - Arrears and penalties - Local improvement levies Module 3: Purchase of Commercial Real 3-12 Tax certificate Local improvements City Planning Department and Building Department - confirm use of property A telephone search can be done in Calgary and Edmonton. A letter search will be required in other centres. The lender’s instructions and loan commitment will often require the submission of a surveyor’s Real Property Report. The borrower should be asked if he has one. If not, instructions should be obtained to order one. Some lenders will accept an older Real Property Report provided it is no more than five years old and if it is accompanied by a statutory declaration to the effect that no alterations have been made to the buildings and structures shown on the report. In addition, the lender’s instructions will also request an opinion on compliance with municipal planning and zoning by-laws. In order to confirm development and zoning compliance, the solicitor should take the following steps. Send two originals of the Real Property Report to the municipal planning office to obtain a compliance certificate that shows that the building as shown on the survey complies with the relevant development and zoning requirements. Sometimes the building does not comply with current zoning regulations because the zoning by-laws or requirements have been changed since the construction of the building. In this instance, the planning department may respond with a letter indicating the non-conformity and that the building may remain as is. Nonetheless, any future renovations to that non-conforming building may be permitted on condition that the building be changed so as to make it compliant with the then building code and zoning regulations. The solicitor’s reporting letter to the lender should indicate the non-conformity and the limitations of non-conforming buildings in terms of reconstruction. The lender’s instructions should be sought as to whether the non-conformity will prevent funding of the loan. In those situations where the planning department refuses to give a letter indicating a non-conforming use (i.e., cases involving new construction where builder has failed to obtain the required building permits or has failed to build in accordance with the approval obtained), the lender will insist that before the loan is advanced, the necessary approvals should be obtained from the municipality. This may involve an appeal to the Development Appeal Board. Although a lender will not normally request a verification of the issue of building and development permits on new construction loans, it is good practice to request the borrower to provide copies of the building and development permits. Module 3: Purchase of Commercial Real 3-13 Where the loan transaction involves an apartment building or other commercial building, the lender’s solicitor should consider making the following additional searches at the appropriate office: a) Letter regarding by-law infractions - by-law inspection branch b) Letter regarding electrical power - applicable power inspection branch c) Letter regarding fire department inspection report or violations - check fire department Court House Actions Bankruptcy Complete search request (Figure 2.5) for actions against the corporate borrower in the Court of Queen’s Bench. Complete a search request for bankruptcy proceedings against the corporate borrower. Personal Property Registry If personal property is part of the loan transaction or a purchase, conduct a search at Personal Property Registry online or through a private registry agent using all variations of the debtor’s/seller’s names or serial numbers, if serial numbered goods are involved. The search results should be examined and any similarities to the property or the parties involved in the mortgage transaction should be noted and brought to the attention of the supervising solicitor. Workers’ Compensation Board Status of account of borrower Write letter to Workers’ Compensation Board as to whether the corporate party’s account with the Board is in good standing. Note that not all parties to a business transaction are subject to the provision of the Workers’ Compensation Act. However, if a party is subject to the Workers’ Compensation Act then you should do this search. Bank of Canada Section 427 Bank Act security Module 3: Purchase of Commercial Real 3-14 Write letter or fax for confirmation whether there is any claim under section 427 registered against the corporate borrower. This search is usually conducted only if the borrower is involved in a retail, wholesale, manufacturing, or farming activity. Industry Canada Bankruptcy Usually the search is by phone to confirm whether the corporate borrower is in bankruptcy and is followed by a letter for search results. The search is also available through the Internet at: https://strategis.ic.gc.ca/sc_mrksv/bankruptcy/bankruptcySearch/engdoc/ Click on the appropriate links to find bankruptcy search. A fee is payable using a credit card number. Employment Standards Letter requesting any claims or action by employees. Clearly this will not apply if you are satisfied that the transaction involved has no employees. Canada Revenue Agency Ensure source deductions made (i.e., Canada Pension Plan and Employment Insurance contributions). For information, go to: http://www.ccra-adrc.gc.ca/tax/business/payroll/menu-e.html Federal Court of Canada Letter requesting a search to see if any certificate filed pursuant to section 223 of the Income Tax Act for unpaid assessments (unpaid federal taxes such as Income tax or EI premiums or GST remittances and other federal taxes) Environmental Search Conducted where there are environmental concerns in respect to the land in which the security interest is being taken. Letter to Alberta Environment requesting that they check their records and advise whether or not they show any discrepancies or outstanding work orders with respect to air, water or hazardous substances Patents, Copyright and Industrial Design If a security interest is required in intellectual property, search at the Canadian Intellectual Property Office (CIPO) to ascertain whether registrations have been made. Go to: http://strategis.ic.gc.ca/sc_mrksv/cipo/welcome/welcom-e.html Module 3: Purchase of Commercial Real 3-15 Remember there is no requirement to register intellectual property, particularly copyright although there are many advantages to the creator of intellectual property to do so. 3.12.2 Search Protocols It is important to recognize that your search process is a work in progress. There are three main phases to a good search protocol. The initial search confirms the parties and property to the transaction. This is where you discover all the surprises. Track your results as they come in. Your search checklist should include a results column so that you can check off the results as they come in. The second phase of searches are performed prior to taking steps such as release of funds or keys, to ensure that a relevant step has taken place or that nothing material has changed. These searches need to be entered into the firm diary system; never rely on your memory. The third phase of searches occurs after the closing or release of funds or release of possession of the goods or land. The parties to a business transaction often make commitments to each other to complete some tasks after closing. These are referred to as “undertakings.” At intervals following the closing of the transaction, you must conduct various searches to ensure that those undertakings have been completed. 3.12.3 Search Results A second, important use of the results is to assist in document preparation. Accurate descriptions of parties and properties will save you the trouble of regenerating your documents or, worse, submitting inaccurate work for registration or signature. A third use of searches is to prepare an accurate Statement of Adjustments. 3.13 THE STATEMENT OF ADJUSTMENTS Purchasers want to know exactly what they must pay on the closing day of the transaction. This is true for residential transactions such as buying a house or a condominium and is equally true in a business transaction. However, statements of adjustments are usually more complicated in business transactions compared to residential transactions. Business transactions and residential real estate transactions rely on statements of adjustments as “balance sheets” to guide the parties through the financial Module 3: Purchase of Commercial Real 3-16 aspects of a transaction. In most business transactions, there will be amounts payable from the purchaser to the vendor but also from the vendor to the purchaser. For example, the purchaser or buyer obviously owes to the vendor the amount of the purchase price. At the same time, if the closing date is after January 1 but before June 30 when municipal property taxes are due, the vendor owes for the amount of taxes incurred from January 1 to the closing date that the purchaser will pay in full on June 30. The opposite result occurs if the closing date is after June 30 in which case the buyer will owe for the taxes that the seller has prepaid after the closing date. Learning to work with a Statement of Adjustments involves a lot of practice. Figure 2.6 is a sample of a Statement of Adjustments. In addition there are online exercises to help understand this important accounting mechanism. We have included a set of statements that will help demonstrate the variables that you are likely to encounter. 3.13.1 What is Adjusted? Common adjustments include: taxes payable on the property usually to the local municipality; amounts held by a lender in a tax account; prepaid contractual obligations such as maintenance contracts; rents payable by tenants; security deposits made by tenants; and vendor financing. The taxes include property taxes, business taxes and other local levies and municipal assessments. A tax account is set up usually by the mortgage lender as a convenience to the titleholder. The titleholder makes the regular periodic payments to the bank including PIT (Principal interest and taxes). The bank collects those payments for taxes and holds them in trust in a “tax account” that is used to pay the taxes in full on June 30. If the deal closes before June 30, the purchaser gets the advantage of those payments made by the vendor into the tax account prior to closing. However, the vendor who paid that amount should get a credit for all of those payments paid into the tax account by the vendor but which are used to pay the taxes that accrue after the closing date. To discover the amount in any tax account, you must do a search with any mortgage lender on the subject property. This “tax account” with the lender must not be confused with the taxes owed to the local taxation authority (such as a City town or village), which is often called by some people, confusingly, the municipal “tax account.” Security deposits are paid by tenants to the vendor landlord. If those tenants continue in the premises after the closing date, the purchaser (new landlord) will be responsible for paying the deposits when the tenants leave. Similarly, the tenants pay rent usually on the first day of each month. That payment is the rent for that month, payable in advance for the whole of that month. If the transaction closes during the month, then an adjustment has to be made. The vendor received all of the rent for the month on the first day of the month, but the purchaser is Module 3: Purchase of Commercial Real 3-17 entitled to that portion of that month’s rent from the closing date forward to the end of that month. Vendor financing is where the vendor lends the purchaser money to pay for the transaction. This is sometimes called vendor take-back financing. Instead of receiving cash for some or all of the purchase price, the vendor takes back from the purchaser a promise to pay, usually accompanied by security such as a mortgage. Vendor take-back financing is an adjustment in the statement of adjustments that reduces the cash payable by the purchaser (i.e., a credit to the purchaser). Searches will provide details that inform the statement of adjustments. The goal in building a statement is to develop a financial snapshot on the closing day that tells the story of the items that the parties want to adjust between themselves without involving third parties. For example, the municipality that collects the taxes will not reimburse the seller and/or collect an underpayment from the purchaser related to the transaction. The parties use the statement to adjust the tax payments and other amounts owing between themselves, such that the purchaser will pay amounts owing or receive refunds payable after the closing day—even where those amounts arose while the seller was in possession of the property. Ultimately, the statement will provide an amount by which the purchase price is adjusted to reflect all of these minor transactions and a final balance owing to close the transaction. The best way to think of statements of adjustments is to ask a simple question: Who incurred a liability (such as taxes), for what period of time and who will be responsible for paying that amount? So for example, if the closing date is after January 1 but before June 30 when taxes are due, the vendor owes for the amount of taxes incurred from January 1 to the closing date. So a closing date of May 1 means that the purchaser will pay the taxes on June 30 for the entire year (January 1 to December 31) but the purchaser should receive a credit in the statement of adjustments for the period the purchaser did not own the property (in this case January 1 to May 1). 3.13.2 When Does the Day Begin? It is often the case that business transactions involve large sums of money with the same large scale of adjustments. Taxes and rents may well be into the tens of thousands or millions of dollars. For example, if the taxes are $100,000.00 per year that is $273.97 per day. If the taxes are $1,000,000.00 per year that is $2739.73 per day, so you can see that a half day is significant in these large transactions. As a result, business transactions will often state not only an adjustment date but also an adjustment time such as 12 Noon (12:00 hours in the Module 3: Purchase of Commercial Real 3-18 24-hour clock system or 12:00 p.m.). In this case, you have to adjust for the half day represented by 12 hours of the closing date. Or the closing time is expressed as Midnight (00:00 hours or 12:00 a.m.). If Noon (12:00 p.m.), then you must adjust for the half day (i.e., the vendor is liable for all expenses and gets all credits up to Noon and the purchaser for the remainder of the day). If the adjustment time is midnight (or sometimes stated as one minute past midnight or 00:01 hours), then the purchaser is liable for the entire 24-hour period beginning one second after midnight (no, we do not adjust for one second or even for the one minute!). If midnight, the date is the day that commenced one second past midnight. That is, the date changes as the second hand of the clock goes past midnight to 24:00:01 or 00:00:01. So as the Wikipedia article on the 24-hour clock states: “In the 24-hour time notation, the day begins at midnight, 00:00, and the last minute of the day begins at 23:59.” Therefore if a closing is set at midnight (00:00) the adjustment is for the entire day that commences at midnight. In the 12-hour time notation, the day begins at midnight, 12:00 a.m., and the last minute of the day begins at 11:59 p.m. 3.13.3 How Long is a Year? Everyone knows there is a leap year every four years. That adds a day to the year so that in a leap year there are 366 days instead of the normal 365 days. Again, because the amounts being adjusted in a business transaction are often large, you should take the leap year into account when preparing a statement of adjustments. For a list of upcoming leap years, check out this site: http://www.timeanddate.com/date/leapyear.html The next four leap years are: 2016, 2020, 2024, and 2028. 3.14 THE GOODS AND SERVICES TAX Almost all businesses are GST registrants because only very small businesses (under $30,000.00 annual revenue and a few other exceptions) are exempted from registration. Therefore almost all businesses are GST registrants and have the obligation to collect and remit GST to the Canada Revenue Agency (CRA; formerly called Revenue Canada). Nonetheless, there are advantages to being a GST registrant even if there were no requirement to register. All registrants can deduct the GST that they pay for supplies as a set-off (or credit) for the GST that they owe on their sales. So for example let’s say a business called Seller Corp. is a GST registrant. It purchases $100 in GST taxable materials from Supply Corp. The total amount it paid Supply Module 3: Purchase of Commercial Real 3-19 Corp. is $105 ($100 plus GST of $5). Seller Corp. used those supplies to create GST taxable goods and sold those goods for $150 thereby making a profit of $50. When Seller Corp. sells the goods for $150, it had to add and collect GST of $7.50 ($150 x 5% = $7.50). Supply Corp. must remit that $7.50 but is entitled to deduct the GST that Seller Corp. paid to Supply Corp. Therefore $7.50 GST collected less $5.00 GST paid to Supply Corp. = $2.50 net GST payable by Seller Corp. to the Canada Revenue Agency. The amount of GST paid by a registrant to its suppliers is called an “input tax credit” and has the effect of lowering the net tax than any GST registrant has to pay to CRA. According to the Excise Tax Act (the ETA), the sale of commercial real property is subject to GST. The purchaser is required to pay and the vendor will be required to collect and remit to the Minister of National Revenue GST equal to 5% of the selling price, subject to the application of section 221(2) of the ETA. That section allows that if the purchaser and the vendor are GST registrants and the purchaser acquires real property for use exclusively in a commercial activity, the purchaser will be entitled to an input tax credit equal to the GST incurred on the purchase price that will totally offset the GST payable. Therefore, by section 221(2) ETA, a supplier who makes a taxable supply of real property by way of sale is not required to collect tax payable by the recipient, where the recipient of the supply (the purchaser) is a GST registrant (i.e. has a GST number). Where the purchaser is a GST registrant, section 221(2) places the obligation on the purchaser to remit the GST. When acting for the vendor in the sale of commercial property, determine whether the purchaser is a GST registrant. The vendor’s solicitor should do the following: 1. Obtain the purchaser’s GST registration number. 2. Obtain from the purchaser a certificate (or a statutory declaration by a corporate officer) from the corporate purchaser that confirms its GST registration number (see Figure 2.8). 3. Conduct a search at Canada Revenue Agency (formerly Revenue Canada) to confirm that the purchaser is registered. Some law firms have made it a practice to telephone Canada Revenue Agency Tax Services Business Inquiries on the date that closing documents are forwarded to a purchaser’s solicitor for registration to ensure that the purchaser does have a valid registration number. You must give the operator the name of the purchaser and the GST registration number. Module 3: Purchase of Commercial Real 3-20 4. In addition, the vendor’s solicitor may impose a trust condition on the purchaser’s solicitor that he or she confirm the purchaser is a registrant on the date that the conveyance documents are submitted for registration and provide such confirmation on that date. When acting for the purchaser, the following should be done: 1. Ensure purchaser is registered under ETA before ownership or possession is acquired, in order to use section 221(2) exemption. 2. If GST is paid, advise purchaser to recover GST by filing with Canada Revenue Agency the appropriate form (GST 60) providing the following details: a. Name and address of vendor and purchaser b. Description of the real property c. Total amount of GST d. Vendor’s GST registration number This form must be filed by the due date of the purchaser’s return for the reporting period in which the acquisition occurred. 3. If GST is payable on the transaction, advise the purchaser to pay GST directly to Canada Revenue Agency. 3.15 DOCUMENTS Whether acting for buyer or seller, business transactions involve preparation and review of a large number of documents. Like searches, these documents may evolve over time. Use a document checklist to track the progress. Other common documents include the Bill of Sale for personal property and the Assignment(s) of contracts to convey rights to a purchaser of existing contracts. It is common in complicated business transactions to run a mock closing to review the documents and ensure that the appropriate parties have been invited to the signing meeting. The sale and purchase of commercial real property involves a substantial amount of money as well as other matters relating to the renting and management of the property. The sale is usually subject to existing leases/tenancies and includes the sale of chattels and assignment of the vendor’s interests in other contracts with Module 3: Purchase of Commercial Real 3-21 third parties relating to the upkeep and maintenance of the property. Purchasers of commercial real estate welcome existing tenants because the purchaser as the new landlord is entitled to the rents payable by the tenants. To make sure that the purchaser is entitled to that rent stream, the vendor will have to sign an assignment of leases and rents in favour of the purchaser. Maintenance contracts include janitorial contracts that the purchaser may wish to continue because the rate is favourable. Other contracts produce other benefits to the purchaser such as the net revenue from contracts with third party service providers such as vending machines that pay a rental fee to the owner of the building that is being sold in the business transaction. The significance for the law firm of these contracts is that they will usually be adjusted and thus appear in the statement of adjustments. For example, if the closing date is mid-month but the rent is payable at the beginning of the month then the purchaser will have a credit from the vendor for the amount of the rent paid to the vendor at the beginning of the month but for the period after closing when the purchaser was entitled to the rent. Thus the closing documents tend to be numerous and may include, among others, the following: Statement of Adjustments (Figure 2.6) Transfer of Land of the Commercial Real Property (Figure 2.7) GST Warranty and Indemnity (Figure 2.8) Bill of Sale of Chattels (Figure 2.9) Assignment of Leases/Tenancies (Figure 2.10) Notice to Tenants of change of ownership and rent to be paid to the purchaser (Figure 2.11) Assignment of contracts of maintenance of the commercial real property, if applicable (Figure 2.12) Tenant Estoppel Certificate (Figure 2.13) Undertaking to Readjust (Figure 2.14) Vendor’s Certificate (Figure 2.15) Assignment of Commercial Real Estate Purchase Contract (Figure 2.19) 3.16 CLOSING In preparation for a closing, a “run through” or mock closing will avoid delay and embarrassment. A final check of the documents against the document checklist will ensure a smooth closing. An important step is to ensure that the parties and property descriptions are accurate. Module 3: Purchase of Commercial Real 3-22 The sale and purchase agreement usually provides for the required closing documents from the vendor and the purchaser. The agreement also stipulates the place, date and time of closing. We have attached sample documents related to closing (Figures 2.7 to 2.15). Some apply to our transaction, some do not. A sample closing agenda that states: 1. Place, date and time of closing. 2. Parties and their solicitors who will be present at the closing. 3. The closing documents to be handed over by the vendor to the purchaser. 4. The amount and form of payment to be made by the purchaser to the vendor. 5. Any conditions which the vendor must satisfy after the closing date. When preparing the closing agenda, review the sale and purchase agreement for the details of the closing documents and other matters required for closing. See Figure 2.16 for a sample closing agenda. Not all sales and purchases involve a closing meeting. Instead, it is quite common for the vendor’s solicitor to forward the transfer documents to the purchaser’s solicitor under cover of a trust letter which sets out the appropriate trust conditions. See Figure 2.17 for a sample trust letter. The trust letter allows the parties’ lawyers to agree to close the transaction using a series of binding requirements contained in the letter. There are two important things to know about trust letters: 1. A trust letter cannot amend the terms of the agreement, and 2. Once the conditions in a trust letter have been accepted, they are binding on the lawyer involved. Breach of trust conditions is enforceable by the Law Society of Alberta. It is a serious offence for a lawyer to breach trust conditions. Note the conditions contained in the sample trust letter as Figure 2.17. Module 3: Purchase of Commercial Real 3-23 3.16.1 Closing Procedures All searches must be updated on the closing date to ensure there had been no changes that will affect the interest of the purchaser. Usually the cash to close is not released to the vendor until all conditions have been complied with by the vendor, including those conditions that are to be satisfied after the completion date. Thus, all conditions and undertakings to be complied with after the completion date must be closely monitored to ensure their due compliance. 3.16.2 Post-Closing Items A summary of the post-closing matters is also important. One of the most important post-closing items is obtaining proof of clear title and release of holdbacks. Holdbacks are common in business transactions. If a condition was not met, lawyers will attempt to quantify the value of that condition and hold back a sum of money to pay for that condition. For example, it may have been a condition of the transaction that maintenance contract be discharged by the seller instead of assumed by the buyer. If that did not occur, the buyer will reserve a portion (“hold back”) of the purchase price to satisfy that discharge. These holdbacks are included in the lawyer’s reporting letter. A sample reporting letter is attached as Figure 2.18. 3.17 STEPS TO FOLLOW IN CLOSING A COMMERCIAL REAL ESTATE PURCHASE A typical business transaction follows these steps: 1. Carry out all the required searches particular to the sale and purchase transaction. 2. Review the sale and purchase agreement; note all the tasks to be done prior to closing, during closing, and after closing; and ensure the tasks are duly completed. 3. Draft the required documents. 4. Prepare the closing agenda. 5. Keep track of all undertakings and conditions to be satisfied after the closing date. 6. Effect registration of documents where applicable. Module 4: Purchase of Commercial Personal 4-2 4.1 INTRODUCTION Personal property is all property that is not real property. In some systems of law, personal property is called moveable property and real property or real estate is called immoveable property. Personal property can include chattels such as cars, trucks or equipment. It can also include less obvious things such the right to collect money, copyright or other intellectual property. It is common to finance the purchase of commercial personal property through vendor financing, or a line of credit, or both. A purchaser may have only a small cash reserve that it does not want to use on the purchase of new equipment so it has arranged for a line of credit to cover both day-to-day expenses for the business and these purchases. Sometimes financing comes from vendor financing or some combination of cash, borrowing and vendor financing. Vendor financing means that the seller of the goods finances the purchase. In effect, the vendor lends the purchaser the money to buy the vendor’s goods. When financing through the vendor, the borrower is usually presented with the vendor’s standard form contract containing the vendor’s terms that may not be negotiable. An important aspect of a commercial personal property transaction is ensuring the client gets clear title to the assets involved. Unfortunately there is no universal, public registry that records and certifies title to personal property in Alberta, or anywhere else for that matter. That’s because, unlike land in Alberta which is fixed and finite, huge numbers of new personal property items are being created or brought into Alberta every day. Think of how many brand new television sets arrive in Alberta stores each day. It is physically impossible to keep track of legal ownership of all those TVs so our system does not even try. Instead, our system provides those persons who have a valid legal claim against one or more of those TVs the opportunity to register notice of their claim in a public registry if they wish, with serious negative consequences to their interests if they do not register. This idea is no different in the purchase of commercial personal property, including all financing documents and the status of any registered claims. 4.2 PURCHASING COMMERCIAL PERSONAL PROPERTY As mentioned, all businesses use personal property in their operations. Some businesses rely heavily on personal property such as manufacturers and transportation companies; others use personal property sparingly such as lawyers and accountants. The amount of a business’s cash reserve that should be dedicated Module 4: Purchase of Commercial Personal 4-3 to acquiring personal property is a business decision. Most businesses will use financing to acquire at least some of the personal property. There are three main forms of financing these purchases: term loans, a line of credit, and vendor financing. By contrast, a lease allows the business to acquire the use of an asset without paying for it up front but with, usually, periodic payments thereafter. At the end of the lease, the business returns the leased property unless there is an option to buy the leased property and the option is exercised. We will include some forms of lease in this module. Paramount for the buyer is obtaining value for the payment(s) of money. Paramount for the seller is having some remedy if the buyer fails to make the payment(s). 4.2.1 Financing Most of you have experience with borrowing money to buy personal property. A common example would be financing the purchase of a car directly from a dealer. This is an example of vendor financing. Vendor financing means that the seller is, in effect, lending the buyer the money to buy the goods the vendor is selling. This is also called, “vendor take back financing” or in the context of real estate “vendor take back mortgage.” Some loans are specific to the asset, a loan for the purchase of a car; other loans are specific to the borrower, using a credit card to buy clothes or anything else, for example. Business transactions operate in a similar way. Businesses will use specific financing to acquire a specific asset or they may use their line of credit to purchase non-specific assets. Below is a summary of various phrases used in commercial financing: 1. Term Loan – usually used in the financing of large projects or purchases. The conditions of the loan require repayment over a specific period of time called the “term.” It provides stable, long-term funding and is attractive when you can project reliable income and a long depreciation period due to the durable nature of the equipment purchased. 2. Demand Loan – as the name implies this loan will be repayable on demand by the lender. The lender will not usually demand full repayment unless the borrower is in default of its obligations under the loan agreement (such as failure to pay the minimum monthly payment). There are two sub-categories of demand loans. First, a revolving demand loan is designed to finance an operating line of credit. The outstanding balance of a revolving demand loan can therefore go up or down according to the requirements of the business so long as a minimum periodic payment is made by the borrower. Second, a non- revolving loan is designed to provide financing for a specific business purpose such as the purchase of equipment or some other asset. In the case of a non- Module 4: Purchase of Commercial Personal 4-4 revolving loan, the loan is usually advanced to an agreed level and then is repaid according to some agreed formula. The balance therefore does not increase but decreases with payments over the passage of time. 3. Vendor Financing – used to finance the purchase of a particular asset. Rather than seek financing from a third party lender or use personal funds, the buyer will buy the asset on specific terms directly from the vendor. The terms include a schedule of payments that include principal and interest payments and remedies in the event of default. This is often called “vendor take-back financing.” The vendor will usually demand a security agreement be signed by the buyer that is registered at the PPR. 4. Long term lease (lease to own) – this type of financing allows the purchaser (lessee) an option, usually at the end of the lease period, to purchase the asset from the vendor (lessor) for a predicted or set price. The price paid to purchase the asset is usually much less than the value of the asset at the beginning of the lease when the property was ‘new.’ Upon exercising this option the lessee becomes the owner of the leased property and, of course, the lease is terminated. A lease-to-own type of lease is different from an ordinary lease where there is no option to purchase. At the end of this type of lease, the property is returned to the lessor (the owner of an asset that is leased under an agreement to the lessee). The lessee is the person who rents real property or personal property from the lessor. 4.3 THE COMMITMENT LETTER A bank may begin the lending process by issuing a commitment letter to the borrower. The commitment letter (Figure 4.2) sets out the terms of the transaction: what documents are required; who is required to sign them; and what additional terms need be met prior to advance of funds. This is a “core” document. Often in negotiations with the bank, many drafts will be created of the commitment letter so it is imperative that you can find the final version of this letter. Thereafter, there may be an additional loan or credit agreement that is sometimes called a master loan agreement. Like the letter of intent, the commitment letter may precede a more formal and more detailed master agreement. However a commitment letter from a bank almost always has a binding effect on the bank. The bank usually agrees to advance money at a certain interest rate for a set or “committed” period of time at a set rate of interest. Very often the loan agreement will replace the commitment letter once the loan agreement is signed. If there is no loan agreement, then the commitment letter Module 4: Purchase of Commercial Personal 4-5 continues in effect. Like letters of intent, there is likely a stream of negotiations leading from an informal commitment to a letter of commitment to a loan agreement. Almost all banks and other lenders demand “security” from the borrower when lending money. Security or, as lawyers call it a “security agreement” is a legal written document that secures the performance of the borrower’s obligation to repay the loan. The most common form of security is the lender’s right on the borrower’s default to seize and sell the borrower’s assets without any further consent from the borrower. The security document gives the lender the right to do those things in advance and those rights become operable upon the borrower failing to repay some or all of the borrowed amount or upon the occurrence of some other default such as failing to insure the secured assets or selling those assets without the lender’s consent. There may be additional financial covenants such as a promise not to encumber the pledged assets by pledging those assets to another creditor unless specifically allowed One type of covenant a business may have to give in the loan agreement is a promise for a certain debt to equity ratio. For example, a 5/2 debt to equity ratio means that there are 5 units of total debt for 2 units of total equity. And, of course, the loan agreement will define what is permitted debt. A lender will argue that debt includes subordinated debt and shareholders’ loans. The borrower will attempt to restrict that calculation to only loan agreement loans such as with a bank. The lender will also tend to exclude from assets things like goodwill or accounts receivable older than 90 days. Therefore, the financial covenants in a loan agreement may be subject to considerable negotiation and even ongoing controversy after the loan is advanced as the lender and the borrower argue about whether or not the borrower is in default of debt to equity ratios. See pp. 195–199 of the Mahaffy text for more details. These financial covenants may also mean that the creditor has access to the confidential financial records of the debtor so that the creditor can confirm debt to equity ratios, for example. 4.3.1 Security Interests The security agreement therefore gives the lender (creditor) certain rights or an “interest” in the personal property of the borrower (debtor). If certain conditions are met, this interest is a security interest and includes the right of the creditor to seize and sell some or all of the debtor’s property in the event of default on the terms of the loan. Generally speaking, a security interest secures the performance of an obligation that the debtor owes to the creditor. That obligation is usually the payment of money pursuant to a loan from the creditor to the debtor. Where the Module 4: Purchase of Commercial Personal 4-6 debtor pledges his property to secure the performance of the obligation to repay the creditor then we can say that the interest of the creditor is a security interest. Of course there are other ways that a creditor may have a security interest and you will have learned that in a course on creditor law such as Credit and Collection Procedures. A security interest is often referred to in the financing document such as the loan or lease contract. These contracts are normally prepared by the creditor and so always contain standard clauses in favour of the creditor that are usually not subject to negotiation. Some of those terms imposed by a creditor can be quite onerous. For example, many loan agreements deem the debtor in default if the debtor fails to make an installment payment or is in default to another creditor (a “cross default provision”), or in some cases where the creditor “in its sole and unfettered discretion” deems the debtor in default. The creditor can temper these provisions by insisting on “materiality” qualifications whereby the creditor is prevented from seeking repayment if the default is minor or “non-material.” In addition the legal system limits the unfettered discretion of the creditor to declare a default to situations that are commercially reasonable. Although most banks seek a covenant where they are the only creditor registered against the debtor’s property, a debtor may give a security interest in personal property to two or more different creditors. If the debtor defaults, those creditors are then in competition. They may all want to seize and sell the property and apply the proceeds to their respective loans. This contest between overlapping or competing creditors is resolved by referring to the Personal Property Security Act, which we will look at shortly. The Act gives a ranking system for competing creditors’ claims. Generally speaking, the security interests that occur first in time will be paid in full before subsequent creditors get any proceeds. 4.3.2 Creditor Rights on Default The law surrounding credit rights on default of the debtor is a large area of practice. At this stage, it’s important to think of some of the demands that creditors can make while there is a chance to negotiate the best deal. That is to say, a borrower should be aware of the demands that most banks and commercial lenders make in their loan agreements. With some negotiation, the borrower may be able to limit the extent of the creditor’s rights. For example, almost all commercial creditors demand a term that indemnifies them of all costs of collection (lawyer’s fees, seizure costs and other forced sale costs) as a result of any default of the debtor. Other terms require indemnification Module 4: Purchase of Commercial Personal 4-7 if taxes are imposed on the financed property or costs of insurance or repair or if environmental remediation costs are required. The borrower should make efforts to place limits on those costs that are otherwise open ended. For example, the costs could be limited to a certain period of time or for certain maximum amounts or the lender has to make “reasonable efforts” to limit those costs. In the case of environmental costs, the borrower would seek to limit his liability to the time the borrower was in possession of the property. In other words, the “indemnity” portion of the loan agreement should not be a blank cheque. Obviously, before signing the contract, the creditor wants certainty in case the creditor has to enforce the contract against the debtor and other creditors (third parties) and the debtor wants to understand the debtor’s obligations under the financing document. This is typically where a lawyer would step in. 4.4 FINANCING DOCUMENTS Readings Mahaffy: pp. 203–211 Let’s review the basic documents that commercial lenders may require from borrowers. The assets available to the borrower govern the type of document required by the lender. Some of these are documents that create a security interest. Others are not. For example, a promissory note and a personal guarantee do not involve the giving of a PPSA security interest in any property, but lending officers and laypersons commonly refer to them as “additional security” or “collateral security” nonetheless. The difference between true security interests and all other financing documents (such as promissory notes and guarantees) is that a document that creates a security interest contains a pledge (or statement) by the borrower that in the event of default of the agreement, the creditor may seize and sell the pledged property of the debtor. An unsecured financing document does not have this pledge and amounts only to a promise to pay the amount owing by the debtor. 4.4.1 Promissory Note The lender may require a promissory note as “collateral security” from the borrower. In a promissory note, the promisor is the person who promises to pay back the creditor. The promisee is the creditor to whom the money is paid. A promissory note does not create a security interest in the property. However, it does qualify as a promissory note or a negotiable instrument under the Bills of Exchange Act, R.S.C. 1985 c. B-5. Therefore, the lender can negotiate or assign Module 4: Purchase of Commercial Personal 4-8 the promissory note to a third party called a subsequent holder. That represents a risk to the borrower because, if that third party qualifies as a “holder in due course,” the third party can sue the borrower directly on the promissory note even if the lender breached some of the terms of the loan or purchase agreement with the borrower. To maintain its status as a negotiable instrument, a promissory note must comply with section 5 of the Act, which states: 1. The promissory note must be in writing. 2. The promise to pay by the maker must be unconditional. 3. The amount payable must be a sum certain, that is, a stated amount, or the amount can be arrived by a formula evident on the promissory note. 4. The date of payment must be ascertainable, which means that the date of payment must be stated or the date can be calculated by viewing the promissory note. 5. The promise to pay must be made to a named person (promisee), or to the order (direction) of the promisee, or to bearer (possessor of the note) who is an assignee from the original lender. Figure 3.1 is an example of a promissory note. 4.4.2 Guarantee A guarantee is a promise to the lender by a third party called a guarantor to pay the debt of the borrower who defaults in payment. A guarantee provides the lender with an additional source for payment of the debt should the debtor default. When making loans to a corporation, a bank usually requires a guarantee from the corporation’s directors or shareholders. This allows the lender an additional source of repayment beyond the borrower corporation by making a guarantor shareholder or director personally liable for the debt of the corporation. In Alberta a guarantee by an individual who is not a corporation (i.e., natural person) must comply with the requirements of the Guarantees Acknowledgment Act, R.S.A. 2000, c. G-11. The Act requires that the guarantor acknowledges his or her signature on the guarantee before a notary public. The notary public must then complete a certificate (Figure 3.3) in the form prescribed by the Act. If the requirements of the Act are not complied with, the guarantee is not enforceable. See Figures 3.2 and 3.3. Most lenders demand that a guarantee cover all past, present and future obligations owed by the debtor to the lender. Lenders also demand that the Module 4: Purchase of Commercial Personal 4-9 guarantor waive or give up any defences such as right of set off. The lender also demands that the guarantor postpone any loans or security that the guarantor may have against the borrower. This means that the lender who demands the guarantee always has priority to the guarantor in collection efforts against the debtor. Since a guarantee is often given by a director or a shareholder of a corporate borrower, this means that the commercial lender always is first in line in the collection of amounts owing under the loan agreement. 4.4.3 Assignment of Book Debts An assignment of book debts is commonly given by businesses to secure their financial obligations to creditors. When a newly formed business is given financing by a bank, the bank usually requires that the business assign its book debts to secure the loan. That way the bank can collect money that is owed to the debtor by third parties. For example, let’s say that MegaBank lends $100,000.00 to LawnCareCorp, a landscaping company. To make sure that LawnCareCorp pays back the loan, the bank asks for the right to collect money that is owed to LawnCareCorp, by LawnCareCorp’s customers. One of those customers is MegaMall Ltd. who pays LawnCareCorp $1,000.00 per month for lawn care in summer and snow removal in the winter. If LawnCareCorp defaults, the bank can use the assignment to collect the money that MegaMall Ltd. owes LawnCareCorp. One way of thinking about an assignment is that when used by the creditor, the debtor’s debtors now owe the money to the debtor’s assignee (creditor). The assignment of book debts gives the right to the creditor (assignee) to collect debts such as accounts payable to the debtor upon default of the debtor. The assignment of book debts can take the form of: 1. A general assignment of book debts, or 2. An assignment of specific debts. The general assignment is the more common form and usually includes both present and future debts. The assignor’s debtor is bound to pay to the assignee only upon receiving notice of the assignment. The debt is discharged if paid to the assignor before receiving notice of the assignment. The assignee takes the assignment of book debts subject to all the rights, set-offs and counterclaims that the debtor has against the assignor at the time of receipt of the notice of assignment. It is therefore important to give notice of the assignment to the debtor as soon as there is intent by the assignee to exercise the right of collecting the debt. Usually, a bank does not exercise its rights as assignee until default by the assignor. The assignment of book debts must comply with the provisions of the PPSA, including registration if it is to be effective as against other persons such as other creditors. The assignment of rents derived from interests in land is not Module 4: Purchase of Commercial Personal 4-10 regarded as an assignment of book debts. It is an interest relating to land and the assignment of rents must be registered in the Land Titles Office in order to be binding on claimants of registered interests in the land. Figure 3.4 is an example of a general assignment of book debts that may be registered at the Personal Property Registry. The creditor can also assign loans to other creditors who may buy the right to collect the loan amount. A borrower may wish to limit this practice because it may bring a new creditor into the administration of the loan. That new creditor would often have access to the debtor’s confidential financial records as part of most loan agreements, as was mentioned earlier. A borrower should never negotiate a provision that the creditor may assign the loan but only with the debtor’s consent. 4.4.4 Debentures: Fixed and Floating Corporations often issue debentures to raise funds. The debenture is evidence of the indebtedness of the issuing corporation to the creditor (holder of the debenture). The debenture may be secured or unsecured, and is negotiable by the holder. A secured debenture contains a floating charge on the issuing corporation’s assets, or a fixed charge on certain assets. Often the secured debenture creates both a floating and specific charge. A fixed charge identifies the assets or property given as security to the debenture. A floating charge does not charge specific assets until the creditor demands payment. Until then the charge “floats” over all of the assets and does not encumber them so long as the debtor is up to date in payments to the creditor. A floating charge is useful, for example, for debtors with revolving inventory such as car dealers. If the debtor is in good standing, no specific charge shows up on each of the inventory vehicles, which allows for ease of sale of those cars to customers. If there were a specific charge on each car, then a partial discharge of the security would have to be made each time a car was sold. However, if the debtor defaults and the creditor demands payment, then the floating charge “crystallizes” and becomes a specific charge on the inventory at the time of demand. The assets or property can be both real property and personal property. Enforcement against the real property is the same as if it is a real property mortgage. Debentures have the advantage insofar as one debenture document can be registered at the Land Titles Office and the Personal Property Registry. Enforcement against the personal property is in accordance with the provisions of the PPSA. In a floating charge, all the corporation’s assets are given as security but they are not specifically listed. This allows the corporation to deal or dispose the assets without requiring the agreement of the holder of the debenture. A floating charge thus allows a corporation to carry out its usual business Module 4: Purchase of Commercial Personal 4-11 transactions with its assets, notwithstanding that they are given as security to the holder of the debenture. If specific real property is given as security, the debenture must be registered in the Land Titles Office in order to be effective against subsequent registered owners or claimants of registered interests. Where the debenture creates a charge on hydrocarbons and minerals on Crown land, notice of the security interest must be given to the Department of Energy and Natural Resources. A debenture creating a fixed or floating charge on personal property must comply with the requirements of the PPSA and be registered in the Personal Property Registry in order to have priority over subsequent claimants. Although the use of the old forms of security documents (i.e. chattel mortgage, conditional sales agreement, general assignment of book debts and floating charge debenture) are not prohibited by the new Personal Property Security Act, most financial institutions are using the new form of security agreement. Banks now use a document called a “general security agreement” or GSA (Figure 3.5) under which the secured party is granted a security interest in all present and after-acquired property of the debtor. 4.4.5 Bank Act, Section 426 Security Under the Bank Act, R.S.C. 1985, c. B, section 426, the chartered banks in Canada may lend money secured by hydrocarbons or minerals in, under or on the ground, in place or in storage. The security is sometimes referred to as “section 426 Assignment” and is in the form set out in Schedule I to the Bank Act. The assignment must be registered in accordance with the laws of the relevant jurisdiction where the security is sited where such registration is possible. There is presently no registration system in respect of hydrocarbon rights in Canada. In Alberta, section 93 of the Mines and Minerals Act, R.S.A. 2000, c. M- 17 creates a registry system for hydrocarbons on Crown lands where the assignment is filed. The registered assignment has priority over any other interests acquired before registration of the assignment except for a builders’ lien registered prior to the registration of the assignment. This applies only where the chartered bank is the registrant of the assignment. In the case of other registrants, priority between the registered assignment and a builders’ lien is governed by the Builders’ Lien Act, R.S.A. 2000, c. B-7 which provides that only moneys advanced prior to the registration of the registration of the builders’ lien has priority over the registered builders’ lien. Module 4: Purchase of Commercial Personal 4-12 4.4.6 Bank Act, Section 427 Security Under section 427 of the Bank Act, a large number of products of the farming, forestry, fishing and manufacturing industries as well as equipment and machinery used in such industries may be given as security to secure present or future loans from chartered banks. The chartered bank must register a Notice of Intention to give security under section 427 with the local or nearest office of the Bank of Canada in order to maintain priority over subsequent mortgagees and purchasers, (in Alberta this office is located in Calgary). The Notice of Intention must be registered not more than three years before the security was given. Failure to register renders the security null and void against subsequent mortgagees and purchasers. The registration provides a statutory method of giving public notice of the chartered bank’s security rights. Once registration is made, anyone acquiring the asset or property is automatically affected with notice of the chartered bank’s interest. The registration of the Notice of Intention does not necessarily mean the existence of a loan. It merely permits the chartered bank to take priority over other securities, as and when the chartered bank subsequently makes loans to the borrower and a specific charge registered against the assets. Because of this unique form of financing, it is necessary that a search be made in the Bank of Canada register or in its local office to determine whether there is a registered Notice of Intention. Upon default by the borrower, the chartered bank is given broad powers under the Bank Act (sections 427(3) and 428) to realize on the security and can sell without taking the procedures outlined in the Civil Enforcement Act. The PPSA does not govern securities given under section 427. You should keep Jane informed where the specific assets covered under s. 426 and s. 427 are the subject matter of a purchase/sale. In that event, extra searches need be performed. 4.4.7 Conflicts with Loan Agreement The variety of the above secured and unsecured creditor instruments means there may be unintended conflicts in the rights and obligations in two or more documents for both creditors and debtors. At the very least, slight differences in the descriptions of those rights between documents may lead to ambiguity and uncertainty as to enforcement of rights. In the result lenders and borrowers should think about a paramountcy clause contained in a master loan agreement. This would state that if there is any conflict in the rights contained in two or more documents that the enforcement provisions in the master loan agreement would prevail. This allows one stop reference to the rights of the parties when enforcing the provisions of two or more loan documents. Module 5: The Personal Property Security 5-2 5.1 THE PERSONAL PROPERTY SECURITY ACT The security interest financing documents discussed in week 4 create rights and responsibilities between the parties who sign them. One of the most important of these is the right of the creditor to take the property back and sell it if the debtor fails to repay the loan secured by the security interest. Debtors enter into a number of transactions for the purchase of commercial personal property and will sign financing documents for each transaction. A creditor always wants to ensure that its right to enforce its contract and seize the property is effective not just against the debtor but also against other creditors who may try to assert a claim against the same property. Creditors are concerned that some other creditor will seize and sell the asset for which the creditor has a security interest. This has created an important and complicated branch of commercial law that is concerned with priorities between creditors over the assets pledged by debtors. Further, the common law and all levels of government contributed to the complexity with multiple forms of legislation and contradictory case law. However, in recent years, provincial governments have attempted to simplify the law: the result is Personal Property Security legislation. The Alberta legislation, Personal Property Security Act (PPSA) was proclaimed in force in October of 1990. This legislation has two main aims: 1. The PPSA provides a unified code for creating and enforcing personal property security interests in personal property; and 2. The PPSA establishes a province-wide, publicly accessible, automated registry for recording personal property security interests. 5.1.1 Attachment and Perfection in a Commercial Loan Transaction Every creditor who wishes security in the property of the debtor essentially wants the exclusive right to seize the debtor’s property should the debtor fail to make the required payments. Some creditors ask that the debtor pledge only part of the debtor’s property. Other creditors ask for a pledge of all of the debtor’s property both existing now at the time of the loan but some even ask for property that the debtor acquires in future. Many debtors, particularly unsophisticated debtors or just debtors anxious to get the loan, agree to these demands. Of course not all debtors agree to these terms. This creates a fair degree of complexity because loan agreements and the extent to which the creditor has a claim varies significantly from creditor to creditor. In addition, sometimes errors occur in the creation and execution of these documents or the process by which the money is advanced from the creditor to the debtor. These factors have created a significant amount of litigation over the years as courts sort through complicated and conflicting claims. The PPSA sought to simplify all of these complications with a more predictable Module 5: The Personal Property Security 5-3 model. To do so the PPSA introduces two important ideas: attachment and perfection of a security interest in personal property. These ideas of attachment and perfection answer two common questions: 1. When is the security interest in the personal property created? 2. When is that security interest enforceable against most third parties? The PPSA says the security interest is created and is enforceable against the debtor and against third parties when attachment and perfection coincide. Without attachment, the lender has only personal rights against the borrower (the right to sue for the debt). If there is only attachment, then the creditor has a security interest in the pledged property but it is enforceable only against the debtor and not against third parties. For attachment to occur between the lender and borrower, two things have to happen: 1. the lender must give value (usually the advance of the borrowed money from the creditor to the borrower), and 2. the borrower must have some ownership rights in the personal property that is pledged. For enforceability of the security interest against third parties—for the lender to be sure its security interest in the collateral is better than third party claims—a few more things must happen: the borrower must sign a security agreement that describes the personal property (the typical loan transaction), and notice of the agreement must be registered at APPRES. If that registration coincides with attachment, then the creditor has achieved perfection of the lender’s security interest. The simple, inexpensive step of registration rewards lenders by giving them the maximum protection possible against competing third party claims. Interestingly attachment and registration can occur in any order. In other words to achieve perfection, a creditor could register first and then advance the money (attachment) or the reverse. All that matters is that there is both attachment and registration together regardless of the order of events. There is another form of perfection that is not very common. Instead of registration the creditor can retain possession of the secured goods and need not register the creditor’s interests. We have all heard the common phrase that “possession is 9/10 of the law.” In the case of the PPSA, a creditor has all of the law and all of the security interest if the creditor retains possession. This is not a common form of Module 5: The Personal Property Security 5-4 unregistered perfected security interest but a pawnshop holding the debtor’s goods to secure repayment of a pawn loan is an example of perfected unregistered security interest. Although a pawn transaction is not a method of financing loans against personal property that appeals to our commercial lender clients, it is also a method of providing financing by taking a security interest in personal property and is covered under the PPSA. The owner of the goods takes them to a pawnshop and is given a loan to be re-paid with interest by a fixed date. As security, the pawnshop owner keeps physical possession of the goods for the agreed time. If the loan is not re-paid on time, the pawnshop owner puts the goods on display for sale to the public. Unlike the bank, the pawnshop owner has physical possession of the secured items during the term of the loan so he/she is not at risk of losing them to a third party who also claims an interest in the goods. The PPSA recognizes the pawn system and says that attachment and possession occur when the pawnshop owner (the secured party) takes possession of the secured items. No registration is needed if the creditor is in possession of the pledged property. See section 10(1) PPSA described later in this module. 5.2 KEY SECTIONS OF THE PPSA AND PPSA REGULATIONS For most commercial secured transactions, the creditor will not have possession of the goods affected by the security interest. To safeguard the creditor’s interest in the debtor’s property, the personal property security agreements must comply with the PPSA and notice of a security interest must be registered in the Personal Property Registry (PPR) to ensure maximum protection for lenders. Qualified users now do that registration online under the APPRES system. Originally the PPR was a paper registry—a secured party filled out a financing statement in the approved form and sent it to PPR for registration. However, the PPR has been converted to an electronic registry and registration is now done online by registry agents or by law firm staff who have access to the service called APPRES Registries On-line. Even though the paper forms are no longer required, they are still approved under the PPSA regulations and they are useful for teaching purposes, so we include them in this manual. To understand how the PPSA does its job, and what we must do to properly protect the interests of our clients in a secured personal property transaction, we must now look at key sections of the PPSA and the regulations that accompany it. The Module 5: The Personal Property Security 5-5 following questions are designed to take you through the key sections of the Act in a logical progression. 5.2.1 What Transactions are Governed by the PPSA? Under section 3(1) of the PPSA, every transaction that in substance creates a security interest is governed by the Act. It is not important what a secured transaction is called or what document is used, or even who has title to the secured property (called collateral). This means that creditors can still use all of the old forms such as: a chattel mortgage, conditional sale agreement, floating charge, pledge, trust indenture, trust receipt, assignment, consignment, lease, trust and transfer of chattel paper. The thing that must be present in any covered transaction is that the agreement must secure payment or performance of an obligation. The obligation is, in most c