Corporate Mergers and Hypothecs: Lenders Beware!

1. The dangers of a merger for hypothecary creditors

When financing a business, a lender will want to minimize its exposure to risk by weighing a multitude of factors. In particular it will want to ensure that the borrower continues to respect certain financial ratios and provides it with sufficient security, often in the form of movable hypothecs on the borrower’s present and future property. 

Once the financing structure has been put in place, the lender must remain vigilant. Certain events, sometimes beyond its control, can impact the extent and rank of the security granted to it. In particular, the merger of two business entities can cause a lot of headaches to the lenders holding security on the property of the entity resulting from the merger.

In theory, a merger should have no effect on creditors’ rights.¹ Difficulties may arise however when the rights of the creditors of each of the amalgamating entities charge the same property, especially universalities of property of the same nature. That is particularly the case where two separate lenders each hold a hypothec, one charging the universality of property of one of the amalgamating entities, and the other charging the universality of property of the second amalgamating entity. After the merger, what is the extent of each creditor’s secured property? Which hypothec will have priority of rank, and on what property? As of the date hereof, there are very few court decisions on these questions. 

2. The case law

In its 1989 decision in Trust Général du Canada v. Compagnie du Trust National ltée², the Quebec Court of Appeal upheld the decision at first instance. This case involved a dispute between two creditors, one of them holding security granted by one of two companies before they merged, and the other holding security granted by the other company before the merger. Trust Général held a hypothec registered in 1978 on the present and future property of Maislin Realties Ltd. (“MR”) while Trust National held the same type of hypothec on the present and future property of Maislin Transport Ltd. (“MT”) registered in 1980. In the late 1980s, MR and MT merged. The corporation resulting from the merger defaulted on a loan payment. Trust National then seized and sold property originally belonging to MT on which it held a first-ranking hypothec.

Trust Général then filed a motion for a declaratory judgment to determine the rights of each of the creditors in this situation where the assets of the two pre-merger entities had become consolidated. In particular, Trust Général maintained that some of the trucks and provincial transport permits sold by Trust National were charged with first-ranking security in its favour that had been granted before the merger, and that its security consequently ranked ahead of that of Trust National.

The Court found that Trust National, holder of the hypothec originally granted by MT, had first-ranking security, despite having registered its hypothec after that of Trust Général. Basing itself on one of the clauses in the deed of hypothec, the Court of Appeal concluded that at the time it took its security, Trust Général did not have the intention of charging the property of MT.

However, in its decision in Banque Royale du Canada v. Banque Canadienne Impériale de Commerce³, the Court of Appeal did not follow the rule posited in the Trust Général case.

The Court pointedly distinguished the Trust Général case, in which the dispute involved property held prior to the merger [TRANSLATION]:

[25] Upon reading the Trust Général decision, it emerges that the dispute centred on property acquired before the merger. In this instance, however, RBC has not proven that it was the case here. The file indicates, rather, that almost all the payments came from property acquired after the merger. 

In this case, the Court applied the rule of earlier registration, as the property charged by the hypothecs did not exist before the merger of the two companies. The Court stated the following in this regard [TRANSLATION]:

[28] The company resulting from the merger does not constitute a new entity. It is merely the continuation, in a single corporate vehicle, of each of the merged entities. The assets of the original companies have been legally combined.

[29] Each company has lost its distinct identity (R. v. Black & Decker Manu. Co., at p. 418; Maurice and Paul MARTEL, La Compagnie au Québec, les aspects juridiques, vol. 1, Ottawa, Wilson & Lafleur, Martel, Ed. updated as at Oct. 1, 1999, p. 874). Each creditor benefits from its own security, which now extends to all the assets of the company resulting from the merger. The rank of each security will be established according to an order or priority that takes into account every security held by each of the creditors of both amalgamated entities.

[30] The general assignment of debts registered on behalf of CIBC in 1981 affects all of the indebtedness owing to Bois ouvré as of the merger, as does that granted to RBC in 1988, but the assignment to CIBC, as it was registered in 1981 and predates that held by RBC, takes precedence over the assignment in favour of RBC. 

3. Conclusion

In short, despite the lessons imparted by the Court of Appeal in the two above-mentioned decisions canvassed above, determining the rights of each hypothecary creditor following a merger can still potentially give rise to a number of issues. In light of the decision in Banque Royale du Canada v. Banque Canadienne Impériale de Commerce, it appears that when the secured property realized upon following the merger was acquired after the merger, the prior rank afforded by earlier publication will be the rule. And according to the decision in Trust Général du Canada v. Compagnie du Trust National ltée, where the property was acquired before the merger (assuming it is still identifiable) the parties’ intentions will have to be determined by the Court. The courts will pay particular attention to the description of the secured property in the deed of hypothec. It should be noted that these two decisions were rendered under the Civil Code of Lower Canada and that, to our knowledge, no analogous decision has been rendered under the Civil Code of Québec. It will be very interesting to follow the development of the case law in this regard. 

Finally, we recommend that the loan agreement include a clause requiring the borrower to obtain the lender’s prior written consent before agreeing to merge. Such a clause would allow the secured creditors of the amalgamating entities to come to an understanding before the merger. But what about a creditor who faces a fait accompli once the effects of the merger have caused it harm? How can it guard against or limit the risks? What are its recourses? These are subjects we will deal with in our next article – stay tuned!