Canada: Priority Agreements In Inventory Financing: Parts And Supplies Should Be Carefully Defined

The recent case of Toronto Dominion Bank v. Wheatland Industries (1990) Ltd.¹ (the "Wheatland Case") is instructive in its interpretation of priority agreements in inventory financing. This is an area that is rarely litigated in Canada and any judicial consideration is welcome. In the Wheatland Case, the Saskatchewan Court of Appeal focused on whether inventory credits (i.e. credits owing by a supplier to a debtor as a result of the debtor having returned parts which were fully paid for to the supplier) formed part of the supplier's collateral and therefore provided the supplier with priority over the general secured lender with respect to such inventory credits. The Court of Appeal, overturning the decision of the Court of Queen's Bench, determined that the supplier had priority to the inventory credits. In making this finding, the court relied heavily on the wording of priority agreements between the secured lender, supplier and debtor and the intent thereunder, industry practice and economic reality. Had the decision of the lower court prevailed, it may well have caused many inventory financiers to re-evaluate the economics of their lending practices. As will be set out below, it is suggested that parties focus on this issue when drafting priority agreements to ensure that the relative priorities of the parties are clear.

Background

The structure in the Wheatland Case was a traditional inventory finance arrangement where the debtor was a dealer in equipment (in this case, farm equipment) who had an operating line of credit from Toronto Dominion Bank ("TD") and two revolving lines of credit from its major equipment supplier, CNH Capital ("CNH"), who had acquired the interests of two of the debtor's previous suppliers. TD was granted a general security interest over the present and after-acquired property of the debtor and CNH was granted a security interest in certain present and after-acquired property of the debtor, including the inventory financed by CNH. Both security interests were registered under the Personal Property Security Act (Saskatchewan) (the "PPSA"), with TD registering first. The parties entered into priority agreements whereby CNH was granted priority over all inventory that CNH financed, while TD was granted priority over all remaining property of the debtor.

TD took the position that since the inventory credits were not assets financed by CNH but were in fact a credit, they should form part of the assets of the debtor which were not subject to the priority in favour of CNH. CNH, on the other hand, claimed that the priority agreements were clear that the inventory credits formed part of CNH's security. The Court of Appeal agreed with the position of CNH, holding that the inventory credits formed part of CNH's collateral under the priority agreements and, accordingly, CNH had priority with respect to the inventory credits.

Analysis

The decision focused on the wording of the priority agreements. Although the priority agreements in question were similar to most priority agreements, the treatment of inventory credits was unique. The priority agreements defined "Credits" as, among other things, all other amounts, credits or claims due or accruing due to the debtor from a manufacturer or distributor of goods, parts and supplies. "CNH Financed Collateral" was defined to include, among other things, (i) all present and after-acquired Credits relating to any item of CNH inventory and including all Credits due or accruing due to the dealer from CNH, and (ii) all choses in action, right and contracts relating to the CNH inventory and all proceeds realized by the debtor from such contracts, the CNH inventory and Credits.

TD argued that parts financed by CNH only constituted "CNH Financed Collateral" as long as such parts remained unpaid and, since the inventory credits related to fully paid for parts, they did not fall within the definition of "CNH Financed Collateral". However, the court did not agree with TD and instead applied a broader interpretation to the word "financed". In reviewing the priority agreements, the court paid particular attention to the definition of "Goods". The court noted there was a distinction between "Goods", which referred to whole or complete units of equipment such as tractors or combines, and "parts or supplies". Since the priority agreements only referred to a subordination by CNH in respect of "Goods" for which CNH had been paid in full, and not in respect of "parts or supplies", it followed that CNH retained priority over "parts and supplies", even if such parts and supplies had been fully paid for. The court was also cognisant of the inventory finance industry as a whole, noting that including parts in the definition of "Goods" would be inconsistent with how parts are supplied and financed.

It is interesting to note that the court firmly rejected the lower court's comment that since TD had registered its security first, any inconsistency in the priority agreements would benefit TD. The court also noted that since CNH likely held a purchase money security interest in the inventory by virtue of the provisions of the PPSA, the priority agreements were restricted to issues outside of the scope of the priorities as set out in the PPSA.

Practice Tips

When drafting a priority agreement, individuals must be precise in defining the property that will be included in or excluded from the scope of the priorities. In the Wheatland Case, it appears that the drafter focused on a particular area and added applicable concepts in the priority agreements but the lower court did not find the precision clear enough. While it is not particularly good drafting to use avoidance of doubt clauses, this case illustrates that a clause regarding intent, written in plain, clear language, would have been helpful and saved legal costs. Given that it is difficult to enumerate all of the circumstances that may apply in a priorities situation, it is suggested that, to the extent possible, clear statements of intent be included in priority agreements.

Footnote

1. [2012] 2 W.W.R. 1, 2011 CarswellSask 622, 2011 SKCA 107, 208 A.C.W.S. (3d) 203, 81 C.B.R. (5th) 298 (Sask. C.A.,Sep 28, 2011)

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.