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Legal Guide

New business ventures invariably need financing and, more often than not, require sources of funding separate and apart from the equity contributed by shareholders, partners or other owners. While debt financings can take a variety of forms, the sources of such financings for most Canadian businesses include banks and other institutional lenders. To a lesser extent, debt financing is also sourced from parent companies or other shareholders or related persons, and even from trade creditors, which frequently offer their products and services on customary trade or payment terms.

Debt financing by banks and other institutional lenders

Most banks and institutional lenders generate the largest portion of their revenues from interest, and fees payable to them on loans and other credit by their customers. Such lenders are in the business of investing in their customers and managing the risks of loan losses resulting from customer defaults. In recent years in Canada, banks and other institutional lenders have been experiencing an increase in competition for corporate and commercial customers, and the investments they represent. To some extent, this increased competition comes as a result of the banking and financial institution industry reforms adopted by the Canadian government, which may allow for new opportunities for foreign banks to acquire or set up financing businesses in Canada. Perhaps to a larger extent, the level of competition here in Canada is a result of economic factors, including a spillover into Canada of industry concentration and increased competition originating in the US, Europe, Japan and elsewhere in the Far East. For whatever the reason, borrowers in Canada are generally well-advised to shop around for financing proposals from those lenders (or investors) that are willing to extend credit on the best available terms.

Once the most attractive financing proposal is obtained from a particular bank or financial institution, and the requisite formal credit application has been submitted and accepted, a written offer to finance, in the form of a term sheet or commitment letter, is normally prepared and delivered to the borrower. The term sheet or commitment letter will summarize the terms and conditions on which the bank or other financial institution will advance credit, including the list of the loan and security documentation required before any advance of the credit will be made. Once the borrower accepts the term sheet or commitment letter by signing it, a binding agreement is created (unless the document provides otherwise). In the case of larger or more complex loan arrangements, a formal loan or credit agreement is normally required which, when settled and executed, will supersede the term sheet or commitment letter.

Although a loan may either be secured or unsecured (generally determined based on a lender’s assessment of the relative credit-worthiness of the borrower and the reduction in the interest rate and fee pricing, which can often result when security is made available), in most instances, security for borrowings will be required and, in certain cases, guarantees of the shareholders, subsidiaries or other related parties will be requested. The form of the required security will depend upon a number of factors, including whether the loan is payable on demand or in instalments over a specified term, or at a specified maturity date. Operating loans are usually payable on a demand basis, whereas term loans are usually paid in instalments over time, subject to the lender’s right to accelerate the entire loan balance upon the occurrence of one or more specified events of default. In Canada, the tendency for banks is to take and hold a number of different forms of security. The following is a list of common types of security which banks and other institutional lenders in Canada may require:

  • •     A general assignment of accounts receivable or book debts;
  • •     A general security agreement creating a security interest in all of the borrower’s (or guarantor’s) present and after-acquired property, assets and undertaking;
  • •     A debenture charging all present and after-acquired property, assets and undertaking of the borrower (or guarantor), and which can include a specific mortgage and charge of real property;
  • •     A pledge of securities whereby ownership of the borrower or guarantor is taken as collateral;
  • •     Security under Section 426 or 427 of the Bank Act (Canada), which provides for the creation and granting of special inventory security, which can only be taken by a Canadian chartered bank and which can only secure direct indebtedness (as well as certain contingent obligations in respect of bankers’ acceptances and letters of credit); such security can only be taken from specific classes of borrowers; and
  • •     In Quebec, security can also be taken on any type of asset, whether real (immovable) or personal (movable), tangible or intangible, in the form of a “hypothec”.

Debt financing by shareholders and other business owners

It is generally recommended that shareholders or other owners of businesses, when making loan advances to their company, obtain security for any and all such advances to the company. Where security is taken, the shareholders or owners who advance the loans will generally have claims that, in the event of an insolvency or bankruptcy, will have priority over the claims of unsecured creditors (including most claims of trade creditors). However, banks and other institutional lenders normally require that shareholders or owners who have made shareholder loans (whether or not such loans are secured), enter into agreements to postpone and subordinate their security in favor of the security held by the banks or institutional lenders.

Non-traditional financings

Banks and other financial institutions, in addition to the conventional types of credit facilities offered to corporate/commercial borrowers, offer other less traditional forms of credit, including derivative or other treasury products or services, to assist borrowers to hedge currency, interest rate or other market risks, to which they may be susceptible. In fact, now, many banks and institutional lenders often require as a condition of their loan or credit facilities, that their borrowers enter into these types of hedging facilities in order to manage their risk, and the risk which the bank or lender indirectly assumes through their investment in the borrower.

Since many of the Canadian banks now own or are affiliated with merchant banks and investment dealers active in the capital markets, the types of credit and advisory products and services which are now available from a single source have become quite broad. In Canada, as in other countries, this trend has translated into an increase in “hybrid” forms of financings, incorporating both debt and equity components, such as through the use of convertible debt instruments or warrants.

Participating febt

Lenders may be persuaded to assume a greater degree of risk or to accept a lower assured yield on a loan, by using a debt instrument which makes the lender’s return on investment dependent upon the success of the business. In addition to the interest on the loan, the lender would also share in the profits of the business when they exceed a certain specified level. Alternatively, the lender may be granted the right to convert the debt instrument into shares of the corporation if the shares appreciate (for example, by way of a convertible debenture).

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