Get Up To Speed On Lending Issues

As the source of loans shifts, lenders and brokers must understand the additional risks

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lending issues

GET UP TO SPEED ON LENDING ISSUES

This article discusses concerns about private lenders with less knowledge, sophistication and experience. The discussion is not intended to include those lenders who are knowledgeable, sophisticated and experienced [for example, the overwhelming majority of mortgage investment corporations (MICs)].

BY TIMOTHY LACK

Recently, the Bank of Canada signalled that interest hikes

will become the new norm to help combat inflation. These rate increases have started, and experts predict there will be plenty more to follow.

But the constant and insatiable need for cash never stops, and the source of loans will likely shift as traditional lending sources become increasingly unavailable to many Canadians. Individuals may turn to private lenders if they want a second mortgage that provides a quick cash infusion. However, mortgage brokers and lenders must understand (and be prepared to explain) how private lending tends to carry additional risks not seen in a traditional first mortgage transaction. There are many legal and factual situations that illustrate the unique risks these mortgages carry, including:

• Lenders with less restrictive lending criteria;

• Lenders accepting borrowers that banks would normally avoid;

• Lenders with less lending sophistication and/or underwriting prowess;

• Borrowers with unstable forms of income such as non-salary, fluctuating levels of income, self-employed, contract work, etc.;

• Borrowers with poor or no credit history; and

• Parties pushing, with a heightened sense of urgency, to complete the transaction.

These issues complicate what would otherwise be more straightforward in a first mortgage. Parties on both sides – borrower and lender – will approach brokers with varying levels of knowledge, sophistication and experience. Be mindful that some borrowers may come with heightened desperation and an unsophisticated private lender may do very little, if any, real due diligence and will bank on their agents/brokers/lawyers to “do it right” and “keep them safe.” In my experience, the broker role in a private mortgage is significantly more pronounced and the “handholding” is in effect right up to funding. Are you ready for this changing role?

As you review the situation in a private loan transaction, a compelling picture emerges depicting the greater risks of second and private lending. And this does not even consider the very real and increasingly prevalent element of fraud. I cannot emphasize enough about taking safeguards to avoid fraud as it just takes one fraudulent transaction to throw your business into disarray. I lump identity theft, valuation fraud and undue influence together in this warning. I have seen it. It’s real. Don’t get caught – brokers and lenders must take extra care and exercise greater vigilance.

PRIORITY ISSUES: MITIGATE THE LOAN-TO-VALUE THREATS While other lending criteria are not always pushed aside, it is not a stretch to say that loan-to-value ratios are determinative for many private lenders.

And of course, no lender wants their loan’s loan-to-value ratios to negatively change as the term of the mortgage progresses. Accordingly, protecting the priority position of the second mortgage transaction against future advances secured by a pre-existing (first) mortgage is of utmost importance. The available protection measures vary by province.

Alberta Alberta has a straightforward approach to priority issues. Section 104 of the Alberta Land Titles Act provides that a mortgage will rank in priority to a subsequent mortgage for all advances up to the registration amount, including subsequent advances, notwithstanding that the subsequent mortgage was registered. Any estoppel arguments for second mortgages to gain priority, such as actual notice, have yet to be tried in Albertan courts.

Ontario Ontario provides priority protection for second mortgages by way of actual notice. The lender of the subsequent (second) mortgage must ensure that the first or prior mortgagee receives actual (as opposed to constructive) notice in writing of the registration of said

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lending issues

subsequent mortgage. This is required pursuant to s. 73 of the Registry Act and s. 93(4) of the Land Titles Act, which provide that such actual notice will allow advances to the subsequent mortgage to rank in priority to the first or prior mortgage.

Actual notice must be provided in writing. Registration alone is not enough to constitute actual notice. Furthermore, the onus is on the subsequent charge holder to provide actual notice of registration to the first or prior lender.

British Columbia A Court of Appeal decision in British Columbia (see Forjay Management Ltd. v. 625536 B.C. Ltd., 2020 BCCA 70 (Forjay)) brought practical application from legislation to case law to legal practice for lawyers doing second mortgages. Section 28 of the Property Law Act (PLA) acts as the B.C. equivalent to Ontario’s protection provisions under ss. 73 and 93(4) of the Registry Act and Land Titles Act, respectively.

More specifically, this Act allows a second mortgage lender to assert priority over further advances made by a first mortgage provided certain fundamental steps are taken. Also, like Ontario, note that an initial or preliminary request for information regarding the status of the first mortgage does not constitute notice under the PLA, and the obligation falls on the subsequent mortgage holder to give the prior mortgagee actual direct express and written notice of registration of the second mortgage registration.

However, please note that while there was no clear definition for what constitutes good and proper notice in the PLA, the case law is clear: notice needs to be actual, direct, express and in writing. As stated, its interpretation was only recently opined upon by the courts, and lawyers are well served with the clear guidance from this case.

The courts ruled that actual notice must be direct, express, written and sent pursuant to s. 28 of the PLA. Lacking any of these elements, regardless of whether the prior mortgagee attained actual knowledge of the subsequent mortgage, would render the notice insufficient in protecting the priority of the subsequent mortgage. Don’t be caught by the suggestion that “everyone knew about the second mortgage.” Give the notice as the Court of Appeal as directed.

“

I readily acknowledge that GST priority seems to be a huge unknown, especially when it is often the small business owner seeking a loan. I further acknowledge that the steps to enhance protection set out above are hardly ready and quick methods for allaying the risks. Unfortunately, the risk remains real and the steps to protect the lender are cumbersome in a hurried deal.

Such notice can also be sent directly by the lender or via an agent/lawyer. I mention this because prior to Forjay there was some doubt as to who could send such notice to give it full effect.

These clearer guidelines do not preclude future issues, especially given the high frequency of priority issues between first and second mortgages. In response B.C. lawyers have developed new practices that, although they go beyond the scope of the PLA and jurisprudence, work to mitigate potential issues and enhance protection for lenders. Lenders and brokers will need to ask their lawyers to take the necessary steps to avail the second mortgage lender of the protections afforded by the PLA.

Takeaways are good. Here are your takeaways to help assert priority against further and higher advances made by a first mortgagee:

1. Confirm the Details of the First Mortgage Lenders, brokers and lawyers must perform a thorough process to confirm the terms, balances and details of the first mortgage. As an experienced second mortgage lawyer, I have been retained to review mortgage files where this confirmation was not performed and the priority fights were full on. Virtually

all banks and credit unions now use “all indebtedness mortgage” type language to describe the principal amount owed under their first mortgages. As such, brokers should pay close attention and request each and every loan facility secured by the registered mortgage. Also, be extremely mindful as to where these balances and information were obtained. Obtaining these balances is often the slowest activity in the critical path of second mortgage financing and, accordingly, the source of such information might be something less fulsome than if the second mortgage lender or their lawyer obtains it directly from the first mortgagee.

2. Send Notice Immediately Upon Registration and Funding Send direct, express written notice to the first mortgagee of your new second mortgage registration pursuant to s. 28 in B.C. or ss. 73 and 93(4) in Ontario. If you learn one thing from this article, this is it.

Keep in mind that virtually all mortgages prohibit subsequent encumbrances being registered on title. The written notice protects the second mortgage lender but also serves as clear notice that the borrower is likely in breach of the terms of their first mortgage. Brokers and lawyers helping the borrower

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obtain a second mortgage must be aware of this and it is prudent, if not fundamental, to tell the borrower of this breach and the risk of recourse being taken by the first mortgagee.

GST SUPER PRIORITY Just as the B.C. courts have brought some needed clarity to how a second mortgagee should give notice to prior mortgagees to protect their priority, the Federal Court of Appeal, in 2020, brought some worrisome clarity to the issue of GST super priority as against mortgage lenders. See Toronto- Dominion Bank v Canada, 2020 FCA 80.

Essentially the court’s decision gave the Canada Revenue Agency (CRA) its Teflon armour for asserting priority for GST obligations of a borrower over secured mortgage loans by asserting that the deemed trust has priority over secured loan funds. This happens when a borrower has outstanding GST obligations payable before a mortgage transaction. Unremitted GST is considered a “deemed trust” as defined by the Income Tax Act, Excise Tax Act, Employment Insurance Act, and the Canada Pension Plan Act. If an individual does not remit these monies to the Receiver General as governed by these Acts, the individual becomes a tax debtor. This results in the tax debtor’s property (as well as any proceeds including those from its sale or foreclosure) being deemed as held in trust for and beneficially owned by the Crown up to the value of the tax debt, regardless of any registered security interests. Yes, this is as scary as it sounds.

The federal court held that unremitted GST ranks in priority to all other interests and that the onus is on the lenders to pay the borrower’s GST obligations out of the funds that went to the lender instead of to CRA. Secured creditors are not considered to be bona fide purchasers, which is otherwise a valid defence raised against deemed trusts. Thus, the super priority will jeopardize the lender’s priority position and make the lender personally liable for the borrower’s GST obligations to the extent that funds were paid to the lender instead of CRA.

However, the super priority does not apply to all situations. It does not survive bankruptcy under the Bankruptcy and Insolvency Act (Canada) upon which CRA loses its deemed trust and is treated as an

unsecured creditor with respect to its claim to unremitted GST/HST. Additionally, the priority position of any mortgage transaction made before the borrower’s failure to remit GST or under the Companies’ Creditors Arrangement Act (Canada) should not be affected by the super priority. There are other nuances about this super priority that are beyond the scope of this article. Also, don’t consider this as a case of “bad law” or a unique fact pattern or even bad arguments. Everything from the public interest to uncertainty for lenders, promoting bankruptcies and the chilling effect on business transaction were raised to no avail in the case.

While hardly a concrete best practices checklist, there are some steps to ensure protection from the super priority:

• Identify high-risk borrowers;

• Advise lenders about the importance of unremitted GST payments;

• Amend mortgage terms to require evidence of tax compliance for all deals, including new and ongoing ones;

• Require enhanced disclosure including, but not limited to, presenting evidence of ongoing tax compliance;

• Obtain a conflict letter at the time of repayment (though subject to audit);

• Require borrowers to provide authorization for CRA to allow lenders to make inquiries regarding outstanding tax liabilities;

• Post cash security until a GST clearance certificate can be obtained;

• Petition the debtor into bankruptcy or to make a filing under the Companies’ Creditors Arrangement Act; and

• Request additional guarantees.

Title insurance may cover loss to unknown super priority liens payable prior to the policy date, with extended coverage available. However, this comes with ceilings on liability coverage. Thus, lenders should seek guidance on these endorsements.

I readily acknowledge that GST priority seems to be a huge unknown, especially when it is often the small business owner seeking a loan. I further acknowledge that the steps to enhance protection set out above are hardly ready and quick methods for allaying the risks. Unfortunately, the risk remains real and the steps to protect the lender are cumbersome in a hurried deal.

INDEPENDENT LEGAL ADVICE I keep repeating that the deals are hurried and the parties always seem desperate to get the funding concluded. This is not always a bad thing so long as the transaction is viewed with a learned eye. Bank transactions easily lend themselves to the lawyer acting for both parties. Private transactions, with higher rates, additional fees and perhaps desperation on the part of the borrower, may dictate that the borrower obtain independent legal advice. Also, as previously stated, some lenders can be less sophisticated with little or no underwriting taking place beyond an assessment of the LTV ratio. The broker and/ or the lawyer have little comfort that there has been a detailed enquiry made about the borrower and their loan transaction.

The additional cost, time and mechanics added to the deal may very well be worth it. I have seen too many defences raised by borrowers in private transactions that could have been nipped in the bud if the borrower had received fulsome clear advice from the beginning. The takeaway here is to let the lawyer decide if the borrower needs independent legal advice and follow that decision.

CONCLUSION The timeframe to close a deal can be extremely short. The challenges that come with second mortgages and unsophisticated private lenders add additional obstacles that may put pressure on the timeline. Therefore, taking prudent measures at the outset will allow brokers to mitigate common issues. In turn, they can then focus on more complex matters, act and react quickly for their client, take charge of the situation and provide top-shelf service.

This article summarizes certain general issues surrounding second mortgages, but the authors advise it is not a substitute for legal advice on a specific lending transaction. Each such transaction has its own particulars, and you should seek appropriate professional and legal advice on each loan transaction.

Timothy Lack is a partner and lawyer at Redpoint Law LLP Vancouver. Research assistance by Jerry Shi, articled student, and Abiel Kwok, summer student. More information: redpointlaw.ca

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