In "True Lease v. Security Lease – Is the Distinction Still Relevant?" which appeared in the June 2008 issue of Collateral Matters, Jill Fraser discussed a 2007 amendment to the Personal Property Security Act (Ontario) (the "PPSA") and whether or not the distinction between a true lease and a security lease was still relevant in light of that amendment.
That issue is one that continues to preoccupy the courts.
Enforcement of Security
In her article, Jill reviewed a 2007 decision of the British Columbia Court of Appeal, DaimlerChrysler Services Canada Inc. v. Cameron, 2007 BCCA 144 (CanLII) ("Cameron") which involved a situation in which the distinction continued to be relevant, namely, application of the provisions governing enforcement of security agreements in the Personal Property Security Act (British Columbia). That decision is applicable in Ontario because Part V of the PPSA (Default – Rights and Remedies) applies to a security interest "only if it secures payment or performance of an obligation" (section 57.1).
As a consequence, although the PPSA otherwise applies to a lease of goods for a term of more than one year, whether or not it secures payment or performance of an obligation, Part V applies to such a lease only if it does so. It is necessary for the lessor, upon default by the lessee, to consider whether the lease is a true lease and therefore exempt from the provisions of Part V, or whether it is a security lease and subject to Part V.
In Cameron, the motion judge held that the lease in question was a security lease. The Court of Appeal reversed that decision. Professor Jacob Ziegel wrote a case comment critical of the decision of the Court of Appeal ("Security Interests and Continuing Challenges in Characterization of Equipment Leases: DaimlerChrysler Services Canada Inc. v. Cameron" (2009), 47 C.B.L.J. 283).
Reorganization or Restructuring
In her article, Jill also noted a second situation in which the distinction between true leases and security leases continues to be relevant: reorganizations or restructurings under Part III of the Bankruptcy and Insolvency Act (the "BIA") and under the Companies' Creditors Arrangement Act (the "CCAA").
The distinction remains relevant in those situations because of provisions in the BIA (section 65(4)(a)) and the CCAA (section 34(4)(a)) that permit persons, after the commencement of proceedings under the applicable statute, to require immediate payment for "the use of leased ... property" that is provided to the insolvent debtor. Courts have held that only a lessor under a true lease may have the benefit of these provisions, and that a lessor under a security lease may not.
Application of the CCAA provision arose in an unreported 2010 decision of the Court of Queen's Bench of Alberta. The court held that the lease in question was a security lease. The unsuccessful lessor sought leave to appeal, under section 13 of the CCAA, which permits a person dissatisfied with an order to seek leave to appeal either from the court that made the order or from the applicable appellate court. The lessor tried the same court first (Royal Bank of Canada v. Cow Harbour Construction Ltd., 2010 ABQB 637 (Can LII)), and, when that application was rejected, it tried the Court of Appeal (De Lage Landen Financial Services Canada Inc. v. Royal Bank of Canada, 2010 ABCA 394 (CanLII)). Reasons for decision were issued by both courts, but, because they deal primarily with what an applicant for leave to appeal must establish, they add little to the discussion of the true lease / security lease distinction.
A recently reported 2011 decision of the Court of Queen's Bench of Alberta, Re 843504 Alberta Ltd., 2011 ABQB 448 (CanLII) ("Skyreach Equipment"), introduced a third situation in which the true lease / security lease distinction remains relevant. Although Skyreach Equipment involved both the CCAA and the BIA, the issue arose in a priority dispute between a lessor of equipment and a secured creditor, with the lessor asserting contractual subordination by the secured creditor.
In 1999, the debtor had executed a general security agreement ("GSA") in favour of the secured creditor. It was validly registered in the Alberta personal property registry. In 2000, the debtor and the lessor entered into a master lease agreement, under which the lessor subsequently leased various vehicles and pieces of equipment to the debtor. The lessor registered a financing statement under the Personal Property Security Act (Alberta), but omitted to describe the collateral 'by item or kind' and did not set out serial numbers. These omissions rendered the security interest under the master lease agreement an unperfected one, and prevented the lessor from relying on the 'super-priority' given to a purchase-money security interest under the Alberta equivalent of section 33 of the PPSA.
Unable to assert a statutory priority, the lessor was left to make an argument based on the Alberta equivalent of section 38 of the PPSA and the provisions of the GSA. Section 38 of the PPSA states: "A secured party may, in the security agreement or otherwise, subordinate the secured party's security interest to any other security interest and such subordination is effective according to its terms."
The provision in the GSA relied on by the lessor was the following: "Borrower will not ... mortgage, pledge, grant or permit to exist a security interest in or lien upon any of the Collateral, now owned or hereafter acquired except for the Permitted Liens." The definition of Permitted Lien in the GSA included "lessor's Liens arising from operating leases entered into in the ordinary course of business." The lessor asserted that the master lease agreement was such an operating lease, and that the GSA provision had the effect of subordinating the security interest under the GSA in favour of the master lease agreement with regard to the leased equipment.
The court held otherwise. It noted first that the term 'operating lease' is used interchangeably with the term 'true lease,' and that the terms 'security lease,' 'financing lease' and 'capitalized lease' are also used interchangeably.
The court made reference to the 15 factors set out in a 1983 article by Ronald Cuming and listed in Jill Fraser's article mentioned above. Those factors will not be listed here.
The court went on to make reference to an article by Toronto lawyer Michael Burke, "Ontario Personal Property Security Act Reform: Significant Policy Changes" (2009), 48 C.B.L.J. 289. In that article, the author wrote that it was possible to make four generalizations from the case law:
- that four factors (what he called 'primary factors') are clearly more important than other factors ('secondary factors');
- that the presence of a primary factor in a lease often determines the issue;
- that secondary factors generally have a corroborative value and are not in and of themselves determinative of the characterization; and
- that, where a primary factor is ambiguous or absent, the court will weigh secondary factors in making the characterization.
The author identified the following primary factors:
- purchase option price – whether the purchase option price is nominal (indicating a security lease) or reflective of fair market value (true lease);
- mandatory purchase – whether the lessee is obligated to purchase the leased equipment (or title automatically transfers to the lessee) at the end of the lease term (security lease);
- open-end leases / guaranteed residual clauses – whether the lessee is liable for any deficiency in the sale of the leased equipment at the end of the lease term (security lease); and
- sale-leaseback transactions – whether the transaction is structured as a sale of the equipment (by the prospective lessee to the prospective lessor) and a leaseback by the buyer to the seller (security lease).
Mr. Burke also identified the following secondary factors:
- the ability to replace/exchange leased equipment (indicative of a true lease);
- the lessor's ability to accelerate payment of all future rental instalments and the residual value (security lease);
- full payment lease (indicative of either form of lease, depending on the language of the provision);
- security deposit (security lease);
- down payment (security lease);
- covenants relating to maintenance, insurance and risk of loss (indicative of either form of lease); and
- lessor's use of 'true lease' and 'security lease' forms for different transactions.
In Skyreach Equipment, the court found that the master lease agreement contained provisions that brought it within primary factor (3) above. At the end of the lease term, the lessee could return the vehicle and the lessor would sell it. The lessee would remain responsible for payment of rent until the end of the month in which the returned vehicle was sold. If the sale proceeds of a vehicle exceeded the termination book value, the lessee kept the surplus. If there was a shortfall, the lessee had to pay that amount to the lessor.
Although the court found some secondary factors in the master lease agreement that were indicative of a true lease, it found that their presence was "insufficient to outweigh the clear effect of the primary factors." The court concluded that the master lease agreement was properly characterized as a security lease and was not a 'Permitted Lien' under the GSA.
It is interesting to note that the provisions relied on by the courts in Skyreach Equipment and Cameron had the same effect, namely, to make the lessor 'whole.' The only difference was the timing when the provisions came into effect – on lease termination in Skyreach Equipment, on the occurrence of default by the lessee in Cameron. In his article, Michael Burke made note of the Cameron exception to the general rule that a guaranteed residual clause is indicative of a security lease.
The true lease / security lease distinction remains very much a relevant issue in Canadian personal property security law. Any thoughts that the 2007 amendments to the PPSA had ended its relevance in Ontario were, as Mark Twain said of reports of his death, exaggerated.
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.