Whether a lease is a "true" or "finance"
lease has been debated in Canadian courts for decades in many
different contexts. The consequences of the categorization of a
lease can have a material impact on the recovery that a lessor may
have in an insolvency of its lessee. The Alberta Court of
Queen's Bench recently released its decision in the matter of
Royal Bank of Canada v. Cow Harbour Ltd. and 1134252 Alberta
Ltd. ("Cow Harbour") on January 23, 2012.
This is one of the most important recent decisions in this debate
and provides significant guidance as to how leases are to be
classified in insolvency cases. We will review, at a high level,
the tests that the court used in making its decision and offer an
alternative analysis of what we believe should be the proper
Generally speaking, if a lease is determined to be a "true" lease, then the lessor is entitled to be paid rent during the restructuring period and may not be subject to certain costs associated with the restructuring. Accordingly, the economic impact of not being a "true" lease can be very significant difference in the recovery obtained. Historically, the determination also impacted whether leases had to be registered under the Personal Property Security Act ("PPSA") but recent changes to the PPSA have made this debate a non-issue. Unfortunately, the statutes governing Canadian insolvency legislation simply utilize the word "lease" but do not provide for any commentary or direction as to the meaning of the term. Reliance is placed on the common law and the common law, not surprisingly, is unclear. To complicate matters, tax and accounting have different tests for "true" and "finance" leases that are not common law driven but rules based.
Lessors will often structure leases such that they will achieve the tax or accounting test for "true" leases, mistakenly thinking that they have achieved the same results for insolvency purposes. The accounting test under GAAP (as opposed to IFRS) is relatively black and white, focusing on residual value and who holds that risk. The legal test for insolvency purposes, however, does not use such a simplistic formulation and, as a result, confusion and frustration in the industry has reigned. While the recent Cow Harbour discussion is helpful in reducing this frustration, it does not end it.
The leading case used in insolvency courts in determining whether a lease is a "true" or "finance" lease is Smith Brothers Contracting Ltd.1 ("Smith Brothers"). This case gave a very narrow and restrictive interpretation. Overly simplified, a true lease is defined as the payment for use of an asset where ownership resides with the lessor and is not a disguised security agreement. The intent of the parties, as opposed to the form of the document, is a key consideration. The complication arose in how the intent of the parties was determined. The court adopted a list of factors used in the US and developed by Professor Cummings. This is referred to as the "Cummings List". In Smith Brothers and other cases, the Cummings List was reviewed as against the subject lease. Then, based on the review of how many factors were indicative of "true" or "finance" lease, a decision was arrived at. In many cases the process involved determining how many factors were on each side of the equation.
It has always been questionable if this approach was correct for two basic reasons:
- The Cummings List is adopted from US law and practice. While
Canada shares similarities in law to the US, there are differences.
At its most simple, one of the factors in the Cummings List is
whether the lease is registered under the Uniform Commercial Code
(the US version of the PPSA). In Canada, this factor is meaningless
as all leases of greater than one year must be registered. As, this
factor is meaningless in a Canadian context, a mere adding up of
factors and seeing how many are on each side is fundamentally
flawed. On a similar vein, certain of the factors if followed would
result in uneconomic activities. The classic example is insurance.
For a long term lease, a lessee can obtain insurance at a lower
cost than a lessor. If a lessor wanted to ensure true lease
treatment utilizing the Cummings List it would arrange for
insurance notwithstanding the higher cost. Uneconomic activities
would be the result.
- If a list of factors is to be developed, consideration needs to be given as to those which carry the highest probative value. To our knowledge there has never been a case decided where the purchase option amount is nominal and the lease was determined to be a "true" lease. In essence, there are clear factors recognized by the industry and courts which are clearly indicative of a "true" lease categorization, regardless of the presence of other factors. Other commentaries have advanced the theory that there are primary and secondary factors and that greater weight needs to be provided to those which carry higher probative value, the prime example being the purchase option.
In Cow Harbour, the Honourable Mr. Justice K.D.
Yamauchi provided an excellent overview of the decision to date and
the various arguments made by commentators. He also recognized that
the court was bound by prior decisions and had to apply the law
based on those prior principles. It is interesting to note that
encompassed in the decision was a discussion of whether there
should be a distinction of the "true" and
"finance" leases in an insolvency context and the
economic impact of such distinction. Justice Yamauchi noted that
the current state of the law is that financing leases are not
considered "leases" for the purpose of insolvency status
but openly questioned whether this was a correct and equitable
result. Many commentators have taken the position that this
original distinction between the two leases is likely wrong from an
economic standpoint and should be reviewed. The analysis set out in
Cow Harbour will assist in the future in making an
alternative finding if the correct set of circumstances arise and
may eliminate this unfair dichotomy.
In making its determination, the court had to strike a balance between existing precedents (as this was a lower court) and the reality of the case. The court clearly accepted the Smith Brothers as the leading case and adopted the Cummings List. Equally, the court was mindful that a holistic approach as opposed to a simple adding up of the factors should be used. While noting that one factor cannot trump the others in respect of the legal test, the court did note that all of the factors taken as a whole must be reviewed in their entirety to determine the intent of the parties. These guiding principles were then utilized in reviewing each of the leases. This approach was adopted by the court to allow them to, on the one hand, follow past precedents, but on the other hand acknowledge that a greater analytic approach was required.
The approach utilized by the court was to review each of the leases as against the Cummings List and then focus on certain of the factors in greater detail. It should be noted that in no circumstance did the court adopt the approach of simply adding up the factors and seeing which side had the majority. Notwithstanding the court's view that no one factor trumps others, what clearly becomes apparent is that certain factors, such as purchase option pricing, became the most significant factor. Factors such as a traditional default clause which provided for the acceleration of rent, which prior decisions held as determinative was rejected. The key test in a default clause was which party retained the surplus.
When reviewing the decision as a whole, certain themes evolved but were not explicitly set out. Interestingly these themes would have been the expectation of most industry observers.
- If there was a purchase option for nominal value or if the
lessee was responsible for the lessor's loss upon the ultimate
disposition of the equipment, then the lease would be a finance
lease. Accordingly, and not unexpectedly, dollar option leases and
TRAC leases will be "finance" lease.
- If a stretch lease is utilized i.e. a lease that has a set
purchase option at a particular time and then if the purchase
option is not exercised the lessee can renew for a period of time
where the lease payments over that renewal period were equal to the
purchase option price, then the lease would be a
- If the purchase option price is set as either (i) a fair market
value (and there is some value of the equipment at the end of the
term); or (ii) as a percentage of the original equipment cost which
is a reasonable estimate of the value of the equipment at the end
of the term, then the lease will, absent other factor to the
contrary, be a "true" lease. The determination of what a
reasonable estimate of the value is not fully explored in this
case. It was clear that the court was deferential to the expertise
of the parties where it was clear that the parties were mindful of
the structure. From a practice point, it is suggested that clients
should better document how they derive the purchase option
- Default provisions where the surplus was retained by the lessor
were indicative of a "true" lease.
- Security deposits, while problematical, can be retained but
they should not be of a size or nature that they change the
economics of the transaction, and that the taking of such a deposit
should be directly related to the risk involved in the
- If the amount of the lease payments made over the term of the
lease, even with a non-nominal purchase option, greatly exceed the
purchase price of the assets, then it is more likely to be
determined to be a "finance" lease. While this principle
was accepted by the court, there was little discussion of the cost
of capital which should be calculated into the equation.
- The inclusion of excess usage costs was helpful in determining
a "true" lease.
- Return conditions that a) could be achieved (i.e. not so complicated that they could not be met) and b) were possible to comply with in an economic sense (i.e. if the equipment has to be returned to the opposite side of the country and the cost of moving the equipment was greater than its value) were also factored into the "true" lease analysis.
Summary – Lesson Learned
The court, while at time using mental gymnastics to distinguish
prior case law, came to what were the expected results at least
from an industry perspective. What was disappointing was that the
process used in coming to this determination was based on outdated
or simply wrong concepts. The judge did an admirable job of
distinguishing previous case law where possible but was still bound
by precedent. It is suggested that a new approach be utilized based
on industry expectations in order to enhance certainty to the
industry when structuring transactions. The rationale is that
absent certainty, a lessor will take a more risk adverse approach
which either reduces liquidity or increases borrowing costs which
reduces productivity. Given that Canada's productivity is a
constant economic problem, any costless change to enhance
productivity should be welcome. It seems odd that one of the stated
goals of insolvency legislation is to assist debtors in
restructuring but the tools to keep them solvent (being able to
lease equipment) prior to filing for protection is so unclear that
finance companies may be unwilling to lend when companies need the
It is suggested that the test should follow the results as set out in Cow Harbour, but it should be set out explicitly. It is reminiscent of the late 1400's when Copernicus reviewed the star charts developed using an earth-centric or Ptolemaic system, which had become over-complicated, and by moving to a heliocentric system (the sun to the centre), simplified the understanding of the motion of planets. There should be a wholesale recognition that the current system has become over-complicated and it would be helpful to re-evaluate the analysis without reliance on the past precedent. It is time for a refresh. Justice Yamauchi went a clear step in that direction in his well written and coherent analysis but it is suggested that a clean break from past decisions would have been more desirable (although it is recognized that a lower court could not make such a radical change).
As noted earlier, the Cummings List is simply not an appropriate test in making the determination. Many of the factors listed are at best minor and should be removed, and the test provides no guidance as to weighing of the factors. This test should be abandoned and a new test adopted. The test should be simple to understand and easy to determine. It is suggested that a test be modeled on the following concepts:
- Is the lessee building up an equity interest in the asset? If
yes, then it is a "finance" lease. If the purchase option
is fair market value (other than a nominal fair market value) or
where it is a reasonable estimate, then equity is not being built
up and a "true" lease would be the result. This simple
test would also eliminate stretch leases as "true"
leases. Clearly the test would have to be mindful of the various
methods lessors use in forcing lessees to purchase at the end of
the term e.g., a) return condition that cannot be met; b) notice
clauses that are obscure; and c) equipment which would cost too
much to maintain.
- Which party has the residual risk? If the lessee has the risk,
then it is a finance lease.
- Is there value of the asset at the end of the term of the
- Which party has the equity of redemption?
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.