Canada: Preserving Priorities: The Curious Case Of Fixtures

Imagine a common situation where, as a lender, you have registered a mortgage against title to a piece of real property owned by your borrower. There is a second mortgage registered on title, and you believe there is plenty of equity in the property. Your borrower did some renovations, but that didn't particularly concern you, given that no construction liens were registered and the renovations improved the overall value of the real property.

Now for a pop quiz: assuming there is no intercreditor agreement with the subordinate lender, can you lose priority with respect to the real property to the subordinate lender? What about another lender whose security interest is not registered on title? If your answer to both of these questions was a qualified "yes", you're at the top of the class. If that answer surprises you, you should read on.
The answer is "yes" due to a combination of two factors: first, the treatment of fixtures at law as being a part of the real property; and second, the often confusing interplay between real property and personal property security law.

As a rule of thumb, fixtures are items of personal property that have become "affixed" (hence the name) or attached to the real property, and are not otherwise simply resting on the land. For example, equipment that is bolted to a floor is a fixture, while a piece of equipment that is simply difficult to move because of its weight, but is not otherwise affixed to the property, is not. Historically, at law, once an item became a fixture, it was considered to be part of the real property and was no longer the personal property of its owner. The result would be that the owner of the real property would be the owner of the fixture, absent some agreement to the contrary.

The treatment of fixtures at law poses an issue both for lenders that finance a tenant's fixtures as if they were personal property and the lenders who may have security in the landlord's interest in the real property. To the personal property lender, the fixture is part of its collateral, owned by its borrower, the acquisition of which is often financed with funds from the personal property lender. To the real property lender, on the other hand, the fixture is an improvement to the real property and belongs to the owner of the real property, and is therefore properly the subject of its mortgage. So what happens when lenders start enforcing their competing security? Somewhat surprisingly, the battle of competing security interests over fixtures is governed not by real property law, but by the Personal Property Security Act (Ontario) (the PPSA).
Under section 34 of the PPSA, if the security interest of the personal property lender attaches to the fixture before the fixture attaches to the lands, that security interest will have precedence over the claim of any other person who has an interest in the real property. If the security interest attaches to the fixture after the fixture attaches to the lands, then that security interest will have precedence over the claim of any other person who has a subsequently acquired interest in the real property, but will be subordinate to any person who had a registered interest in the real property at the time the security interest in the goods attached (and who had not consented to the security interest in the fixture or disclaimed an interest in the fixture).

To a real property lender, this may seem like heresy. After all, it is first in priority on title and the fixture is part of the real property. However, it may help to think of the fixture financing as similar in nature to a purchase money security interest. It is generally understood that where a lender's funds are used to finance the acquisition of certain goods, the perfected security interest in those goods has super-priority over other prior security interests in the same collateral (provided the interest was perfected properly and in the manner required by the PPSA). Similarly, where a personal property lender is lending money to finance the acquisition of a particular fixture, it makes sense that it should take priority over the security interest of other prior security interests. Otherwise, it might result in a windfall to those lenders who were prior in time.

However, for the real property lender, this means that in certain circumstances, it is possible for the lender to lose priority over a portion of the real property (i.e., the fixture) even where its security might be first in time. This is true not just vis-à-vis the lender financing the fixture, but also, strangely, against subordinate lenders.
This very situation arose in a case called G.M.S. Securities and Appraisals Limited v. Rich-Wood Kitchens Limited and The National Trust Company. In that case, the borrower took out a first mortgage from a conventional real property lender to finance the acquisition and construction of its property. The borrower then had cabinets installed, which were unpaid for and secured by an attached security interest in favour of the cabinet financer. The borrower then took out a second mortgage on the real property, and the second mortgagee had no notice of the cabinet financer's interest because the cabinet financer had not yet registered its financing statement under the PPSA or in the Land Registry Office. When everything collapsed, the parties were left trying to sort out their order of entitlement to the property and the cabinets.

Under real property law, things should have proceeded simply enough: the first mortgagee should have come first, followed by the second mortgagee and then the cabinet financer. However, under the PPSA, the cabinet financer could claim ahead of the first mortgage as to just the cabinets (since its security interest attached before the cabinets were installed). The second mortgagee, however, who had no notice of the cabinet financer's interest, would rank ahead of the cabinet financer when it came to the cabinets.

As a result, even though the first mortgagee was ahead of the second mortgagee under real property law, when it came to the cabinets, it ranked behind the second mortgagee! In the result, the court awarded the sale proceeds to the first mortgagee, after deducting the full amount for the cabinets due to the cabinet financer, with the balance to the second mortgagee. However, the court also recognized that there was a circular priority problem and that any resolution would be at odds with one statute or the other.

The above situation can become even more complicated where one of the mortgages secures a revolving credit facility. Section 34(2) of the PPSA provides that the fixture financer's security interest will be subordinate to a subsequent purchaser for value without notice of the fixture financer's interest and the interest of a creditor with a prior recorded security interest who makes subsequent advances without notice of the interest in the fixtures. To complicate matters even more, in order to be effective, notice of the security interest in the fixtures needs to be registered in the appropriate Land Registry Office, rather than under the PPSA.

In order to protect lenders from situations such as the above, lawyers will often pursue an intercreditor agreement, which agreement will set out the relative priorities of the lenders in respect of various pieces of collateral. Admittedly, the intercreditor agreement is only an effective solution if the lenders are aware of each other, but prudent lenders should nonetheless endeavour to obtain intercreditor agreements once they become aware of other lenders on the scene.

For the fixture financer, obtaining an intercreditor agreement or some form of consent from prior registered secured parties is even more important, as it will not want to rely on proving time of attachment of its security interest in order to protect the priority of its interest in the fixture. Without such an agreement or consent, the fixture financer whose security interest attaches after the goods become affixed to the real property will be subordinate in priority to the prior registered secured parties. The fixture financer should also make sure to register notice of its interest in the appropriate Land Registry Office; otherwise it will not be protected against subsequent advances under revolving credit facilities or subsequent purchasers of the property. A waiver or estoppel letter from the other secured creditors (to the extent obtainable) will also help it to establish its priority.

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.

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