Originally published in Blakes Bulletin on Financial Services, May 2007
Since the introduction of the PPSA in Ontario in 1976, the issue of whether a lease is a true lease or a security lease has generated more litigation and controversy than any other specific issue under the PPSA. How a lease is ultimately characterized can have serious consequences. If the lease is a true lease, then that lease is completely outside the scope of the PPSA. If the lease is a security lease in the sense that it secures the payment or performance of an obligation, then that lease falls completely within the scope of the PPSA. Unfortunately, unlike the Uniform Commercial Code, the PPSA provides virtually no guidance on when a lease will be considered to be a under the PPSA.
It is possible to make some broad generalizations from the case law on this characterization process. Some provisions in a lease are clearly more important than others in this characterization process. For example, after a number of conflicting lower court decisions, in 2000, the Ontario Court of Appeal in Crop & Soil Service Inc. v. Oxford Leaseway Ltd. conclusively held that a residual value guarantee in a lease is indicative of a security lease. If a lease contains a purchase option that may be exercised by the lessee at the leased goods’ fair market value and such price is not nominal, then such a lease has in almost all reported cases been characterized as a true lease. Most of the other provisions in a lease, however, only have a corroborative value and are not in and of themselves determinative.
There are, however, more than a few cases which cannot be easily explained by these generalizations. In these cases, it appears that other factors external to the terms of the lease agreement have been used by the courts to tip the scale from what should have been a true lease characterization to a security lease characterization. One of the best examples of this is a 1994 Ontario General Division decision in Adelaide Capital Corp. v. Integrated Transportation Finance Inc. Not surprisingly, many lessors – except those where the value of their leased goods does not justify the cost of making a PPSA filing – are no longer willing to play the characterization game. It has simply become too much of a gamble. Instead, these lessors file a financing statement in respect of their leases, knowing that section 46(5)(b) of the PPSA permits a lessor to do a precautionary PPSA filing without that PPSA filing creating a presumption that the lease is a security lease.
To introduce more certainty on this issue, as well as to bring the Ontario PPSA in line with the PPSAs in the other jurisdictions of Canada, Bill 152 introduces the concept of "leases for a term of more than one year" and effectively deems such true leases to be security interests under the PPSA. Accordingly, such true leases will fall within the conflicts, registration, perfection and priority provisions of the PPSA, but they will not be subject to the rights and remedies provisions set out in Part V of the PPSA. Indeed, one of the side benefits of the inclusion of long-term true leases under the PPSA is that lessors of such leases will be able to benefit from the "mobile goods" conflict rule and the special fixture and accession priority rules under sections 34 and 35 of the PPSA. These PPSA rules are much more advantageous from a lessor’s perspective than the corresponding common law rules.
The definition of "leases for a term of more than one year" has an expanded meaning. As expected, it applies to any true lease with an actual term of more than one year. It also extends to any true lease with the potential of having a term exceeding one year, such as a lease for an indefinite term or a lease for a term of less than one year but which is automatically renewable for one or more terms, the total of which may exceed one year. In addition, the definition covers an overholding lessee permitted by the lessor. If the initial and any renewal terms of a true lease is less than one year and, with the consent of the lessor, the lessee retains uninterrupted or substantially uninterrupted possession of the leased goods for a continuous period of more than one year, such a lease will become subject to the PPSA, but only after the lessee’s possession exceeds one year.
There are two narrow exceptions to this definition. The PPSA will not apply to a true lease, even if it has a term that is greater than one year, if:
(i) the lessor is not regularly engaged in the business of leasing goods; or
(ii) the leased goods are household furnishings or appliances that are subject to a lease of land and such goods are incidental to the use and enjoyment of the land.
The addition of this new term into the PPSA lexicon does not mean that the distinction between a security lease and a true lease will become an interesting historical footnote. The distinction will still be relevant, not only within the PPSA context, but also in other non-PPSA contexts and disputes.
Within the PPSA, the distinction will remain relevant in determining whether the enforcement provisions in Part V of the PPSA apply to the particular lease. As noted above, a lessor’s rights and remedies under a true lease – as opposed to a security lease – will not be subject to limitations set out in Part V of the PPSA, including the requirement to (i) provide notices of disposition to the lessee and other interested parties and (ii) account for any surplus. In the case of a true lease, the lessor’s remedies will be governed by the more lax common law principles and the terms of the lease agreement. For example, unless the lease provides otherwise, a lessor is entitled to retain any surplus from the sale of the leased goods at the end of the true lease.
Outside of the PPSA context, the distinction between a true lease and a security lease will remain relevant. For example, section 65.1(4) of the Bankruptcy and Insolvency Act (Canada) and section 11.3 of the Companies’ Creditors Arrangement Act (Canada) provide that a stay under either of those statutes does not apply to a true lease. Accordingly, lessors under "true leases" are entitled to exercise certain remedies that are unavailable to other creditors, including lessors under "security leases". The distinction will also continue to be relevant in determining whether a lessor has a right to collect and retain "overhold" rent. If the lease is a true lease, a court will permit the lessor to retain any overhold rent, but not if the lease is characterized as a security lease.
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.