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This article does not consider the issues raised by tax or financial accounting
matters as they are addressed elsewhere. Due to the absence of a specific
factual context, the summary nature of this article and the attempt to cover the
laws of several jurisdictions, this article is intended to assist the business reader
in identifying issues and should not be relied upon as legal advice.
•
TORONTO
•
MONTRÉAL
•
CALGARY
To readers familiar with civil law codifications of leasing laws, the Canadian laws
affecting the leasing industry may appear to be a patchwork quilt of laws, which
do not necessarily fit together in a well–ordered and comprehensive manner.
This is caused, in part, by the common law, which is heavily precedent based
and evolves over time. However, the law, applicable to the leasing industry is
less than well organized for two additional reasons: (i) Canada's constitutional
structure and history result in both federal and provincial laws affecting the
industry and in different provinces enacting different laws to address the same
issues within their own boundaries; and (ii) the equipment leasing industry draws
its legal foundations from the law governing rentals (usually of real property) and
from the law governing secured transactions while, in truth, equipment leasing
has issues in common with both areas and has unique issues which are not
adequately addressed by either of these areas.
OTTAWA
•
This article provides an overview of the legal issues typically encountered in the
equipment finance and the leasing business in Canada and, for those familiar
with previous editions of this article, highlights recent developments of interest.
The goal of the article is to assist: (i) non-Canadian equipment lessors interested
in the Canadian market place; and (ii) Canadian equipment vendors and
financiers seeking a greater understanding of the legal issues affecting their
business. After a review of recent developments and an overview of the
Canadian legal system, the article considers issues in cross-border leasing into
Canada, followed by the issues encountered when establishing and operating a
leasing business in Canada. The approach taken is to raise legal issues as they
naturally occur during the establishment of a leasing organization, the
development of a business strategy, the completion of leasing transactions, the
funding of a portfolio and, finally, the enforcement of a lease.
VANCOUVER
Kevin A. McGrath
August 2002
World Leasing Yearbook 2003 – Canada – Legal Issues by K.A. McGrath
Recent Developments
Since the 2002 edition of this article, several matters of note have taken place in
Canadian law with respect to equipment finance and leasing in Canada:
(i)
the enactment of legislation which affects non-Canadian equipment
financiers which are related to banks and which are in, or which seek to
enter, Canada to conduct leasing activities;
(ii)
the enactment by the federal government of updated and more
comprehensive money laundering legislation;
(iii)
the establishment by the federal government of a capital leasing pilot
project under the Canada Small Business Financing Act; and
(iv)
the continuing question and judicial determination of what priority federal
government (the "Crown") claims enjoy in relation to the claims of other
secured creditors against debtors.
As mentioned in the previous editions of this article, Bank Act (Canada)
amendments were proposed to, among other things, facilitate the easier entry of
foreign banks and their various subsidiaries (including leasing subsidiaries) into
Canada. As a result of the enactment on June 14, 2001 of An Act to Establish
the Financial Consumer Agency of Canada and to Amend Certain Acts in
Relation to Financial Institutions (the "FCA Act"), the Bank Act and various other
Canadian federal statutes were amended in a variety of respects. Although the
FCA Act received Royal Assent on June 14, 2001, the majority of the provisions
of the FCA Act were not proclaimed in force until October 24, 2001.
With respect to foreign bank entry, including the entry of non-deposit taking
equipment financing subsidiaries of foreign banks, the stated aim of the new
legislation is to provide flexibility for foreign banks wishing to operate in Canada
and to streamline regulatory approvals. However, notwithstanding that stated
objective, foreign banks are now prohibited from providing financial services in
Canada and from carrying on any commercial activities in Canada unless a
statutory exemption is available or an approval order is obtained. The exemption
provisions are complex but offer greater clarity and may raise significant
business opportunities for leasing companies. The wide net thrown around nonCanadian financiers by the broad "foreign bank" definition continues unchanged
under the amended Bank Act (thereby catching most commercial conglomerates
and non-bank financiers with a "bank" in the corporate group). A key threshold
issue under the Bank Act continues to be whether a foreign bank meets the
conditions for designation as a "foreign bank".
As previously noted, the definition of a "foreign bank" for purposes of the Bank
Act is very broad in scope. Any entity that carries on, as a material part of its
business, a financial services business outside Canada may find that it is a
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"foreign bank" within the meaning of the Bank Act. The definition includes "real"
regulated foreign banks and so called "near" foreign banks, which are affiliated
with a regulated foreign bank. A foreign bank will be a designated foreign bank,
by order of the Minister of Finance (Canada) (the "Minister"), for purposes of the
Bank Act if (i) it is a bank according to non-Canadian laws, (ii) it uses the word
“bank”, “banking” or equivalent in its corporate name, (iii) it is regulated as a bank
outside of Canada, or (iv) if it is not any of (i), (ii) or (iii) above, but the foreign
bank's corporate group derives a "prescribed material percentage" (currently,
35% is the prescribed percentage) of its consolidated total assets or revenues
from the foreign banks in the corporate group. A designation order will only be
made if the foreign bank, directly or indirectly, wishes to carry on business in or
invest in Canada. If a foreign bank is designated, then it will be subject to all of
the regulations provided for in the Bank Act and will be subject to the same
powers and restrictions in Canada as those applicable to Canadian banks.
If a foreign bank is not designated in accordance with the criteria described
above, it may apply for an exemption order from the Minister relieving it from the
application of most of the requirements of the Bank Act. A foreign bank that is
subject to an exemption order will, however, have an obligation to advise the
Minister of any changes in circumstances that may affect its eligibility for
designation. The consequences of losing an exemption order is that, when
designated, the foreign bank will have to comply with all of the provisions of the
legislation including the restrictions on powers, business activities and
permissible investments of designated foreign banks conducting business in
Canada. This could lead to the required divestment of certain Canadian
business activities.
As a result of the new legislation, the regulatory regime governing leasing
subsidiaries of foreign banks in Canada or entering Canada, whether actively
engaged in banking in Canada or only engaged in leasing and related nonbanking financial services (i.e. not taking deposits or performing other core
banking activities), remains complex but should be more flexible.
The second new development is the enactment by the federal government in late
2001 of updated and more comprehensive money laundering legislation. During
the course of 2001 and 2002, the federal government proclaimed into force the
Proceeds of Crime (Money Laundering) and Terrorist Financing Act (the
"Proceeds of Crime Act") and various regulations thereunder in order to help
detect and deter money laundering and the financing of terrorist activities. The
Proceeds of Crime Act implements and mandates significant reporting, record
keeping, client identification and other requirements for various persons,
including financial service providers, in respect of "suspicious" transactions and
large cash transactions. Failure to comply with the legislation can result in
significant penalties. The Proceeds of Crime Act also establishes the Financial
Transactions and Reports Analysis Centre ("FINTRAC") as the government
agency responsible for the collection, analysis and disclosure of the information
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to assist in the detection, prevention and deterrence of money laundering and
terrorist financing in Canada and abroad. The Proceeds of Crime Act requires
various persons to report "suspicious" transactions and to also keep records and
provide reports to FINTRAC in respect of large cash transactions. Large cash
transactions, generally, are transactions in the amount of $10,000 or more and
include, without limitation, (i) as of June 12, 2002, the sending or receiving of
international electronic fund transfers of $10,000 or more through the SWIFT
network, (ii) as of November 30, 2002, other international electronic fund
transfers of $10,000 or more (through non-SWIFT networks), and (iii) as of
November 30, 2002, large cash transactions involving amounts of $10,000 or
more. The scope of the Proceeds of Crime Act is very broad and it applies to
numerous persons (including financial entities) and various types of transactions.
Although beyond the scope of this article, the provisions of the Proceeds of
Crime Act should be reviewed by lessors that operate or wish to operate in
Canada in order to determine whether or not the Act is or will be applicable to
them. If the Proceeds of Crime Act is applicable, then the relevant entity will
have to establish an adequate compliance program in order to ensure that it
complies with the myriad of record keeping and reporting obligations imposed by
the Act.
The third new development is the establishment by the federal government of a
capital leasing pilot project under the Canada Small Business Financing Act
("CSBFA"). One of the Canadian federal government's long-standing programs
to help small and medium-sized business enterprises ("SME") access financing
is the small business loan guarantee program established pursuant to the
CSBFA. This program encourages qualified financial institutions to lend funds to
SME's by sharing the related risk through a partial guarantee, provided by the
federal government, on any loss related to the loan. With the recent enactment
of the Canada Small Business Financing [Establishment and Operation of
Leasing Pilot Project] Regulations (the "Project Regulations"), the federal
government's small business loan guarantee program has been expanded, on a
pilot project basis as of April 1, 2002, to cover lease financing transactions, not
just loans (the "Project"). The purpose of the Project is to test the extension of
the CSBFA type loan-loss sharing program to leasing and to determine, after a
five year Project period, whether it would be feasible as a viable permanent
addition to the core CSBFA loan guarantee program. The Project will test the
ability of a CSBFA type program to address (i) a market gap in financing options
(especially for younger firms and start-up SMEs and those seeking leases of less
than $100,000), and (ii) a distortion created by the CSBFA loan program in
favour of loans, particularly in cases where a lease makes more economic sense
to the SME seeking financing. According to the federal government, the
feasibility of the Project will be measured primarily by its success in satisfying two
key objectives: (i) incrementality (i.e. that the leases made under the Project
would not have been made in the absence of it or would have been made on less
favourable terms for the SME); and (ii) cost recovery (i.e. that the Project will be
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independently cost recoverable where user fees will cover projected claim
payments over the life of the leases made during the five years of the Project).
The operation of the Project is essentially the same as is the case for the
government's existing loan guarantee program. Namely, SMEs will apply directly
to authorized private sector financial institutions and leasing companies for
access to financing under the Project, and not to the federal government.
Designated lessors will be responsible for credit decisions and the administration
of leases, including realization on security and personal guarantees and, in the
case of default, submission of claims to the federal government. Under the
Project, an eligible lessor includes (i) a member of the Canadian Payments
Association ("CPA"), (ii) a member of a central cooperative credit society that is a
member of the CPA, (iii) a leasing company or lease funder operating in Canada
and who maintains (a) a rating of "BBB" or better issued by a Canadian bondrating agency, or (b) a participation in a securitization program approved by a
Canadian bond rating agency, and (iv) any other organization designated by the
Minister. Before entering into the lease, the lessor must apply the same due
diligence to the lease as if it had not been subject to the CSBFA including: (i)
assessing the credit worthiness of the lessee; (ii) assessing the lessee’s ability to
service the lease payments, (iii) selecting a lease term similar to a lease that is
not subject to the CSBFA, and (iv) in the case of used equipment, substantiating,
in writing, the fair market value and economic life of the equipment.
The Project will only apply to eligible small businesses, namely, for profit
businesses carried on in Canada with annual or projected gross revenues below
$5,000,000 and which have no agricultural, charitable or religious purpose.
Eligible leases will be for equipment necessary for the operation of the lessee’s
business. The lease may be for new or used equipment provided that the
equipment has an economic life greater than the term of the lease. The lease
must not be for (i) equipment for which the financed amount is greater than 100%
of the cost of the equipment; (ii) real property, or (iii) equipment that is the subject
of a conditional sale. In addition, under the Project and the existing loan
guarantee program, the maximum aggregate amount of outstanding leases and
loans to a borrower and related borrowers cannot exceed $250,000. The
financing rate is up to 100% of the cost of the equipment. The maximum annual
imputed rate of interest on a lease must not exceed the aggregate of 13.25% per
annum plus the government of Canada bond rate in effect on the day on which
the lease is signed. The maximum term of the lease (including renewals) must
not exceed 10 years from the date on which the lease was signed.
For those eligible leases registered under the Project, the federal government will
pay up to 85% of the eligible losses, after realization on all security and
guarantees. The fee level paid by the lessee will remain the same as for the
federal government's loan guarantee program with an up-front registration fee of
2% of the cost of the equipment and an administration fee of 1.25% on the end of
month outstanding balance of the lease, paid quarterly in arrears. For those
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lessors interested in becoming involved in the Project, the Project Regulations
contain detailed rules with respect to registration, reporting requirements, due
diligence, security and personal guarantees, claim procedures and audit and
evaluation requirements.
The fourth development of note is the continuing unresolved issue concerning
the nature and extent of the priority that Crown claims enjoy in relation to the
claims of other secured creditors of debtors. This has proven to be a continuing
legal battle ground in Canada over the course of the past year. The Income Tax
Act (Canada) was amended retroactive to June 15, 1994 to grant to the federal
Crown a first priority interest over all property of a debtor for unremitted source
deductions (i.e. Canada Pension Plan contributions, Employment Insurance
premiums) and unremitted goods and services tax regardless of any prior
security interest granted by the debtor to a third party, with the exception of a
mortgage granted over a real property. This has been referred to as a "superpriority" by Canadian commentators and has been the subject of a number of
conflicting judicial decisions. The apparent rationale behind the provisions of the
Income Tax Act is that because business taxpayers collect employee deductions
at source and goods and services tax for the government, these amounts are not
the property of the taxpayer, rather they are considered funds held in trust for the
government that a taxpayer is required to remit. The federal government's
concern appears to be taxpayer use of unremitted source deductions and goods
and services tax as a form of financing of the taxpayer's business. This rationale
suggests that when an insolvency occurs, creditor losses are reduced because
unremitted Crown funds were improperly used by the customer of those
creditors. There have been a number of contradictory judicial decisions to date
interpreting the nature and scope of the Crown's super-priority. In some cases,
the Crown, as a result of the super-priority, has been found to have priority over
the interests of other secured creditors, while in other cases the rights of secured
creditors have been found to prevail over those of the Crown. Although two
appellate level decision favourable to lessors/financiers have been rendered, one
in Saskatchewan on January 5, 2002 and one in British Columbia on April 18,
2002, there has not been, to date, any definitive Supreme Court of Canada
judicial decision which provides clarification as to the exact scope, nature and
extent of the super-priority provision applicable in favour of the Crown pursuant
to the Income Tax Act (Canada).
The Canadian Legal System
Canada's legal system reflects its history in at least two respects. First, Canada
is a federal state composed of ten provinces (and three territories) reflecting the
confederation of British dependencies and colonies in North America, which
began in 1867. This confederation resulted in a division of powers between the
federal government and the provincial governments. Each level of government
has certain areas exclusively within its authority and shares authority with the
other level of government on certain matters. This split of jurisdiction, as
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discussed below, results in both federal and provincial laws affecting the leasing
industry.
Secondly, while nine of the provinces and the territories have legal systems firmly
rooted in English common law, Quebec has a civil law system reflecting its
French heritage. While important differences exist between the common law
provinces, the general principles are usually portable. On the other hand,
Quebec's Civil Code is markedly different in its approach when compared with
the common law systems in the rest of Canada. Consequently, concepts and
principles from the common law legal systems may not exist in Quebec.
No unified codification governing the law of leasing exists on either a federal or
provincial level. While federal laws generally govern matters considered to be of
national importance and provincial laws govern matters of local interest such as
property and civil rights, both federal laws (e.g. laws governing banks,
bankruptcy, foreign investment, income and value added taxation, customs and
duties, competition law and usury) and provincial laws (e.g. laws governing
secured financings, income and sales tax, sales of goods, assignments of
receivables, contract laws, consumer protection and judicial procedures) affect
the leasing industry.
Further, Canada's obligations under its international treaties, such as the North
American Free Trade Agreement ("NAFTA") and treaties governing the
recognition of foreign arbitration awards and international factoring of
receivables, may also affect the leasing industry. Should Canada put into force
international obligations such as the UNIDROIT Convention on International
Financial Leasing made at Ottawa in 1988, certain aspects of the leasing industry
(e.g. cross-border leases) may be dramatically affected. In addition, the
proposed UNCITRAL Convention On Assignment In Receivables Financing may,
if adopted, affect international assignments of leases and other equipment
finance receivables.
Generally speaking, freedom of contract will prevail in Canada. However,
statutory laws limit this freedom, as may considerations of equity and public
policy. In areas such as consumer protection and other situations where
governments have perceived an inequality of bargaining power (e.g. farmers;
standard form contracts), the state has intervened to limit freedom of contract to
protect the disadvantaged.
Cross-Border Leasing
Leaving aside tax issues, few legal impediments exist to cross-border leasing
into Canada. A choice of foreign law which has a legitimate connection to the
transaction (e.g. a jurisdiction in which the lessor resides) will be upheld by
Canadian courts, even though the lessee and leased asset are in Canada and
the lease contract is concluded within or outside Canada. However, the laws
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governing the location of the leased asset and the lessee will still have to be
carefully considered. While parties are free to choose which law will govern their
relations, certain provisions of a foreign law lease may not be enforceable for
reasons of local public policy or may be superceded by a local statutory scheme
which regulates an area of conduct (e.g. enforcement of a lease upon a customer
default; bankruptcy). To ensure that difficulties will not arise when attempting to
enforce a foreign law lease in a Canadian jurisdiction, it is prudent to have
lawyers familiar with the local laws review the foreign law lease to identify
potential difficulties. For example, local laws will govern the right of a lessor to
exercise remedies and recover the leased asset and may protect a lessee
resident in a province from the exercise of all of the rights granted to the lessor in
the lease.
It is also possible for a Canadian lessee to submit to the jurisdiction of another
court when foreign law is selected. Usually, this should be a non-exclusive
choice of jurisdiction to enable the lessor to sue the lessee in the contractually
chosen jurisdiction or in the province where the leased assets and the lessee
(along with its other assets) reside. Practically speaking, local court proceedings
are required when seizure of local assets is necessary (e.g. repossession of the
leased asset or execution of a judgement against the other assets of a lessee)
and certain matters (e.g. bankruptcy) will be dealt with by the local courts and
laws with jurisdiction over all of the assets of a lessee. Such local court
proceedings may arise because the lessor seeks a trial in the jurisdiction where
the lessee or leased asset reside or because the lessor has obtained a
judgement outside of such jurisdiction and is seeking to execute upon it. As a
result of case law and reciprocal enforcement of judgement legislation, Canadian
courts will, subject to normal exceptions (e.g. such as those concerning matters
of public policy), recognize and enforce foreign judgements provided procedural
fairness existed.
It is interesting to note that, although Canada has a single set of federal income
tax laws and a unified set of accounting standards, with each province
representing a separate legal jurisdiction, the same choice of law, selection of
forum and cross-border enforcement issues exist at a provincial level. For
example, a lease between a British Columbia lessor and an Alberta lessee is, for
certain purposes, a cross-border lease. However, due to the routine nature of
commerce between the provinces, inter-provincial cross-border leasing does not
typically raise significant issues.
With cross-border leases, a few additional legal issues should be considered.
First, if the asset is not resident in Canada before the lease, issues related to the
importation of the asset and customs and duties payable, and possible
remissions for temporary importation, should be considered.
Second, from a currency perspective, no foreign exchange controls exist in
Canada and the parties are free to denominate their lease contract in any
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currency. However, as a case in point that local laws need to be considered,
judgments of the Canadian courts are rendered in Canadian currency and, if the
lease is in another currency, consideration should be given to including currency
conversion provisions to protect a lessor against currency fluctuations.
Third, if the lessor in a cross-border lease is a "foreign bank" under the Bank Act
(Canada), a banking law issue may arise. The definition of "foreign bank" is quite
broad and includes any entity which is a bank under the laws of another country,
any entity with the word "bank" in its name that provides financial services, any
entity that takes transferable deposits and lends money, any entity which carries
on an activity in another country which, if carried on in Canada, would be the
business of banking and any entity related (e.g. affiliated) with such an entity.
Under the Bank Act, a foreign bank shall not directly or indirectly undertake any
business in Canada. Financial leasing (as discussed below) is an activity, which
is carried on by Canadian banks and their subsidiaries and it may be said to be
part of the business of banking. Consequently, a cross-border financial lease by
a foreign bank to a Canadian lessee may, depending on the facts, result in a
foreign bank carrying on business in Canada. If so, this would be a prohibited
activity under the Bank Act, unless the foreign bank obtains a regulatory consent
or establishes an appropriate regulated entity to conduct its Canadian business.
Therefore, it is prudent to structure a cross-border financial lease with a foreign
bank lessor in a manner which will minimize the risk that the foreign bank is
engaging in business in Canada (rather than doing business in its own country
although it provides financing into Canada). For example, the risk of the foreign
bank being said to be doing business in Canada when leasing to a Canadian
lessee is lessened if the cross-border lease is negotiated and documented
outside of Canada, using a foreign currency and payments made outside
Canada, and is governed by the laws of, and administered by people resident in,
a jurisdiction other than Canada.
While few legal issues impede cross-border leasing, this is not a frequently used
transaction structure in Canada. The reasons for this are tax, marketing and
operational. From an operational perspective, to the extent that the ticket sizes
are smaller and the credit qualities are mixed, local portfolio administration is
more practicable. From a marketing perspective, leaving aside larger ticket
transactions, most Canadian lessees have a preference for an in-Canada lessor
due to the ability to develop a local relationship and the avoidance of issues
raised by a cross-border leases (e.g. withholding tax). However, even when
operational and marketing issues are not a barrier, tax reasons pose the greatest
barrier to cross-border leasing into Canada (e.g. 25% withholding tax on lease
payments, which may be reduced by treaty to a lower amount). Several creative
structures have, however, evolved to address the tax issues raised by crossborder leases.
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Establishing a Canadian Leasing Presence
Most of the Canadian leasing industry is conducted within Canada and not on a
cross-border basis. Non-Canadian lessors seeking to do business in the
Canadian market will typically establish operations in Canada. This section
considers issues related to the establishment of leasing operations in Canada.
Different issues arise depending on whether: (i) the Canadian lessor will be
established by a Canadian or a non-Canadian; (ii) the person establishing the
entity is, or is related to, a bank (i.e. Canadian or foreign); and (iii) the presence
will be a start-up (de novo) operation or an acquisition of an existing Canadian
lessor.
If the person establishing the Canadian lessor is a non-Canadian, there are no
foreign exchange restrictions or prohibitions on repatriation of profits (although
when funding Canadian operations tax issues should be considered). It is,
however, necessary for non-Canadians to comply with the Investment Canada
Act when they acquire or establish a new business in Canada. Compliance is
achieved in most start-up situations by notification to the Canadian government.
However, if the non-Canadian will acquire an existing Canadian business,
depending on the size of the acquisition, a review and approval of the acquisition
by Investment Canada may be required. Ultimately, the Investment Canada test
for whether the establishment or acquisition of a Canadian business is
acceptable is whether it will be a "net benefit to Canada". Generally speaking, it
is not difficult to show that investment in a business venture in Canada will be of
net benefit to Canada and this rarely poses an issue for a non-Canadian entering
the leasing industry.
If the entity seeking to enter the Canadian leasing industry is a Canadian or
foreign bank (or is affiliated with or otherwise related to such a bank), the Bank
Act needs to be considered and complied with. From a bank regulatory
perspective, equipment finance and leasing activities: (i) may be conducted in
Canada by entities which are unrelated to banks and other similar regulated
financial institutions on an unregulated and unlicensed basis (subject only to
other licensing requirements of general application to corporations or of a
local/provincial genesis); and (ii) may, subject to restrictions imposed by the Bank
Act, be conducted by (a) Canadian banks, designated foreign banks, or
authorized branches of foreign banks regulated under the Bank Act, either
directly or through a financial leasing entity, or (b) non-designated foreign "near"
banks which are not actively regulated under the Bank Act.
First, with respect to the ability of Canadian incorporated banks (both Canadian
and foreign owned) and branches of foreign banks to conduct leasing activities,
the Bank Act and the Financial Leasing Entity Regulations made pursuant
thereto permit Canadian banks and branches of foreign banks to establish a
"financial leasing entity" to engage in leasing activities, subject to certain
restrictions. In addition, a Canadian incorporated bank or a foreign bank branch
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may carry on directly the activities of a financial leasing entity. Generally, the
policy is to ensure that the regulated banking entity is involved in financings and
not in the provision of goods and services. For example, a financial leasing entity
currently: cannot direct customers to equipment dealers; is not permitted to enter
into leases of vehicles under 21 tonnes or leases of personal household property;
must enter into leases for the purpose of extending credit; may only lease
equipment selected by lessee; is subject to a maximum of 10% of the portfolio
being represented by unguaranteed residual positions; and, must recover its
investment in equipment with not more than a 25% residual position. Generally,
a foreign bank with a Canadian bank subsidiary or a Canadian branch may only
establish, acquire or own a leasing or financial services business/entity if a
Canadian bank would be permitted to do so. A financial leasing subsidiary may
be held directly by the foreign bank (i.e. need not be owned by the Canadian
bank subsidiary of the foreign bank).
Second, in the case of a foreign bank seeking to conduct "financial leasing" in
Canada through a non-bank subsidiary (i.e. not through a regulated Canadian
foreign bank subsidiary or a regulated full service branch or lending branch of a
foreign bank), the provisions of the Bank Act will again apply. Under the Bank
Act different rules will apply to foreign banks that fall into one of three general
categories: (i) near banks that are not "designated", (ii) regulated "designated"
foreign banks that carry on commercial but no financial activities in Canada, and
(iii) regulated "designated" foreign banks that provide financial services in
Canada. The criteria for designation of a foreign bank has been discussed
above. The Minister will not designate a foreign bank unless it, or entities it
controls (such as a financial leasing entity), carries on business in Canada. If a
foreign bank does not meet the criteria for designation, it will be treated as a near
bank. If a foreign bank is not designated, it may apply for an exemption order
from the Minister relieving it from the application of most of the requirements of
the Bank Act. A foreign bank that is subject to an exemption order will have an
obligation advise the Minister of changes in circumstances that may affect its
eligibility for designation.
Foreign banks that do not have financial establishments in Canada are
authorized by the Bank Act to acquire or hold investments, including commercial
investments, in Canada. To take advantage of this exception, a foreign bank and
entities associated with it may not control or be a major owner (e.g. hold more
than 20% of the voting shares or 30% of the non-voting shares) of a Canadian
financial institution or financial services provider.
The Bank Act provides that designated foreign banks and entities associated with
them that seek to carry on financial services activities in Canada are limited to
investments permitted to Canadian banks. These foreign banks and associated
entities may not carry on activities or make investments in Canada that a
Canadian bank cannot carry on or make, such as automobile leasing or
operating leasing (as opposed to financial leasing) activities. Nevertheless, the
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Minister may authorize a foreign bank or associated entity with a financial
establishment in Canada to invest in a Canadian commercial business (other
than leasing) that is the same as or is similar, related or incidental to the
business outside Canada of the foreign bank or its associated entity. These
investments may require the prior approval of the Minister.
If a designated foreign bank or entity associated with it contravenes the Bank Act
or fails to comply with any terms and conditions of an order, the Minister may
require the bank or its associated entity to divest its investment. Unless the
Superintendent of Financial Institutions Canada grants an exemption, a foreign
bank or entity associated with it that has received a ministerial order must
provide annually (i) financial statements, (ii) a list of its activities and businesses,
and (iii) other prescribed information.
Both Canadian and non-Canadian persons seeking to acquire a Canadian lessor
need to consider the provisions of the Competition Act which govern mergers.
While any merger (e.g. acquisition), which is anti-competitive will raise a
competition law issue, the thresholds for pre-notification are reasonably high
when acquiring an operating business. Regardless of whether a transaction is
over the notification thresholds, if the parties wish comfort that it is not an anticompetitive merger, they may request an advance-ruling certificate. Generally,
due to the perception that equipment leasing provides an important alternative
source of capital and that it provides competition to the traditional (e.g. chartered
bank) lenders in Canada, acquisitions in the Canadian leasing industry will
generally not be considered anti-competitive unless they represent a traditional
lender removing a source of competition or threaten the viability of the non-bank
lending market itself (either in general or in a specific market).
A person seeking to establish a new Canadian leasing business must choose to
operate either through: (i) a new corporation; or (ii) in the case of a foreign
person, through a branch of a foreign corporation or, in the case of a Canadian
person, through a division of an existing Canadian company. Except in the case
of equipment vendors, which are establishing leasing operations as an ancillary
operation to their equipment sales activities, the norm is for the market entrant to
establish a new corporate entity under the federal or provincial laws. Canadian
law permits both federally incorporated companies and provincially incorporated
companies. For example, in the case of an Ontario incorporated company
versus a federally incorporated company, the differences are fairly minor and the
choice is usually made based on cost, convenience (e.g. the requirement for
Canadian resident directors) and timing.
When establishing leasing operations, it is necessary to determine the
geographic scope of the operations in Canada, particularly in light of the product
mix, which the lessor will offer, to ensure compliance with local provincial laws.
For example, certain provinces (e.g. Saskatchewan for financiers in general) may
require the lessor to obtain provincial licences and it is generally necessary to
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"extra-provincially" register in each province where the financier will engage in
business. It is also necessary to consider whether municipal business licences
are required.
Doing business in Quebec raises certain issues for a new market entrant.
Quebec's official language is French. All contracts in Quebec must be written in
the French language (unless the parties to the contract expressly agree
otherwise) and the French language is the required language of business
communication in Quebec. Further, a company doing business in Quebec
should have a French form of its name (unless it is a French or bilingual name to
begin with).
Product Mix
Most equipment lessors in Canada offer a selection of lease products (e.g.
leases with and without purchase options; fair market, fixed price and nominal
price purchase options; operating leases; full-payout leases; "stretch" leases and
"leveraged" leases). In addition, many financiers will, from time to time, purchase
(or occasionally enter into) conditional or installment sale contracts or complete
transactions where the financier loans money to the customer who then
purchases an asset and grants security over the asset to the financier (e.g. a
chattel mortgage; also known as a loan and security transaction). The form of
the end-customer finance product raises different legal issues.
Ontario and the Yukon Territory utilize the "old" or "Ontario" model Personal
Property Security Act ("PPSA") legislation. Under the Ontario model, the
structure of the lease transaction will determine whether the law governing
security interests and secured transactions will govern the transaction as a
secured financing (e.g. because it is a lease intended as security) or whether
such law will recognize a transaction as a "true" lease which is outside of the
PPSA. If a lease is a true lease, the lessor is accorded the traditional rights of an
owner (rather than merely rights as a secured creditor) of the leased equipment
and its rights as owner need not (but may) be protected by registrations under
the PPSA. If a lease creates a security interest, it will be subject to the
provisions of the PPSA (which applies to every lease that secures payment or
performance of an obligation) and the lessor's rights to the leased asset must be
protected by PPSA registrations.
Classification of a lease as a true lease or as a security lease can be difficult and
is always fact specific. If the economic substance of the transaction is a sale
(e.g. the lessee has an option to purchase the goods at a price which will in all
probability result in the lessee exercising that option), the lease is probably a
security lease and not a true lease. The Court will also look at the role of the
parties (e.g. is the lessor an equipment vendor leasing part of its inventory and
responsible for ensuring that the equipment functions, or is it a third party
financier; the latter case leading to the conclusion that the lease was intended as
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security) and the intent of the parties, as well as considering the economic effect
of the transaction and any other relevant factors (e.g. who bears risk of loss or an
unexpected decline of the economic value of the leased asset).
Failure to make a PPSA security registration because of incorrectly categorizing
a security lease as a true lease may result in the loss of the equipment to a
bankruptcy trustee or a creditor which perfected its security interest in the
lessee's/debtor's assets. Therefore, as PPSA legislation generally provides that
registration of a transaction does not create a presumption that the transaction
fell within the scope of the legislation, it is general practice in Ontario to err on the
side of registering leases where a true lease is not unequivocally in existence.
Other provinces, which have enacted the "western" model PPSA legislation do
not rely upon the true lease versus security lease distinction (e.g. British
Columbia, Alberta, Nova Scotia, Newfoundland, Prince Edward Island, New
Brunswick and Saskatchewan). In these provinces, if the lease is entered into for
a term in excess of one year, the lease is considered to be a security agreement
requiring registration under the applicable PPSA legislation to protect the lessor's
claim on the leased equipment. In these provinces the only issues arise when
the lease term may be greater or less than one year (e.g. due to renewal and
termination options).
Quebec operates a security registration system under the Civil Code of Quebec.
This system is different than a PPSA form of registry. Since 1994, it does
provide for a central registry for certain forms of equipment finance contracts (the
Registry of Personal and Moveable Real Rights) such as contracts of "leasing"
(i.e. "credit-bail") and security agreements known as "hypothecs". Since
September 1999, Phase II of the registry provides for the registration of leases
and other title retention contracts.
Prior to the adoption of PPSA legislation, conditional sales legislation governed
many leases and all conditional sales (i.e. a lease was, despite its legal form,
treated as a conditional sales contract if the lessee will acquire ownership of the
goods upon the completion of all the payments or the performance of any other
condition). Consequently, leases with purchase options could be categorized as
a conditional sale and practice was that they should be registered according to
the conditional sale legislation.
With conditional sale contracts, a risk exists for the financier that the implied
terms under applicable sale of goods legislation and general law are not or
cannot be excluded. If so, a financier may find itself unable to enforce the
conditional sales contract due to equipment related issues. Stated another way,
it is difficult for a financier to isolate itself from equipment related issues when it
is, legally speaking, the person is selling the equipment. For this reason,
financier's often prefer to be the assignee ("free of equities") of conditional sales
contracts rather than the original conditional vendor.
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In Canada, any person may lend money and take security against the asset
purchased with that money. Consequently, a lessor may also engage in loan
and security (e.g. chattel mortgage) transactions. As such transactions are
security transactions, they will, as required by applicable law, require registration
to protect the financier's claim on the financed equipment. However, as loan and
security transactions do not rely on a title retention security interest in the
equipment, this may raise issues for the financier as it will be more difficult to
defeat the competing claims of other creditors (e.g. claims by a landlord for
distress; claims by a bank under Bank Act security).
Business Model
In establishing and operating a Canadian leasing company, the portfolio is
usually generated along one or more of the following business models:
(i)
tripartite leasing transactions where the lessor purchases the equipment
from an equipment vendor (which may or may not be in an ongoing
relationship with the lessor) at the request of the lessee for the purpose of
entering into the lease transaction;
(ii)
a vendor lease transaction where the lessor is also the equipment vendor
and is entering into the lease transaction to facilitate its equipment sales
activities;
(iii)
purchases of leases (and, in most cases, the leased equipment) where the
original lessor (e.g. the equipment vendor) initiated the lease transaction
with the customer and sells all or part of its rights related to the lease to
the financier (who is often in an ongoing relationship with the original
lessor); and
(iv)
sale and lease-back transactions where the lessor is purchasing
equipment from the ultimate lessee for the express purpose of providing
the use of the equipment back to the equipment seller/lessee under a
lease.
In Quebec, the tripartite lease will usually result in a transaction known as a
"leasing" ("credit-bail"). Quebec law recognizes that such leases are finance
leases where the risk of loss and the obligation to repair is commonly assumed
by the lessee and, generally speaking, such leases will be enforceable as
unconditional "hell or high-water", net leases. On the other hand, where the
transaction is a vendor lease (generally when the lease does not fit within the
criteria for a leasing), Quebec law terms this a "lease" ("louage") and the Quebec
Civil Code will imply terms into that lease which impose obligations on the lessor
(e.g. equipment is delivered in good repair and is suitable for its intended use;
the lessor will maintain the equipment and accept a reduced rent if the equipment
is defective); while most of the implied terms can be waived by express
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agreement, a greater risk exists with a "lease" ("louage"), when compared with a
"leasing" ("credit-bail"), that the lease will not create an unconditional, "hell or
high water", payment obligation.
Where the leasing company is generating its portfolio through purchases of
leases or lease receivables, this is an unregulated activity (although regulated
financial institutions such as banks are permitted to engage in purchases of lease
receivables - often called "factoring" – and to complete purchases of financial
leases). Generating a portfolio generated through purchases of pre-existing
leases involves, in addition to the customer lease transaction, a second
transaction when the leasing company purchases the lease. In addition to
concerning itself with the lease transaction and a valid perfection of the lessor's
claim on the leased asset, the purchaser of the lease and/or lease receivables
must ensure that it receives good title to the purchased property and, to the
extent the purchaser does not acquire the lease or the leased equipment, that
the purchaser has a first claim (i.e. security interest) on such additional property.
Under PPSA legislation, every assignment of lease receivables requires a
security registration to perfect the assignment (i.e. to give the purchaser a first
claim on the purchased receivables). In addition, the purchaser must take steps
to satisfy itself that the assignor had clear title to the property being sold. In
PPSA jurisdictions this can be accomplished by a search against the assignor
and a review of any security documents which may evidence an interest in the
property being acquired and, if necessary, a waiver or confirmation from the
assignor's other creditors to ensure that they do not have any claims on such
property. In addition, where the financier is purchasing or taking a security
interest in the leased equipment, it is prudent to ensure that that equipment is
free of title retention or other security interests. Generally a bona fide purchaser
of equipment for good value acquires title free of security interests granted by the
seller to others provided the sale is in the ordinary course of the seller's business
and the purchaser did not know that the sale would cause a breach of the preexisting security; however, unusual or out-of-the ordinary course of business
transactions (e.g. sales of fixed assets), or where the purchaser knows about the
pre-existing security, may not result in the passage of clear title if the equipment
was encumbered.
It is also important for the financier purchasing the leases to carefully review their
terms. For example, it is essential that the purchaser acquire the leases free of
any equities or rights of set-off, counterclaim or defense, which the customer may
have against the original lessor. In the absence of such a provision in the lease
(or in a subsequent agreement with the lessee), the financier will be reliant on the
indemnity of the original lessor (which is a necessary part of the purchase
agreement) should such an equity, set-off, counterclaim or defense to payment
result in non-payment.
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Finally, when purchasing leases, in addition to making required security
registrations, notification to the lessee of the acquisition is prudent in all
jurisdictions to ensure that the lessee will not be discharged by making payments
to the original lessor and to limit any other equities which may arise in the future
between the assignee and the lessee/debtor. Notification to the lessee is also
required in Quebec to perfect the purchaser's claim over the claims of third
parties (such as creditors of the original lessor). In jurisdictions where the
purchased contract was originally registered, the registration should ideally be
amended to record the purchaser as the new lessor/creditor (although this raises
practical problems with bulk purchases).
Where the portfolio is being generated by sale and lease-back transactions, the
lessor must ensure itself that the assets being acquired from the customer for the
purpose of entering into the lease are not encumbered. Conducting a search
against the customer to determine other secured creditors and reviewing any
security agreements, which may encumber the asset, along with the documents
under which the customer originally acquired the asset, will assist in ensuring
that the financier acquires title to the equipment free of other claims.
In Quebec, only a tri-partite transaction can result in a "leasing" ("credit bail") and
a sale lease-back transaction will result in a "lease" ("louage"). As discussed
above, the lessor under a "lease" ("louage") must attempt to avoid certain implied
obligations; as these are generally equipment related, they are obligations a
financier would normally seek to avoid.
As sale lease-back transactions often arise with customers experiencing liquidity
difficulties (e.g. the customer completes the sale lease-back to liquidate part of its
investment), special care must be taken to ensure that the sale lease-back
cannot be characterized as: a fraudulent conveyance; a settlement, assignment
or preference which defeats the legitimate claims of creditors; or oppressive to
secured creditors or other stakeholders in the corporation. Ensuring that the sale
lease-back is a bona fide transaction for fair value (and not an attempt to remove
assets from other creditors) will help to protect the financier.
Asset Types
Financing certain forms of tangible moveable personal property may raise special
legal issues (e.g. vehicles, aircraft, ships, railway rolling stock software, fixtures).
First, when leasing vehicles, the lessor must not only ensure that it has perfected
its security interests as required by applicable provincial law, the lessor must also
ensure it is complying with the applicable provincial requirements for: (i) the
required form of vehicle registration (e.g. some provinces require the lessor or
financier to register their interest on the vehicle registration), (ii) statutory
minimum vehicle insurance and, (iii) to the extent the lessor may later be
required to sell vehicles, any applicable motor vehicle dealer licensing schemes.
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When selecting asset classes which will be leased it is noteworthy that a lessor
is, in law, the owner of the leased asset and may therefore be sued and, in the
worst case, held liable if the equipment causes harm to persons or property.
With a lessor that is acting merely as a financier, the risk is remote that it would
be found to have liability for the improper use of, or for a defect in, a leased
asset.
However, where the lessor is providing installation or ongoing
maintenance services or has provided representations as to the quality and
performance of the equipment, it is more likely that a lessor will be liable for
damages to persons or property caused by the equipment.
With assets such as vehicles, aircraft and marine vessels, a lessor needs to
ensure that the property and the lessor are adequately covered by the lessee's
insurance policies. The lessor may wish to consider whether its own insurance
policies provide excess or contingent insurance coverage, particularly where the
assets are high–risk assets.
As with vehicles, special registration requirements exist for certain shipping
vessels and it is necessary to comply with those registration requirements to
protect the lessor's interest. With aircraft, no central registration system exists for
security interests and it is necessary to anticipate the jurisdictions in which the
airplane will be used to ensure that appropriate security registrations are made.
A federal registry exists for railway rolling stock and common practice is to make
this filing in addition to complying with provincial security registration
requirements.
Where the lessor will be financing equipment and related intangibles such as
software, unique issues are raised. The lessor must take care not to
unintentionally imply in the lease (e.g. by listing the software as equipment) that it
has the rights to lease the software (unless it has made arrangements with the
software licenser to take a license and grant a sub-license to the end customer)
as this may violate the software licensor's copyright. Where software will not be
licenced by the lessor to the lessee, it is important to ensure that the
lessee/licensee and the vendor/licensor have privity of contract to ensure that
software issues are worked out directly between the software vendor and the end
customer; this is accomplished very simply in the case of "shrink wrap" licenses.
Where the software will be licenced by the software vendor to the customer with
payments over time, a common transaction structure is for the software vendor to
grant payment terms to the licensee and to then assign the license payments to a
financier (raising the same issues, as discussed above, as an assignment of
lease receivables). This may assist the software vendor by facilitating revenue
recognition (e.g. due to the transfer of credit risk), providing cash to fund its other
business activities and lowering the vendor's "days sales outstanding" figures.
An alternative structure, for use in special circumstances, is to have the financier
become a licensee of the software with the right to grant a license to the end
customer (a "back-to-back" license structure). A back-to-back license structure
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raises issues for the financier if the intellectual property infringes the rights of
third parties, if the software fails to perform or if other ongoing obligations to the
customer are not adequately performed by the software vendor; such structure
should also be considered from a tax perspective. Consequently, a back-to-back
license should not be used in routine transactions.
Customer Classification
A lessor must ensure that its leases are enforceable against the lessee (e.g. the
lessee had capacity to enter into the lease and the lease was duly authorized,
executed and delivered). With business corporations in Canada, this is generally
not an issue. Business corporations usually have the powers of a natural person
and they are not, unless a restriction is adopted by the shareholders or directors
(e.g. in articles, by-laws, resolutions or a shareholders agreement), restricted
from entering into lease transactions. Further, even if restrictions are adopted,
the "indoor management rule" (also known as the doctrine of apparent authority)
protects persons dealing with directors, officers and other representatives of a
corporation. For example, under this rule, if a representative of a corporation is
acting within the actual or usual authority accorded to such a representative,
such corporation cannot deny the act of such a representative who purports to
bind the corporation, even if an internal procedure has not been followed (e.g.
the person did not have actual authority). The result in most cases is that lessors
may not need to review the documents creating and organizing the lessee to
ensure that the lessee had the capacity to contract or to ensure that the apparent
representatives of the lessee had the power to act on its behalf; nevertheless,
prudent practice is to do so to ensure the lessee has no defence due to lack of
capacity or due to a lack of authority by its representatives. Finally, in
transactions between a lessor and a business corporation, freedom of contract
will generally govern their relationship and Canadian courts will, in the absence
of public policy considerations or legislative intervention, uphold agreements
between businesses in accordance with their terms.
When the customer is not a business corporation, these conclusions may not
hold. Where the lessee is an individual and, in particular, an individual entering
into the lease for consumer, personal or household purposes (i.e. not for
business), the lessor must ensure that the transaction complies with applicable
consumer protection legislation. Consumer credit reporting legislation generally
requires that a credit report on a consumer should only be disclosed with the
consumer's written consent and that consumers are entitled to review their credit
files and to see who has requested a report. Provinces have enacted consumer
protection legislation to ensure full disclosure to consumers (e.g. mandatory
disclosure of the true cost of borrowing), to restrict the rights of a financier in
making security registrations against consumers (e.g. PPSA provinces limit the
length of a registration against a consumer) and to provide greater protection for
the consumer where the lessor enforces a lease (e.g. granting the customer
protection against repossession in certain circumstances or requiring the lessor
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to seize the leased asset or sue the lessee, but not both). Unfortunately,
consumer protection legislation, which is usually based on lending transactions,
does not always work well for leasing transactions (e.g. cost of credit disclosure
relies upon a fixed amount being financed and repaid while, with vendor leasing
programs and residual interests, these amounts may not be fixed due to blind
discounts, volume rebates and a variety of end of lease options).
Equipment financiers and lessors are being affected by the enactment and
coming into force of new consumer protection and cost of credit disclosure
legislation which applies to leasing transactions. The first provincial legislation
resulting from the 1998 Federal-Provincial Agreement for the Harmonization of
Cost of Credit Disclosure Laws came into force in Alberta in September 1999. All
other Canadian provinces and the federal government are expected to implement
and enact harmonized legislation by the end of 2002.
The new costs of credit disclosure laws are an attempt to harmonize similar but
disparate consumer disclosure laws across Canada and to simplify what has
often been confusing disclosure. The new laws will generally include disclosure
of borrowing cost and plain language requirements. These new laws will apply to
all equipment leases to individuals which have a term in excess of four (4)
months. With respect to leases, disclosure of end of lease purchase options,
early purchase options, early termination provisions, events of default, additional
charges, down payments, security deposits and other amounts due at signing
and total lease cost will be required. With open-ended leases (e.g. guaranteed
residuals), the lessee's liability for declines in residual value is limited. The
advertisement of lease rates requires full disclosure (making such advertising
difficult). Disclosure to the lessee will be required before the lessee enters into a
lease or otherwise obligates itself to complete a lease transaction. The upside
to the new laws, once implemented nationwide, will be easier compliance for
financier and fair competition on disclosed matters.
Other entities also raise unique issues as leasing customers. For example, with
government (e.g. federal and provincial governments), lessors must consider the
risk of "non-appropriation" and whether the assignment of a government contract
and/or debt requires compliance with special formalities. Despite entering into a
multi-year lease, unless an appropriation has been made for all future payments
under the lease out of current revenues (a situation most governments avoid as it
requires a current period allocation of financial resources for a future obligation),
the government is able to avoid its obligations under the contract by not making
an appropriation to pay the lease in future years. Practically speaking, the
exercise of the right of non-appropriations is not common. With governments,
the assignability of government debts and financing contracts is often restricted
by statute (e.g. the Financial Administration Act (Canada)) and failure to comply
with the laws governing such assignments may result in an invalid and/or
ineffective assignment. Further, care must be taken to ensure that the
representatives of the government body have the capacity to bind the
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government.
Similarly, with municipalities, crown corporations, hospitals,
universities and school boards, similar issues of ensuring future payments are
unconditional and of ensuring representatives have authority to bind the lessee
must be considered. With all such entities, the question of whether the entity has
the capacity to enter into a lease ("ultra vires") must be considered. Careful
review of the legislation governing those bodies is often required.
Legal counsel should also be consulted if the customer is an Indian band,
embassy, farmer, co-operative, not-for-profit organization, a minor or a person
with a mental incapacity as special rules may apply when contracting with these
customers.
Documenting Lease Transactions
Generally speaking, lease documentation in Canada is similar to that found in
other common law jurisdictions (e.g. England, United State of America) in the
world. To ensure lease commencement and to evidence the facts necessary to
establish a valid purchase money security interest in PPSA provinces, the
delivery and acceptance certificate is an important document. Despite the
apparent similarity of Canadian lease documentation to the documentation in use
in other countries, various federal and provincial statutes should be considered
when drafting a lease (e.g. PPSA legislation, the Bankruptcy and Insolvency Act
(Canada), the Interest Act (Canada), the Quebec Charter of French Language,
the Saskatchewan Limitation on Civil Rights Act, the Alberta Guarantees
Acknowledgment Act, etc.).
Canadian leases generally require the lessee to maintain and provide evidence
of: (i) adequate property loss insurance coverage with, in most circumstances,
the lessee named as loss payee, and (ii) depending on the type of asset,
adequate public liability insurance to protect the lessor from claims arising due to
damage caused by the equipment to persons or third party property, with the
lessor named as an additional insured. It is common practice for leases to permit
the lessor to purchase insurance at the lessee's expense for the lessor's
protection should the lessee elect not to do so; however, when structuring and
implementing such a program, care must be exercised to ensure that the lessor
does not engage in selling or underwriting insurance as these are usually
activities regulated by the provinces.
To complete a lease transaction, the non-vendor lessor must purchase the
equipment from the vendor. While such equipment purchase relationships may
be governed by comprehensive "sales-aid" vendor finance program agreements,
such transactions of purchase and sale are also commonly completed by simple
commercial documentation such as a purchase order or an invoice. When
relying on standard sale documentation, it is important to ensure that the terms
are appropriate for a lease transaction. For example, the terms of sale should
permit the lessor/purchaser to provide the benefit of any warranties or
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maintenance rights to the lessee.
In certain circumstances, a separate
installation agreement, software license and/or maintenance agreement between
the vendor and the lessee may be appropriate. Ultimately, the lessor's objective
is to ensure that it acquires good title, free of all adverse claims, to the
equipment. As mentioned above, the law generally permits a bona fide
purchaser for value, without notice of adverse claims, to acquire good title to
goods purchased from a merchant in the ordinary course of that merchant's
business. In other circumstances (e.g. a sale lease-back or purchase of fixed
assets), the lessor must ensure that no person has a prior interest in the
purchased equipment.
With guarantees, special considerations may arise. If the guarantor is a
corporation affiliated with the lessee or if the lessee is an individual associated
(e.g. shareholder, director) with the guarantor, the financial assistance provisions
of the incorporating statute (e.g. which may restrict guarantees where the
guarantor does not meet certain solvency tests) should be considered. Where
the guarantor is an individual, provincial legislation (e.g. the Alberta Guarantees
Acknowledgement Act) should be considered and, where the guarantor is an
individual related to the lessee (e.g. a spouse) but is not the owner, consideration
should be given to requiring independent legal advice.
Security Registrations
In the provinces of Ontario, Manitoba, Saskatchewan, Alberta, British Columbia,
Nova Scotia, Prince Edward Island, Newfoundland and New Brunswick, and in
the Nunavut Territory, the NorthWest Territories and Yukon Territory, "UCC-type"
PPSA legislation has been enacted. Quebec has not passed PPSA legislation
but has adopted a different modern system for registering personal property
lease and security interests.
The PPSA legislation is similar but is not uniform. It provides for a central
registry in which security interests are registered and it is common for
registrations and for searches to be made electronically from remote computer
terminals. When a creditor obtains a security interest (e.g. a lessor completes a
transaction which is or may be a transaction creating a security interest - a lease
intended as security or a lease with a term in excess of one year, depending on
the province), the creditor must file a financing statement in prescribed form to
record its interest in the classes of the debtor's/lessee's assets which are
collateral (e.g. "equipment" and "other"). Once the lease documentation is
complete, the lessee has acquired rights in the property and the lessor has
registered an appropriately completed financing statement, the lessor has a
perfected security interest in the leased asset.
The PPSA system is not a title based registry system (as it does not create a
registry for ownership and subsidiary interests in personal property) but is a
notice based system where parties with security interests can ascertain (through
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searches) and protect (through registrations) their priority to the debtor's personal
property. To obtain a first-ranking PPSA security interest in a debtor's asset, a
creditor must either be the first to perfect (e.g. register) against that collateral,
obtain a "purchase money security interest" ("PMSI") or obtain the agreement of
prior registrants that its subsequent registration will have priority. Where the
leasing company is not the first to register against the collateral, leasing
companies commonly rely upon the PMSI rules to ensure that they have a
perfected first-ranking security interest in leased equipment. Provided the leased
equipment is not inventory in the hands of the lessee, a PMSI is obtained by
registering the financing statement within a prescribed period of time following
the date on which the lessee obtains possession of collateral (e.g. ten days in
Ontario). As the registration of a financing statement may, with the lessee's
consent, be completed at any time prior to the delivery of the collateral (as well
as being completed after the delivery of the collateral and before the expiration of
the PMSI registration period), it is relatively easy for a lessor to ensure that it is
registered in time to acquire a PMSI.
By correctly completing the financing statement (e.g. to include "accounts" or
"other" collateral in the registration), a lessor under a properly drafted lease may
also claim a first priority to any proceeds from the leased equipment should the
lessee (with or without permission) sell or sublease the leased equipment.
It is of great assistance to financiers that they are able to make one notification
filing under the Ontario PPSA and shelter future transactions under that
registration (provided of course the terms of the registration are broad enough to
cover the subsequent transactions and the initial registration has not expired).
Consequently, with a proper initial registration, it is not necessary to make a new
registration with each new lease.
Where the asset leased will not be used by the lessee as equipment (e.g. it will
be inventory or it will not remain as tangible moveable personal property used in
the course of its business), special issues may arise. For example, where the
asset will become a fixture to the property, to fully protect the lessor it is
necessary to make a notification filing on the title to the real property. Where the
asset will become an accession (i.e. become incorporated within another asset),
special rules govern competing claims on the ultimate asset. Where the leased
asset is inventory (e.g. where a lessor is "head leasing" a rental fleet to a lessee),
special PMSI procedures must be followed which include notification to all prior
registrants against the class of collateral, which is "inventory".
In Quebec the registration requirements vary depending on whether the
transaction is a tripartite "leasing" ("credit-bail") or whether it is a direct vendor
"lease" ("louage"). In both cases, the Quebec Civil Code requires the lessor to
record its interest in the leased asset in the appropriate central register. While
failure to register does not cause the lease or leasing to be unenforceable, the
lessor will, with a unregistered claim, lose its priority against other creditors of the
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lessee which have properly registered their interest and will not have the right to
follow the asset into the hands of a person who purchases it from the lessee. As
leases and leasings are title retention contracts, they will, if properly registered,
take priority over all previously and subsequently registered charges against the
lessee's assets.
In 1994, the Civil Code of Quebec provided for the Phase I of the Registry of
Personal and Moveable Real Rights - this allowed the registration of security on
moveable personal property. Failure to register security, or to preserve a
registration under the previous law by registration, will result in the security not
being opposable to claims of other creditors and subsequent assignees in good
faith where they have properly registered their claims. In late 1999, Phase II of
the Registry of Personal and Moveable Real Rights came into force. Under
Phase II it is, within 15 days, necessary to register all new: (i) conditional sale
and other title retention agreements; (ii) leases with a term of more than one year
affecting moveable personal property; and (iii) leasing contracts affecting certain
categories of assets. Registration is necessary for a lessor to be able to enforce
its rights against third parties. The registration requirement in respect of leases
with a term of one year or more is to be calculated giving affect to all renewal
options. The registration system permits the registration of a "master" agreement
between persons who will enter into successive transactions. In addition to
leases with a term of more than one year, leasing contracts and other security
granted by individuals on various forms of moveable assets such as automobiles
must be registered. As a result, lessors and equipment financiers in Quebec are
able to complete the registrations required to perfect their interest in the financed
assets and ascertain, through searches of the registry, their priority in respect of
such assets. While the Quebec Civil Code provides a substantially different
scheme of debtor/creditor law and registrations than is in place in the balance of
Canada, the current Civil Code, with the enactment of Phase II, gives Quebec a
modern system of priorities and registrations for personal property.
Funding a Lease Portfolio
A variety of techniques exist for funding a lease portfolio.
include:
Such techniques
(i)
a loan by the funder to the lessor secured by a security interest in the
lessor's lease portfolio (e.g. lease receivables and leased equipment);
(ii)
arranging syndications/participations in lease transactions or portfolios of
leased transactions to thereby transfer the risk to the funder on, in most
cases, a non-recourse basis; and
(iii)
securitizations of the lease portfolio receivables.
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In the case of a securitization, the lessor typically sells its portfolio of finance
receivables (and the related security interests) to a special purpose vehicle
("SPV"). The lessor will continue to service the portfolios, subject to certain
restrictions designed to protect investors, in its ordinary course of business. The
lessor will often overcollateralize the SPV, or take a subordinated position in the
SPV, to provide additional protection for the investors; alternatively, or in
addition, a third party credit enhancement may be required (e.g. a secondary
purchase commitment, credit insurance or a letter of credit). The key is that the
SPV is "bankruptcy remote" and its ownership of the transferred portfolio is not
affected by the insolvency of the lessor (except to the extent that losing the
servicer of the portfolio will affect the economic value of the investment). To
ensure bankruptcy remoteness, the lessor must have disposed of the portfolio
and cannot be considered to have received a loan secured by the portfolio. To
assist with ensuring bankruptcy remoteness, the SPV is a separate entity; the
SPV is usually a trust (with a charitable beneficiary) to minimize provincial capital
tax and federal large corporations tax. To ensure that the transfer will not be
attacked by unsecured trade creditors, compliance with any applicable bulk sales
legislation is required (i.e. bulk sales legislation protects trade creditors where a
debtor sells its operating assets out of the ordinary course of business without
ensuring payment to its unsecured creditors). Currently the availability of "multiseller" securitization conduits in Canada has lowered the barriers to smaller or
first time securitizing lessors accessing the securitization market.
With any of the above techniques (loan and security, syndications/participation or
securitization), a registration may be required by the funder/SPV against the
lessor to record the assignment of receivables or grant of a security interest. In
addition, it is necessary to consider whether the security registrations in the
portfolio should be amended to reflect the new ownership of the assets and
whether (and, if so, when) notices of the assignment should be given to lessees.
Enforcing a Lease
Generally speaking, if a lessee is in default, the lessor's rights are governed by
the terms of the lease (which usually provides a variety of rights and remedies:
acceleration; repossession; sale; termination) and by the applicable law
governing the enforcement of leases and security agreements. In Canada these
laws generally permit a lessor, either directly or through a third party agent, to
regain possession of the leased asset through "self-help". If, however, the
lessee denies access to the leased asset, the lessor should obtain a court order
to enable it to recover the asset. If the financier has security on "all or
substantially all" of the debtor's assets, the financier must comply with the notice
provisions under the Bankruptcy and Insolvency Act ("BIA") before seizing the
debtor's assets; if this legislation does not apply, the common law governing
reasonable demand must be followed.
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After seizure of the equipment and giving the requisite notices of sale, the lessor
may sell the asset; thereafter the lessor may usually seek to recover any
deficiency from (and must normally account for any surplus to) the lessee.
Generally speaking, prior to disposing of repossessed collateral, the secured
creditor will be obligated to give notices to the debtor and other creditors with an
interest in the asset to afford them an opportunity to redeem the asset. If the
lease is a "true lease", the provisions under the PPSA governing security
enforcement do not apply.
Providing the lessor duly registered its interest in the leased equipment (or has a
true lease in a true lease jurisdiction), the lessor should have a first-ranking claim
on the leased asset and will be able to realize on the leased asset in priority to
the bankruptcy trustee and other creditors. However, in certain circumstances,
landlords (by exercising a right of distress), repairman (by exercising a
repairman's lien) and persons with preferred claims (e.g. government claims for
unremitted taxes and other statutory liens and deemed trusts) may have priority.
As the PPSA is a notice based system, it is also possible for a lessor which is not
diligent to lose its priority if its registration expires, if the lessee changes its name
or if the collateral is transferred to another jurisdiction (e.g. the lessor does not
renew its registration, amend the registration after the change of name or perfect
its security interest in the new jurisdiction within the prescribed period of time).
If a lessee is in default under a lease, the lessee may be insolvent and the
lessor's rights will be subject to applicable bankruptcy legislation. The BIA is the
primary Canadian statute governing insolvency of corporations and individuals.
The Companies' Creditors Arrangements Act ("CCAA") is older legislation which
may be utilized by certain debtors to reorganize their affairs. The BIA and the
CCAA contain provisions under which an insolvent debtor is protected from its
creditors to allow it time to reorganize and under which the debtor can seek to
change the terms of its indebtedness with the support of most (but not all)
creditors. During a reorganization, both Acts provide for a stay to stop creditors
from exercising their rights as secured parties and to restrict others (e.g.
suppliers) from terminating contracts with the debtor as a result of the
reorganization.
The BIA and CCAA were amended in 1997, in part, to provide that a stay of the
rights of creditors (i.e. to allow an insolvent to reorganize) did not have the effect
of prohibiting a lessor from requiring immediate payment for leased property
provided after the stay is granted. After these amendments it had been open to
argument that these amendments permitted lessors to require continuing
payment for leased goods while the insolvent reorganized, regardless of whether
the lease was a true lease or a finance lease. However, recent cases have held
that, where the lease is akin to a secured financing, the lessor will be treated as a
secured creditor with respect to the rights of the reorganizing insolvent person
(e.g. the lessor will be subject to the stay) and will not be entitled to receive
rentals during the reorganization (except to the extent distributions are made to
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creditors) or to enforce the lease due to non-payment (e.g. seize the leased
asset). While not necessarily following the analysis of "true lease" versus "lease
intended as security" under the provincial personal property security legislation
(discussed above), the courts evidenced their intention to inquire into the
substance of lease transactions to determine if the lease is a true lease (e.g. a
contract of bailment where the lessee pays for use of the asset) or a financing
arrangement (e.g. where the lessee has the liability of a debtor but acquires, by
virtue of the lease, the rights of an owner). On the plus side of the recent
jurisprudence, it was recognized that leased property in the possession of the
insolvent lessee may still be considered to have been "provided" after the
reorganization commences, even if it had been under lease before the
reorganization commences (i.e. it is considered to be "provided" in the sense that
the use of the leased property is available on an ongoing basis after the
reorganization commences) - the key is that it must have been leased under a
"true" lease, and not provided to the lessee under a financing arrangement,
before the reorganization commences. Also on the plus side are statements that
if a lease is a true lease and rent payments are to be made during the
reorganization, failure to make such payments should give the lessor the right to
recover the leased property.
Generally speaking, the objectives of the lessor when the lessee seeks
protection from its creditors depends on the nature and quality of the equipment
and the expectation whether the lessee will be able to successfully reorganize. If
the equipment value is greater than the lessor's investment, the lessor should be
satisfied with repossession of the equipment to enable it to realize on its value. If
the equipment value is not sufficient to enable the lessor to recover its
investment and a reasonable probability exists that the lessee will be able to
successfully reorganize its affairs without seriously compromising its obligations
to the lessor, the lessor should support the reorganization plan.
If a reorganization proposal fails, or if a lessee is petitioned into bankruptcy or
voluntarily makes an assignment into bankruptcy, the lessor should, in the case
of a lease which creates a security interest, provided required security
registrations are perfected, be permitted to recover the leased equipment and to
realize on its value; if the lessor loses its priority to the equipment, it will rank as
an unsecured creditor.
Conclusion
The above survey of legal issues in the Canadian leasing industry reflects the
sophistication and complexity of the laws affecting lessors and the difficulties
caused by the development of laws to govern the financing of equipment use
based on laws related to secured financings, conditional sales and rentals.
Due to the nature of this article, the issues raised represent the "tip of the
iceberg" but, experience has shown that people who are able to identify tips of
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the icebergs in a timely manner stand the best chance of safely navigating
through danger. Hopefully this article will assist the reader in identifying issues
so they are able to obtain timely legal advice.
It must be emphasized that, despite the absence of a unitary codified system of
laws governing leasing, the laws governing leasing in Canada provide a good
foundation for the industry and, with proper legal advice to address the
complexities, these laws enable lessors and lessees to conduct business with a
high degree of confidence and with the knowledge that a fair and reliable legal
system supports their activities.
This article was written by Kevin A. McGrath, a partner with the Toronto office of
Borden Ladner Gervais LLP, Barristers & Solicitors, one of Canada’s largest full
service law firms with over 600 lawyers, trade-mark agents and other
professionals and offices located in Calgary, Montreal, Ottawa, Toronto and
Vancouver. The Toronto office of Borden Ladner Gervais LLP is located at
Scotia Plaza, 40 King Street West, Toronto, Ontario, Canada, M5H 3Y4, (Tel:
416-367-6057). Grateful acknowledgement is provided to Mark E. White, director
and head of Global Structured Finance (Canada), RBC Capital Markets, Royal
Bank of Canada, the author and co-author of previous editions of this article.
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