In the context of a tenant’s bankruptcy, Justice Romaine of the Alberta Queens Bench recently characterized a deposit provided under a lease as a security interest, as opposed to pre-paid rent, forcing an unsecured landlord to remit the money to a trustee in bankruptcy.

The Court emphasized the verbiage of the lease in order to determine the intention of the parties. Among other details, the lease provided that the deposit was “to be held without interest by the Landlord as security for the performance by the tenant of its obligations under the lease”.[1] The landlord failed to register a security interest under the Personal Property Security Act (Alberta) (“PPSA”). As a result, it was ordered to remit the deposit to the trustee in bankruptcy for a secured creditor who held a general security agreement (“GSA”) over the tenant.

The provisions of the lease played a significant role and the decision emphasizes the importance of carefully drafting the terms in connection with a deposit given under a lease.

Background

Surefire Industries Ltd. (“Surefire”) leased its property from York Realty Ltd. (“York”) (the “Lease”). In fall 2013, Surefire was placed under receivership, but was later declared into bankruptcy - Duff & Phelps Canada Restructuring Inc. was appointed as trustee of Surefire’s estate (the “Trustee”). Shortly after bankruptcy, the Trustee disclaimed the Lease and York retained possession of a deposit made under the Lease for $3,187,500. Alignvest Private Debt Ltd. (“Alignvest”) had a GSA over the assets of Surefire and also entered into a priority agreement with York, whereby York acknowledged the validity of Alignvest’s security interest and subordinated its own interest to Alignvest’s. As previously noted, York did not register its security interest.

York took the position that the deposit should be characterized as pre-paid rent and not security for Surefire’s performance of the obligations under the Lease. Therefore, York argued, ownership of the deposit passed on payment and should not form part of Surefire’s estate. Alignvest took the position that the deposit secured performance of Surefire’s obligations under the Lease, and was therefore a security interest. As a result, it should be remitted to the Trustee where Alignvest has priority as a secured creditor.

Law & Analysis

York relied on Re Abraham, where the Ontario Court of Appeal found that a non-refundable deposit to be applied to rental payments or defaults of the tenant was pre-paid rent. On the other hand, Alignvest relied onRe Champion Machine and Tool Co. Limited, a case distinguishing Abraham on the basis that the deposit was defined as a “security deposit”, and was to be retained in the event of a breach of covenant or applied to the last month of rent. In Champion, the benefit of the deposit fell to the trustee in bankruptcy and not the landlord.

Without specifically citing the application of Abraham or Champion, the Court stated that it must “look to the wording of the lease to determine the intention of the parties with respect to the deposit, whether it should be characterized as pre-paid rent, liquidated damages or security and whether it would be non-refundable in the hands of the tenant and thus with respect to the trustee in bankruptcy”.[2]

Justice Romaine examined the provisions of the Lease that characterized the deposit, which stated the deposit was “to be held without interest by the Landlord as security for the performance by the Tenant of its obligations under the Lease”[3] and if Surefire was not otherwise in default, the deposit was to be applied to rent falling due in the future. Furthermore, the Court held the following were indications that the deposit was security:[4]

  • The section of the Lease was entitled “Security Deposit/Rent Credit” and the deposit was defined as a “Security Deposit”
  • Prior to the receivership, York did not exercise the use of the deposit where rental payments were late
  • The deposit was only applicable to future rents once they fall due

Based on the wording of the lease and the fact that the deposit could be refunded to Surefire in particular circumstances, the Court determined that the parties intended to create a security interest, as opposed to pre-paid rent.

York also submitted that because the deposit was made under a lease (ie. interest in land), it was therefore excluded from the application of the PPSA under section 4(g). The Court rejected this argument, drawing a distinction between “right to payment” under an interest in land and “security for that right”. Furthermore, the fact that the deposit may be applied to rent is not relevant – the Court held that simply because the parties have chosen a different mechanism to enforce the security, it does not change the characterization of the interest as a security.

Conclusion

The decision emphasizes the importance of drafting precise language with respect to rental or security deposits. As landlords do not typically register deposits under the applicable Personal Property Security Act, they must ensure that their leases do not create an unintended security interest over deposits that are subject to the claims of secured parties.