Prepaid Rent or Security Deposit? It's All in the Drafting
In 2015, Alberta’s Court of Queen’s Bench and Court of Appeal were asked to determine whether the sum of $3,187,500 (the “Deposit”) paid pursuant to a commercial lease (the “Lease”) was a security deposit or prepaid rent. The Court in Alignvest Private Debt Ltd v. Surefire Industries Ltd, 2015 ABQB 148 (“Surefire”), upheld in York Realty Inv. v. Alignvest Private Debt Ltd., 2015 ABCA 355, ultimately ruled that the Deposit was a security deposit and not prepaid rent. For the Landlord, York Realty, the result required them to deliver up the Deposit to the trustee in bankruptcy.
In Surefire, the matter began as a result of the sale and subsequent leaseback between York Realty Ltd., as the purchaser and landlord (“Landlord”), and Surefire Industries Ltd. as the seller and tenant (“Tenant”). Under the terms of the Lease, the Tenant was required to provide the Deposit to the Landlord. Rather than being paid in cash, the balance due on close for the sale of land was adjusted to reflect the Deposit held by the Landlord.
The wording in the Lease in regard to the deposit were as follows:
“6. Security Deposit/Rent Credit
(a) The Tenant will pay to the Landlord … a deposit of … $3,187,500 plus goods and services tax (the “Security Deposit”), which Security Deposit is to be held without interest by the Landlord as security for the performance by the Tenant of its obligations under the Lease … Subject to the foregoing, the Security Deposit will, provided that the Tenant has paid all amounts due to the Landlord under this Lease and is not otherwise in default …, be applied during the term as follows:”
The Deposit would be applied to monthly rents starting on the 13th month of the term and thereafter certain specific months to follow during the term. The Deposit could also be applied in the event of default by the Tenant. As is typically the case, the Landlord did not register its interest in the Deposit with the Personal Property Registry.
During the tenancy, the Tenant was granted an initial order under the Companies’ Creditors Arrangement Act (“CCAA”). Not long after, the CCAA proceedings were terminated and the Tenant was placed into receivership by Alignvest Private Debt Ltd (“APD”). APD was a secured creditor of the Tenant and held a registered security interest over all of the Tenant’s assets. In the period of time leading up to the appointment of a receiver, the Tenant had defaulted on payment of rent to the Landlord. However, the Landlord chose not to exercise its rights under the Lease to apply the Deposit to the default in rents at that time. The Tenant later brought the rents current. The Tenant was declared bankrupt and, during the period of time the Tenant was not in default, the trustee in bankruptcy disclaimed the lease.
In the subsequent dispute between the Landlord and ADP, ADP asserted the position that the Deposit held by the Landlord was the Tenant’s property and therefore subject to ADP’s secured interest. The Landlord’s position was that the Deposit was in fact “pre-paid” rent or, alternatively, non-refundable deposits to be applied to rent regardless of default, and therefore rightfully the Landlord’s.
In order to determine the character of the Deposit, both the Court of Queen's Bench and the Court of Appeal looked to the specific terms of the Lease. In assessing the characterization of the Deposit, the following were found to be indications that the Deposit was in fact a security deposit:
- 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” and if the Tenant was not in default, the Deposit would be credited to the rent periods identified in the Lease;
- The terms "Security Deposit" and "Prepaid Rent" in various clauses of the Lease were indicative of an intention to treat the concepts differently:
- In the section of the Lease entitled “Security Deposit/Rent Credit”, the Deposit was defined as a “Security Deposit”; while a separate amount of $500,000, credited to the Tenant for initial rents, was described as "prepaid rent".
- In the event the Landlord had to apply the portion of the Deposit to rent arrears or other defaults, the Tenant would have been required to make payment to replenish it. This notion of replenishment was found by the Court of Appeal to be inconsistent with the concept of prepaid rent, as prepaid rent is generally a set amount to which the landlord is entitled upon execution of the Lease, and not an account that requires replenishment;
- The Deposit was only applicable to future rents as they became due, and not immediately credited to the Landlord;
- Other terms of the Lease could result in the Deposit being refunded/reverting to the Tenant, including in the event of a disclaimer of the Lease confirmed by a court, as it was in this case.
Based on the wording of the Lease, and the fact that the Deposit could be refunded to the Tenant in certain circumstances, both Courts determined that the parties intended the Deposit to be a security deposit and not pre-paid rent. The Deposit, therefor, was property of the Tenant.
In her decision, Justice Romaine further held that the Landlord had a security interest in the security deposit which could have been registered under the terms of the Personal Property Security Act (“PPSA”) and perfected. But as stated earlier, and as is commonly the case, the Landlord did not register its interest. Romaine, J. further held that the Landlord’s Deposit did not fall within the exclusions set out in sections 4 (f) and (g) of the PPSA. Consequently, the Landlord’s claim to the security deposit was unsecured and subordinate to ADP’s perfected interest.
On Appeal, the Justices upheld the security deposit finding, and so were not required to assess the further issues of the requirement to register the security interest, or the applicability of the exclusionary sections in the PPSA. They further confirmed they did not endorse the lower court’s finding on those points as they were not necessary to the decision required to be made.
The Court of Appeal, however, addressed the issue of set off with regard to the Landlord’s entitlements in bankruptcy, and applied the Bankruptcy and Insolvency Act and the Landlord’s Rights on Bankruptcy Act in granting the Landlord set off for 3 month’s accelerated rents and for damages for repairs to the premises.
Despite the Court of Appeal's refusal to endorse the decision regarding the security interest issue, Surefire provides a cautionary tale and guidance to landlords on how to potentially minimize the risks arising from a tenant’s insolvency. In particular:
- ensure when drafting a lease, it demonstrates a clear intention to characterize pre-paid sums as irrevocable, non-refundable amounts capable of immediate credit to the landlord upon execution of the lease, and not as security deposit for performance of tenant covenants;
- In the case of existing Leases, where an insolvency event is imminent or warning signs exist (and the tenant is in default), may well warrant applying the security deposit without delay to cure the default before an insolvency filing occurs or creditors take enforcement action; and
- if a landlord intends to have a security interest in a deposit, perfect the security interest in accordance with the Personal Property Security Act (Alberta), or applicable legislation in other provinces. Such a decision is subject to weighing the cost and administrative effort to do so which may practically include requests for priority from tenants’ lenders, and requests for discharges long after the tenant has vacated the premises.
Surefire signals a development that requires landlords to more carefully consider drafting Lease provisions that govern security deposits and pre-paid sums. In particular, the cases highlight some of the mechanisms available to landlords to protect their rights to security deposits or pre-paid sums.
Invitation for Discussion:
If you would like to discuss this article in greater detail, or any other business law matter, please do not hesitate to contact one of the lawyers in the Business Law group at Shea Nerland LLP.
Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.