Cow Harbour True Lease Characterization Decision 'Released'

Whether a lease is a “true” or “finance” lease has been debated in Canadian courts for decades in many different contexts. The consequences of the categorization of a lease can have a material impact on the recovery that a lessor may have in an insolvency of its lessee. The Alberta Court of Queen's Bench recently released its decision in the matter of Royal Bank of Canada v. Cow Harbour Ltd. and 1134252 Alberta Ltd. on Jan. 23, 2012. This is one of the most important recent decisions in this debate and provides significant guidance as to how leases are to be classified in insolvency cases. We will review, at a high level, the tests that the court used in making its decision and offer an alternative analysis of what we believe should be the proper process.

Generally speaking, if a lease is determined to be a “true” lease, then the lessor is entitled to be paid rent during the restructuring period and may not be subject to certain costs associated with the restructuring. Accordingly, the economic impact of not being a “true” lease can be a very significant difference in the recovery obtained. Historically, the determination also impacted whether leases had to be registered under the Personal Property Security Act (“PPSA”), but recent changes to the PPSA have made this debate a non-issue. Unfortunately, the statutes governing Canadian insolvency legislation simply utilize the word “lease” but do not provide for any commentary or direction as to the meaning of the term. Reliance is placed on the common law and the common law, not surprisingly, is unclear. To complicate matters, tax and accounting have different tests for “true” and “finance” leases that are not common law driven but rules based.

Lessors will often structure leases such that they will achieve the tax or accounting test for “true” leases, mistakenly thinking that they have achieved the same results for insolvency purposes. The accounting test under GAAP (as opposed to IFRS) is relatively black and white, focusing on residual value and who holds that risk. The legal test for insolvency purposes, however, does not use such a simplistic formulation, and as a result confusion and frustration in the industry has reigned. While the recent Cow Harbour discussion is helpful in reducing this frustration, it does not end it.

'True' or 'Finance' Lease

The leading case used in insolvency courts in determining whether a lease is a “true” or “finance” lease is Smith Brothers Contracting Ltd. [1998] B.C.J. No. 728 (B.C.S.C.); Re Philip Services Corp., [1999] O.J. No. 5117 (S.C.J.). This case gave a very narrow and restrictive interpretation. Overly simplified, a true lease is defined as the payment for use of an asset where ownership resides with the lessor and is not a disguised security agreement. The intent of the parties as opposed to the form of the document is a key consideration. The complication arose in how the intent of the parties was determined. The court adopted a list of factors used in the United States and developed by Professor Ronald C.C. Cuming of the University of Saskatchewan. This is referred to as the Cuming List. In Smith Brothers and other cases, the Cuming List was reviewed as against the subject lease. Then based on the review of how many factors were indicative of a “true” or “finance” lease, a decision was arrived at. In many cases the process involved determining how many factors were on each side of the equation.

It has always been questionable if this approach was correct for two basic reasons:

The first is that the Cuming List is adopted from U.S. law and practice. While Canada shares similarities in law to the United States, there are differences. At its most simple, one of the factors in the Cuming List is whether the lease is registered under the Uniform Commercial Code (the U.S. version of the PPSA). In Canada, this factor is meaningless as all leases of greater than one year must be registered. As this factor is meaningless in a Canadian context, a mere adding up of factors and seeing how many are on each side is fundamentally flawed. In a similar vein, certain of the factors if followed would result in uneconomic activities. The classic example is insurance. For a long-term lease a lessee can obtain insurance at a lower cost than a lessor. If a lessor wanted to ensure true lease treatment utilizing the Cuming List it would arrange for insurance notwithstanding the higher cost. Uneconomic activities would be the result.

Second, if a list of factors is to be developed, consideration needs to be given as to those that carry the highest probative value. To our knowledge there has never been a case decided where the purchase option amount is nominal and the lease was determined to be a “true” lease. In essence, there are clear factors recognized by the industry and courts that are clearly indicative of a true lease categorization, regardless of the presence of other factors. Other commentaries have advanced the theory that there are primary and secondary factors and that greater weight needs to be provided to those that carry higher probative value, the prime example being the purchase option.

Cow Harbour

In Cow Harbour, the Honourable Mr. Justice K.D. Yamauchi provided an excellent overview of the decision to date and the various arguments made by commentators. He also recognized that the court was bound by prior decisions and had to apply the law based on those prior principles. It is interesting to note that encompassed in the decision was a discussion of whether there should be a distinction of the “true” and “finance” leases in an insolvency context and the economic impact of such distinction. Justice Yamauchi noted that the current state of the law is that financing leases are not considered “leases” for the purpose of insolvency status but openly questioned whether this was a correct and equitable result. Many commentators have taken the position that this original distinction between the two leases is likely wrong from an economic standpoint and should be reviewed. The analysis set out in Cow Harbour will assist in the future in making an alternative finding if the correct set of circumstances arises and may eliminate this unfair dichotomy.

In making its determination, the court had to strike a balance between existing precedents (as this was a lower court) and the reality of the case. The court clearly accepted Smith Brothers as the leading case and adopted the Cuming List. Equally, the court was mindful that a holistic approach as opposed to a simple adding up of the factors should be used. While noting that one factor cannot trump the others in respect of the legal test, the court did note that all of the factors taken as a whole must be reviewed in their entirety to determine the intent of the parties. These guiding principles were then utilized in reviewing each of the leases. This approach was adopted by the court to allow it to, on the one hand, follow past precedents, but on the other hand acknowledge that a greater analytic approach was required.

The approach utilized by the court was to review each of the leases as against the Cuming List and then focus on certain of the factors in greater detail. It should be noted that in no circumstance did the court adopt the approach of simply adding up the factors and seeing which side had the majority. Notwithstanding the court's view that no one factor trumps others, what clearly becomes apparent is that certain factors, such as purchase option pricing, became the most significant factors. Factors such as a traditional default clause that provided for the acceleration of rent, which prior decisions held as determinative, were rejected. The key test in a default clause was which party retained the surplus.

When reviewing the decision as a whole, certain themes evolved but were not explicitly set out. Interestingly, these themes would have been the expectation of most industry observers.

• If there was a purchase option for nominal value or if the lessee was responsible for the lessor's loss upon the ultimate disposition of the equipment, then the lease would be a finance lease. Accordingly, and not unexpectedly, dollar option leases and TRAC leases will be finance leases.
• If a stretch lease is utilized, i.e., a lease that has a set purchase option at a particular time and then if the purchase option is not exercised the lessee can renew for a period of time where the lease payments over that renewal period were equal to the purchase option price, then the lease would be a finance lease.
• If the purchase option price is set as either: 1) a fair market value (and there is some value of the equipment at the end of the term); or 2) as a percentage of the original equipment cost which is a reasonable estimate of the value of the equipment at the end of the term, then the lease will, absent other factors to the contrary, be a “true” lease. The determination of what constitutes a reasonable estimate of the value is not fully explored in this case. It was clear that the court was deferential to the expertise of the parties where it was clear that the parties were mindful of the structure. From a practice point, it is suggested that a client better document how it derives the purchase option amount.
• Default provisions where the surplus was retained by the lessor were indicative of a “true” lease.
• Security deposits, while problematical, can be retained, but they should not be of a size or nature that they change the economics of the transaction, and the taking of such a deposit should be directly related to the risk involved in the transaction.
• If the amount of the lease payments made over the term of the lease, even with a non-nominal purchase option, greatly exceeds the purchase price of the assets, then it is more likely to be determined to be a finance lease. While this principle was accepted by the court, there was little discussion of the cost of capital that should be calculated into the equation.
• The inclusion of excess usage costs was helpful in determining a “true” lease.
• Return conditions that: 1) could be achieved ( i.e., not so complicated that they could not be met), and 2) were possible to comply with in an economic sense ( i.e., if the equipment has to be returned to the opposite side of the country and the cost of moving the equipment was greater than its value) were also factored into the “true” lease analysis.

Summary: Lesson Learned

The court, while using great skill at reconciling prior case law, came to what were the expected results, at least from an industry perspective. What was disappointing was that the process used in coming to this determination was based on outdated or simply wrong concepts. The judge did an admirable job of distinguishing previous case law where possible, but was still bound by precedent. It is suggested that a new approach be utilized based on industry expectations in order to enhance certainty to the industry when structuring transactions. The rationale is that absent certainty, a lessor will take a more risk-adverse approach that either reduces liquidity or increases borrowing costs, which reduces productivity. Given that Canada's productivity is a constant economic problem, any costless change to enhance productivity should be welcome. It seems odd that one of the stated goals of insolvency legislation is to assist debtors in restructuring, but the tools to keep them solvent (being able to lease equipment) prior to filing for protection are so unclear that finance companies may be unwilling to lend when companies need the greatest assistance.

It is suggested that the test should follow the results as set out in Cow Harbour, but it should be set out explicitly. It is reminiscent to the late 1400s when Copernicus reviewed the star charts developed using an earth-centric or Ptolemaic system that had become over complicated, and by moving to a helocentric system (the sun to the center) simplified the understanding of the motion of planets. There should be a wholesale recognition that the current system has become over complicated, and it would be helpful to re-evaluate the analysis without reliance on the past precedent. It is time for a refresh. Justice Yamauchi went a clear step in that direction in his well-written and coherent analysis, but it is suggested that a clean break from past decisions would have been more desirable (although it is recognized that a lower court could not make such a radical change).

As noted earlier, the Cuming List is simply not an appropriate test in making the determination. Many of the factors listed are at best minor and should be removed, and the test provides no guidance as to weighing of the factors. This test should be abandoned and a new test adopted. The test should be simple to understand and easy to determine. It is suggested that a test be modeled on the following concepts:

• Is the lessee building up an equity interest in the asset? If yes, then it is a finance lease. If the purchase option is fair market value (other than a nominal fair market value) or where it is a reasonable estimate, then equity is not being built up and a “true” lease would be the result. This simple test would also eliminate stretch leases as “true” leases. Clearly, the test would have to be mindful of the various methods lessors use in forcing lessees to purchase at the end of the term, e.g., 1) return condition that cannot be met; 2) notice clauses that are obscure; and 3) equipment that would cost too much to maintain.
• Which party has the residual risk? If the lessee has the risk, then it is a finance lease.
• Is there value of the asset at the end of the term of the lease?
• Which party has the equity of redemption?

Jonathan Fleisher is chair of Cassels Brock and Blackwell LLP's Equipment and Asset Finance Group and is located in Toronto, Ontario. He has particular expertise assisting U.S. commercial finance companies, both public and private, with establishing operations in Canada, providing both legal and practical business advice. Suhuyini Abudulai is an associate in the firm's Equipment and Asset Finance Group. Her practice focuses on corporate finance matters, representing lenders and borrowers in various secured and unsecured financing transactions. The authors may be reached at [email protected] and [email protected], respectively.

Whether a lease is a “true” or “finance” lease has been debated in Canadian courts for decades in many different contexts. The consequences of the categorization of a lease can have a material impact on the recovery that a lessor may have in an insolvency of its lessee. The Alberta Court of Queen's Bench recently released its decision in the matter of Royal Bank of Canada v. Cow Harbour Ltd. and 1134252 Alberta Ltd. on Jan. 23, 2012. This is one of the most important recent decisions in this debate and provides significant guidance as to how leases are to be classified in insolvency cases. We will review, at a high level, the tests that the court used in making its decision and offer an alternative analysis of what we believe should be the proper process.

Generally speaking, if a lease is determined to be a “true” lease, then the lessor is entitled to be paid rent during the restructuring period and may not be subject to certain costs associated with the restructuring. Accordingly, the economic impact of not being a “true” lease can be a very significant difference in the recovery obtained. Historically, the determination also impacted whether leases had to be registered under the Personal Property Security Act (“PPSA”), but recent changes to the PPSA have made this debate a non-issue. Unfortunately, the statutes governing Canadian insolvency legislation simply utilize the word “lease” but do not provide for any commentary or direction as to the meaning of the term. Reliance is placed on the common law and the common law, not surprisingly, is unclear. To complicate matters, tax and accounting have different tests for “true” and “finance” leases that are not common law driven but rules based.

Lessors will often structure leases such that they will achieve the tax or accounting test for “true” leases, mistakenly thinking that they have achieved the same results for insolvency purposes. The accounting test under GAAP (as opposed to IFRS) is relatively black and white, focusing on residual value and who holds that risk. The legal test for insolvency purposes, however, does not use such a simplistic formulation, and as a result confusion and frustration in the industry has reigned. While the recent Cow Harbour discussion is helpful in reducing this frustration, it does not end it.

'True' or 'Finance' Lease

The leading case used in insolvency courts in determining whether a lease is a “true” or “finance” lease is Smith Brothers Contracting Ltd. [1998] B.C.J. No. 728 (B.C.S.C.); Re Philip Services Corp., [1999] O.J. No. 5117 (S.C.J.). This case gave a very narrow and restrictive interpretation. Overly simplified, a true lease is defined as the payment for use of an asset where ownership resides with the lessor and is not a disguised security agreement. The intent of the parties as opposed to the form of the document is a key consideration. The complication arose in how the intent of the parties was determined. The court adopted a list of factors used in the United States and developed by Professor Ronald C.C. Cuming of the University of Saskatchewan. This is referred to as the Cuming List. In Smith Brothers and other cases, the Cuming List was reviewed as against the subject lease. Then based on the review of how many factors were indicative of a “true” or “finance” lease, a decision was arrived at. In many cases the process involved determining how many factors were on each side of the equation.

It has always been questionable if this approach was correct for two basic reasons:

The first is that the Cuming List is adopted from U.S. law and practice. While Canada shares similarities in law to the United States, there are differences. At its most simple, one of the factors in the Cuming List is whether the lease is registered under the Uniform Commercial Code (the U.S. version of the PPSA). In Canada, this factor is meaningless as all leases of greater than one year must be registered. As this factor is meaningless in a Canadian context, a mere adding up of factors and seeing how many are on each side is fundamentally flawed. In a similar vein, certain of the factors if followed would result in uneconomic activities. The classic example is insurance. For a long-term lease a lessee can obtain insurance at a lower cost than a lessor. If a lessor wanted to ensure true lease treatment utilizing the Cuming List it would arrange for insurance notwithstanding the higher cost. Uneconomic activities would be the result.

Second, if a list of factors is to be developed, consideration needs to be given as to those that carry the highest probative value. To our knowledge there has never been a case decided where the purchase option amount is nominal and the lease was determined to be a “true” lease. In essence, there are clear factors recognized by the industry and courts that are clearly indicative of a true lease categorization, regardless of the presence of other factors. Other commentaries have advanced the theory that there are primary and secondary factors and that greater weight needs to be provided to those that carry higher probative value, the prime example being the purchase option.

Cow Harbour

In Cow Harbour, the Honourable Mr. Justice K.D. Yamauchi provided an excellent overview of the decision to date and the various arguments made by commentators. He also recognized that the court was bound by prior decisions and had to apply the law based on those prior principles. It is interesting to note that encompassed in the decision was a discussion of whether there should be a distinction of the “true” and “finance” leases in an insolvency context and the economic impact of such distinction. Justice Yamauchi noted that the current state of the law is that financing leases are not considered “leases” for the purpose of insolvency status but openly questioned whether this was a correct and equitable result. Many commentators have taken the position that this original distinction between the two leases is likely wrong from an economic standpoint and should be reviewed. The analysis set out in Cow Harbour will assist in the future in making an alternative finding if the correct set of circumstances arises and may eliminate this unfair dichotomy.

In making its determination, the court had to strike a balance between existing precedents (as this was a lower court) and the reality of the case. The court clearly accepted Smith Brothers as the leading case and adopted the Cuming List. Equally, the court was mindful that a holistic approach as opposed to a simple adding up of the factors should be used. While noting that one factor cannot trump the others in respect of the legal test, the court did note that all of the factors taken as a whole must be reviewed in their entirety to determine the intent of the parties. These guiding principles were then utilized in reviewing each of the leases. This approach was adopted by the court to allow it to, on the one hand, follow past precedents, but on the other hand acknowledge that a greater analytic approach was required.

The approach utilized by the court was to review each of the leases as against the Cuming List and then focus on certain of the factors in greater detail. It should be noted that in no circumstance did the court adopt the approach of simply adding up the factors and seeing which side had the majority. Notwithstanding the court's view that no one factor trumps others, what clearly becomes apparent is that certain factors, such as purchase option pricing, became the most significant factors. Factors such as a traditional default clause that provided for the acceleration of rent, which prior decisions held as determinative, were rejected. The key test in a default clause was which party retained the surplus.

When reviewing the decision as a whole, certain themes evolved but were not explicitly set out. Interestingly, these themes would have been the expectation of most industry observers.

• If there was a purchase option for nominal value or if the lessee was responsible for the lessor's loss upon the ultimate disposition of the equipment, then the lease would be a finance lease. Accordingly, and not unexpectedly, dollar option leases and TRAC leases will be finance leases.
• If a stretch lease is utilized, i.e., a lease that has a set purchase option at a particular time and then if the purchase option is not exercised the lessee can renew for a period of time where the lease payments over that renewal period were equal to the purchase option price, then the lease would be a finance lease.
• If the purchase option price is set as either: 1) a fair market value (and there is some value of the equipment at the end of the term); or 2) as a percentage of the original equipment cost which is a reasonable estimate of the value of the equipment at the end of the term, then the lease will, absent other factors to the contrary, be a “true” lease. The determination of what constitutes a reasonable estimate of the value is not fully explored in this case. It was clear that the court was deferential to the expertise of the parties where it was clear that the parties were mindful of the structure. From a practice point, it is suggested that a client better document how it derives the purchase option amount.
• Default provisions where the surplus was retained by the lessor were indicative of a “true” lease.
• Security deposits, while problematical, can be retained, but they should not be of a size or nature that they change the economics of the transaction, and the taking of such a deposit should be directly related to the risk involved in the transaction.
• If the amount of the lease payments made over the term of the lease, even with a non-nominal purchase option, greatly exceeds the purchase price of the assets, then it is more likely to be determined to be a finance lease. While this principle was accepted by the court, there was little discussion of the cost of capital that should be calculated into the equation.
• The inclusion of excess usage costs was helpful in determining a “true” lease.
• Return conditions that: 1) could be achieved ( i.e., not so complicated that they could not be met), and 2) were possible to comply with in an economic sense ( i.e., if the equipment has to be returned to the opposite side of the country and the cost of moving the equipment was greater than its value) were also factored into the “true” lease analysis.

Summary: Lesson Learned

The court, while using great skill at reconciling prior case law, came to what were the expected results, at least from an industry perspective. What was disappointing was that the process used in coming to this determination was based on outdated or simply wrong concepts. The judge did an admirable job of distinguishing previous case law where possible, but was still bound by precedent. It is suggested that a new approach be utilized based on industry expectations in order to enhance certainty to the industry when structuring transactions. The rationale is that absent certainty, a lessor will take a more risk-adverse approach that either reduces liquidity or increases borrowing costs, which reduces productivity. Given that Canada's productivity is a constant economic problem, any costless change to enhance productivity should be welcome. It seems odd that one of the stated goals of insolvency legislation is to assist debtors in restructuring, but the tools to keep them solvent (being able to lease equipment) prior to filing for protection are so unclear that finance companies may be unwilling to lend when companies need the greatest assistance.

It is suggested that the test should follow the results as set out in Cow Harbour, but it should be set out explicitly. It is reminiscent to the late 1400s when Copernicus reviewed the star charts developed using an earth-centric or Ptolemaic system that had become over complicated, and by moving to a helocentric system (the sun to the center) simplified the understanding of the motion of planets. There should be a wholesale recognition that the current system has become over complicated, and it would be helpful to re-evaluate the analysis without reliance on the past precedent. It is time for a refresh. Justice Yamauchi went a clear step in that direction in his well-written and coherent analysis, but it is suggested that a clean break from past decisions would have been more desirable (although it is recognized that a lower court could not make such a radical change).

As noted earlier, the Cuming List is simply not an appropriate test in making the determination. Many of the factors listed are at best minor and should be removed, and the test provides no guidance as to weighing of the factors. This test should be abandoned and a new test adopted. The test should be simple to understand and easy to determine. It is suggested that a test be modeled on the following concepts:

• Is the lessee building up an equity interest in the asset? If yes, then it is a finance lease. If the purchase option is fair market value (other than a nominal fair market value) or where it is a reasonable estimate, then equity is not being built up and a “true” lease would be the result. This simple test would also eliminate stretch leases as “true” leases. Clearly, the test would have to be mindful of the various methods lessors use in forcing lessees to purchase at the end of the term, e.g., 1) return condition that cannot be met; 2) notice clauses that are obscure; and 3) equipment that would cost too much to maintain.
• Which party has the residual risk? If the lessee has the risk, then it is a finance lease.
• Is there value of the asset at the end of the term of the lease?
• Which party has the equity of redemption?

Jonathan Fleisher is chair of Cassels Brock and Blackwell LLP's Equipment and Asset Finance Group and is located in Toronto, Ontario. He has particular expertise assisting U.S. commercial finance companies, both public and private, with establishing operations in Canada, providing both legal and practical business advice. Suhuyini Abudulai is an associate in the firm's Equipment and Asset Finance Group. Her practice focuses on corporate finance matters, representing lenders and borrowers in various secured and unsecured financing transactions. The authors may be reached at [email protected] and [email protected], respectively.