How To Understand The Law In Canada On Equipment Leasing

Transcription

1 World Leasing Yearbook 2003 Canada Legal Issues Kevin A. McGrath August 2002 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. 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. 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. CALGARY MONTRÉAL OTTAWA TORONTO VANCOUVER

2 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) (ii) (iii) (iv) 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; the enactment by the federal government of updated and more comprehensive money laundering legislation; the establishment by the federal government of a capital leasing pilot project under the Canada Small Business Financing Act; and 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, 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 non- Canadian 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 2

3 "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 3

4 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 4

5 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 5

6 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 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 6

7 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 7

8 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 8

9 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. 9

10 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 10

11 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 11

12 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 12

13 "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 13

14 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. 14

15 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) (ii) (iii) (iv) 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; 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; 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 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 15

16 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. 16

17 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. 17

18 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 18

19 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 19

20 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 All other Canadian provinces and the federal government are expected to implement and enact harmonized legislation by the end of 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 20