Prepaid rent or a security deposit? The distinction is an important and potentially costly one for landlords in the current economic climate. In 2015, the Alberta Court of Appeal in York Realty Inc. v Alignvest Private Debt Ltd., 2015 ABCA 355 [Alignvest CA] upheld a decision of the Court of Queen’s Bench (Alignvest Private Debt Ltd. v Surefire Industries Ltd., 2015 ABQB 148 [Alignvest QB]) declaring that a $3.2-million deposit from York’s bankrupt tenant, Surefire Industries Ltd., was a security deposit, rather than prepaid rent and consequently was not the property of the landlord and had to be returned to the tenant.

Security Deposit vs. Prepaid Rent

Monies deemed to be prepaid rent are ideal for landlords whose tenants become bankrupt or insolvent. Prepaid rents are non-refundable to the tenant in the event of its bankruptcy or insolvency, as they become the property of the landlord, usually upon execution of the lease. In contrast, a security deposit is potentially refundable to a tenant, or its trustee in bankruptcy or receiver, and thus treated as the tenant’s property subject to creditor claims and the statutory scheme of distribution under insolvency legislation.

The York-Surefire Lease

The lease between Surefire as tenant and York as landlord stipulated, amongst other things that:

• the tenant was required to pay a security deposit of $3,187,500, to be held without interest by the landlord as security for the performance by the tenant of its obligations under this lease, in addition, the tenant paid prepaid rent which had been credited to rents payable;
• the landlord, in its sole discretion, was entitled to apply any portion or all of the security deposit during the term to any sums outstanding or owing by the tenant under the lease resulting from rent owed or breach of the lease;
• after the landlord had applied any portion of the security deposit, the tenant, on demand, was required to top up the security deposit to equal the amount originally held by the landlord as such;
• provided that the tenant paid all amounts due to the landlord under the lease and was not otherwise in default under the terms of the lease, the security deposit would be applied as rent towards the 13th, 14th, 28th, 29th and 60th months of the term; and
• in the event of a default, the landlord was entitled to retain the security deposit for its own use.
• While Surefire was in receivership, York applied for an order that it was entitled to retain the Surefire’s deposit. Alignvest Private Debt Ltd., a secured creditor of Surefire, applied for an order directing York to pay the deposit to Surefire’s trustee. York argued that the deposit was actually prepaid rent and became its property on execution of the lease, which entitled it to retain the deposit.

Drafting Hindsight is 20/20

Whether a sum held by a landlord is prepaid rent or a security deposit is fact-specific, and is dependent on the specific terms of the lease in question. Both Alberta courts in Alignvest held that Surefire’s deposit was a security deposit for the following reasons, based on the terms of the lease and the parties’ treatment of the deposit:

• the deposit was defined as a security deposit in the relevant lease provisions, and labelled Security Deposit on the final statement of adjustments, while Rent Credit was distinguished from a security deposit elsewhere in the lease;
• the lease stated the deposit was to be held by the landlord “as security for the performance by the tenant of its obligations under this Lease” which suggests security language, triggering the issue of priority amongst creditors under the Personal Property Security Act (PPSA);
• the lease granted York a right to retain the deposit in the event of a default of rent, but York did not exercise its option at the time and did not apply the deposit to rental payments that were late and, at the date of disclaimer of the lease, all rent owing had been paid;
• although the lease credited the deposit to specific months’ rent, usually an indication of prepaid rent, the credit was not immediate and related to dates after the disclaimer of the lease and, additionally, was conditional on no default by the tenant at the time of the application; and
• the notion of replenishing the deposit is inconsistent with the concept of prepaid rent.

Real Property and the PPSA

After classifying Surefire’s deposit as a security deposit, the Court in Alignvest QB determined that York held a security in the security deposit which it failed to register under the PPSA leaving York, in the Court’s opinion, with an unsecured interest behind Surefire’s secured creditors. Although not discussed, it is interesting to note that York had agreed to subordinate its (unregistered) security interest to Alignvest. Registering a security interest in a security deposit is not common marketplace practice, and York argued that requiring it to perfect its rights in the deposit by registration would upset the efficiency of commercial and residential leasing law.

The PPSA has exclusionary provisions that state that the PPSA does not apply to an interest in land, or “a right to payment” arising from an interest in land, which includes rental payments under a lease (ss. 4(f) and (g)). The Court determined that the landlord had an interest in money or an intangible that secures performance of an obligation and specifically not excluded from the PPSA as an interest in a right to payment that arises in connection with an interest in land. The lease provided that Surefire’s deposit secured not only the payment of rent under the lease, but other obligations. There has been debate as to whether the Court in Alignvest QB was correct in finding that the deposit was a security interest to which the PPSA applied. The Court of Appeal deemed it unnecessary to the resolution of the appeal to address registration of a security interest under the PPSA and whether certain exceptions to the application of the PPSA applied. The Court of Appeal expressly did not endorse the reasoning of the Court below in that regard.

The intersection of real property interests and personal property legislation is still in flux and questions such as whether a landlord needs to register its interest in a security deposit have not been answered with any finality. The interplay of federal and provincial bankruptcy and insolvency legislation adds an additional layer of complexity.

The Bottom Line

The bottom line is that a landlord may be required to refund a security deposit to a tenant or its representative, which, as York can attest to, can be sizeable. It is very important that a lease be drafted with clarity, so as not to leave revenues and priority to judicial interpretation. When drafting a commercial lease or dealing with a tenant who appears to be on the eve of insolvency, one should consult legal counsel with the following considerations in mind:

New Lease

• Say what you mean – be clear, call the amount “prepaid rent” not “security deposit” and avoid conflicting language, not only in the lease itself but in all dealings with the tenant.
• Substance over form – avoid security language.
• Follow the rules – do not make the return or applicability of a deposit conditional.
• Security deposits should be non-refundable.

Pre-existing Lease

• If a lease potentially supports an interpretation of a security deposit, consider whether registering and perfecting that interest to secure priority is worth the time and cost of doing so, keeping in mind that the Court’s finding in Alignvest QB that a security deposit under a lease constitutes a security interest to which the PPSA applies was not endorsed by the Court of Appeal.
• If a tenant defaults on rent or appears to be on the verge of insolvency, consider applying the security deposit to remedy the default early in the process.
• If circumstances similar to those in Alignvest exist, consult a lawyer early, to ensure any rights to retain funds are exercised in a timely way.