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.
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.
| Prepaid Rent | Security Deposit | |
|---|---|---|
| Purpose | Consideration for future use and occupation of the premises | Security to guarantee the tenant's performance of covenants under the lease |
| Conditions | Unconditionally to be applied to specific rental months | Conditional (application usually dependent on a condition precedent such as no default under the lease) |
| Refund | Non-refundable in all circumstances | Refundable |
| Amount | Set sum | May include a requirement to replenish if used to ensure performance |
The lease between Surefire as tenant and York as landlord stipulated, amongst other things that:
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:
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 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: