A recent Alberta case [Alignvest Private Debt Ltd. v. Surefire Industries Ltd., 2015 ABQB 148] reminds us of the limitations of the security deposit. The outcome will appear to many landlords to be counterintuitive.

Landlords not surprisingly think of the security deposit as a “pot of money” available to be applied towards performance of the tenant’s obligations “no matter what”. In contrast, a trustee in bankruptcy might look upon the security deposit as a credit to which the bankrupt tenant is entitled, and which is available to the trustee to apply for the benefit of unsecured creditors.

The Court in this case aligned with the trustee in bankruptcy.

Facts of the case and judgment of the Court

The facts of the case briefly stated are:

• A sale and lease back transaction occurred in February 2013 between York Realty Ltd. as purchaser/landlord and Surefire Industries Ltd. as seller/tenant. The lease provided for a security deposit of $3,187,500.
• Alignvest Private Debt Ltd. held a registered general security agreement granted by Surefire in March 2013 over the assets of Surefire.
• Surefire was declared bankrupt in December 2013.
• Alignvest claimed priority to the security deposit as against York. This was supported by an agreement entered into by York in favour of Alignvest whereby York acknowledged the validity of Alignvest’s security and York subordinated its interest until Surefire’s obligations to Alignvest were paid in full.
• The trustee in bankruptcy took the position that the security deposit was intangible personal property (i.e. a monetary credit due to Surefire) to which Alignvest’s security attached. Implicit in the trustee’s position is that in order to be protected against the trustee the landlord’s claim to the security deposit would have to have been registered under Alberta’s Personal Property Security Act.

The Court held that:

“In summary, the deposit is security for obligations under the lease and not prepaid rent. It does not fall under an exclusion to the provisions of the PPSA, and as a security interest should have been perfected by registration. As it was not, it is subject to Alignvest’s perfected security interest.”

Along the way, the Court commented that:

“The characterization of the deposit under this lease should not be taken as determinative of the characterization of deposits under other forms of lease, and is limited to this specific lease and the intervention of a secured creditor with a perfected security interest.”

Analysis and comment

This ruling does not bode well for landlords holding security deposits.

If a tenant stays solvent and keeps its creditors at bay, the security deposit can serve its purpose as intended. But landlords can be unpleasantly surprised to find that “when you most need it, it’s not there”. If the tenant is in bankruptcy, the security deposit may be characterized as a credit owed to the tenant. The security deposit may be interpreted to be a security interest that requires “perfection” by a filing by the landlord under personal property security legislation (or else the landlord’s claim could lose priority to other creditors).

What can a landlord do?

If a landlord holds a security deposit of the size in the Alignvest case, $3,187,500, then clearly the landlord will be well advised to register under applicable personal property security legislation. A single–tenant landlord might choose to do the same, rather than take any risk. Commercial landlords of multiple tenancies will want to consider an overall approach taking into account overall costs and administration. Unfortunately, the practical alternatives are not appealing. Among the possibilities for commercial landlords to consider are:

• The landlord could routinely file under personal property security legislation for all leases with a security deposit, but that entails cost and administrative hassle (including increased requests for priority by tenants’ lenders, and requests for discharges long after the tenant has left the scene);
• A letter of credit is an alternative, but letters of credit have their own legal foibles and administrative issues; and
• The landlord’s argument will be improved by using an alternative approach framing the “deposit” as an upfront payment (akin to rent paid upfront under a prepaid lease) instead of a security deposit – but this alternative approach (if implemented as stridently as would be required) can be cumbersome to present and explain to tenants, and is not assured of being successful.

Conclusion and summary

The take-away points on this are:

(i)            appreciate that security deposits have limitations and vulnerabilities;

(ii)           on a case by case basis, consider whether to register under applicable personal property security legislation; and

(iii)          if the creditors are circling, consider applying the security deposit right away (if the tenant is in arrears) and / or taking steps to shore up your position (e.g. belatedly filing under the personal property security legislation might be helpful) before an insolvency filing occurs or the trustee in bankruptcy or creditors take enforcement action.