November 01, 2019

Leasing Challenges In The Canadian Bank Regime

John Teolis

Introduction

One of the most heatedly discussed bank regulatory issues in Canada relates to leasing and, in particular, operating leasing and, specifically, motor vehicle leasing by banks.
The severe restrictions on the leasing activities of banks illustrate what the Canadian banks have long maintained which is that they have very few “friends” in the government financial policy sector. These restrictions which have really no basis in solvency or prudential lending, are the direct result of the intense pressure by various participants in the leasing industry including the automotive dealers to ensure that the banks are restricted from the operating lease field with the result that the motor vehicle dealers and their related captive finance companies have a virtual monopoly in that area.
The purpose of this article is to describe these limitations on the banks. In this regard, the restrictions apply not only to the domestic banks, but also, based on the “level playing field” principle to the effect that whatever restrictions are imposed on a Canadian bank should also be imposed on a foreign bank, the rules apply equally to the foreign banks that carry on business in Canada.

Governing Principles

The fundamental principle under the Bank Act (the “Act”) behind the leasing rules is that a Canadian bank or a foreign bank may only carry on a leasing business if it is a leasing business that may be carried on by an entity known under the Act as a "financial leasing entity". A financial leasing entity is one of the types of corporations in which a bank is permitted to have a substantial investment (basically, an investment more than 10% of the voting shares or 25% of the equity of the entity).

The Act sets out the types of leasing activities which may be carried on by a financial leasing entity. The restrictions apply equally to leasing activities carried on by a bank, directly or through a subsidiary. Accordingly, although the Act and the Financial Leasing Entity Regulations (the “Regulations”) passed pursuant to the Act are phrased in terms of the activities of a financial leasing entity, these provisions apply equally to leasing activities carried on directly by a bank, directly or through a subsidiary.

Note, however, that certain limitations on the activities of financial leasing entities, in particular, those relating to conditional sale agreements, do not apply to activities carried on directly by a bank.

The term "financial leasing" is not defined in the Act nor the Regulations. However, the Act and the Regulations make it clear that the types of activities permitted for a financial leasing entity are restricted to:

(a) the financial leasing of personal property, excluding (i) leases of "motor vehicles" with a "gross vehicle weight" of less than twenty-one tonnes, and (ii) leases with natural persons in respect of "personal household property";
(b) conditional sales of personal property (excluding conditional sale agreements relating to the same types of property as are excluded for leases);
(c) the administration of financial lease agreements and conditional sales agreements; and
(d) the raising of money for the purpose of financing the foregoing activities and the investment of that money pending its use for those activities.

Special Rules Relating To Motor Vehicles And Personal Household Property

The term "motor vehicle" is defined to mean:

a motorized vehicle designed to be used primarily on a public highway for the transportation of persons or things, but does not include:

(a) a fire-engine, bus, ambulance or utility truck, or
(b) any other special purpose motorized vehicle that contains significant special features that make it suitable for a specific purpose.

The term "gross vehicle weight" is defined in respect of a motor vehicle as:

the gross vehicle weight that is specified by the manufacturer of the motor vehicle as the loaded weight of:

(a) the motor vehicle, or
(b) in the case of a motor vehicle designed to pull a trailer, the motor vehicle with the trailer.

The term "personal household property" is defined as personal property that is:

(a) leased by a natural person pursuant to a financial lease agreement or purchased by a natural person pursuant to a conditional sales agreement, and
(b) intended primarily for the personal use or enjoyment of a lessee or purchaser or of a natural person who is not dealing at arm's length with the lessee or purchaser.

Please note that it is not sufficient that the standard form lease/conditional sale contract contain a representation to the effect that the property leased or conditionally sold will not be used for personal household purposes if the circumstances of the transaction suggest otherwise. This may be of particular concern in respect of "small ticket items", including personal computers.

A financial leasing entity cannot:

(a) engage in any business other than those outlined in paragraph 3 above. As a result, a financial entity cannot make loans;
(b) engage in leasing or conditional sales of motor vehicles with a gross vehicle weight of less than twenty-one tonnes;
(c) engage in leases or conditional sales with natural persons in respect of personal household property;
(d) direct its lease or conditional sale customers or potential customers to particular dealers (the concern here is with the "tied selling");
(e) enter into or accept an assignment of a financial lease agreement or a conditional sale agreement, other than a financial lease agreement or conditional sale agreement the primary purpose of which is the extending of credit to the lessee or purchaser (this emphasizes the principle that the business of a financial leasing entity is the granting of credit and not the ownership of collateral);
(f) enter into a financial lease agreement or conditional sale agreement in respect of personal property, including personal property that is affixed to real property, that is to be leased or purchased, but not including personal property that was (i) selected by the lessee or purchaser and acquired by the financial leasing entity at the request of the lessee or purchaser or (ii) previously acquired by the financial leasing entity in respect of another financial lease agreement or conditional sale agreement; or
(g) enter into a financial lease agreement or conditional sale agreement that entails responsibility on the part of the financial leasing entity to install, promote, service, clean, maintain or repair the property that is the subject of the agreement (in other words, a financial leasing entity is not to be involved in the operating aspects of the leased collateral).

Although the most public and controversial aspect of the leasing restrictions are those relating to motor vehicles, there are certain other fundamental principles in the leasing regime which preclude operating leasing of any kind.

Each financial lease agreement and conditional sale agreement entered into by a financial leasing entity must include a provision assigning to the lessee or purchaser, or setting out the responsibilities of the financial leasing entity in respect of, the benefit of all warranties, guarantees or other undertakings made by the manufacturer or supplier in respect of the personal property that is the subject of the agreement. This is consistent with the concept that a financial leasing entity is a financier rather than a manufacturer or dealer.

Residual Risk

A financial leasing entity is not allowed to take any significant risk with respect to residual value of leased equipment. This is the principle that prohibits a financial leasing entity from engaging in "high residual" leases. As noted above, the term "financial leasing" is not defined in the Act or the Regulations. Similarly, the term "operating lease" is not used in the Act or the Regulations. As a result, the concept of "significant risk" is defined, by implication, as a lease that does not provide a certain guaranteed minimum payment (the "Total Yield") to the financial leasing entity. Section 7 of the Regulations provides that:

(a) A financial leasing entity must ensure that every financial lease agreement entered into by it yields:

(i) a return to the financial leasing entity that is not less than its full investment in the property that is the subject of the agreement; and
(ii) a rate of return that is reasonable, taking into account the term and the other conditions of the agreement and the rate of return sought by other lessors in respect of the financial leasing of similar property under similar terms and conditions.

(b) For the purposes of (a) above, the calculation of the return under a financial lease agreement must take into account:

(i) rental charges that have been or are to be paid by the lessee under the lease agreement; and
(ii) estimated tax benefits accruing to the financial leasing entity on account of the lease agreement, including tax credits and capital cost allowance claims; and

(c) either:

(i) where the lessee or a third party who is dealing at arm’s length with the financial leasing entity has, on or before the commencement of the lease agreement, contracted to purchase the leased property or has unconditionally guaranteed the resale value of the leased property at the date of the end of the lease agreement, the amount of the purchase price or resale value; or
(ii) in any other case, the amount of the estimated residual value of the property or twenty-five percent of the cost of acquisition of the property to the financial leasing entity, whichever is the lesser.

"Estimated residual value" is defined in the Regulations to mean, in respect of personal property that is the subject of a financial lease agreement with a financial leasing entity, "the value of the property immediately after the end of the lease agreement, as estimated by the financial leasing entity at the time the lease agreement was entered into".

The effect of clause (c) is that, on an individual basis, the estimated residual value of each item of property being leased which is included in determining the Total Yield cannot exceed 25% of its cost of acquisition unless, in effect, the lessee or a third party guarantees the residual. Each lease transaction must be reviewed for compliance with these requirements.

Guaranteed Residuals

It should be noted, generally, that any third party guarantee or purchase obligation must be in place at the commencement of the lease agreement. However, the Canadian banking regulator, the Office of the Superintendent of Financial Institutions (“OSFI”) has agreed that a third party guarantee may be added following the acquisition of a lease portfolio or a leasing entity. In addition, OSFI has previously advised that a financial leasing entity cannot use a partial third party guarantee to reduce residual exposure to less than 25% but not to nil. That is, only one of clause (c)(i) or (ii) of subsection 7(2) is to be applied.

For example, if the residual would otherwise be 35% and residual insurance is to be obtained, the insurance must reduce the residual risk to nil, not merely to below 25%. This is illogical since the regulatory policy clearly allows a residual risk of up to 25%. Nevertheless, this is clearly OSFI policy.

An Example

In light of the significance and relevance of the permitted residual rules, it might be useful to set out an example of how these residual rules work.

Let us assume, for the purpose of illustration, that the cost of the equipment to be leased is $100,000.

Pursuant to Section 7 of the Regulations, the leasing entity is only entitled to enter into a financial lease agreement that provides it with the following financial return:

(a) a return (the “Required Return”) that is not less than its full investment in the property (that is, $100,000); and
(b) a rate of return that is reasonable, taking into account the terms and other conditions of the agreement.

Let me emphasize that there are only three components that may be taken into account in computing the Required Return, namely:

(a) rental charges that are payable by the lessee;
(b) estimated tax benefits accruing to the lessor (let us assume this amount is nil in this example); and
(c) one, but only one, of either (a) the amount of the purchase price of the leased property, in circumstances where the lessee or a third party who is dealing at arm's length with the lessor (an "Independent Third Party") has agreed, on or before the commencement of a lease agreement, to purchase the leased property, or (b) the resale value of the property, in circumstances where the lessee or an Independent Third Party has, on or before the commencement of the lease agreement, unconditionally guaranteed the resale value of the leased property at the end of the lease agreement.

The requirement that the third component has to be either (a) the guaranteed purchase price or resale value or (b) the estimated residual value means that a lessor may not take into account both the guaranteed purchase price or resale value and the estimated residual value in determining whether the lease yields the Required Return.

In addition to the limit on the residual value for each specific lease discussed above, Section 8 of the Regulations imposes a limit on the aggregate residual value risk that may be taken by a financial leasing entity on the portion of the entire portfolio in respect of which the financial leasing entity is relying on the estimated residual value in determining the Total Yield:

The sum of the estimated residual value of all leased properties held by a financial leasing entity that are referred to in subparagraph 7(2)(c)(ii) shall not at any time be more than 10% of the sum of the costs of acquisition of those leased properties by the financial leasing entity.

Residual values that are guaranteed pursuant to subparagraph 7(2)(c)(i) are not included in this determination.

There have been some specific exceptions from these operating lease restrictions. As a result of direct pressure from Canadian companies that have a need for railcars to transport their products, it is possible to obtain an order from the Canadian Minister of Finance which would allow a bank to carry on a very focused railcar leasing business that did not have to comply with the restrictive rules that would otherwise apply to the leasing of railcars.

These orders are very difficult to obtain from a policy standpoint unless the applicant can establish the order will benefit Canadian entities that need to move their products by rail.
 

John Teolis

John Teolis is a partner with Norton Rose Fulbright Canada and can be reached at (416) 216-4812 or by email at john.teolis@nortonrosefulbright.com