The Law of Commercial Leasing in Canada 1999

2. Quality and Performance Issues Affecting the Lessee

2.1  Introduction: Terms Implied at Common Law

[18] Since the primary objective of the lessee in most leasing transactions is the acquisition and use of the goods subject to the lease, many of his or her concerns will be common to those of a purchaser. These include full and fair disclosure of information relating to the transaction, as well as assurances of timely delivery, uninterrupted use and possession and acceptable quality and performance of the leased goods.

[19] In a transaction involving only lessee and lessor, these issues might be addressed through the law of contract, the law of bailment, the law of sales or some combination of the three. A modern legal analyst might approach inter partes problems by first considering whether the transaction in question is in substance a sale, despite its formal guise as a lease. If it is, it would fall within the scope of the provincial Sale of Goods Acts,15 which imply into the contract statutory terms mandating that the goods supplied must correspond with their contractual description, and that those sold by a business seller must meet standards of merchantable quality, fitness for purpose and correspondence with sample. The Act also imposes upon the seller specified delivery obligations and implies contractual terms relating to the seller's title to the goods and warranting the buyer's uninterrupted possession thereof.

[20] The functionalist approach has in fact prevailed in United States courts who, before the passage of UCC Article 2A, routinely applied the provisions of UCC Article 2 on Sales to transactions that were substantively sales, though structured as leases.16 In fact, the similarity of many aspects of contracts of sale and lease prompted considerable discussion over the desirability of simply amending Article 2 to include leases, rather than enacting a separate statutory regime.17 While the latter course was ultimately adopted through promulgation of Article 2A, the leasing article was to a great extent modeled after Article 2.

[21] The Canadian tradition has been rather more literalist. The general scope provision of the Sale of Goods Acts defines a contract of sale as one in which the seller transfers or agrees to transfer "the property in the goods" to the buyer. At a minimum, this contemplates the transfer or agreed transfer of the whole of the seller's proprietary interest. Since a lease reserves title to the lessor, transferring only a limited interest to the lessee, a transaction structured as a lease cannot meet the definitional test determining application of the Sale of Goods Act.18 Its provisions are therefore not directly available to a lessee, and Canadian courts have shown no inclination to adopt a functionalist characterization that would bring transactions structured as a lease within the Act.

[22] While no statutory framework therefore exists to protect the interests of a lessee in matters relating to the goods themselves, terms corresponding to those of the Sale of Goods Act have been implied in contracts of lease at common law, often by way of analogy with the statutory implied terms of sales law. The pertinent jurisprudence is traditionally regarded as part of the common law of bailment, though the modern trend is to focus on the contractual aspects of the lease relationship with the result that little distinction remains between the law of bailment and the law of contract in connection with issues other than those relating to the parties' proprietary rights.19 Unfortunately, some uncertainty prevails in connection with the implication of terms in contracts of lease at common law.

[23] Though courts have consistently found lessors subject to an implied duty to provide goods fit for the lessee's communicated purpose, they are divided on whether their liability to fulfil that duty is strict or subject to a lesser standard of reasonable care.20

[24]  It is also not clear whether courts will imply a condition of merchantable quality, or some equivalent, in a contract of lease. In spite of their apparent willingness to reason by analogy with contracts of sale in some contexts,21 there is little if any authority for the implication of such a term in a lease.22 In contracts of sale, the condition of merchantable quality imposes a requirement of general suitability much broader than the condition of fitness, which is dependent both upon an express or implied communication of purpose and a finding of actual reliance by the buyer on the seller's skill and knowledge in providing appropriate goods.23 Nor is an obligation imposed on a lessor at common law to maintain the leased goods,24 or to warrant their durability. 25

[25] The need to find a basis upon which to impose liability for defective goods in contracts of lease has sometimes been filled through implication of a term requiring that the goods correspond with their contractual description, equivalent to the term implied by statute in a contract of sale. In sales law, the condition is breached where the goods provided are essentially different from the contract description, in the sense that they are different in kind from what was to be delivered. 26 However, in the context of contracts of hire, some courts have resolved problems of deficient quality through a rather dubious expansion of the scope of liability under such a term, concluding that seriously defective goods are "essentially different" than what the lessor was to provide.27

[26]  In a few cases involving automobiles, Canadian courts have implied a contractual obligation on the part of the lessor to provide a vehicle that could be driven safely, without reference either to presumed intention or to the common law principles governing relationships of lease or hire as a basis for that implication. 28 These cases appear to approach the requirement of safe performance as an implicit aspect of the contractual description - that is, the lease is not simply the lease of an automobile, but the lease of a safe automobile.

[27] The law is similarly unsatisfactory with respect to implied terms relating to title and to the lessee's right to undisturbed possession of the goods leased. At common law, the lessor impliedly warrants that the hirer will enjoy uninterrupted use of the goods for the period of hire. Disturbance of possession by the lessor/bailor or a third party would thus entitle the hirer to damages. While there is no common law warranty of title imposed on the lessor,29 there is English authority to the effect that such a warranty is implied in a contract of hire-purchase, which compares in many respects to a lease containing an option to purchase. Such a warranty ensures that the owner is in a position to convey title to the hirer at the time that the option to purchase is exercised.

[28] Professor Ziegel has pointed out that neither of the traditional sales warranties of quiet possession or title are entirely appropriate to most contracts of lease. While the warranty of quiet possession offers insufficient protection against defects in the lessor's title prejudicing exercise of a purchase option, the warranty of title overprotects a lessee insofar as her interest is confined to use and possession during the term of the lease.30

[29] In the result, the implication of terms imposing obligations relating to the quality of and title to goods subject to the lease offers a somewhat indeterminate degree of protection to lessees. The fact that the law is less than precise in this respect may be regarded as relatively inconsequential, in view of the standard practice of contractually excluding whatever terms might be implied. On the other hand, one cannot assume that all lease contracts will include an enforceable exclusionary provision. If resort must in some instances be had to general principles of law to determine the rights of a lessee, one would hope that those principles are clearly defined and that their application is predictable. This cannot be said of the terms regarding quality, title and undisturbed possession that might be implied in contracts of lease at common law.

2.2 The Effect of Contractual Exclusionary Provisions

[30]  Since the 1989 decision of the Supreme Court of Canada in Hunter Engineering Co. v. Syncrude Canada Ltd.,31 it has been clear that a contractual provision excluding or limiting express or implied warranties or any other liability that might otherwise arise in a contractual relationship is prima facie enforceable according to its terms. An exclusionary provision will operate to exclude warranties of quality or performance if, read in the contractual context in which it is used, it was clearly intended to have that effect regardless of the degree to which the performance rendered by the sheltered party might appear deficient. While Hunter Engineering is generally taken to have laid to rest the so-called doctrine of fundamental breach, some courts remain reluctant to enforce exclusionary provisions in lease contracts when the leased goods have proven seriously defective.

[31] A number of Ontario courts have refused enforcement of contractual provisions excluding implied terms, or under which the lessor waives any defence against an action for unfulfilled monetary obligations, including unpaid future rent. The finding that there was a "fundamental breach" of an implied term as to the safety or quality of the leased goods has been held to relieve the lessee of his or her payment obligations.32 However, most other courts have refused to allow lessees to escape clear contractual waivers.33 The judicial ambivalence reflected in these disparate decisions no doubt reflects a level of uncertainty regarding the rights of lessees in connection with problems of quality and performance.

2.3 Quality and Performance in Transactions Involving Third Party Financial Institutions

[32] Even if terms may be implied in a contract of lease to protect the lessee's expectations as to performance, quality and uninterrupted use of the goods, those warranties are of limited relevance in transactions involving a third party financial institution. This is true both where the transaction is a finance lease, and where there is an assignment of lease from a supplier- lessor to a finance company or bank.

[33] In the first situation, the leased goods are purchased by the financial institution from a supplier, and then leased to the lessee. The performance obligations implied in a sale transaction are thus owed by the supplier to the lessor, not to the lessee who is not privy to the contract of sale. Since the lease invariably excludes any and all obligations relating to the quality and performance of the goods,34 the lessee enjoys the benefit of any legally implied terms only to the extent that the contract of sale provides for assignment of the lessor's warranty rights as against the supplier to the lessee. If the supplier has made representations regarding performance or quality directly to the lessee, the latter may in addition invoke the common law doctrine of "collateral contract", pursuant to which such representations may be given contractual effect, supporting an action against the supplier for breach.35

[34] The typical contractual reordering of the legal rights and obligations that would otherwise inhere in this kind of transaction is appropriate, assuming that the lessor's role is solely to finance the lessee's acquisition of goods provided by the supplier. The lessor rarely plays a part in selection or evaluation of the goods, or in determination of their suitability for the purposes of the lessee. 36 It should therefore not be subject to liability for their deficient performance. In fact, it has been argued that no terms relating to quality or performance should be implied in this sort of leasing contract, either by statute or at common law. 37 On the other hand, there is no reason why the supplier should be immune from liability for the quality of the goods it has supplied to an identified lessee, any more than if the goods had been sold to the lessee directly.

[35] While the contractual definition of the parties' rights appears for the most part to effectively facilitate the appropriate outcome in a finance lease, the fact that those rights are not established by statute subjects all three parties to some degree of uncertainty. A lessee can only claim warranty protection to the extent that the supplier's or manufacturer's warranties are effectively assigned to her. Even an effective assignment may not fully protect the lessee, since the damages recoverable for breach of a warranty of quality may be limited to those suffered by the lessor. The lessee is in reality assigned only the lessor's right to enforce the warranties as to quality, not the warranties as such.38

[36] From the perspective of the lessor, an element of risk is associated with its necessary reliance on the contractual exclusionary provision. Though it seems that such provisions are for the most part enforced, they may be ineffective if the court so construes the contract that the exclusion does not shield the lessor from liability for a serious defect in the goods. Further, they may be invalidated on the grounds of unconscionablity or, in the opinion of Wilson J. as expressed in Hunter Engineering v. Syncrude, on the grounds that they are unreasonable.39

[37] Though the supplier risks little in such a transaction, it may be subject to some uncertainty in assessing the precise extent of its liability to the lessee in relation to the leased goods.

[38] Similar issues arise where the lessor supplies goods to the lessee, but assigns the lease to a third party financer.40 In the absence of contrary contractual provision, the assignee assumes the contractual rights of the lessor, subject to any claims or defences of the lessee in existence at the time that the lessee acquires knowledge of the assignment. 41 However, in practice the contract of lease will ordinarily contain a cut-off or waiver of defence clause pursuant to which the lessee relinquishes any claims or defences against the assignee. Since this precludes a lessee from raising a deficiency in the leased goods as a defence to the assignee's claim for the rent, the practical potency of any warranties of quality is considerably diluted, even if the lessee retains rights against the lessor.42 Where the assignee is simply a financer and not the supplier of the goods, the contractual elimination of any performance or quality obligations is appropriate, as it is in the context of the finance lease.  43 In the absence of empirical data, it is difficult to determine whether Canadian lessees are in practice sufficiently protected by their rights against the assignor, combined with ancilliary service contracts and manufacturers' warranties.

2.4 Statutory Responses

[39] Uncertainty over the nature and extent of lessors' warranties implied at common law in contracts of lease was one of the factors motivating promulgation of UCC Article 2A. 44 In addition, its drafters appreciated that the special features of a finance lease transaction warranted clear definition of the rights and obligations of the three parties involved. 45

[40] All of the express and implied warranty provisions of UCC Article 2 on Sales are incorporated, with appropriate modification, in Article 2A. 46 The lessee therefore enjoys a set of default rights against the lessor, supporting defined remedies for the goods' defective quality or performance, and for interference with the lessee's possession. The warranties of fitness47 and merchantability 48 parallel those implied in contracts of sale under Article 2. 49 However, the warranties against interference with possession are specifically tailored to address the limited nature of a lessee's interest. 50

[41] The efficacy of the warranty against interference to fully protect a lessee has been the subject of some debate. 51 While it is premature to attempt at this stage to define precisely how such a warranty should be drawn, it is worth noting that an appropriate definition of the proprietary rights and obligations of the parties to a lease would constitute one of the more meaningful components of any statutory reform of leasing law. The implication of terms relating strictly to the quality and performance of the goods, though beset with some uncertainty, is relatively simple by way of comparison with the difficulty involved in relying on dated common law notions or presumed intent to regulate the complexities of the parties' proprietary relationship in a modern lease transaction.

[42] Article 2A defers to the parties' substitution of their own risk allocations by allowing disclaimer of the statutory warranties.52 However, to the extent that there is no disclaimer, the benefit of the statutory warranties is extended to third parties who might reasonably be expected to use or be affected by the leased goods, overcoming the barrier of privity that in general still precludes third party claims in Canada.53

[43] The assignment of leases by retail lessors of goods to a finance house is accommodated by Article 2A. However, the provisions regulating alienability of the parties' interests under a lease are very complex.Though an assignment is effective notwithstanding contractual provision to the contrary, an elaborate set of rules establishes remedies for breach of contractual provisions prohibiting assignment, including the creation of security interests and other charges. In addition, transfers that materially impair the prospect of obtaining return performance or materially alter contractual risk allocations trigger defined consequences.

[44] One of the most important features of Article 2A is its delineation of special rules tailored to the realities of a finance lease. The lessor is exempted from the statutory warranties of merchantability and fitness,55 and is subject only to a limited warranty against interference with possession.56 However, the lessee is given the benefit of the express and implied warranties given by the supplier to the lessor in the supply contract, to the extent of the lessee's leasehold interest.57 A supplier may effectively exclude or modify warranty obligations in the supply contract, thereby precluding warranty claims by the lessee. However, this is consistent with the general right of lessees who are themselves the supplier of goods to contract out. Furthermore, the definition of "finance lease" ensures that the lessee in such a transaction has advance notice of the terms of the supply contract, including, of course, any exclusionary provisions, before he or she is bound to the lease.58

[45] Although Article 2A is remarkably comprehensive in its coverage of the issues that might arise in a lease transaction, the scope of its application is limited by the choice to exclude transactions that, though framed as a lease, are in substance a security agreement. 59 Since finance leases will often in substance be security agreements, this exclusion significantly limits the impact of those provisions relating to such transactions.

[46] A finance lease, or any other, that is designed primarily to secure the payment obligations of the lessee will fall subject only to UCC Article 9, which does not address warranty obligations at all. This is, in the writer's opinion, anomalous. The fact that a transaction is designed to secure performance of a payment obligation does not mean that it has no other dimensions. A security lease also involves the acquisition and use of the leased goods by the lessee. Problems arising in connection with that aspect of the transaction must be resolved in a security lease as well as in a true lease. The analogy of a conditional sale contract demonstrates this point.

[47] A conditional sale contract is indisputably a security agreement, both under UCC Article 9 and under the Canadian Personal Property Security Acts. The seller's formal retention of title is designed to secure payment of the purchase price. Insofar as that facet of the transaction is concerned, the goods function as collateral. However, the transaction also involves the supply of goods by the seller to the buyer. In that respect, the buyer deserves and is legally entitled to the same warranty protections as a buyer under an outright contract of sale.

[48] The lessee under a security lease is in a position comparable to that of a buyer under a conditional sale contract. However, Article 2A's exclusion of security leases casts the parties to such a transaction back upon the common law, with all its uncertainties, to resolve issues arising from deficiencies in the quality or performance of the goods subject to the lease, or from a third party's interference with the lessee's possession.60

[49] Furthermore, the exclusion of security leases from Article 2A obliges those affected by such a transaction to engage in the frequently difficult determination of whether the lease in question is or is not a security lease. This is particularly true in connection with finance leases. To quote a noted American commentator,

The most frequently litigated "commercial law" issue relating to personal property leases has been whether a purported lease is a so-called "true lease" or merely a disguised secured sale or loan. Since the Code has been widely enacted the issue has usually been framed as whether a lease is one "intended as security" within the meaning of section 1-201(37), defining "security interest". The cases dealing with the lease-security interest issue, as a group, are hopelessly contradictory and confusing.61

[50] Since those lines were written, the issue has been addressed through the amendment of UCC §1-201(37).62 The amended provision defines a series of criteria designed to assist in the determination of whether a lease is or is not in substance a security agreement. However, these amendments do not appear to have entirely resolved the problem of characterization. 63

[51] The preservation of such a problematic distinction to no apparent purpose is perplexing. Were any attempt at statutory regulation of finance leases to be undertaken in Canada, the drafters would be well advised to avoid it.

[52] The unique features of a finance lease are addressed by the Unidroit Convention on International Financial Leasing 64 in the context of international lease transactions. The Convention adopts the general approach taken in UCC Article 2A, except that it applies to all finance lease transactions falling within its definitional provisions, which accommodate security leases.65 Under the Convention, the supplier owes the same duties to the lessee as if the lessee were a party to the supply agreement and as if the equipment were to be supplied directly to the lessee.  66 At the same time, it exempts the lessor from liability to the lessee for loss relating to the leased equipment, except to the extent that it arises due to the lessee's reliance on the lessor's skill or judgment.67

2.5  Conclusions

[53] The foregoing discussion reveals two significant deficiencies in existing Canadian law. No clear set of default warranty provisions exists defining the rights and obligations of parties to a lease in connection with the quality and performance of the leased goods. The lessor's title obligations and the content of an implied term defining the lessee's right to uninterrupted possession are similarly uncertain.

[54] Secondly, no special rules or principles of law have been developed to address the tripartite relationship involved in a finance lease. Specifically, the absence of a contractual relationship between supplier and lessee prevents the lessee from seeking contract remedies against the supplier for deficiencies in the quality or performance of the goods.

[55] The 1993 amendments to the British Columbia Sale of Goods act represent one possible response to the first general deficiency. 68 Under those amendments, the statutory terms regarding quality and title implied in contracts of sale were extended, in their existing form, to consumer leases. However, it is doubtful that uniform measures to that effect referable to all lease contracts would have a significant impact.

[56] The direct application of sales law to leases does not appropriately respond to the distinct issues arising from a lease transaction, particularly in connection with matters of title and possession. Furthermore, the imposition of a set of implied warranties should not be approached in isolation. Meaningful statutory reform should address related issues, including the other primary performance obligations of the lessor (such as delivery), the reciprocal performance obligations of the lessee, remedies for breach by either party and the consequences of assignment. In other words, the exercise is of the proverbial "all or nothing" variety. In view of the apparent lack of any perceived commercial or political interest in undertaking Article 2A style reform, the unlikely success of such an enterprise may not warrant the effort involved.69 This is particularly true given the propensity of commercial parties to contract out of statutory warranty and remedies provisions.

[57] However, a more limited exercise addressing the contractual relationships of parties to a finance lease is a feasible undertaking. The peculiar features of these relationships that warrant separate attention will be explored further below.

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