Jan 9, 2020
Letters of credit, tenant bankruptcy and lease disclaimers – Is your LC worth the paper it’s written on?
Published Jan. 6, 2020 | renx.ca
The October 2019 Ontario Superior Court of Justice decision in 7636156 Canada Inc. v OMERS Realty Corporation
illustrates an issue that often arises between a trustee in bankruptcy and a commercial landlord: what are a landlord’s rights to claim under security given to it by the bankrupt?
The bankrupt tenant and the landlord (OMERS) entered into a lease in 2014. The lease required that the bankrupt deliver a $2.5 million renewable letter of credit (the “LC”) to the landlord. The lease provided that the LC was being held “as security for indemnification of Landlord in respect of any losses, costs or damages incurred by Landlord … resulting from any … disclaimer … of this Lease … as a result of … the bankruptcy of Tenant or otherwise“.
The Lease also provided that—if the Lease were kept in good standing for 36 months after the initial term—the LC would be reduced to approximately $1.35 million.
The trustee disclaimed the Lease in 2018.
The landlord drew down the LC for the full $2.5 million and filed a proof of claim with the trustee, in which the landlord reserved its right to claim damages for lost rent, restoration costs, etc.
The trustee denied the landlord’s proof of claim for the full amount of the LC. Instead, the trustee submitted that the landlord was only entitled to 3 months’ accelerated rent (approximately $623,000) or, in the alternative, $1.35 million (being the reduced amount of the LC as the Lease was kept in good standing for 36 months).
What amount is the Landlord entitled to draw under the LC as a result of the trustee disclaiming the Lease?
The landlord was only entitled to 3 months’ accelerated rent and was required to pay the LC’s balance to the trustee.
- S.71 of the Bankruptcy and Insolvency Act (BIA) provides that all of a bankrupt’s property rights, including a bankrupt’s rights under a lease, vest in the trustee (subject to the BIA and secured creditors rights).
- S.30(1)(k) of the BIA and s.38(1) of the Commercial Tenancies Act gives a trustee the right to disclaim (i.e. surrender) a lease.
- S.136(1)(f) of the BIA grants a landlord a “preferred claim” for 3 months’ accelerated rent following a bankruptcy. This right was not disputed in this case.
- It is settled case law in Ontario that “a disclaimer of a lease by a trustee in bankruptcy operates as a voluntary surrender of the lease by the tenant with the consent of the landlord, which extinguishes all obligations of the tenant under the lease.”
- The landlord argued that the LC was an “autonomous contract” between the bank, as issuer of the LC, and the landlord, as beneficiary of the LC, and therefore the trustee had no right to limit the amount drawn by the landlord. However, the Court disagreed with the landlord based on leading case law that held: “…if security taken by the landlord secures the obligations of the tenant under the lease, then when those obligations end, the security can no longer be enforced in respect of obligations yet to be performed.“
- Further, the bank “… had no independent obligation to make any payment to the Landlord pursuant to the LC“. Instead, the bank’s obligation under the LC “was wholly dependent on the continued existence of the Bankrupt’s obligations to the Landlord under the Lease“. That ended when the lease was disclaimed.
- Accordingly, the Court held that because the bank owed no obligation to the landlord and because the Lease was disclaimed by the trustee, the landlord’ claim was limited to 3 months’ accelerated rent and the balance drawn had to be returned to the trustee.
- The Court said that if its decision was wrong, the landlord would only be entitled to the reduced LC amount.
- Finally, the Court also noted that, when describing a rent payment, “promptly” means: “…within a reasonable time and not on the actual date that the rent is due.”
- Letters of Credit (and other security) securing “the obligations of the tenant under the lease” will not be security for damages suffered as a result of the loss of the lease on disclaimer by a trustee.
- Landlords and lenders taking security must review their lease as well as the form of security itself, and, if needed, amend each to act as security for the damages that result from the loss of the lease.
- If a contract provides for a payment (e.g. rent) to be made “promptly”—especially in regards to a pre-condition to the exercise of an option—be aware that the payment can be made after the due date without being a default and the option may not be lost.
- Disclaiming a lease does not necessarily affect a claim against an assignor or a lease guarantor as those are independent obligations. However, the language of the assignment clause in the lease and in the guarantee must be reviewed to determine if the obligations end on the tenant’s bankruptcy.
Thank you to Thomas Witteveen, articling student, for assisting in the finalization of this article.