Commercial landlords often obtain security from their tenants with respect to their lease obligations.

Such security can take the form of a security deposit, a guarantee/indemnity, a charge on the tenant’s assets by a general security agreement, a specific charge on property, a letter of credit or a combination of those options.

Due to the COVID-19 pandemic and the continuing and growing lockdowns on businesses, it is a virtual certainty that we will see higher rates of bankruptcies in 2021 than we have seen in the past. Those landlords holding security from their tenants need to know if that security will survive bankruptcy of the party that gave it.

There have been some conflicting court decisions in Ontario regarding the effect on security where the party providing it goes bankrupt but the October 28, 2020 decision of the Ontario Court of Appeal[1] (the “7636156 Canada case“) will give comfort to landlords holding letters of credit for bankrupt tenants if the lease and letters of credit are properly worded.

The Facts

In 2014, the tenant leased an industrial building for 10 years and gave a $2.5 million letter of credit (the “LC“) to the landlord, renewable annually and expressly surviving tenant bankruptcy.

The tenant made an assignment in bankruptcy on May 1, 2018 and a trustee in bankruptcy (the “Trustee“) was appointed. In accordance with its right at law, the Trustee disclaimed the lease (i.e. terminating it) on July 23, 2018.

When the tenant went bankrupt there were no rent arrears. Subsequently, the landlord drew on the LC three times. On May 2018 before the lease disclaimer date for rent default and twice afterwards for rent default, restoration costs and the remaining unamortized costs of the improvements made by the landlord to the premises as per the Lease.

The LC provided for its reduction if the tenant was never in default and had “promptly” paid its rent (it was late twice by 1-2 days). The LC issuer paid the landlord in accordance with the landlord’s draw requests.

The Trustee sought to have the draws repaid to the benefit of the bankrupt’s estate other than for the landlord’s claim to three months accelerated rent under the Bankruptcy and Insolvency Act, Canada and the trial judge agreed. The landlord appealed.

Decision:

The landlord was successful.

The Court of Appeal over-turned, found that the landlord was entitled to draw the full amount of the LC notwithstanding that the Trustee disclaimed the lease and also that the LC had not been reduced (as conditionally provided for in the Lease) since the Tenant had failed to pay its rent on the due date on two occasions and that failure meant the pre-condition to the LC reduction was not met.

Reasons:

The Court of Appeal held that:

* Letters of credit are autonomous by their nature i.e. independent from the business transaction they are issued for. “The beneficiary of a letter of credit obtains a gold standard of payment assurance for the underlying commercial transaction. Stand-by letters of credit create a potential obligation for the issuer that is completely independent of the business arrangement for which it was an inducement.”;[2]

* Nothing in the Bankruptcy and Insolvency Act, Canada nor the law (absent fraud) supersedes the autonomous nature of a letter of credit nor a landlord’s right to draw down on it to the maximum amount in accordance with its terms.

* In each case, the terms of the lease and the letter of credit must be carefully read including for what the letter of credit is security for. In the 7636156 Canada case:

– The LC was expressly stated to be given “as security for indemnification of Landlord in respect of any losses, costs or damages incurred by Landlord …. or resulting from any termination, surrender, disclaimer or repudiation of this Lease whether by Landlord as a result of the default of Tenant or in connection with any insolvency or bankruptcy of Tenant or otherwise. [Emphasis added.].

– The lease expressly provided that the LC “would continue to stand as security in the event the Tenant became bankrupt and the Lease was disclaimed in the bankruptcy proceeding.”

In terms of the two instances of the late payment of rent by 1-2 days and the Trustee’s claim for reduction of the LC, “promptly” does not mean “within a reasonable time” after rent is due but rather, on the date the rent is due and so the reduction was not applicable.

Lessons

1. The lease and the security – letter of credit, security deposit, indemnity etc. – must be worded clearly to apply to indemnify the landlord for losses arising as a result of the tenant’s bankruptcy not just as security for the tenant’s lease obligations (which end on lease disclaimer).

2. Fraud is an exception to the right to call on a letter credit or retain the monies drawn and requires a “rigorous standard of proof” on the trustee.

3. A trustee’s disclaimer of lease: (i) only benefits the bankrupt; (ii) does not operate for all purposes; and (iii) only ends the landlord’s right against the bankrupt’s estate not the right under an independent obligation with the issuer of the letter of credit.

4. As in the 7636156 Canada case, a landlord’s “proof of claim” should state that the landlord is the beneficiary of the letter of credit, the letter of credit is not an asset of the debtor, is independent of the landlord/tenant relationship, the funds belong to the issuer until drawn down and therefore the trustee does not have any claim on the drawn or undrawn portion of the letter of credit.

5. In order to draw down on a letter of credit, or other security, make sure that you have a right to do so, including proper delivery of the notice of default where required and expiry of the applicable cure period without cure.

6. The term “promptly” means the day the rent is due (and by implication, likely the due date for any other obligation with a fixed day for performance).

Disclaimer: This article is for general information purposes only and not intended as or to be relied upon for legal advice. Consult with a lawyer for your unique situation.

*If there is a general real estate or leasing related question you would like to see addressed in a future article in “The Legal Corner”, please contact me directly by e-mail at dgold@robapp.com with your suggestion. Not all requests can be accommodated.

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[1] 7636156 Canada Inc. (Re), 2020 ONCA 681

[2] Kevin McGuinness, The Law of Guarantee, 3rd ed. (Toronto: LexisNexis, 2013), at §16.47