Commercial Landlords: Managing the Risk of an Insolvent Tenant
Two recent decisions of the Court of Appeal for Ontario highlight the exposure that commercial landlords have to insolvent tenants but also what a landlord can do to protect itself from the consequences of a default.
When a commercial tenant defaults on its lease, among other remedies available to it, a commercial landlord can claim future damages from the tenant for the rent due over the course of the unexpired term of the lease.
In a bankruptcy, that remedy is significantly curtailed by virtue of the provisions of the federal Bankruptcy and Insolvency Act [BIA]. Namely, pursuant to section 136(1)(f), the landlord enjoys a priority (subject to some higher ranking priorities, such as the expenses and fees of the Trustee, certain wage claims, etc.) for
arrears of rent for a period of three months immediately preceding the bankruptcy and accelerated rent for a period not exceeding three months following the bankruptcy if entitled to accelerated rent under the lease, but the total amount so payable shall not exceed the realization from the property on the premises under lease, and any payment made on account of accelerated rent shall be credited against the amount payable by the trustee for occupation rent.
The BIA also provides that the Trustee may disclaim the lease (s. 30(1)(k)).
The landlord in Curriculum Services Canada/Services Des Programmes D’Études Canada (Re)[efn_note]2020 ONCA 267 [Curriculum].[/efn_note] argued that it had become entitled to claim as an unsecured creditor in the tenant’s bankruptcy for damages equivalent to the rent payable for the unexpired term of the lease (a claim that would have been worth in excess of $4 million).
The Court of Appeal rejected this position. In short, Justice van Rensburg, speaking for a unanimous panel, held that the landlord’s position failed to distinguish between repudiation and disclaimer. A repudiation occurs where one party to the contract — for example, the tenant — indicates by words or action that it no longer intends to be bound by its obligations under the lease — for example, by ceasing to pay rent. In a typical non-insolvency situation, this would entitle the landlord to accept the repudiation and claim damages for the unexpired portion of the lease term. A Trustee’s position, however, is different. That is, it has a statutory right to disclaim the lease. In contrast to repudiation, disclaimer brings all parties’ rights to an end. The court therefore concluded that the landlord could claim for its priority three-month claim, but the bolder claim as an unsecured creditor with a claim worth $4M was rejected.
So what’s a landlord to do?
This would seemingly indicate that the BIA is not the most landlord-friendly of statutes and ought to give any commercial landlord pause for thought when assessing the credit risk of a new prospective tenant.
But all is not lost.
Along with protections afforded by mechanisms such as personal guarantees (which ought to be assessed with an eye towards the creditworthiness of the guarantor), landlords may wish to consider availing themselves of standby letters of credit. Enter the recently decided appeal in 7636156 Canada Inc. (Re).[efn_note]2020 ONCA 681.[/efn_note]
In this case, the tenant had provided a $2.5 million standby letter of credit (“LOC”) to secure its obligations under the lease.
When the tenant availed itself of protection under the BIA, the landlord made a claim on the LOC. Meanwhile, as in Curriculum, the Trustee disclaimed the lease. The tenant’s Trustee took the position that the landlord could make no such claim given that the disclaimer had brought the rights and obligations of all parties under the lease to an end (as per Curriculum).
Applying well-entrenched principles attached to standby letters of credit, the Court held that the obligation to satisfy payment under the letter of credit was entirely separate from the underlying debt. The landlord had satisfied the terms for payment in the letter of credit (namely, showing that it had suffered damages as a result of the tenant’s bankruptcy). The bank therefore had an independent obligation to pay out the landlord.
A word of warning: much in this case turned on the terms of the letter of credit, which specifically contemplated the possibility of a disclaimer of the lease. For assistance in specific circumstances, please contact us.
Landlords can suffer significant negative consequences on the bankruptcy of a tenant, particularly where there is a lengthy period remaining on the lease. In instances where the limited priority provisions of the BIA would not be sufficient in event of a tenant bankruptcy, a landlord may be well advised to require a standby letter of credit on terms that will trigger payment, even in event of a trustee’s disclaimer of the lease.