Sigh of Relief for Commercial Landlords: Letters of Credit Unaffected by a Tenant’s Bankruptcy

This article also appears in the bankruptcy and restructuring blog ‘Restructuring Roundup’.

The Ontario Court of Appeal, in 7636156 Canada Inc. (Re), 2020 ONCA 681 (“7636156”), recently affirmed the autonomy of documentary letters of credit as valid security for the obligations of a tenant under a commercial lease when that lease is disclaimed by the tenant or the tenant’s trustee in bankruptcy. This is good news for landlords as it resolves previous uncertainty regarding a landlord’s ability to rely on a stand-by letter of credit as collateral security in connection with a lease transaction. Subject to the “fraud exception” to the autonomy of letters of credit, and provided that the lease and the letter of credit are properly drafted, the Court of Appeal has confirmed that a landlord will be entitled to call on the letter of credit to satisfy its claim for losses arising from the disclaimer or termination of a tenant’s lease in an insolvency proceeding.

In so finding, the Court of Appeal overturned the decision of the motion judge that limited the landlord’s recovery to the three-months’ accelerated rent claim allowed by section 136(1)(f) of the Bankruptcy and Insolvency Act (“BIA”).

In 7636156, the tenant (“Tenant”) leased an industrial building from the landlord (“Landlord”) on a ten-year term expiring in May 2024. In May of 2018, the Tenant made an assignment into bankruptcy and a trustee was appointed (“Trustee”). Shortly after its appointment, the Trustee disclaimed the Tenant’s lease. Pursuant to the terms of its lease, the Tenant had arranged for a $2.5 million letter of credit to be issued by a bank and provided to the Landlord, as beneficiary under the letter of credit (the “LC”). The LC was backed by an equal amount of cash collateral held by the bank. The lease and the terms of the LC specifically stipulated that the LC was to stand as security for any losses, costs or damages of the Landlord arising from the Tenant’s failure to perform its obligations under the lease or resulting from the termination, surrender, disclaimer or repudiation of the lease in connection with an insolvency or bankruptcy proceeding of the Tenant. The LC was in good standing at the time the lease was disclaimed. The Landlord drew upon the LC, both before and after the disclaimer, and in the process drew down the full amount of the $2.5 million LC.

The Trustee brought a motion to determine the Landlord’s entitlement to draw upon the LC. The lower court judge decided that the Landlord’s allowable draw on the LC was limited to the amount of its three-months’ accelerated rent claim under section 136(1) of the BIA. The Landlord appealed, submitting that the LC created independent obligations between the issuing bank and the Landlord as beneficiary, and that these obligations should remain unaffected by the Trustee’s disclaimer of the Tenant’s lease.

The Court of Appeal held that:

  1. letters of credit are fundamentally autonomous from the underlying transaction between the applicant and the beneficiary, and, in the absence of fraud, the bank has an independent obligation to make payment to the beneficiary, which is unrelated to the actual performance of an underlying contract, including a lease. When documents specified under a letter of credit are delivered or “presented” to an issuing bank and those documents appear on their face to constitute a “complying presentation”, the bank is obligated to honour the letter of credit. There was no evidence of fraud or other impropriety on the part of the Landlord in the underlying transaction and, accordingly, there was no valid constraint to the autonomy principle; and
  2. there was no provision in the BIA, or a principle of Canadian bankruptcy law that overrides the autonomy principle or precludes the Landlord from drawing on a letter of credit for amounts in excess of its preferred claim against the bankrupt’s estate for three months’ rent. To find such a limitation would mean accepting the proposition that the BIA does not permit a landlord to take security from its tenant through the vehicle of a letter of credit for amounts in excess of the preferred claim, which is not supported by the language of the BIA.

The Court also noted that a landlord’s entitlement to draw on a letter of credit will turn on the particular language of the lease and letter of credit. In 7636156, the lease and LC specifically provided that the LC was to act as security for indemnification of the Landlord for losses resulting from any termination, surrender, disclaimer, or repudiation of the lease, in connection with, among other events, any insolvency or bankruptcy. The LC was to remain unaffected and unreleased by the bankruptcy of the Tenant or the disclaimer of the lease. This highlights the importance of a properly drafted lease and letter of credit.

Overview of Analysis

The weight of the Court of Appeal’s analysis focused on the autonomy of letters of credit and the distinction between the principles governing letters of credit and those governing the claims that a landlord may make against the estate of a bankrupt tenant. The Court also engaged in a thorough review of the case law governing the interplay between a trustee’s disclaimer and a landlord’s ability to draw on a letter of credit.

While the case law pulled in several directions, the Court looked to its previous decisions in Lava Systems Inc. (Receiver & Manager of) v. Clarica Life Insurance Co. (2001), [2002] O.J. No. 2526 (ONCA) and Curriculum Services Canada (Re), 2020 ONCA 267, as well as the Supreme Court decision in Crystalline Investments Ltd. v. Domgroup Ltd., 2004 SCC 3 for guiding authority to overturn the motion judge’s decision.

The lower court’s finding that the disclaimer of a lease by a trustee in bankruptcy ends the lease as if it had been consensually terminated by the parties was based on the well-known cases of Cummer-Yonge Investments Ltd. v. Fagot, [1965] 2 O.R. 152 and Mussens Ltd., Re, [1933] OWN 459 (Ont. SC). The Court of Appeal held that the lower court had overstated the effect of disclaimer in part because it neglected to consider the impact of Crystalline Investments, which overturned Cummer-Yonge and because it did not have the benefit of the recently-decided Curriculum Services which found: (i) the disclaimer of a lease by a tenant’s trustee benefits only the insolvent party, (ii) the deemed consensual termination of the lease via disclaimer does not operate for all purposes, and (iii) the disclaimer of the lease ends only the landlord’s rights against thebankrupt tenant’s estate.

The Court acknowledged that Crystalline Investments, although overturning Cummer-Yonge and directing that disclaimer should not relieve third parties of their contractual obligations, did not specifically examine whether its reasoning, which dealt with assignors and guarantors, was equally applicable to landlords on letters of credit. Where the lower court filled the void by concluding that Cummer-Yonge was not applicable, the Court of Appeal instead looked to its own decision in Lava Systems, which also involved a landlord’s claim to draw on an irrevocable letter of credit provided by a tenant that subsequently became bankrupt. Lava Systems applied the principle of autonomy of letters of credit, subject to two exceptions: (i) where the bank had assigned to the Trustee any claim it had against the Landlord and the Trustee proved that the Landlord acted fraudulently in drawing on the letter of credit, and (ii) the Trustee had a claim against the Landlord for any “improper” draws made on the letter of credit for which the Trustee had reimbursed the bank. Neither exception applied in the present case.

The Court of Appeal also commented that to accept the Trustee’s arguments and let the lower court decision stand, the court would in effect be accepting the proposition that the BIA does not permit a landlord to take security from its tenant through the vehicle of an letter of credit if that security exceeded the amount of a claim for accelerated rent under the BIA. Such a proposition is not supported by the language of the BIA and would run counter to long-standing principles of autonomy of letters of credit.

“Prompt” means Prompt

In its motion, the Trustee also advanced an alternative argument that the LC should have been reduced in value in accordance with the terms of the Lease which allowed for a reduction in the value of the LC at a certain point provided the Tenant has never been in default and has “promptly” paid all rent. The Landlord drew down the full $2.5 million, which the Trustee alleged exceeded the mandatory reduction to $1.36 million triggered on the 37th month of the initial term of the LC.

The Tenant had twice failed to pay rent when due (the first day of each calendar month). In the motion judge’s view, the word “promptly” meant “within a reasonable time” and not on the actual day that rent is due. The Court of Appeal disagreed, finding that the context of the Lease required that the term “promptly” means payment of rent when due – namely the first date of each calendar month. Accordingly, the pre-conditions for a reduction in the value of the LC were not met and the value of the LC was properly $2.5 million.

For further information, please contact any member of our RPP or Bankruptcy & Restructuring Groups.

 

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