Good News for Landlords – Letter of Credit Draws are Not Limited to a Landlord's Preferred Claim under the BIA

On October 28, 2020, the Ontario Court of Appeal released its decision in 7636156 Canada Inc. (Re), 2020 ONCA 681 ("OMERS"), on appeal from the decision of the Ontario Superior Court of Justice in 7636156 Canada Inc. v. OMERS Realty Corporation, 2019 ONSC 6106. The case held that the Landlord was entitled to draw on the full amount of a letter of credit obtained by virtue of its lease with an insolvent tenant instead of just the preferred claim equal to three months' worth of accelerated rent under the insolvency laws.

In OMERS, the Landlord leased its property to the Tenant for a term of ten years. After four years, the Tenant made an assignment in bankruptcy, and shortly thereafter, the Trustee disclaimed the lease. Schedule C of the lease required the Tenant to arrange for a letter of credit ("LOC") in favor of the Landlord as beneficiary. The lease stipulated that the LOC stood as security in the event of the Tenant's bankruptcy. In accordance with its rights under the lease, the Landlord drew down the full amount of the LOC after the bankruptcy. The Trustee moved for a determination of the total amount that the Landlord was entitled to draw on the LOC and sought repayment of any excess withdrawals by the Landlord.

The motions judge found in favor of the Trustee and rejected the Landlord's submission that it was entitled to draw on the LOC for damages suffered as a result of the disclaimer of the lease. The motions judge concluded the Landlord was only entitled to draw on the LOC for three months' accelerated rent for the following reasons: 1) a trustee's disclaimer of a lease operates as a voluntary surrender of a lease by the tenant with consent of the landlord, which extinguishes all obligations of the tenant under the lease; and 2) upon disclaimer of the lease, a bankrupt tenant no longer owes any obligations to the landlord under the lease. According to the motions judge, this conclusion was not affected by the SCC's in Crystalline because in OMERS, the bank's obligation to make payments (as the issuer of the LOC) was wholly dependent on the continued existence of the tenant's obligations under the lease.

The Landlord appealed. The Ontario Court of Appeal found that the motions judge erred in finding that the Landlord's entitlement to draw on the LOC is limited to its preferred claim under the BIA. The following points are worth noting: (a) the Court noted that the lower court did not have the benefit of the Court of Appeal's decision in Curriculum, which clarified that the trustee's disclaimer of a lease does not operate as a voluntary surrender of a lease with the consent of the landlord for all purposes. Rather, a trustee's disclaimer of a bankrupt tenant's lease ends the rights and remedies of the landlord against the bankrupt tenant's estate for the unexpired term of the lease, apart from the three months' worth of accelerated rent provided under the BIA and the Commercial Tenancies Act (Ontario); (b) the principle of independence or autonomy (also referred to as the "autonomy principle") applies to LOCs because the issuing bank has an obligation to make payment to the beneficiary which is independent of the underlying transaction; (c) upon an in-depth review of jurisprudence, the Court found that the principles of insolvency law do not override the principle of autonomy of LOCs, nor do they limit the landlord's right to draw on the LOC in excess of its preferred claim under the BIA; (d) the Court recognized the recent SCC decision in Chandos, which deals with the "anti-deprivation rule". Applying the Chandos case, the anti-deprivation rule is not offended when commercial parties protect themselves against a contracting counterparty's insolvency by taking security, acquiring insurance, or requiring a third-party guarantee.

Canadian landlords can now breathe a collective sigh of relief since the Ontario Court of Appeal has overturned the troubling lower court decision in OMERS and confirmed that: (i) a landlord's entitlement to draw on a LOC in the event of a tenant's bankruptcy or insolvency is not limited to the landlord's preferred claim under the BIA for three months' worth of accelerated rent; and (ii) the anti-deprivation rule will not be offended when a landlord protects itself against a tenant's bankruptcy or insolvency by taking security or requiring a third-party guarantee.

Is there fraudulent intent if the tenant removes its goods when there are no rental arrears but stops paying rent after vacating?

Unique to the commercial landlord and tenant relationship is the landlord's right to exercise its right of distress if a tenant is in rental default. Because of the importance of this landlord remedy, s. 50 of the Commercial Tenancies Act (the "CTA") attaches costly consequences to any person who "willfully and knowingly aids or assists" the tenant in "fraudulently or clandestinely" removing, conveying, or carrying off the tenant's goods and chattels. If the landlord can establish such liability, the cost is double the value of the goods removed. In Brantfield Management Ltd. v. Benevito Foods Inc., 2019 ONSC 1202, the Superior Court examined this extraordinary landlord right and shed some light on when fraudulent intent will be found.

The Landlord brought an action for unpaid rent and claimed that individual defendants were liable under s. 50 of the CTA for fraudulently or clandestinely removing the Tenant's goods. The lease provided that if the Tenant failed to pay rent or took any steps by way of dissolution, winding up, or liquidation of its assets, or made a sale of its assets in bulk, then the Landlord had an immediate right of re-entry on to the premises with a further right to sell the Tenant's assets found on the premises. After the Tenant lost its biggest customer, it became clear that the Tenant's business was no longer viable and an auction of their equipment was publicly advertised. The individual defendants each played a part in introducing potential buyers and/or selling or showing the equipment to potential buyers. There were no rental arrears when the equipment was sold and removed from the premises, but the Tenant stopped paying rent after vacating.

The Court found that the Landlord had the onus of proving that the individual defendants fraudulently removed and sold assets belonging to the Tenant in order to prevent the Landlord from distraining for arrears of rent and that they willfully and knowingly aided or assisted the Tenant in removing its equipment. The Court considered factors that indicated fraudulent intent.

It found that given that the Landlord was aware of the auction, there was no removal of the Tenant's equipment at night or during non-business days, there was no evidence the Tenant had sought rental indulgences from the Landlord, the Tenant had not run up arrears of rent while formulating a plan to sell its business, and there was nothing to suggest that the removal of equipment was done in a manner other than in the open, ultimately, there was no fraudulent intent or a clandestine removal of the Tenant's equipment. The Court stated that the mere fact that the Tenant did not seek the Landlord's permission or give notice of its intention to sell and remove its equipment from the Premises does not, in and of itself, result in a finding of fraudulent intent.

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