Can a Tenant Stop Paying Rent as a Result Of COVID-19?

When the government ordered the closure of all non-essential businesses, tenants quickly turned to their leases to see if the pandemic would qualify as force majeure and discharge them from their rent obligations. Hengyun International Investment Commerce Incv9368-7614 Québec Inc., 2020 QCCS 2251, ("Hengyun") was one of the first Canadian cases to consider force majeure in the context of COVID-19 government-mandated shutdowns. It sparked hope for tenants that rent relief was possible.

In Hengyun, the Landlord and the original Tenant, VFC, entered into a five-year lease to operate a gym. VFC soon made an assignment in bankruptcy and 9368-7614 Québec Inc. ("Québec Inc.") began operating on the premises. At issue was whether Québec Inc. had a right to occupy the premises and a right to reduced rent as a result of problems in the premises and the COVID-19 pandemic.

The lease contained a superior force (force majeure) clause, but it provided that it would not operate to excuse the Tenant from the prompt payment of rent. Québec Inc. argued that despite the language in the lease, it should be relieved from its obligation to pay rent because its inability to operate was caused by superior force. The Landlord argued that the pandemic did not qualify as superior force, and even if it did, the superior force clause obligates Québec Inc. to pay rent notwithstanding an event of superior force.

The Court concluded that Québec Inc. did not need to pay rent for March, April, May, and part of June 2020 (the period of the government-ordered closure). The Court relied on Article 1470 of the Civil Code of Québec ("CCQ"), which defines superior force as "an unforeseeable and irresistible event," and found that the COVID-19 pandemic was a superior force because: (i) it could not reasonably have been foreseen at the time the lease was contracted; and (ii) the requirement of irresistibility was satisfied as the government-mandated closure prevented any tenant in Québec Inc.'s situation from paying its rent and not just those who lacked sufficient funds. The Court determined the Landlord was prevented by superior force from fulfilling its obligation to Québec Inc. to provide it with peaceable enjoyment of the premises and, as a result, the Landlord could not insist on the payment of rent for this period in accordance with Article 1694 of the CCQ.

Because this decision was rendered under the civil law in Québec, its application to the common law provinces was uncertain until recently. The case of Durham Sports Barn IncBankruptcy Proposal, 2020 ONSC 5938, ("Durham") has provided some certainty as the Ontario Superior Court considered this very same question.

In Durham, the Tenant operated an elite athletic performance centre. As with all non-essential businesses, the Tenant was forced to shut down from March 19, 2020, to May 25, 2020, and was only allowed limited operations during the later Phase II re-opening. The Tenant sought to rely on Hengyun and argued that because force majeure interfered with its quiet enjoyment, the Landlord could not insist on payment of rent.

The Court refused to apply Hengyun. It found that the doctrine of "superior force" in the CCQ (relied upon in Hengyun) is a doctrine that does not exist in Ontario. In addition, while the force majeure clause did relieve the Landlord from providing quiet enjoyment, it did not relieve the Tenant from paying rent. The Landlord's obligation to provide quiet enjoyment was subject to the payment of rent. Since the Tenant did not pay rent during the stated periods, the Landlord's obligation to provide quiet enjoyment did not arise. As a result, the Court found the Tenant was not entitled to any rent relief during the government-mandated shutdown.

Landlords have welcomed the Durham decision. It has provided some certainty that despite these unusual times, the law is as it should be, at least for now.

Does Resulting Physical Damage under an Insurance Policy Require Actual Tangible Damage or Can It Include Loss of Use?

Where rent abatement for the COVID-19 pandemic is not available, some tenants have turned to their insurance to see if it covers business interruption caused by COVID-19. This coverage has not traditionally been available where there is no "physical" damage (or loss). However, the recent case of MDS IncvFactory Mutual Insurance Company (FM Global), 2020 ONSC 1924, ("MDS") may have opened the door to the possibility of this coverage for COVID-19 business interruption losses.

MDS purchased radioisotopes from Atomic Energy of Canada Limited's Nuclear Research Universal Reactor (NRU), which it processed and sold for use in medical products. In 2009, there was a leak of radioactive tritium. The reactor was shut down for 15 months. The leak was localized and did not cause any damage to the NRU reactor core. Still, the forced shutdown resulted in a significant loss of profits to MDS.

At the time of the shutdown, MDS had a worldwide all-risks policy with Factory Mutual Insurance Company. It included coverage for losses to MDS, such as loss of profits, flowing from physical damage to a supplier "directly resulting from physical loss or damage of the type insured by this Policy." MDS submitted a claim for loss of profits but was denied coverage on the basis that the loss did not result from any "physical loss or damage." MDS sued for breach of contract.

Since the policy did not define "physical damage," the key issue was whether resulting physical damage required actual tangible damage to the NRU reactor core or whether it included loss of use of the NRU. The Court ultimately concluded that the resulting physical damage contemplated loss of use of the NRU.

In MDS, the Court broadly interpreted the term "physical damage" to include the "impairment of function or use of tangible property," but only after it considered the policy's specific language, the factual matrix, and the parties' reasonable expectations. This careful approach must be taken in any claim for COVID-19 business interruption loss. It remains to be seen whether COVID-19 business interruption losses will be covered until we have a case dealing with such a claim.

Limitations Act vs. Real Property Limitations Act

In Stonequest Management IncvAndritz va Tech Hydro Ltd., 2019 ONSC 3273, the Landlord sought to recover alleged underpayment of utility costs from the Tenant. Under the lease, the Tenant was responsible for paying all of its separate accounts for electricity, but due to a problem with unlabeled or mislabeled meters at the property, the Tenant was undercharged.

The Tenant brought a motion for summary judgment dismissing the Landlord's action as statute-barred. Ontario's Limitations Act2002 provides for a two-year general limitation period. The Real Property Limitation Act ("RPLA") provides for a six-year limitation period for the recovery of rent arrears. Under the Limitations Act, the Landlord's claim was statute-barred since the Landlord issued its claim two years and 13 days from the date the Landlord knew or ought to have known that it had a claim against the Tenant.

The Landlord argued that the six-year limitation period should apply instead since utilities fall within the definition of "additional rent" in the lease. The Court rejected this argument and concluded that "rent" under the RPLA means the payment due under a lease between a tenant and landlord as compensation for the use of land or premises. The Court found that to conclude otherwise would allow parties to shelter a claim under the RPLA by simply designating the disputed amount as "rent" under a lease. As a result, the Court concluded that the six-year limitation period under the RPLA was not available to the Landlord.

It is questionable whether this decision was decided correctly. However, landlords should err on the side of caution when it is unclear whether the arrears relate to compensation for the use of land or premises and initiate an action within the two-year limitation period.

Coping With the Aftermath of Co-Tenancy Failure—Is Your Co-Tenancy Clause Enforceable?

In Old Navy (CanadaIncv Eglinton Town Centre Inc., 2019 ONSC 3740, the Tenant brought an application for declaratory relief and the refund of overpaid rents for an alleged co-tenancy failure. The Letter of Intent ("LOI") and lease contained a co-tenancy provision naming Danier Leather as one of a small number of key tenants and providing for a reduction in rent if there was a co-tenancy failure. There was a notable and unexplained discrepancy between the version of the co-tenancy in the LOI and the lease. The co-tenancy in the LOI included a reciprocal termination right if a co-tenancy failure continued for a period of six months or longer. In contrast, the formal lease only had a tenant termination right.

More than 15 years into Old Navy's term, Danier Leather declared bankruptcy and ceased conducting business in the shopping centre. Even though its sales did not suffer because of such closure, Old Navy sought to assert its right to the reduced rent. It claimed Danier's closing amounted to a co-tenancy failure.

The Landlord argued that the co-tenancy provision was poorly drafted, unreasonable, and did not reflect the intention of the parties, which was that occupancy by the key tenants was only applicable during the initial opening and it was the 80% occupancy test that was applicable during the term.

The Court favoured the Landlord's position. It found that the provision is not a commercially reasonable position. It offends the business efficacy rule of interpretation for the Landlord to be bound for an indefinite period to accept rent that barely covered common area expenses and resulted in the Landlord receiving no rent for the actual use of the premises.

Although the Court elected not to render judgment on whether the co-tenancy provision was an unenforceable penalty, parties should be careful when drafting a co-tenancy provision to ensure that: (i) any reduction in rent is commensurate with damages suffered by a tenant; and (ii) the co-tenancy clause includes a sunset clause with a stipulated time limit on any rent relief.

Liquidated Damages vs. Penalty

Where a contract stipulates a monetary consequence upon breach, a term that imposes damages that represent a genuine pre-estimate of the damage will generally be enforceable as "liquidated damages." In contrast, a term that does not represent a genuine pre-estimate of damages will be deemed an unenforceable penalty.

The case of Health Quest IncvArizona Heat Inc., 2019 NLSC 52, reviewed the difference between liquidated damages and penalties. The lease included a requirement for a $50/day fee for the late payment of rent. The Landlord had agreed to use its "best efforts" to have the premises ready for occupancy by a specific date, but there were delays, and, as a result, the Tenant refused to pay for the fit-up work and minimum rent for November and December.

The lease imposed a $50/day charge for late payment of rent. The Tenant argued that this fee amounted to a penalty and was unenforceable. The Court confirmed that whether a payment is a genuine pre-estimate of damage or a penalty required the entire agreement to be considered. If it is a pre-estimate of damage suffered by the Landlord, it is enforceable. If it is a threat held over the Tenant in terrorem, it is not enforceable. In this case, the Court sided with the Tenant. It held that the $50/day fee was a penalty because the amount was arbitrary and there was no evidence relating the fee to costs actually incurred by the Landlord for non-payment.

It is important to remember that although parties may agree in writing that amounts are a genuine pre-estimate of damages, they must actually be a genuine pre-estimate of damages to be enforceable. To avoid an unenforceable finding, parties should ensure that they can demonstrate a careful and reasoned analysis showing a link between the fee charged and the costs incurred on default.

Landlords Beware: Do Your Own Due Diligence

In JCP Drugs Limited vDaniels Leslieville Corporation, 2019 ONSC 5295, the Court considered the enforceability of an Agreement to Lease and whether the Landlord breached this agreement by refusing to grant the Tenant possession until the Tenant signed the standard form lease prepared by the Landlord.

The Tenant agreed to lease premises for "a pharmacy and family medical clinic." After signing the Agreement to Lease, the Landlord learned that the Tenant intended to dispense methadone from the premises. The Landlord informed the Tenant that dispensation of methadone was not a permitted use under the agreement and sought assurances from the Tenant that the premises would not be used for this purpose. The Landlord later delivered its standard form lease, but with additional covenants, agreements, and conditions about the use of the premises relating to the dispensation of methadone. The Tenant refused to sign the lease and commenced this application for relief.

The Court held that the Agreement to Lease was binding and enforceable and that the Landlord breached the agreement by denying the Tenant possession unless it signed the lease with additional use restrictions not contemplated in the Agreement to Lease. The Court found the Tenant was not obliged to disclose its methadone sales or its extent to the Landlord. There is no general duty to disclose material facts relevant to another party's decision to enter a contract except in limited circumstances. In this case, a sophisticated commercial entity, like the Landlord, should not be able to challenge the enforceability of a valid agreement due to its own failure to ask questions about "intended uses" and to exercise due diligence before signing the agreement.

Be Careful not to Lose Your Claim for Prospective Rent by Claiming Accelerated Rent

In Can-Faith Enterprises Incv0932784 B.CLtd., 2019 BCSC 1332, the Tenant exercised its option to renew but sought a second option, which the Landlord ignored. In accordance with the lease, the matter proceeded to arbitration to determine market rent; the Tenant did not attend and denied the option had been exercised. The Tenant stopped paying rent and the Landlord terminated the lease and commenced an action for breach of contract.

The Court considered whether the Landlord was entitled to recover, as separate remedies, damages for the loss of prospective rent for the five-year renewal term and three months' accelerated rent. The Landlord argued that it was entitled to recover both, as the accelerated rent clause was included to provide a remedy if the Tenant became insolvent. The Tenant argued that the accelerated rent clause was a liquidated damages clause, which represented all the damages that the Landlord may recover for the loss of prospective rent.

The Court found that the accelerated rent clause was a pre-contractual estimate of damages for the Tenant's breach of the lease. By seeking to enforce this clause as a separate remedy, the Landlord had elected to accept this amount as a complete remedy for the Tenant's default.

Depending on the wording in a lease, an accelerated rent clause may either be an advanced payment of rent or separate liquidated damages. Where a landlord wants to recover damages for prospective loss arising from a breach, it must be careful not to enforce an accelerated rent clause, which is a liquidated damages clause, or risk being found to have accepted the accelerated rent as a complete remedy for the entire breach.

Rights of a Commercial Landlord as a Creditor in the Bankruptcy of a Tenant

The case of Curriculum Services Canada/Services Des Programmes D'Etudes Canada (Re), 2020 ONCA 267, ("Curriculum") deals with the rights of a commercial landlord, as a creditor, following the disclaimer of a lease by the trustee in bankruptcy.

Following the Tenant's bankruptcy, the Landlord filed a proof of claim in bankruptcy asserting a preferred claim under the Bankruptcy and Insolvency Act ("BIA") for three months' rent accelerated rent and an unsecured claim for tenant inducements and rent payable for the unexpired portion of the term ("Future Damages"). The trustee in bankruptcy disclaimed the lease and allowed the rental arrears portion of the Landlord's preferred claim (limited to the value of the property on the premises). The trustee was silent on the Landlord's claim for accelerated rent and disallowed the Landlord's claim for Future Damages.

The Landlord appealed the trustee's decision to the Ontario Superior Court of Justice, pointing to the seminal case of Highway Properties LtdvKelly Douglas and CoLtd., [1971] S.C.R. 562 (S.C.C.), ("Highway Properties") where the Supreme Court of Canada ("SCC") introduced the concept that a landlord, who terminates the lease of a defaulting tenant, is entitled to claim damages equal to the rent that would have been payable for the unexpired term of the lease less the rentable value of the premises for that period of time. The Landlord argued that its losses flowing from the disclaimer of the lease are contractual damages and should be treated equally with any contractual damages potentially suffered by the Tenant's other creditors. The Superior Court sided with the trustee and dismissed the Landlord's appeal.

The Ontario Court of Appeal allowed the Landlord to rank as an unsecured creditor for the balance of its preferred claim. However, it found that the disclaimer of the lease by the trustee in bankruptcy operated to end the Tenant's obligations under the lease and dismissed the Landlord's claim as an unsecured creditor for the Future Damages.

The Court of Appeal explained that Mussens Ltd., Re, [1933] O.W.N. 459 (Ont. S.C.), ("Mussens") stands for the principle that, under Ontario law, the trustee of a bankrupt tenant is permitted by statute to bring an end to the lease and all future obligations of the tenant thereunder by surrendering possession of the leased premises or disclaiming the lease within three months of the bankruptcy.

The Court found that while it would not support an interpretation of Mussens that would characterize a disclaimer as a consensual surrender for all purposes, Crystalline Investments LtdvDomgroup Ltd., [2004] 1 S.C.R. 60 (S.C.C.), left intact the rule articulated in Mussens that on disclaimer of a commercial lease by its trustee, an Ontario landlord has no claim as an unsecured creditor in the bankrupt tenant's estate for Future Damages, except to recover the three months' accelerated rent as provided under the BIA.

Further, while Highway Properties recognized that a lease is also a contract and provided for a landlord's option to accept a tenant's repudiation and sue for Future Damages, the case did not address a situation of bankruptcy or insolvency. The remedies for a tenant's repudiation do not apply once a trustee has disclaimed the lease.

While the Ontario Court of Appeal correctly allowed the Landlord's preferred claim for three months' accelerated rent, it is questionable, in our view, whether their decision regarding Future Damages is correct in law, given the SCC's decision in Highway Properties. Unfortunately, since the Landlord chose not to appeal to the SCC, the Court of Appeal's decision in Curriculum is now binding law in Ontario and will be relied upon by trustees in bankruptcy to reject a landlord's unsecured claim for Future Damages.

Anti-Deprivation Rule and its Impact on Enforceability of Provisions in Commercial Leases

On October 2, 2020, the SCC released its decision in Chandos Construction LtdvDeloitte Restructuring Inc., 2020 SCC 25. The case reaffirmed the common law rule of anti-deprivation, which renders invalid any provision taking away value from a bankrupt or insolvent estate. The "anti-deprivation rule" voids contractual provisions that operate to remove value from an insolvent person's estate that would otherwise be available to the creditors. The rule involves a two-part test: (i) the clause must be triggered by an event of insolvency or bankruptcy; and (ii) the effect of the clause must be to remove value from the insolvent's estate. The rule exists to protect unsecured creditors who may lose out on rightful compensation due to contractual provisions triggered by bankruptcy or insolvency.

In this case, Chandos Construction Ltd. ("CCL"), a general contractor, entered into a construction agreement with Capital Steel Inc. ("CS"). The agreement included a provision requiring payment of 10% of the agreement price to CCL if CS committed any act of bankruptcy, insolvency, or ceased to run its operation, as an inconvenience fee for completing the work using alternate means. CS made an assignment in bankruptcy before the completion of the subcontract. CCL sought to set-off the 10% fee against amounts it owed to CCL under the subcontract. Deloitte Restructuring, the trustee in bankruptcy, sought a determination on whether this provision is enforceable.

The lower court ruled in favour of CCL and found that the provision was valid based on: (i) there was no attempt to avoid the bankruptcy laws, but, rather, the provision serves a commercial purpose; and (ii) the anti-deprivation rule protects against devaluing the estate, but does not prohibit parties from making claims for liquidated damages. The Court treated the provision as a liquidated damages clause as opposed to an attempt to circumvent bankruptcy laws or a penalty clause.

The Alberta Court of Appeal reversed the trial court's decision and held that the provision was invalid on two grounds by: (i) violating the penalty clause rule; and (ii) violating the anti-deprivation rule. The Court looked at the history of the anti-deprivation rule in Canadian jurisprudence. It noted that it has not been eliminated either by subsequent cases or legislation. The most significant point, however, was to characterize the rule as effects-based as opposed to purpose-based. This means that as long as a provision is triggered by the bankruptcy or insolvency of a person and has the effect of devaluing the estate to the prejudice of the creditors, it will be invalid.

The SCC dismissed CCL's appeal. The Court agreed with the Court of Appeal's reasons and held the provision to be invalid. The following points are worth noting: (i) the Court gave effect to the legislative scheme set out by the Parliament in s. 71 of the BIA, which provides that the property of the bankrupt must pass and vest in the trustee. As such, "any avoidance, whether intentional or inevitable, is surely a fraud on the statute"; (ii) the Court confirmed the effect-based approach. This was done to promote certainty in contracts and ensure the rule is effective in all situations, not just ones involving the clearest cases of avoidance of insolvency or bankruptcy laws.

The Court also held that the anti-deprivation rule does not apply in the following situations: (i) contractual provisions that eliminate property from the estate, but not its value; (ii) contractual provisions not triggered by bankruptcy or insolvency; and (iii) contractual provisions that protect parties against a counterparty's insolvency or bankruptcy by taking security, acquiring insurance, or requiring a third-party guarantee.

It is also worth noting that a strong dissent argued against the application of the anti-deprivation rule if there is a bona fide commercial purpose, allowing parties to freely contract and protect their self-interest.

The bottom line is that when applying the anti-deprivation rule, courts will look at whether the contractual provision has the effect of depriving the estate of assets upon bankruptcy, and not whether the intention of the contracting party was commercially reasonable. It is also important to note that the SCC held that the anti-deprivation rules 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.

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 IncvOMERS 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 10 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: (i) 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 (ii) 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 decision 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: (i) 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); (ii) 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; (iii) 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; and (iv) 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.

Special acknowledgement and thanks to Radha Lamba, Student-at-Law, for her valuable assistance in preparing this article.

Originally Published by 2021 Canadian Lexpert Directory.

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