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Security deposits are a common practice in commercial leasing. They are defined as the payment of a sum of money by the tenant to guarantee performance of the latter's obligations under the terms of the lease. Contrary to popular belief, this practice is not prohibited, but a valid legal instrument if paid voluntarily by the tenant.
Commercial leases often include clauses negotiated between the parties, requiring the tenant to pay a security deposit to the landlord. However, in the event of a tenant's notice of intention, proposal or bankruptcy, the landlord may be required to remit the sums received from the tenant as a security deposit to the trustee, under the Bankruptcy and Insolvency Act (the "BIA").
In this article, we will focus on the treatment of security deposits paid to landlords in the event of tenant insolvency. We will also look at the best practices to adopt when drafting commercial leases to ensure that the landlord's rights are preserved.
Case Law on Security Deposits
On numerous occasions, the courts have been asked to decide the fate of the security deposit in the event of a tenant's notice of intention, proposal or bankruptcy under the BIA. They concluded that the deposit paid by the tenant to guarantee performance of its obligations constituted a movable hypothec with delivery. This hypothec, despite being granted by the tenant in favour of the landlord, cannot be set up against an insolvency trustee or a hypothecary creditor holding a second-ranking movable hypothec on the same property.
The Court of Appeal of Quebec came to the same conclusion in1while specifying that, if the tenant goes bankrupt and the landlord has a security deposit, the order of priority will not be the same one stipulated in the Civil Code of Québec.
In fact, despite the landlord's status of secured creditor by virtue of its movable hypothec with delivery, the landlord will not be able to enforce any hypothec held on the assets of the tenant that is now insolvent, and will instead have to refer to the order of priority provided for in section 136 of the BIA.
In other words, the sum collected by the landlord as a security deposit to guarantee performance of the tenant's obligations under the terms of the lease will be unenforceable against the insolvency trustee, since the related security was never realized prior to the onset of bankruptcy.
In such circumstances, the landlord will simply enjoy the privilege granted under section 136(1)(f) of the BIA. This well-defined privilege is subject to the rights of secured creditors and is limited to the amount realized on the assets located on the premises covered by the lease.
Prepaid Rent: An Option Worth Considering
Thus, to mitigate the negative repercussions of a tenant's potential insolvency, it would be to the landlord's advantage to ask the tenant for prepaid rent rather than a security deposit.
Prepaid rent is a sum of money that the tenant pays in advance to the landlord. The payment of this sum is therefore akin to a non-refundable payment of rent collected in advance, to pay arrears in the event of the tenant's default.
The advantage of prepaid rent is that it provides better protection for the landlord, who becomes the owner of the amount paid. In other words, the amount collected becomes an integral part of the landlord's assets once it is paid upon signing of the lease.
Since this amount belongs to the landlord, it will be enforceable against the tenant's insolvency trustee, thereby protecting the landlord's rights in the event that the tenant defaults on its rent payments.
The Importance of Drafting Commercial Leases
In light of the above, it is crucial that lease clauses be drafted so as to eliminate any ambiguity when it comes to the true owner of the amount collected by the landlord, in particular by avoiding the use of the term "security deposit."
On the other hand, a deposit clause drafted in such a way as to emphasize the non-refundable nature of the deposit is essential in order to clarify the intention of the landlord and the tenant regarding the remittance of a sum of money, and to preserve the landlord's rights in the event of a notice of intention, proposal or bankruptcy of the tenant under the BIA.
Other Tools Lessors Can Leverage to Protect Themselves
There are other solutions at the landlord's disposal to guarantee the tenant's obligations under the terms of the lease, including:
- bank letters of credit;
- third-party guarantees.
How We Can Help
Given the importance of drafting commercial lease clauses to protect a landlord's rights, it is strongly recommended that you seek the advice of an experienced lawyer who can guide you and help you fully understand the issues surrounding the security options available to landlords when it comes to commercial leases.
Footnote
1 Restaurant Ocean Drive Inc. v. Sam Levy & Associés Inc., 1997 CanLII 10235 (QC CA).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
