Key Conclusions

In a recent decision, 7636156 Canada Inc. (Re), 2020 ONCA 681, the Ontario Court of Appeal (ONCA) confirmed that a landlord’s right to collect under a letter of credit (LOC) taken as security in connection with a lease is not limited to the landlord’s preferred claim of three months’ arrears of rent and three months’ worth of accelerated rent under the Bankruptcy and Insolvency Act (BIA). Commercial landlords should consider the risk profiles of their current and prospective tenants to confirm whether the protections offered by letters of credit should be considered. Landlords should further review their standard leases to make sure that any existing provisions requiring the issuance of letters of credit are in line with those considered in 7636156. In addition, the terms and conditions of the letter of credit may also have an impact on its qualification and enforcement in insolvency contexts.

Overview of the law

The BIA, Companies’ Creditors Arrangement Act (CCAA) and various provincial statutes allow the trustee of a bankrupt tenant to disclaim any lease of property.

Under the BIA, the landlord of a bankrupt tenant is entitled to a preferred claim for arrears of rent for a period of three months immediately preceding the bankruptcy and for a period not exceeding three months following the bankruptcy, provided that it is entitled to accelerated rent under the lease. This preferred claim is subject to the value of the realization of the property located within the leased premises.

A fundamental element of the utility of a LOC is based on the autonomy principle, which dictates that a LOC, though provided in connection with an underlying commercial transaction, is autonomous from such underlying transaction. Payments under LOCs are required to be made upon the satisfaction by the beneficiary of such LOCs of the conditions stipulated in such LOCs and, in the absence of very few exceptions, are not dependent on any other matters, claims or disputes arising in the separate commercial transactions pursuant to which they are issued. 

Facts of the case

7636156 Canada Inc., the tenant, leased a commercial property from OMERS Realty Corporation, the landlord, for a term of 10 years commencing on May 1, 2014. The tenant made an assignment into bankruptcy in May 2018, and the tenant’s trustee in bankruptcy disclaimed the lease in July 2018.

The lease provided for the delivery by the tenant to the landlord of a LOC, which LOC would stand as security for, among other things, losses experienced by the landlord as a result of the tenant’s bankruptcy or the disclaiming of the lease by the tenant. The tenant arranged for a LOC to be issued in favour of the landlord. Relying on the provisions of the lease, the landlord made various draws under the LOC upon the tenant’s assignment into bankruptcy, which draws were made both before and after the disclaimer of the lease in July 2018. The landlord’s aggregate draws amounted to the full $2.5 million amount of the LOC. The tenant’s trustee brought a motion asking the Ontario Superior Court of Justice to determine the total amount of the LOC that the landlord was entitled to draw.

Decision of the Ontario Superior Court of Justice

The trustee sought a determination by the Court that the landlord had made withdrawals from the LOC which were in excess of its entitlements on account of the tenant’s bankruptcy proceedings and its disclaimer of the lease. The landlord put forward its position that it was entitled to draw the entire LOC notwithstanding the disclaimer of the lease.

The court agreed with the trustee and determined that the landlord’s entitlement to collect on the LOC was limited to the three months’ of accelerated rent provided under the BIA (the tenant did not owe any arrears of rent). The court’s reasoning was essentially that, the disclaimer of the lease by the tenant operated as a voluntary surrender of the lease, meaning that the tenant ceased to have any obligations to the landlord under the lease. Since any draws under the LOC depended on obligations owed by the tenant to the landlord pursuant to the lease, no draws in excess of the statutorily provided preferred claim of three months’ worth of rent could be made on the LOC.

Decision of the Ontario Court of Appeal

The ONCA reversed the decision of the lower court and found that the landlord‘s claim on the LOC was not limited to the preferred claim under the BIA. In coming to its decision, the ONCA undertook a fairly extensive review of the jurisprudence in the area and also discussed its own recent finding in Curriculum Services Canada/Service Des Programmes D’Études Canada (Re), 2020 ONCA 267. This case was decided after the decision in 7636156 and was not considered by the Ontario Superior Court of Justice as a result. 

The ONCA reaffirmed its finding in Curriculum that the disclaimer of a lease in the context of a tenant’s bankruptcy proceeding does not act as a voluntary surrender of the lease by the tenant and landlord for all purposes – as was found in the lower court decision. Instead, the disclaimer limits the landlord’s right to collect against the estate of the bankrupt tenant for any amounts owing in excess of the aforementioned preferred claim in connection with the unexpired term of the lease. The ONCA then went on at some length to uphold the autonomy principle as it relates to LOCs. The ONCA grounded this finding on the strict requirement that an issuing bank make payment on a LOC provided that a complying presentation (a draw request which satisfies all conditions outlined in the subject LOC) is made by the beneficiary. The bank is not required to review any matters related to the underlying transaction prior to issuing payment on the receipt of a complying presentation. The fraud exception as it relates to LOCs, which generally relates to irregularity on the face of documents submitted with requests, was briefly discussed as a potential exception to this requirement, but there was no evidence in 7636156 that the landlord acted inappropriately in making its requests for draws.

The ONCA held that the autonomy of LOCs is not overridden by the assignment into bankruptcy of the party which arranged the LOC or by the disclaimer of the lease pursuant to which it was issued. The ONCA, as a result, could not find any support in the BIA or in any other principle of Canadian bankruptcy law, which would limit the amount available to the landlord under the LOC to the preferred claim of three months’ accelerated rent that the landlord was entitled to claim against the tenant’s estate. The LOC in 7636156 was specifically drafted to stand as security for exactly the situation in which the tenant found itself. The ONCA agreed that courts generally should not dilute the security provided by LOCs as they serve important commercial functions which would be undermined if their autonomy were to be removed in the context of a bankruptcy. On the basis of these findings, the ONCA found that the landlord was entitled to draw up to the entire amount of the LOC for the damages that it suffered.

Conclusion

This decision has provided much needed clarity on a subject that has not often been dealt with by the courts. While the terms of the lease and of the LOC may have an impact on the outcome of a particular claim, this decision provides useful confirmation of the notion that LOCs can be relied upon by landlords in cases of insolvency, and that they will not generally form part of the bankrupt tenant’s estate. It stands to reason that this decision will be of relevance to Québec stakeholders and practitioners as well. Although adjustments may have to be made to account for peculiarities of Québec civil law in certain circumstances, it remains that in Québec as well, the LOC can be relied upon as a form of security that is excluded from tenant’s patrimony and, therefore, from the “property of the debtor” within the meaning of the BIA and CCAA.