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Leasing Bulletin: Good News For Landlords – Letter Of Credit Draws Are Not Limited To A Landlord’s Preferred Claim Under The BIA


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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 under its lease with an insolvent tenant instead of
just the preferred claim equal to three months’ worth of
accelerated rent under the insolvency laws.

Background

Law

Upon a tenant’s assignment in bankruptcy, a trustee in
bankruptcy has the power to disclaim any lease of property (see Bankruptcy and Insolvency Act, s.
30(1)(k) (“BIA”) and Commercial Tenancies Act, R.S.O. 1990,
c. L.7, s. 39(1)).

Following a tenant’s assignment in bankruptcy, the landlord
is entitled to a preferred claim for three months’ worth of
accelerated rent under s. 136(1)(f) of the BIA if such accelerated
rent is provided under the lease.

An important legal principle pertains to the autonomy of
documentary letters of credit. An issuing bank is obliged to honour
a draw or other demand for payment under a letter of credit
(“LOC”) upon compliance with the conditions specified in
the LOC. A fundamental characteristic of such securities is the
autonomy from the underlying transaction between the applicant and
the beneficiary.

Facts

OMERS Realty Corporation (“Landlord”) leased its
property to 7636156 Canada Inc. (“Tenant”) for a term of
10 years, commencing on May 1, 2014, and expiring on the last day
of April 2024 (the “Lease”). In May 2018, the Tenant made
an assignment in bankruptcy and in July 2018, the Trustee
disclaimed the lease.

Schedule C of the Lease required the Tenant to arrange for a LOC
in favour of the Landlord as beneficiary. The Lease stipulated that
the LOC stood as security in the event of the Tenant’s
bankruptcy. The LOC was issued by Bank of Nova Scotia for $2.5
million and was backed by cash collateral supplied by or on behalf
of the Tenant. Per its rights under the Lease, the Landlord made
draws on the LOC after bankruptcy, before and after the Trustee
disclaimed the Lease, to the full amount of the LOC, $2.5 million.
The Trustee moved for a determination of the total amount that the
Landlord was entitled to draw on the LOC.

Lower Court Decision

The Trustee’s Motion – Ontario Superior Court of
Justice

The motions judge found in favour 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 that 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 decision of the Supreme Court of Canada in
Crystalline
Investments Ltd. v. Domgroup Ltd.
, 2004 SCC 3
, because in
OMERS, the bank’s obligation (as issuer of the LOC) to make
payments was wholly dependent on the continued existence of the
tenant’s obligations under the lease.

Ontario Court of Appeal

  • The Court noted that the lower court did not have the benefit
    of the Court of Appeal’s decision in Curriculum
    Services Canada/Service Des Programmes D’Études Canada
    (Re)
    , 2020 ONCA 267
    , 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 with respect to 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).

  • 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,
    independent of the underlying transaction.

  • 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.

  • The Court recognized the recent Supreme Court of Canada
    decision in Chandos Construction Ltd. v. Deloitte
    Restructuring Inc.
    , 2020 SCC 25

    (“Chandos“), which deals with the
    “anti-deprivation rule”. The anti-deprivation rule
    invalidates contractual provisions triggered by an event of
    bankruptcy or insolvency and which have the effect of removing
    value from a bankrupt’s or insolvent’s estate. 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.

Takeaway and Implications

Canadian landlords are breathing a collective sigh of relief now
that the Ontario Court of Appeal has overturned the troubling lower
court decision in the OMERS case. There are a few key
takeaways from the appeal decision. First, 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. Second, based on the decisions in Chandos and
OMERS, 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.

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.

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