Tenant bankruptcies in the COVID-19 era: tenant bankruptcy and letters of credit – Lexology

In the face of increased tenant bankruptcies caused by the COVID-19 pandemic, a key question arises for commercial landlords: what protection do I have from the security provided by my tenant? Tenant-supplied security under a lease can take many forms, including a third party guarantee or indemnity, prepaid rent, a cash deposit, and a letter of credit (an LOC). Crucially, certain forms of security will be more beneficial to a landlord in the face of a tenant bankruptcy, especially where the lease has been disclaimed by the tenants trustee in bankruptcy.

What you need to know

Bankruptcy & landlord relief

For a landlord, the primary benefit of an LOC surrounds how this form of security is applied in the face of a bankrupt commercial tenant. Funds previously delivered by a bankrupt tenant as a cash security deposit automatically fall into the pool of property to be distributed amongst the bankrupt tenants creditors.1 This may also be the case for prepaid rent, depending on the wording of the lease.2 Additionally, though a guarantee or an indemnity may survive a tenants bankruptcy and lease disclaimer,3 each is only as good as the financial covenant of the party guaranteeing or indemnifying, and that covenant may have changed since the guarantee or indemnity was first provided.

Canadas Bankruptcy and Insolvency Act (the BIA) and Ontarios Commercial Tenancies Act (the CTA) provide certain statutory limits on the preferred (albeit unsecured) claim a landlord has over a bankrupt tenants property, being up to three months of rental arrears, and three months of accelerated rent (providing the lease grants the latter right) (the Preferential Claim).4 Depending on the extent of the bankrupt tenants liabilities and the creditors who rank in priority to the landlord in priority, the landlord may recover little if anything.

It is in this context of legislative creditor hierarchy that the benefits of an LOC, particularly an irrevocable standby LOC, generally outweigh other forms of security.

Common law approach in a commercial leasing context

While jurisprudence has generally held that a landlord is able to receive payment under an LOC without having to compete with the bankrupt tenants other creditors, there is some uncertainty with respect to the extent of an LOCs autonomy, and the amount a landlord would be permitted to draw down where a lease has been disclaimed in bankruptcy.

Historically, the courts have taken two distinct approaches to what effect bankruptcy can have on a landlords ability to benefit from a third partys contractual obligation to make payment relating to a tenants obligations under a lease (e.g., a guarantor, or a third party Issuer). First, a number of decisions following the decision of Cummer-Yonge Investments Ltd. v. Fagot et al. held that, a bankrupt tenants obligations under a lease came to an end once the lease was disclaimed, such that a landlords recovery under a LOC with a third party Issuer was limited to its Preferential Claim.5 Other courts took an alternative approach to the question, following the obiter dicta of the Supreme Court of Canada in Crystalline Investments Ltd. v. Domgroup Ltd., in which the Court held that a third partys obligation to make payment could continue despite the lease being disclaimed, with the result that a landlords draw on an LOC was not necessarily limited to its Preferential Claim.6 While neither Cummer-Yonge nor Crystalline expressly dealt with LOCs, the legal community and subsequent case law applied the principles relating to third party payment obligations and disclaimers to LOCs held as security for commercial lease obligations.

The uncertainty of the extent of a landlords entitlement to draw on an LOC came to a head in 2019 with the Ontario Superior Court decision of 7636156 Canada Inc. v. OMERS Realty Corporation (OMERS).The Court held that the banks obligation to make payment to the landlord under an LOC was wholly dependent on the continued existence of the bankrupt tenants obligations to the landlord under the lease. The Court held that since the tenants trustees disclaimer of the lease extinguishes a bankrupt tenants continued obligations under the lease, the landlords entitlement to recovery under the LOC was limited to the Preferential Claim.7 After being appealed, the Ontario Court of Appeal recently released its decision on OMERS,8 which provides much needed clarity on the extent to which a commercial landlord can draw on an LOC, holding that there is no provision within the BIA, nor principle of bankruptcy law, that overrides the autonomy principle, and barring the existence of an exception to the principle of autonomy, that the landlord was entitled to draw on the full amount of the LOC.9

Recognizing the varied case law that preceded OMERS, the Court engaged in a thorough analysis of the jurisprudence. The Court addressed the different approaches taken at length, ultimately refusing the trustees argument that the principles of insolvency law automatically override the autonomy of LOCs as a result of a trustees disclaimer of a lease, such that a landlord is only entitled to draw on an LOC up to the amount of the Preferential Claim.10 The Court then reiterated the autonomy principle applicable to standby LOCs, being that the obligation of the Issuer to a beneficiary of an LOC must at all times be independent of the actual performance of the underlying contract (i.e., the lease)11. The Court noted that such autonomy of LOCs is essential for their commercial risk-minimization function,12 and proceeded to consider a possible exception to the principal of autonomy, being where the beneficiarys request for a draw is fraudulent.

The Court proceeded to look to the language of the lease and the LOC, both of which contemplated the LOC continuing to stand in the event of bankruptcy and disclaimer, significant factors in the Courts conclusion that the landlords draw on the LOC was not subject to the fraud exception to the autonomy principle13. However, an in-depth discussion of this exception to the autonomy principle is outside of the scope of this article. While the Court has provided guidance on how a tenants bankruptcy impacts a landlords ability to draw on a LOC, ultimately, whether the landlord is entitled to draw on an LOC and the amount of same involves a fact-based analysis, taking into account the language of the lease and of the LOC, as well as the circumstances surrounding the draw.

Notice of intention to make a proposal under the BIA

LOCs should also be considered within the context of a tenant that has filed a Notice of Intention to Make a Proposal under the BIA (a NOI).

Once a commercial tenant files an NOI, the tenant has the right to benefit from:

During the stay, the BIA requires the tenant to prepare and file a formal proposal with its creditors. While bankruptcy can be avoided if the tenant is successful in filing its proposal, and having its creditors approve same, if the tenant fails to file the proposal before the end of the stay, or if the creditors do not approve the proposal, the tenant is automatically deemed bankrupt.

Importantly, creditors, including landlords, may be entitled to challenge the stay. Section 69.4 of the BIA allows a creditor to request relief from the stay by providing evidence to the court demonstrating that the continued operation of the stay is likely to materially prejudice the creditor, or that there are other equitable grounds on which the Court should relieve the creditor from the stay.17 Similarly, Section 50.4(11) of the BIA allows a landlord (as a creditor) to seek a declaration for the earlier termination of the 30 day period for filing a proposal or any extension previously granted by the court, upon satisfying the court that:

A recent decision of the Alberta Queens Bench considered whether a landlords demand for payment under an LOC may not fall within the scope of proceedings that are subject to the stay granted under Section 69.1 of the BIA. In Tri-State Signature Homes Ltd, Re the Court held that drawing down on an LOC is outside of the scope of the actions prohibited by a stay, on the basis that a landlords demand for payment under an LOC relates to an obligation owed by the Issuer to the landlord, rather than an obligation of the tenant.18

Court ordered stays under the CCAA

In addition to NOIs under the BIA, it is necessary to consider the impact on an LOC where a tenant applies for, and the Court subsequently issues, an order under Section 11 of the Companies' Creditors Arrangement Act (the CCAA). While the process of restructuring under the BIA is relatively regimented, the CCAA is more flexible and allows the courts significant discretion in making orders that are appropriate in the circumstances to advance the restructuring.

That said, the CCAA also involves a stay of proceedings which restricts creditors from taking steps against the company or its assets, or from terminating contracts with the company (including based on insolvency clauses). One notable difference is how the CCAA deals with LOCs. Section 11.04 of the CCAA contains language clarifying that no order for a stay granted under Section 11.01 has an affect on any action, suit or proceeding against a person, other than the company in respect of whom the order is made, who is obligated under a letter of credit or guarantee in relation to the company.19 As such, except for exceptional circumstances in which the Court exercises its inherent jurisdiction, drawing down on an LOC issued by a third party Issuer to a landlord would not fall within the scope of the activities prohibited by a stay granted under the CCAA.20 Importantly, there is no equivalent to Section 11.04 within the BIA.

Final thoughts

When entering into a lease, a landlord should consider which form of security best meets its specific needs. If it is an LOC, special attention must be paid to, , the form, terms and conditions as well the creditworthiness of the Issuer, among other things. Where a landlord will prefer an irrevocable standby LOC, a tenant may prefer a conditional revocable LOC. There may be limitations on the amount a landlord is permitted to draw upon, and the timing for same, depending on the facts at hand. This includes whether the LOC is worded such that it intended to provide security for rental arrears or for all of a tenants obligations, whether it is to continue to apply in the event the tenant files for bankruptcy or if the lease has been disclaimed, whether there is a stay of proceedings, and if fraud is suspected.

Any entity (including landlords) considering accepting an LOC as security, or holding an existing LOC as security for another entitys performance under an agreement should carefully consider the optimum time to draw down on that security, especially if there have been one or more defaults under the agreement in question, and the likelihood of future defaults. With the unprecedented economic uncertainty caused by the COVID-19 shutdowns, it remains to be seen whether the courts will distinguish the current law even further, in an effort to provide recourse to the aggrieved party.

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Tenant bankruptcies in the COVID-19 era: tenant bankruptcy and letters of credit - Lexology