The Ontario Court of Appeal recently ruled that a landlord was entitled to draw the full amount of its tenant’s $2.5 million letter of credit following the tenant’s bankruptcy.

Commercial Tenant Required to Take Out Letter of Credit

The tenant had leased an industrial building from the landlord. The term of the lease was ten years, commencing on May 1, 2014 and expiring on the last day of April 2024.

The lease required the tenant to arrange a letter of credit in the amount of $2.5 million in favour of the landlord as beneficiary for an initial term of one year, renewed annually on an automatic basis. The lease also stipulated that the letter of credit was to continue to stand as security should the tenant become bankrupt. The tenant therefore arranged for an irrevocable standby letter of credit on May 2, 2014 in the amount of $2.5 million in favour of the landlord as beneficiary, which was renewed annually.

The tenant made an assignment in bankruptcy on May 1, 2018. A trustee was appointed for the bankrupt tenant’s estate. The trustee disclaimed the lease on July 23, 2018.

Following the tenant’s assignment in bankruptcy, the landlord made three demands to draw on the letter of credit up to its full amount of $2.5 million. The draws covered the following losses claimed by the landlord:

(a)      $207,732 for rent for May 2018;

(b)      $1,621,160 for rent for the months of August 2018 through to and including April 2019;

(c)      $368,479 for the unamortized cost for the landlord allowance as per the terms of the lease, inclusive of interest; and

(d)      $302,628 for restoration costs, as per the terms of the lease.

On a motion brought by the trustee, the motion judge determined that the landlord was only entitled to draw on the letter of credit to recover the amount of its preferred claim for three months’ accelerated rent under s. 136(1)(f) of the Bankruptcy and Insolvency Act (the “BIA”). In the alternative, the motion judge concluded that, in accordance with the terms of the lease, the letter of credit should have been reduced to approximately $1.35 million on May 1, 2017, with the landlord’s draws limited to the reduced amount.

The landlord appealed. It submitted that the independent obligations created by the letter of credit between the bank and itself as beneficiary were not affected by the trustee’s disclaimer of the lease. Nor, on a proper interpretation of the lease, did the amount of the letter of credit reduce in May 2017.

Court of Appeal Rules that the Landlord Was Entitled to Draw Full Amount

The court began by explaining that a fundamental characteristic of a standby letter of credit is its autonomy from the underlying transaction between the applicant and the beneficiary. The general rule is that an issuing bank is obliged to honour a draft under a documentary credit when the tendered documents appear on their face to be regular and in conformity with the terms and conditions of the credit.

However, an exception exists to the principle of autonomy of letters of credit. The exception arises in the case of fraud by the beneficiary.

In this case, the court found that the trustee had not demonstrated that the landlord’s conduct fell within the fraud exception to the principle of autonomy of letters of credit. Therefore, the court found that the landlord had been entitled to draw on the letter of credit to the amount available.

Additionally, the court rejected the trustee’s argument that, where the trustee of a bankrupt tenant has disclaimed a lease, the principles of insolvency law override the autonomy of letters of credit so as to limit the right of a landlord to draw on a letter of credit to a claim for three months’ accelerated rent. The court stated:

“To accept the Trustee’s position would, in effect, be tantamount to accepting the proposition that the BIA does not permit a landlord to take security from its tenant, through the vehicle of a letter of credit, that would exceed the amount of a claim for accelerated rent under BIA s. 136(1)(f). Yet, the BIA does not contain any such language of limitation or prohibition.”

Therefore, the court concluded that the motion judge erred in limiting the landlord’s entitlement to draw on the letter of credit to its preferred claim under BIA s. 136(1)(f) for three months’ accelerated rent and the landlord had been entitled to draw up to the full amount available under the letter of credit.

As a result, the court allowed the appeal and set aside the order of the motion judge.

Get Advice

Entering in to a commercial lease represents a huge financial commitment and comes with significant legal risk. Because of this, it is critical for both landlords and tenants to obtain the advice of an experienced commercial leasing lawyer when negotiating a commercial lease and certainly before finalizing any agreement.

At DBH Law in Calgary, our experienced commercial real estate lawyers help our clients manage the risks of commercial leasing by providing trusted guidance in all aspects of their leasing affairs.

Contact the experienced commercial real estate team at DBH Law in Calgary to see how we can help you through your commercial leasing matters. We work with our clients every step of the way, negotiating for you and protecting your interests in the event of a dispute. Please reach out to us online or by phone at 403.252.9937 to talk today.