Commercial Tenancies, Letters of Credit and Bankruptcy

By Eric Lay of Merovitz Potechin LLP on Thursday January 21, 2021.

One method used by commercial landlords to secure against losses from commercial tenancies is to require tenants to post letters of credit (“LCs”), that the landlord can draw upon in defined circumstances.

Though certainly useful, in Ontario there has been uncertainty over what amounts landlords can draw upon from an LC where a tenant becomes insolvent and a trustee in bankruptcy disclaims the lease (as it is entitled to do under s. 30(1) of the Bankruptcy and Insolvency Act, and s. 39(1) of the Commercial Tenancies Act).   Under these statutes, a trustee’s claim for the unexpired term of the lease is limited to a preferred claim to three months’ accelerated rent (if the lease so provides). 

In a recent case at the Ontario Court of Appeal, a trustee in bankruptcy attempted to argue that a landlord’s draw on a letter of credit posted by its tenant was limited to the three months accelerated rent permitted by statute.  The Court disagreed and held that in the case before it the landlord was entitled to draw on the LC for the full value of its claimed losses.

The Court went through a detailed analysis of the interplay between the law governing  letters of credit and insolvency law and held, in essence, that where leases and LCs are drafted such that the LCs are independent or autonomous obligations, the landlord’s right to claim under the LC is unaffected by a trustee’s disclaimer.  The “autonomy principle,” properly applied, means that where the LC is created as an obligation independent of the underlying transaction it secures – a lease, in this case – the rights of the beneficiary of the LC are not affected by the bankruptcy of the tenant.

This decision brings some certainty to what has been a difficult area and is good news for commercial landlords – at least for the moment.  The trustee in this case has sought leave to appeal the decision to the Supreme Court of Canada, and the matter may end up in front of that Court for reconsideration.   For now, however, landlords already secured by properly drafted tenant LCs can breathe a bit easier knowing that their security will survive a tenancy bankruptcy, and landlords looking for ways to secure commercial tenancies against insolvency risk should consider letters of credit.

How our lawyers can help with Commercial Tenancies

If you have any questions or need assistance with a dispute regarding insolvency or a commercial tenancy, contact our commercial litigation team. For advice on drafting leases and security for landlords, contact our business law team.