Bankrupt tenant: Can a landlord draw on a letter of credit after the trustee disclaims the lease?

In 7636156 Canada Inc. (Re)[1], the Ontario Court of Appeal ("OCA") confirmed the right of a commercial landlord to draw on a letter of credit given as security pursuant to a lease, even when the draw takes place after the termination of the lease by the tenant's trustee in bankruptcy.  The decision of the OCA provides important guidelines with respect to provisions that should be included in leases and letters of credit to protect the rights of landlords.

In 7636156, the tenant ("Tenant"), leased an industrial building from the appellant landlord ("Landlord"). The Tenant made an assignment in bankruptcy on May 1, 2018. The Fuller Landau Group Inc. ("Trustee") was appointed trustee of the bankrupt Tenant's estate and disclaimed the lease ("Lease") on July 23, 2018.

Pursuant to the terms of the Lease, the Tenant had put in place a $2.5 million letter of credit ("LOC") from a financial institution (the "Bank") in favour of the Landlord. The LOC was fully cash-collateralized and the Bank registered a financing statement against the Tenant. The Landlord made draws on the LOC after the Tenant's bankruptcy, both before and after the Trustee's disclaimer of the Lease. The draws were for the full amount of the LOC.

The first draw was made on May 16, 2018, before the disclaimer of the Lease. The second and third draws occurred after the disclaimer. The draws covered the following losses claimed by the Landlord:

1. rent for May 2018;
2. rent for the months of August 2018 through to and including April 2019;
3. unamortized cost for the Landlord Allowance; and
4. restoration costs.

In support of each demand, the Landlord provided the Bank with a certificate confirming the indebtedness of the Tenant under the Lease and that the amount "is due and payable to the Beneficiary by [the Tenant], payment of which has been requested from [the Tenant] and has not been received". The Bank accepted the Landlord's draws under the LOC and paid out the full amount of the LOC.

On a motion brought by the Trustee, the motion judge determined that the Landlord was only entitled to draw on the LOC to recover the amount of the Landlord's preferred claim for three months' accelerated rent under s. 136(1)(f) of the Bankruptcy and Insolvency Act. [2] The OCA overturned the decision of the court of first instance.

The appellate Court noted that a fundamental characteristic of standby letters of credit is their autonomy from the underlying transaction between the applicant (the Tenant) and the beneficiary (the Landlord). Disputes between the parties to the underlying contract concerning its performance generally cannot justify a refusal by an issuing bank to honour a draft accompanied by apparently conforming documents. This is the principle referred to as the autonomy of documentary credits.[3]

An exception exists to the general rule that an issuing bank is obliged to honour a draft under a documentary credit. The exception arises in the case of fraud by the beneficiary which has been (a) sufficiently brought to the knowledge of the bank before payment of the draft, or (b) demonstrated to a court called on by the customer of the bank to issue an interlocutory injunction to restrain the bank from honouring the draft.[4] The beneficiary under a letter of credit is not entitled to make a demand for payment under a letter of credit where there is no right to make such demand as between the beneficiary and the applicant under the terms of the underlying contract. However, given the principle of the autonomy of letters of credit, the fraud exception is carefully constrained to protect the commercial utility of letters of credit.

In 7636156, the LOC authorized the Landlord to draw on the Bank by a draft at sight that was accompanied by "your signed statement certifying that the amount drawn under this [LOC] is due and payable to you by [the Tenant] that you have requested payment of the said amount from [the Tenant] and have not received payment". The Bank honoured all three draws made by the Landlord; the OCA inferred that the Bank concluded that the documents presented by the Landlord appeared on their face to constitute complying presentations. The Trustee's position was that the Landlord had no right to make demands on the LOC after the disclaimer of the Lease, with the result that the Landlord's conduct fell within the fraud exception to the autonomy principle. The OCA disagreed.

The terms of the Lease specifically contemplated that the LOC would serve as security for "any losses, costs or damages […] resulting from any termination, surrender, disclaimer or repudiation of this Lease […] in connection with any insolvency or bankruptcy of Tenant or otherwise."

The Lease also specifically contemplated that the LOC would continue to stand as security in the event the Tenant became bankrupt and the Lease was disclaimed in the bankruptcy proceeding:

"If at any time during the term of the [LOC], Tenant defaults in the payment of any Annual Rent or other amounts payable under this Lease or in the performance of any of its other obligations under this Lease or if this Lease is surrendered, terminated, disclaimed or repudiated whether by Landlord as a result of default of Tenant or in connection with any insolvency or bankruptcy of Tenant or otherwise, then Landlord at its option may, in addition to any and all other rights and remedies provided for in this Lease or at law, draw a portion of or all of the Principal Amount of the [LOC], whereupon the proceeds thereof shall be applied firstly towards repayment of the cost of Landlord's Work and other costs referred to above, secondly to compensate Landlord for damages suffered by it as the result of Tenant's default, and the balance, if any, will be returned to Tenant.

The rights of Landlord hereunder, in respect of the [LOC], shall continue in full force and effect and shall not be waived, released, discharged, impaired or affected by reason of the release or discharge of Tenant in any receivership, bankruptcy, insolvency, winding-up or other creditors' proceedings including, without limitation, any proceedings under the Bankruptcy and Insolvency Act (Canada) or the Companies Creditors' Arrangement Act (Canada), or the surrender, disclaimer, repudiation or termination of the Lease in any such proceedings and shall continue with respect to the periods prior thereto and thereafter as if the Lease had not been surrendered, disclaimed, repudiated, or terminated." [Emphasis added.]

In addition, the OCA found significant that the LOC specifically stated that:

"This Credit will not be released, discharged or affected by the bankruptcy, receivership or insolvency of [the Tenant] or by [the Tenant] ceasing to exist … nor by any disclaimer or repudiation of the [Tenant] lease with you."

The OCA therefore found that the agreement between the Landlord and Tenant was that the rights of the Landlord under the Lease in respect of the LOC would continue in full force and effect in the event of the Tenant's bankruptcy, and any disclaimer therein, as if the Lease had not been disclaimed. The Court also found that the terms of the Lease and LOC clearly gave the Landlord the right to draw on the LOC for losses arising from the disclaimer of the Lease in the Tenant's bankruptcy proceeding.

The Court noted that to conclude otherwise would 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), even though the BIA itself does not contain any such language of limitation or prohibition.

The following words of Brown J.A. speaking for the Court of Appeal are particularly important to those involved in the drafting of commercial leases:

"[…] a landlord's entitlement to draw on a letter of credit in a given case will turn on the particular language of the lease and letter of credit. In the present case, […] the Lease specifically provides that the LOC acts as security for indemnification of the Landlord for losses "resulting from any termination, surrender, disclaimer or repudiation of this lease … in connection with any insolvency and bankruptcy or otherwise" and that the Landlord's rights in respect of the LOC were not affected by the disclaimer of the Lease in any bankruptcy proceeding but would "continue with respect to the periods prior thereto and thereafter as if the Lease had not been surrendered, disclaimed, repudiated or terminated." As well, the LOC expressly states that it will not be released, discharged or affected by the bankruptcy of the Tenant or the disclaimer of the Lease."[5]

The important takeaways from this decision are two-fold: A tenant's bankruptcy, or the disclaimer of a lease by a trustee, does not invalidate the autonomy of letters of credit and the independent relationship between their beneficiaries and the issuing banks. However, the ability (or inability) of a landlord to call on a letter of credit for losses or damages arising out of a disclaimer or bankruptcy will be contingent on the language of the lease and letter of credit.