The landlord, the trustee in bankruptcy and the deposit: Who is entitled to the deposit when a tenant files for bankruptcy?

23 April 2020

As the economic crisis brought on by the novel coronavirus (COVID-19) pandemic deepens, commercial landlords would be wise to review the deposit language contained in their leases with their counsel. In particular, the wording of the rent deposit and security deposit provisions should be examined more closely and consideration given to who would be entitled to the deposit in the context of a tenant bankruptcy.  This is especially important for commercial landlords who are currently dealing with defaulting tenants or are negotiating rent abatement and/or deferral arrangements with their tenants.

This article will address who, in a tenant bankruptcy, is entitled to the deposit paid by a tenant in respect of a commercial lease: the landlord or the tenant's trustee in bankruptcy? Typically, when a tenant becomes bankrupt and a trustee looks to collect the assets of the tenant, a deposit that is provided as prepaid rent is the property of the landlord and cannot be seized by the trustee. However, a deposit that is provided to secure the performance of a tenant's covenants under a lease remains the property of the tenant, and would likely vest in and have to be surrendered to its trustee. The classification of a deposit as either a rent deposit or as a security deposit is fact-specific and will depend in each instance on the wording of the lease.

Prepaid rent

In Champion Machine & Tool Co, Re, 1971 CarswellOnt 59 (Ont SC) ("Champion"), the Court considered the history of case law going as far back as 1921 and confirmed that an amount of money paid by a tenant to a landlord as prepaid rent cannot be recovered by the tenant's trustee in bankruptcy on the basis that the trustee can have no higher right to recover the prepayment of rent than the bankrupt tenant; since the tenant is not entitled to a refund of prepaid rent, neither is the bankruptcy trustee. 

Of particular note in Champion is that even though the lease indicated that the deposit was made to secure the performance of the covenants of the tenant thereunder, it also expressly stipulated that the remainder of the deposit was to be "applied to rent for the last month of the term", resulting in its characterization as prepaid rent.

Security deposit

Conversely, in a subsequent case, L & W Distributors Ltd (N & D Supermarkets), Re, 1973 CarswellOnt 75 (Ont SC) ("L & W Distributors"), the Court held that a deposit that was being held by the landlord to secure the performance by the tenant of the terms and conditions of the lease (similar to Champion) was in fact a security deposit because the lease went a step further and also stated that the balance of the deposit was to be returned to the tenant at the expiration of the term.  

While the Court did find the deposit to be a security deposit in L & W Distributors, it also held that the tenant had defaulted on the covenant to pay rent multiple times and, as a result, the deposit was allocated to remedy such breaches as far as the deposit would extend.

Intention of the parties

The findings in the above-noted cases highlight the importance of reviewing the lease as a whole to determine how a deposit would be characterized. The language of the lease will not be the only thing that the court will study. The intention of the parties will also be considered, as was the evidenced in a more recent case from Alberta, Alignvest Private Debt Ltd v Surefire Industries Ltd, 2015 ABQB 148 ("Alignvest"), aff'd York Realty Inc. v Alignvest Private Debt Ltd., 2015 ABCA 355. In Alignvest, the Court was tasked with determining whether the landlord was entitled to retain the deposit, or whether the deposit should be remitted to the trustee as part of the tenant's estate, and ultimately subject to the claim of a secured creditor.

The Alberta Court of Queen's Bench applied a number of principles that a court should use when trying to determine what the parties intended to be a deposit's purpose, starting with the language of the lease itself. In finding that the deposit at issue was a security deposit rather than prepaid rent, the Court considered a number of factors, including, without limitation, the following:

  1. The deposit was defined as a security deposit in the lease and was to be held "as security for the performance by the tenant of its obligations under the lease";
  2. The tenant paid a separate rent deposit pursuant to the lease;
  3. If, at any time during the term, the landlord utilized any portion of the deposit, the tenant was obligated to "top it up" (which is inconsistent with the concept of a prepaid rent deposit, but consistent with the concept of a security deposit);
  4. Provided the tenant had performed all of its obligations under the lease and it was not then in default, the deposit was to be applied towards payment of rent during specific months of the tenancy (which is consistent with the concept of a prepaid rent deposit),but such credit was not to occur until later dates, none of which had occurred at the time that the lease was disclaimed; and
  5. In an event of default, the landlord was entitled to use the deposit to cure any such default, yet the landlord had not exercised this right with respect to past late rental payments.

The Alberta Court of Appeal affirmed the bankruptcy judge's decision. While the lease contained indicia that pointed in both directions, the Court held that the dominant intention of the parties was that the deposit be characterized as a security deposit.

The finding in Alignvest confirms the general principle set out above: a security deposit becomes part of the estate of a bankrupt tenant, whereas prepaid rent, which is not repayable to a tenant (and, by extension, to its trustee in bankruptcy), remains the property of the landlord.

Application in the context of COVID-19

As most commercial landlords are well aware, the on-going COVID-19 pandemic is already impacting the ability of many commercial tenants in remitting their rent payments.  As time continues to pass, the financial impact on businesses will increase, possibly pushing some into bankruptcy proceedings, and the inability of tenants to sustain on-going rental payments will become more pronounced. As such, it is imperative for commercial landlords to review their leases now, and, provided the language allows it, consider applying existing security deposits towards rent shortfalls at this time (such as, for example, as part of a rent deferral agreement), rather than waiting until a tenant is teetering on the edge of bankruptcy. Timing here is key; certain transactions (such as applying security deposits to outstanding rental payments) can be more easily challenged or reversed by a Court if made too close to or following a tenant's bankruptcy filling. If the tenant has a precarious financial situation, acting as early as possible is in the landlord's interest. Knowing who is likely entitled to the deposit is a key piece of information that can assist the landlord in making the decision of if, how, and when to act to enforce the landlord's rights under the Lease.

Given all of the complexities involved in making the foregoing assessments, and the fact-specific nature of each determination, we encourage you to involve a lawyer in this process.

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