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Can Landlord Avail Itself of Bankrupt Tenant’s Letter of Credit?

A company was the tenant of a commercial landlord that owned an industrial building. The 2014 lease between them had required the tenant to supply an unconditional letter of credit in the landlord’s favour. It had a principal amount of $2.5 million, a declining balance governed by a stipulated formula, and an initial one-year term to be renewed annually. The letter of credit was intended to secure the tenant’s obligations to the landlord under the lease.  These included any damages or losses arising from the tenant’s failure to pay rent or perform other obligations under the lease, including for bankruptcy-related causes.

The tenant went bankrupt in 2018 and a trustee in bankruptcy was appointed. At that point, the tenant was up-to-date on its rent obligations and had never defaulted on them previously.

The trustee chose this juncture to disclaim the lease between the tenant and the landlord.  The landlord nonetheless drew down the full $2.5 million under the letter of credit, with about $625,000 of it being intended to cover three months’ accelerated rent for the unexpired term of the lease, pursuant to s. 136 of the Bankruptcy and Insolvency Act.

The trustee objected to the landlord taking anything over $625,000.  Although it did not dispute the landlord’s entitlement to three months’ accelerated rent, the rest of the draw-down related to alleged damages for the tenant’s breach of the lease. In the trustee’s view, the proper recourse for redressing the latter was through a court action, not under the letter of credit.

Relying on its disclaimer of the lease, the trustee asked the court’s permission to access the letter of credit funds currently in the landlord’s hands, by way of an order forcing the landlord to repay the trustee any excess amounts received.

The court granted the trustee’s request.  First, it confirmed the landlord was indeed entitled to draw down about $625,000 for accelerated rent. However, once the tenant made an assignment in bankruptcy, it ceased to have the right to deal with its property; those rights passed to the trustee instead.

Here, the trustee had validly exercised its option to disclaim the lease. In law, this operated as a voluntary surrender of the lease with the consent of the landlord, which in turn extinguished all further obligations by the tenant, under its terms.

This also meant the landlord was not entitled to draw on the letter of credit, even though it had been provided by the tenant as security.  That document had merely afforded the landlord protection for any rent amounts owed up to the date of the disclaimer – but not thereafter.

The court ordered the landlord to pay the trustee about $1.875 million, which was $2.5 million less the three months’ accelerated rent of about $625,000.  See 7636156 Canada Inc. v. OMERS Realty Corporation, 2019 ONSC 6106.