Is a landlord entitled to draw on a letter of credit if a lease is disclaimed by a trustee?
The trustee brought a motion for a determination of the amount that the bankrupt’s landlord was entitled to draw down on a letter of credit provided by the bankrupt to the landlord as security for its obligations under a lease.
The landlord owns an industrial building in Vaughan, Ontario. The bankrupt previously carried on business at the premises. The bankrupt and the landlord entered into a lease for the premises in February of 2014. The lease required the bankrupt to provide the landlord with an unconditional letter of credit (“LC”) in favour of the landlord in the principal amount of $2.5 million for an initial term of one year, to be reviewed annually.
The bankrupt deposited $2.5 million with the Bank of Nova Scotia (“BNS“) to secure BNS’ obligations under the LC. On July 23, 2018, the trustee disclaimed the lease. The landlord subsequently fully drew the $2.5 million under the LC.
The landlord delivered a proof of claim to the trustee in the amount of $623,196.84 for three months’ accelerated rent for the months of May, June and July 2018. The trustee did not dispute that the landlord was entitled to this amount of money both under the lease and in accordance with s. 136(1)(f) of the Bankruptcy and Insolvency Act (the “BIA“). However, the trustee disallowed the proof of claim as the landlord had reserved the right to make a claim for damages for breach of the lease and had not taken into account its draw on the LC for rent for May 2018.
The sole issue for the Court to determine was the amount that the landlord was entitled to draw under the LC as a result of the disclaimer of the lease by the trustee. The trustee argued that the landlord was only entitled to draw $623,196.84 on the LC for three’ months accelerated rent pursuant to s. 136(1)(f) of the BIA. The landlord argued that it was entitled to draw down the entire amount of the LC (i.e. $2.5 million) pursuant to both the LC and the terms of the lease. The landlord submitted that the LC was an independent third-party obligation of BNS, and the proceeds of the LC were not the bankrupt’s property even if the LC is secured by the bankrupt’s property.
Pursuant to s. 71 of the BIA, upon the bankrupt’s assignment in bankruptcy, it ceased to have any capacity to dispose of or otherwise deal with its property, which immediately passed to and vested in the trustee. The bankrupt’s property included its rights as a tenant under the lease.
Sections 146 and 136(1)(f) of the BIA address the rights of the landlord of a bankrupt tenant. Section 146 provides that the rights of landlords are to be determined according to the law of the province in which the leased premises are situated, subject to, inter alia, the priority claim provided in s. 136 of the BIA. Section 136(1)(f) sets out a landlord’s preferred claim in a bankruptcy.
There was no dispute that the landlord had a preferred claim in the amount of $623,196.84 for three months’ accelerated rent. In Ontario, however, disclaimer of a lease by a trustee operates as a voluntary surrender of the lease by the tenant with the consent of the landlord, which extinguishes all obligations of the tenant under the lease. If security taken by the landlord secures the obligations of the tenant under the lease, then when those obligations end, the security can no longer be enforced in respect of obligations yet to be performed. Thus, a landlord is not entitled to draw on a letter of credit provided as security under the lease for any amounts in excess of the landlord’s three months’ accelerated rent preferred claim under the BIA.
The Court held that the landlord was only entitled to draw on the LC in the amount of $623,196.84.
Counsel: Harvey Chaiton of Chaitons LLP for the Trustee in Bankruptcy, Fuller Landau Group Inc. and S. Michael Citak of Gardiner Roberts for the Landlord, OMERS