The coronavirus pandemic is having a devastating impact on the global economy and has caused economic activity to grind to a halt. The ongoing global crisis will unfortunately push many businesses into bankruptcy. There are significant implications for commercial landlords and tenants from the resulting financial crisis.
When tenant insolvencies arise, commercial landlords are often faced with precarious situations. If a bankruptcy order is granted by the court, this order will stay all proceedings and actions against the tenant. This precludes the landlord from exercising its rights of distress and terminating the commercial lease. The following paragraphs will assess a commercial landlord’s remaining rights and remedies and will provide our recommendations for commercial landlords.
Federal and provincial legislative scheme
Tenant bankruptcy under a commercial lease is governed by federal and provincial legislation that impose strict limitations in relation to recovering rental arrears, accelerated rent and rent for the unexpired portion of the commercial lease. The federal legislation applicable to tenant bankruptcy is the Bankruptcy and Insolvency Act1 (BIA), which sets out a distributive scheme relating to the bankrupt tenant’s estate. Applicable provincial legislation is the Alberta Landlord’s Rights on Bankruptcy Act2 (LRBA).
The federal BIA describes the preferential claim of a commercial landlord where a tenant goes bankrupt and prescribes a scheme of distribution of the proceeds realized from the bankrupt’s property. Moreover, a stay of proceedings is automatically imposed by a bankruptcy order. The provincial LRBA further limits a commercial landlord’s remedies.
Section 136(1)(f) of the BIA limits a landlord’s preferred claim to three months of arrears immediately preceding the bankruptcy and three months of accelerated rent, if the commercial lease provides for accelerated rent. The landlord’s claim ranks subsequent to a secured creditor’s claim. Under sections 3 and 4 of the LRBA, a landlord has no right to claim as debt any money due to the landlord from the lessee for any portion of the unexpired term of the commercial lease (beyond the landlord’s preferred claim to three months of arrears and three months of accelerated rent referred to above).
Types of security
Generally speaking, there are five types of security a landlord can take under a commercial lease: (a) cash deposit from a tenant; (b) irrevocable letter of credit issued by the tenant’s lender; (c) guarantee or indemnity from a third party unsecured or secured by a letter of credit or other security; (d) a loan from a related company to the commercial landlord to the tenant; or (e) other forms of collateral security such as a collateral charge on personal property or real property granted by the tenant or a third party.
Security deposits, sureties from third parties and letters of credit
Security deposits are vulnerable to being challenged in court, as demonstrated in the Alberta Court of Appeal decision Surefire.3 This case dealt with a landlord holding a large cash deposit from a bankrupt tenant, and the court held that such deposit was a security deposit rather than prepaid rent. Consequently, the court determined the deposit was not the landlord’s property but rather formed part of the bankrupt tenant’s estate and had to be returned to the tenant.
Given the case law and the court’s classification of deposits, it is likely that a better solution than relying on a security deposit is to seek a surety from a third party in the form of a guarantee or indemnity either unsecured or secured by a letter of credit or other security or requiring a letter of credit from the tenant’s lender. Pursuant to obiter dicta by the Supreme Court of Canada in the Crystalline decision,4 landlords may be able to claim against a third-party guarantor or indemnifier after a commercial lease has been disclaimed by a trustee in bankruptcy, as the guarantee or indemnity will not be discharged by the termination or disclaimer of the commercial lease. The same reasoning should apply to a letter of credit.
This reasoning, however, has been cast into doubt by the OMERS decision,5 which resurrected what is commonly known as the Cummer-Yonge6 line of cases and limited the recovery by the landlord under a letter of credit from a third-party bank to the three months’ accelerated rent due under the commercial lease.7 Given the OMERS decision, commercial landlords may want to consider obtaining an indemnity from a third party secured by a letter of credit from the indemnifier’s lender, instead of seeking a letter of credit from the tenant’s lender. A further alternative would be for the landlord to have another company make a loan to the tenant and for the loaning company to collaterally secure this amount by way of security agreement or other security.
Given the foregoing, our conclusions are:
- Letters of Credit. Commercial landlords may wish to seek a letter of credit either from the tenant’s lender or its indemnifier’s lender.8 While we believe a letter of credit likely survives a tenant’s bankruptcy (based on Crystalline), we note the OMERS case casts some doubt on this. Until this point is settled, it is likely preferable for commercial landlords to take an indemnity and if necessary collaterally secure the indemnity with a letter of credit or other security.
- Loans to Tenants. A commercial landlord may wish to consider is having a third-party company make a loan to the tenant and for such loan company to collaterally secure this amount by way of security agreement or other security.
- Indemnities. A common practice in commercial leasing is to use indemnities instead of guarantees. An indemnity may be included in a section of the commercial lease (and the indemnifier should be a party to the lease) or in a separate indemnity agreement (among the landlord, indemnifier and the tenant). Indemnities are generally regarded as preferable security by most commercial landlords, given an indemnity agreement is likely enforceable against the indemnifier notwithstanding the bankruptcy of the tenant (based on Crystalline).
- Prepaid Rent. Pursuant to the Alberta Court of Appeal’s reasoning in the Surefire case, the characterization and function of a deposit is relevant as to whether a landlord can retain such funds where a tenant goes bankrupt. Unless the amount being held under the commercial lease constitutes prepaid rent (rent paid and retained by the landlord prior to the term to cover a prepaid rent payment), it is not the landlord’s property and will likely remain the property of the bankrupt tenant’s estate. Describing the amount being held under the commercial lease as prepaid rent instead of a security deposit may be an option if sureties from third parties are unavailable to the landlord. However, given the Surefire case, if the amount being held under the commercial lease is not truly prepaid rent, such an option will likely fail.
- PPSA Considerations. If the commercial lease contains a security deposit, a landlord may register the interest and subsequently file a financing statement to perfect its interest in accordance with the Alberta Personal Property Security Act9 (the PPSA), provided the commercial lease creates a security interest in the deposit. The required time, effort and cost requirements of registering may, however, outweigh potential benefits, especially where the deposit amount is not substantial. Such registration would be subordinate to all other registrations that might have priority under the PPSA. In addition, such security agreement may not be enforceable against secured creditors in the event of the tenant’s bankruptcy as described below.
- Security Agreements. There may be a strong argument, pursuant to Ontario case law,10 that upon a tenant’s bankruptcy, the obligations of a tenant end and any security taken by a landlord regarding the tenant’s obligations yet to be performed under the commercial lease is unenforceable. As a result, a landlord may lose its security interest and become a preferred creditor pursuant to section 136(1)(f) of the BIA. Secured creditors would then have priority over the landlord’s preferred claim notwithstanding the security agreement granted by the tenant to the landlord. According to case commentary and obiter comments in Natco,11 it may be possible to draft a security agreement with language stipulating that a landlord’s security interest in respect of the obligations of a tenant survives bankruptcy, however, there is currently no case law to support this and it may be contrary to the current trends in the law.
- Enforcing Remedies. If a tenant defaults on its commercial lease by failing to pay rent, a landlord should immediately take action and consider enforcing its remedies as soon as possible, including immediately applying any security deposit being held against amounts owing.
The authors would like to thank Oliver Zachmann, articling student, for his contribution to this legal update.
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