Court File and Parties

COURT FILE NO.: BK-18-2372959-0031 DATE: 2019-10-22

SUPERIOR COURT OF JUSTICE – ONTARIO COMMERCIAL LIST (IN BANKRUPTCY AND INSOLVENCY)

RE: IN THE MATTER OF THE BANKRUPTCY OF 7636156 CANADA INC., OF THE CITY OF VAUGHAN, IN THE PROVINCE OF ONTARIO

BEFORE: Hainey J.

COUNSEL: Harvey Chaiton, for the Trustee in Bankruptcy, Fuller Landau Group Inc. S. Michael Citak, for the Landlord, OMERS

HEARD: July 12, 2019

ENDORSEMENT

BACKGROUND

[1] This is a motion by the Fuller Landau Group Inc., in its capacity as the trustee in bankruptcy (“Trustee”) of 7636156 Canada Inc. (“Bankrupt”) for a determination of the amount the Bankrupt’s landlord, OMERS Realty Corporation, (“Landlord”) was entitled to draw down on a letter of credit provided by the Bankrupt to the Landlord as security for the Bankrupt’s obligations under a lease, and for an order for payment to the Trustee of any excess amount received by the Landlord under the letter of credit.

FACTS

[2] The Landlord owns an industrial building in Vaughan, Ontario (“Premises”). The Bankrupt previously carried on business at the Premises.

[3] The Bankrupt and the Landlord entered into a lease for the Premises in February 2014 (“Lease”).

[4] On July 23, 2018 the Trustee disclaimed the Lease. At the time the Bankrupt’s rent was up to date and there had been no events of default under the Lease.

[5] The Lease required the Bankrupt to provide the Landlord with an unconditional letter of credit in favour of the Landlord in the principal amount of $2.5 million for an initial term of one year, to be reviewed annually. (“LC”)

[6] Schedule C to the Lease provides that the LC was to be held by the Landlord for the following purpose:

The Letter of Credit shall be held by landlord as security for indemnification of Landlord in respect of any losses, costs or damages incurred by Landlord arising out of the failure by Tenant to pay Annual Rent or any other amounts payable under this Lease or resulting from any failure by Tenant to observe or perform any obligations contained in this Lease or resulting from any default under this Lease or resulting from any termination, surrender, disclaimer or repudiation of this Lease whether by Landlord as a result of the default of Tenant or in connection with any insolvency or bankruptcy of Tenant or otherwise.

[7] There are provisions in the Lease that provide for the reduction in the principal amount of the LC as follows:

If Tenant is not then and has not been in default of its obligations under this Lease and has at all times promptly paid all Rent throughout the Term, the Letter of Credit shall decline in value as set out in subparagraph (b) below (the value of the Letter of Credit from time to time being hereinafter referred to as the “Principal Amount”)

Section 2(b)(i) of Schedule C provides as follows:

(i) on the thirty-seventh (37th) month of the initial Term, the Letter of Credit may be reduced by an amount equal to fifty percent (50%) of the Permitted Decline Amount (as herein defined) …

For the purposes of Paragraph 2(b) of Schedule C, “Permitted Decline Amount” means: a sum equal to (I) Two Million, Five Hundred Thousand Dollars ($2,500,000), less (II) an amount equal to the Annual Rent, the estimated Operating Costs and Taxes, and HST thereon, payable by Tenant for the last month of the initial term.

[8] The Trustee and the Landlord agree that, to the extent that the above noted conditions to reduction of the LC are met, on the 37th month of the initial term of the Lease, the closing balance of the LC would have been $1,357,135.53.

[9] Although the Landlord acknowledges that there were no events of default under the Lease prior to the Bankrupt’s bankruptcy, it claims that rent was not paid promptly by the Bankrupt on a number of occasions. The Landlord did not, at any time prior to May 1, 2017 inform the Bankrupt that it was not paying rent promptly.

[10] In May 2014 the Bank of Nova Scotia (“BNS”) issued the LC that was renewed annually thereafter. The LC was issued ‘in connection with lease payments and lease defaults for’ the Premises.

[11] The Bankrupt deposited $2.5 Million with BNS to secure BNS’ obligation under the LC. The LC does not include a covenant from BNS to perform the Bankrupt’s obligations under the Lease.

[12] Since the disclaimer of the Lease by the Trustee the Landlord has fully drawn the $2.5 Million under the LC. The $2.5 Million received by the Landlord is on account of the following:

(a) $207,732.28 for rent for May 2018;

(b) $1,621,160.72 for rent for the months of August 2018 through to and including April 2019;

(c) $368,479 for the unamortized cost for the Landlord Allowance (inclusive of interest); and

(d) $302,628 for restoration costs.

[13] The Landlord delivered a proof of claim to the Trustee dated May 17, 2018 (“Proof of Claim”) in the amount of $623,196.84 for three months’ accelerated rent for the months of May, June and July 2018. The Landlord noted in the Proof of Claim that it reserved the right to claim under the LC for damages for lost rent for the balance of the term, restoration costs, and unamortized costs of the Landlord Allowance.

[14] The Trustee did not dispute that the Landlord was entitled to $623,196.84 for three months’ accelerated rent under the Lease and in accordance with section 136(1)(f) of the Bankruptcy and Insolvency Act, R.S.C. 1985, c. B-3, as amended (“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.

ISSUE

[15] The sole issues that I must decide is the amount the Landlord is entitled to draw under the LC as a result of the disclaimer of the Lease by the Trustee.

POSITIONS OF THE PARTIES

[16] The Trustee submits 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. In the alternative, the Trustee submits that the Landlord was only entitled to draw up to a maximum of $1,357,135.53 under the LC because the terms of the Lease required the principal amount of the LC to be reduced to this amount as of May 1, 2017.

[17] The Landlord submits that it was entitled to draw down on the entire amount of the LC in the amount of $2.5 Million, both pursuant to the LC and the terms of the Lease. Further, it is the Landlord’s position that the Trustee “cannot obtain redress against the Landlord under the LC”.

ANALYSIS

[18] I have concluded that the Landlord was only entitled to draw $623,196.84 on the LC for three months’ accelerated rent for the following reasons.

[19] 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, subject to the BIA and to the rights of its secured creditors, immediately passed to and vested in the Trustee.

[20] The Bankrupt’s property included its rights as a tenant under the Lease. Pursuant to s. 30(1)(k) of the BIA and s. 38(1) of the Commercial Tenancies Act, R.S.O. 1990, c. L. 7. as amended (“CTA”), the Trustee was entitled to disclaim the Lease, which it did on July 23, 2018.

[21] 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, among other things, the priority claim provided in s. 136 of the BIA.

[22] A landlord’s preferred claim in a bankruptcy is set out in s. 136(1)(f) of the BIA as follows:

… for arrears of rent for a period of three months immediately preceding the bankruptcy and accelerated rent for a period not exceeding three months following the bankruptcy if entitled to accelerated rent under the lease, but the total amount so payable shall not exceed the realization from the property on the premises under lease, and any payment made on account of accelerated rent shall be credited against the amount payable by the trustee for occupation rent.

[23] There is no dispute that the Landlord has a preferred claim in the amount of $623,196.84 for three months’ accelerated rent which it was entitled to draw on the LC.

[24] However, the law in the Province of Ontario has been well settled for over 80 years that a disclaimer of a lease by a trustee in bankruptcy 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.

[25] This principle was established in Re Mussens Ltd., 1933 CarswellOnt. 52 (S.C.). In Mussens the tenant was in liquidation and the liquidator surrendered possession of the leased premises to the landlord’s trustee in bankruptcy. In response to the trustee’s claim that it was entitled to damages for future rent Chief Justice Rose held at para. 6 as follows:

6. I think that by his letter of April 21, 1932, confirmed in his letter of June 21, 1932, the liquidator exercised his right to ‘surrender possession or disclaim’ the lease, and that when he had exercised that right the obligation of the tenant, the insolvent company, to pay rent was at an end. It did not require a statute to confer upon the liquidator power to surrender possession or disclaim the lease with the consent of the lessor; the statute means I think that whether the lessor is or is not willing the liquidator may surrender possession or disclaim the lease, and that if he does so surrender possession or disclaim the lease the tenant in liquidation shall be in the same position as if the lease had been surrendered with the consent of the lessor. Of course if the lease were surrendered with the consent of the lessor there could be no suggestion of any further liability on the part of the lessee to pay rent and no suggestion that by failing to pay rent the tenant was committing a breach of covenant and was rendering himself liable for liquidated or unliquidated damages.

[26] Chief Justice Rose further concluded at para. 7 that no damages can be recovered by a landlord for breach of the tenant’s covenant in a lease for the following reasons:

… the Ontario statute contains no similar saving of the rights of the lessor, and I think that the result is that in Ontario the liquidator has been given a statutory right to commit a breach of the insolvent’s covenant, and that no right of compensation for the statutory breach having been given to the covenantee no damages can be recovered.

[27] The principles enunciated by Chief Justice Rose in Mussens have repeatedly been applied to a disclaimer of a lease by a trustee in bankruptcy. For example, in Cummer-Yonge Investments Ltd. v. Fagot, 1965 CarswellOnt. 4 (S.C.). Chief Justice Gale adopted the reasoning in Mussens and held at paras. 15 and 17 as follows:

15. Apart entirely from this decision, however, I am not persuaded that a disclaimer of a lease by a trustee in bankruptcy has the consequence contended for by counsel for the plaintiff in this action. Assuming, for purposes of argument, that his submission that the sole effect of the trustee’s disclaimer is simply to divest him of his entire interest in the lease is correct, it nevertheless does not follow in law that that interest thereupon reverts to the bankrupt tenant. As indicated previously, whatever interest the tenant had in the lease prior to bankruptcy was, by operation of s. 41(5) of the Bankruptcy Act, vested in the trustee upon the filing of the assignment. In my view, when the trustee subsequently disclaimed that interest, all the rights and obligations which he inherited from the bankrupt were wholly at an end.

16. I therefore find that, upon the bankruptcy of the tenant, all of its rights and obligations under the lease, including its liability to perform the covenant to pay rent, irrevocably passed to the trustee in bankruptcy. After that date, there were no covenants in the lease which the lessee was required to perform, and the defendants’ guarantee of “the due performance by the Lessee of all its covenants in this lease” thereupon became inoperative.

[28] Chief Justice Gale’s decision in Cummer-Yonge was upheld by the Court of Appeal for Ontario.

[29] In Linens N Things Canada Corp., 2009 CarswellOnt. a landlord filed a proof of claim that included costs of building the structure, amounts provided under the lease as tenant’s allowance, and the commission paid on the lease itself by the landlord. The trustee disallowed these claims, which was appealed by the landlord. The Registrar in Bankruptcy reviewed the applicable provisions of the BIA and CTA and, relying on Mussens, dismissed the landlord’s appeal, holding as follows at para. 21:

21. Even more, the CTA and its predecessors, has been found for the better part of a century to have the effect of a consensual ending of the lease, and the cases recognize that this is a statutorily permitted breach for which there is no damage remedy, beyond the s. 38 CTA and s. 136 BIA preferred claim.

[30] The Landlord submits that it only claimed three months’ accelerated rent in the amount of $623,196.84 against the Bankrupt’s estate but that it was entitled to draw on the LC to satisfy its claims of damages for the loss of rent for the balance of the term of the Lease and restoration costs to the Premises and its unamortized costs of the Landlord allowance provided to the Bankrupt.

[31] The Landlord bases its position on the fact that the LC is an ‘autonomous contract between the issuer and the beneficiary’. The Landlord submits that the LC in this case “is an independent third-party obligation” of BNS, “and the proceeds” of the LC “are not the debtor’s property even if it is secured by the debtor’s property”.

[32] According to the Landlord, because of the autonomy of the LC, the Trustee has no legal right to obtain redress from the Landlord under the LC.

[33] I do not accept the Landlord’s submissions for the following reasons.

[34] In Titan Warehouse Club Inc. (Trustee of) v. Glenview Corp., 1988 CarswellOnt. 135 (S.C.), a trustee applied for the determination of the rights of a landlord to claim under a letter of credit following the bankruptcy of the tenant. A letter of credit had been issued to the landlord to ‘guarantee to the Landlord the payment by the Tenant of Rent and Additional Rent payable pursuant to the Lease’. Montgomery, J. concluded that the landlord was only allowed to draw on the letter of credit for rent up to the date of the disclaimer of the lease. He stated as follows at para. 18:

18. In my view, the Cummer-Yonge Investments Ltd, supra, decision is dispositive of the application and the counter-application. The landlord is afforded protection by the letter of credit for any amount of rent owing up to the date of disclaimer but not thereafter.

[35] An appeal by the landlord was dismissed by the Court of Appeal for Ontario for the following reasons at para. 2:

2. In our opinion, the letter of credit incorporated the terms of the lease by reference. Clause 22.00 thereof states that the letter of credit was intended to guarantee to the landlord payment of the rent by the tenant. In our view, the words making the letter of credit payable ‘in the event of the bankruptcy of the tenant’, read in the context of the clause as a whole, must be related to the stated purpose of the letter of credit.

[36] Although Blair J. (as he was) concluded in 885676 Ontario Ltd. (Trustee of) v. Fromet Holdings Ltd., 1993 CarswellOnt. 186 (Gen. Div.) that a landlord could draw down on a letter of credit on the basis that it was security for the tenant’s obligations, the correctness of this decision has been questioned.

[37] In my view, the correct approach was followed by Feldman J. (as she was) in Peat Marwick Thorne Inc. v. Natco Trading Corp. 1995 CarswellOnt. 55 at para. 13 as follows:

With great respect to the decision of Blair J., in my view 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. The result is the same as with a guarantee, if it is a guarantee of the obligations of the tenant. If the obligations of the tenant are released once the lease is disclaimed, then the guarantor of those obligations is no longer guaranteeing performance by the tenant. This was the result in Cummer-Yonge …

[38] The British Columbia Court of Appeal came to the same conclusion in West Shore Venturer Ltd. v. K.P.N. Holding Ltd., 2001 BCCA 279 at paras. 33 and 36 as follows:

33. That brings us to ‘the other obligations of the Lessee in respect of the lease.’ The trustee in bankruptcy surrendered possession three months after the bankruptcy. The effect of the surrender is set out in s. 29(3) of the Commercial Tenancy Act. It is that upon the surrender of possession ‘the tenancy shall terminate’. Once the tenancy has terminated, there cannot be any further obligations of the tenant under the lease, nor do we think that any rights or obligations of the landlord could survive, except perhaps in relation to consequential delivery of real or personal property which cannot justly be retained when the tenancy comes to an end. So the tenancy terminated and all obligations between Doppler and K.P.N. came to an end three months after the bankruptcy. Up to the date K.P.N. had not had to incur any expenditures, nor had it suffered any losses. Any expenditures after that and any losses suffered after that are not losses which can be regarded as arising from a failure of Doppler to discharge ‘other obligations of the Lessee in respect of the lease’ within the meaning of clause 3A.1.

34. In our respectful opinion, Madam Justice Feldman correctly analyzed the cases in Peat Marwick Thorne Inc. v. Natco Trading Corp. The feature which distinguishes the cases where the security for the tenant’s obligations continues is not whether the security is a primary security, like a letter of credit, or a secondary security, like a guarantee. Rather, the key question is: ‘What obligations are secured?’ If the obligations secured are the obligations of the tenant under the lease then the security is no longer security for anything when the obligations of the tenant under the lease come to an end. But where the obligations secured are obligations, perhaps independent obligations, to make good the losses suffered by the landlord by reason of the tenant’s bankruptcy or other default, which might well include damages for loss of rent over the duration of the tenancy, then those separate obligations might well survive the bankruptcy of the tenant.

[39] For all of these reasons I have concluded that the law of the Province of Ontario remains that, upon the disclaimer of a lease by a trustee in bankruptcy, the bankrupt no longer has any obligations owing to the landlord under the lease, and the 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 s. 136(1)(f) of the BIA.

[40] I agree with the Trustee’s submission that this conclusion is not impacted by the Supreme Court of Canada’s decision in Crystalline Investments Ltd. v. Domgroup Ltd., 2004 SCC 3. In Crystalline, a tenant assigned a lease to one of its subsidiaries. The consent of the landlord was not required for the assignment. The terms of the lease provided that “[n]otwithstanding any assignment or sublease the lessee shall remain fully liable under this lease and shall not be released from performing any of its covenants, obligations or agreements in this lease and shall continue to be bound by this lease.”

[41] The assignee filed a notice of intention to make a proposal and gave the landlord notice of its intention to repudiate the lease pursuant to section 65.2 of the BIA, which was not challenged by the landlord. The lease was repudiated effective March 31, 1994. The landlord subsequently sought payment from the assignor, which declined to pay. The landlord commenced an application and obtained summary judgment against the assignor. That decision was reversed by the Court of Appeal for Ontario. The landlord appealed to the Supreme Court of Canada.

[42] Major, J. writing for a unanimous Supreme Court, explained the purpose of s. 65.2 of the BIA as follows at para. 28:

28. I, thus, agree with the Court of Appeal that s. 65.2 should be read narrowly. The plain purposes of the section are to free an insolvent from the obligations under a commercial lease that have become too onerous, to compensate the landlord for the early determination of the lease, and to allow the insolvent to resume viable operations as best it can. Nothing in s. 65.2, or any part of the Act, protects third parties (i.e., guarantors, assignors or others) from the consequences of an insolvent’s repudiation of a commercial lease. That is to say that they remain liable when the party whose behalf they acted becomes insolvent.

[43] At para. 42 Major J. concluded as follows:

42. The House of Lords went on to overrule Stacey v. Hill. In my opinion, Cummer-Yonge should meet the same fate. Post-disclaimer, assignors and guarantors ought to be treated the same with respect to liability. The disclaimer alone should not relieve either from their contractual obligations.

[44] In my view, Major J’s comments do not apply to BNS’ obligations as the issuer of the LC because its obligation to make payment to the Landlord under the LC was wholly dependent on the continued existence of the Bankrupt’s obligations to the Landlord under the Lease. BNS had no independent obligation to make any payment to the Landlord pursuant to the LC unlike an assignor or guarantor who has its own independent contractual obligations with a landlord to perform the tenant’s obligations under the Lease.

[45] For these reasons the Crystalline decision has no impact on my conclusion that the Landlord was only entitled to draw on the LC in the amount of $623,196.84 on account of its claim for three months’ accelerated rent.

[46] In view of my conclusion it is not necessary to decide whether the value of the LC should be reduced to $1,357,135.53 which is the Trustee’s alternative position.

[47] However, if my conclusion that the Landlord is only entitled to recover three months’ accelerated rent is wrong, then I would conclude, on the evidence before me, that the LC should be reduced to $1,357,135.53 for the following reasons.

[48] The terms of the Lease clearly require the LC to be reduced to $1,357,135.53 as of May 1, 2017 if there have been no events of default under the Lease and the Bankrupt has paid rent promptly. I find that the language used in the Lease makes this reduction in value of the LC mandatory if these conditions are met.

[49] There were no events of default under the Lease before the bankruptcy and the delays by the Bankrupt in paying rent were relatively minor. Further, the Landlord never advised the Bankrupt that it had failed to pay rent promptly under the terms of the Lease.

[50] In my view, the term “promptly” means within a reasonable time and not on the actual date that the rent is due. I find that the Bankrupt paid its rent within a reasonable time.

[51] For these reasons I have concluded that the value of the LC was reduced to $1,357,135.53 as of May 1, 2017.

CONCLUSION

[52] For the reasons set out above, the Trustee’s motion is successful. There shall be an order requiring the Landlord to pay to the Trustee $1,876,803.14 which is $2.5 Million less three months’ accelerated rent of $623,196.84.

COSTS

[53] The Trustee is entitled to costs of the Motion. If the parties cannot agree on costs they may schedule a 9:30 a.m. attendance with me to settle costs.

[54] I thank counsel for their helpful submissions.

Hainey J.

Date: October 22, 2019