Letters of Credit as security in a Commercial Lease - Court of Appeal Provides Certainty
In the commercial leasing context when a landlord and tenant enter into a long term lease, they are making serious financial commitments to each other. Often a landlord is taking a chance on a small business owner who doesn't necessarily have the deepest pockets. The landlord regularly makes serious financial commitments to the tenant including paying commissions to a leasing broker, constructing certain improvements in the leased premises, etc.
Generally speaking, a landlord can request security to cover some of these risks and the tenants obligations under the lease by requesting a security deposit to help secure the tenant's obligations under the lease. For additional security, they can also require that the tenant provide them with a standby demand letter of credit. The landlord will then include in the lease a list of those circumstances when it will be permitted to draw on the letter of credit. These circumstances may include significant damage to the leased premises, non-payment of rent, etc. The letter of credit has long been a favourite form of security for landlords because of how it was treated in a tenant bankruptcy or insolvency scenario. The prevailing wisdom was that the letter of credit is an independent contract between the bank that issued the letter of credit and the landlord who is the beneficiary of the letter of credit, and so if the tenant or its trustee disclaims the lease, the letter of credit wouldn't be subject to the same kind of restrictions that attach to security deposits held by a landlord - in particular capping what a landlord can recover from a bankrupt tenant to three months' rent.
However, in recent trial level decisions, courts have muddied the waters somewhat and held that the amount that a landlord can recover from a standby demand letter of credit held as security by a landlord is in fact subject to the Bankruptcy and Insolvency Act (Canada), provisions which cap what a landlord can recover from an insolvent tenant to three months rent.
The Ontario Court of Appeal in its decision in 7636156 Canada Inc. (Re), 2020 ONCA 681, has reversed the course of recent trial level decisions in finding that a letter of credit is valid security for the obligations of a tenant under a commercial lease and the ability of the landlord to draw down on the letter of credit will turn on the specific wording of the lease - if the lease and the letter of credit provide that a landlord is able to draw down on the letter of credit in the event of an insolvency, the landlord may do so, and the amount it can draw down under the letter of credit will not be limited by the statutory provisions of the Bankruptcy and Insolvency Act limiting the Landlord's ability to recover to three months rent if the lease is disclaimed.
This decisions of the court of appeal is very good news for landlords who require the security that letters of credit provide to reduce their risks in commercial tenancies. It also provides the necessary certainty to both parties to know how a letter of credit will be treated in an insolvency scenario. For a very thorough examination of this decision, please follow this link for a great analysis by McCarthy Tétrault LLP of the decision and other recent decisions:. For assistance in commercial leasing matters, including advice on structuring the security deposit and letter of credit provisions of a lease, please reach out to Northview Law by scheduling a consultation here.