Court Confirms Autonomy of Letters of Credit, Rules Landlord May Draw for Full Claim Amount

In a recent decision, the Ontario Court of Appeal (Ontario Appeal Court) reversed a lower court decision, which had created much concern among commercial landlords that routinely rely on letters of credit (LCs) to secure their commercial leases. The lower court limited the draw on an LC to the landlord’s preferred claim under the Bankruptcy and Insolvency Act (BIA), namely three months’ arrears and three months’ accelerated rent. The Ontario Appeal Court reaffirmed that the insolvency of the party providing the LC does not override the “autonomy principle” that governs LCs, thereby providing comfort to landlords as to the security provided by their tenants and, more generally, to commercial parties who rely on letters of credit in the ordinary course of their commercial dealings to protect them in the event of insolvency.

BACKGROUND

On October 28, 2020, in 7636156 Canada Inc.(Re) (7636156 Canada), the trustee in bankruptcy (Trustee) of 7636156 Canada Inc. (Bankrupt), brought a motion for determination of the amount that the Bankrupt’s landlord (Landlord) was entitled to draw down on an LC provided to the Landlord as security for the Bankrupt’s obligations under a lease (Lease) and for payment of any excess amount not entitled to be drawn to be paid to the Trustee. To secure its reimbursement obligation to the LC issuer, the Bankrupt had deposited cash collateral with the LC issuing bank.

The Lease was disclaimed by the Trustee following its appointment, pursuant to the provisions of the BIA, after which the Landlord drew on the full amount of the LC to partially satisfy its claims for accelerated rent for the remainder of the term of the Lease, in addition to certain other costs incurred by the Landlord.
The Trustee took the position that the Landlord was only entitled to draw on the LC for three months’ accelerated rent, in accordance with the Landlord’s preferred claim under section 136(1)(f) of the BIA and asked for the excess amount drawn by the Landlord on the LC to be remitted to the Trustee and made available to the creditors of the Bankrupt, in accordance with their legal priorities. The Trustee also argued that because the Bankrupt’s indemnification obligations to the LC issuer for all amounts drawn under the LC were secured by cash collateral, the estate would be deprived of all such funds that would be applied by the LC issuer towards those reimbursement obligations.

Under section 136(1)(f) of the BIA, upon disclaimer of a real property lease by a trustee in bankruptcy, a landlord is entitled to recover as a preferred claim:

1. Rent arrears for a period of three months immediately preceding the bankruptcy, and

2. Accelerated rent for a period not exceeding three months following the bankruptcy, provided that accelerated rent is available under such lease.

Pursuant to the BIA, the total amount payable as a preferred claim cannot exceed the realization from the property on the premises subject to the lease. Further, pursuant to section 146 of the BIA, the rights of landlords in respect of residual unsecured claims are to be determined according to the law of the province in which the leased premises are situated. In Ontario, as a result of sections 38 and 39 of the Commercial Tenancies Act and case law considering such provisions and the effect of a disclaimer, the disclaimer of a lease by a trustee in bankruptcy ends any go-forward obligations owing by the bankrupt to the landlord under the lease, and the landlord has no claim for damages for the unexpired term of the lease beyond its claim for three months’ accelerated rent.

The Landlord’s position was that it is well established that an LC is “an autonomous contract” between the LC issuer and the LC beneficiary and that the LC issuer’s obligation to the LC beneficiary is an independent obligation. Therefore, according to the Landlord, the Trustee had no legal entitlement to obtain redress against the Landlord in respect of the LC, regardless of whether or not the Bankrupt’s indemnification obligations to the LC issuer were secured by the debtor’s property through cash collateral.

Lower Court Decision

In October 2019, the Ontario Superior Court found that the Landlord was only entitled to draw on the LC for three month’s accelerated rent and that the LC issuer’s obligation to make payment under the LC was wholly dependent on the continued existence of the Bankrupt’s go-forward obligations to the Landlord under the Lease, which came to an end upon disclaimer of the Lease by the Trustee in accordance with the law in Ontario.

Ontario Appeal Court Decision

On October 28, 2020, the lower court decision was unanimously reversed by the Ontario Appeal Court, which accepted the Landlord’s position that the LC was a wholly autonomous contract between the LC issuer and the LC beneficiary. The Ontario Appeal Court went on to hold that the autonomy of an LC is not altered by insolvency law and that while a disclaimer ends certain rights and remedies of a landlord as against a bankrupt tenant’s estate, it does not end the rights and remedies of a landlord against third parties, including issuers of LCs.

The Ontario Appeal Court noted that when rendering its decision, the lower court did not have the benefit of the Ontario Appeal Court’s April 2020 decision in Curriculum Services Canada/Services Des Programmes D’Études Canada (Re), which clarified that a trustee’s disclaimer does not operate as a voluntary surrender for all purposes, but only as between the landlord and the bankrupt tenant and its bankruptcy estate.

The Ontario Appeal Court also noted the specific language in the LC and the Lease, both of which were clear that the LC was to secure all losses, costs and damages of the Landlord arising from the insolvency or bankruptcy of the Bankrupt or as a result of any breach, default, termination, surrender, disclaimer or repudiation of the Lease, whether as a result of an insolvency or bankruptcy of the Bankrupt or otherwise.

Additionally, the Ontario Appeal Court clarified the scope of the narrow exception of fraud to the general rule that an issuing bank is obligated to honour a draft under an LC when presented with documents that, on their face, conform with the terms and conditions of the LC. The fraud exception requires some impropriety, dishonesty or deceit, including where the demand can be said to be clearly untrue or false, utterly without justification or made where it is apparent that there is simply no right of payment. It does not apply where there is a legitimate contractual dispute.

Further, the Ontario Appeal Court provided helpful guidelines to LC issuers and their respective duties when presented with LC draw-down documents that, on their face, appear to be compliant. According to the Ontario Appeal Court, in such circumstances an LC issuer does not have a duty to satisfy itself by independent inquiry that the beneficiary has not engaged in fraud. Instead, it is only required to determine whether fraud has been established where it is apparent on the very documents presented to it or when allegations of fraud are brought to the LC issuer’s attention.

Lastly, the Ontario Appeal Court considered whether the LC arrangements offended the “anti-deprivation” rule that was recently acknowledged on October 2, 2020, by the Supreme Court of Canada in Chandos Construction Ltd. v. Deloitte Restructuring Inc., because the bankruptcy estate would be deprived of the cash collateral and concluded that they did not.

It remains to be seen whether the Trustee will seek leave to appeal to the Supreme Court of Canada.

While not considered in the decision, the Ontario Appeal Court’s decision in 7636156 Canada is consistent with the 2019 decision of the Saskatchewan Court of Appeal (Saskatchewan Appeal Court) in Veolia Water Technologies, Inc. v. K+S Potash Canada General Partnership (K&S Potash). 

In K&S Potash, the Saskatchewan Appeal Court also confirmed that an issuer is required to honour a draw on an LC when it is accompanied by documents, which on their face, appear to be in compliance with the terms of and conditions of the LC, unless there is a strong prima facie case of fraud.

The Saskatchewan Appeal Court considered the circumstances in which an LC beneficiary can be enjoined from drawing on an LC on the basis that, notwithstanding the terms of the LC itself, the draw would breach an agreement between the beneficiary and the LC applicant as to the circumstances in which a draw can be made.

In coming to its decision, the Saskatchewan Appeal Court also emphasized the importance of maintaining the predictability of law and certainty of commercial relations and confirmed that an essential characteristic of LCs is that the obligation of the LC issuer to pay exists, independent of any dispute among the parties about the performance of the underlying contract.

The Saskatchewan Appeal Court did not go as far to say that an LC beneficiary could never be enjoined from drawing on an LC and raised the possibility that, on different facts, it may be arguable that a beneficiary could be enjoined from drawing on an LC such as where there is a clear breach of an express contractual restriction on the conditions that must be satisfied in order to draw on the LC. However, on the facts of that case, the Saskatchewan Appeal Court found that such clear breach was not established.

Leave to appeal the decision in K&S Potash to the Supreme Court of Canada was denied on October 10, 2019.

TAKEAWAY

7636156 Canada reaffirms the autonomy principle for LCs. The obligation of an LC issuer to honour a draw on an LC securing a bankrupt tenant’s obligations for the term of a commercial lease is an independent obligation that is not overridden by principles of insolvency law. The narrow “fraud exception” to the autonomy principle is subject to a rigorous standard of proof.

For further information, please contact:

Milly Chow                                416-863-2594
Aryo Shalviri                             416-863-2962
Caitlin McIntyre                         416-863-4174

or any other member of our Restructuring & Insolvency group.