Ontario Court Revisits Issue of Landlord Drawing on a Letter of Credit in Excess of BIA Preferred Claim

In 7636156 Canada Inc. v. OMERS Realty Corporation¹ (“7636156 v. OMERS”), the Ontario Superior Court of Justice (Commercial List) (the “Court”) held that a bankrupt’s landlord was only entitled to have drawn down on a letter of credit by an amount equal to the landlord’s priority claim for three months’ accelerated rent, rather than by the full amount of the letter of credit, and ordered that the landlord pay over the excess to the bankrupt’s trustee. The issue of a landlord’s ability to draw on a letter of credit in excess of its entitlements under the Bankruptcy and Insolvency Act² (the “BIA”) priority regime has been given a very inconsistent treatment by courts in Ontario. Though possibly correct in the result it reached, the Court did not add any clarity to this jurisprudence as it followed Ontario case law that was distinguishable on the facts without consideration of the most recent and on point decision of the Ontario Court of Appeal.

Under the terms of its lease (the “Lease”), 7636156 Canada Inc. (the “Tenant”) was required to arrange for a letter of credit in the principal amount of $2.5 million (the “LC”) as a security for its indemnification of the Landlord for any losses, costs or damages arising from the Tenant’s failure to pay rent or other amounts under the Lease. The LC was issued by a bank (the “Bank”) in return for deposit by the Tenant of cash collateral in the amount of $2.5 million to secure the Bank’s obligations under the LC.

The Tenant made an assignment in bankruptcy on May 1, 2018, and its trustee in bankruptcy (the “Trustee”) informed the landlord (the “Landlord”) that it had no objection to the Landlord making partial draws on the LC to cover occupation rent payable during the bankruptcy.³ The Landlord drew down on the LC for May rent and filed a proof of claim for the three months’ accelerated rent. The proof of claim included a reservations of rights to draw down further on the LC for another nine months of rent owing to the end of the Lease term (in addition to the three months’ accelerated rent), plus other amounts owing to the Landlord under the Lease.

The Trustee disallowed the Landlord’s proof of claim because of its failure to account for the May rent already drawn and because of the reservation of rights it contained. On July 23, 2018, the Trustee disclaimed the Lease, as permitted under paragraph 30(1)(k) of the BIA. After the Lease was disclaimed, the Landlord drew down on the full remaining balance of the LC for rent through the end of the Lease term and other amounts owing under the Lease.⁴

The Trustee subsequently brought a motion for a determination of the amount that the Landlord was entitled to have drawn down on the LC, and an order for the Landlord to pay the Trustee any excess. The Court held that the Landlord only had a preferred claim in the amount of $623,196.84 for three months’ accelerated rent under paragraph 136(1)(f) of the BIA, and ordered that it pay over the balance of the $2.5 million to the Trustee.⁵

The starting point of the Court’s reasoning was the premise that, upon disclaimer by the Trustee, no further obligations existed under the Lease. Pursuant to section 146 of the BIA, rights of landlords are to be determined according to applicable provincial law (subject only to certain other provisions of the BIA). Like paragraph 30(1)(k) of the BIA, Section 39 of the Ontario Commercial Tenancies Act⁶ (the “CTA”) gives a trustee in bankruptcy the right to disclaim a lease. Ontario jurisprudence has long held that a disclaimer of a lease by a trustee in bankruptcy pursuant to section 39 of the CTA (or its predecessors) is equivalent to a voluntary surrender of the lease by the tenant with the consent of the landlord, the result of which is the extinguishment of all the tenant’s post-disclaimer obligations under the lease.⁷ Since all of a bankrupt tenant’s estate vests in its trustee pursuant to section 71 of the BIA, disclaimer by the trustee disclaims the entirety of the tenant’s obligations under a lease.⁸

The Landlord in 7636156 v. OMERS did not, however, regard its draws upon the LC to be in respect of claims against the Tenant’s estate, which it admitted were limited to the three months’ accelerated rent claim set out in its proof of claim.⁹ Rather, by making draw requests, it was calling on the Bank’s independent obligations under the LC.¹⁰

The above-cited case law, which holds that disclaimer of a lease by a trustee terminates all a tenant’s post-disclaimer obligations, also holds that such disclaimer likewise terminates all liability under a guarantee for such post-disclaimer lease obligations.¹¹ In Titan Warehouse Club Inc. (Trustee of) v. Glenview Corp. (“Titan Warehouse”), the Ontario Court of Appeal (the “ONCA”) extended this ratio to a letter of credit given as a guarantee of rent obligations under a lease.¹²

In 885676 Ontario Ltd. (Trustee of) v. Frasmet Holdings Ltd.¹³ (“Frasmet”), Justice Blair of the Commercial List, as he then was, distinguished Titan Warehouse precisely because the letter of credit in that case had been intended as a guarantee of arrears in rental payments, whereas, on the fact before him, the letter of credit was intended as security for the all tenant’s obligations under the lease. This distinction between a letter of credit given as guarantee versus a letter of credit given as security was subsequently rejected by Justice Feldman, as she then was, in Peat Marwick Thorne Inc. v. Natco Trading Corp.¹⁴ (“Natco Trading”), though only in obiter dicta, as the case does not appear to have involved a security by way of a letter of credit. The distinction was also rejected, following Natco Trading in preference to Frasmet, by the British Columbia Court of Appeal (the “BCCA”) in West Shore Ventures Ltd. v. K.P.N. Holding Ltd.¹⁵ (“West Shore Ventures”). The BCCA held that the absence of post-disclaimer tenant obligations meant that there could no sooner be post-disclaimer obligations secured by a letter of credit than there could be post-disclaimer obligations guaranteed by a letter of credit.

The Court in 7636156 v. OMERS viewed Titan Warehouse and Natco Trading to be the law in Ontario. The Court included little discussion of Frasmet, declining to follow it simply because the “correctness of this decision has been questioned.”¹⁶ The Court did not, however, consider the most recent OCA decision on point, that of the unanimous OCA in Lava Systems Inc. (Receiver & Manager of) v. Clarica Life Insurance Co. (“Lava Systems”),¹⁷ which was released subsequent to both Natco Trading and West Shore Ventures and, most importantly, followed Frasmet.

Both Frasmet and Lava Systems followed the 1987 decision of the Supreme Court of Canada in Bank of Nova Scotia v. Angelica-Whitewear Ltd. (“Angelica-Whitewear”) where Justice LeDain for the court held that an issuer’s obligation under a letter of credit is an independent obligation:

“The fundamental principle governing documentary letters of credit and the characteristic which gives them their international commercial utility and efficacy is that the obligation of the issuing bank to honour a draft on a credit when it is accompanied by documents which appear on their face to be in accordance with the terms and conditions of the credit is independent of the performance of the underlying contract for which the credit was issued. Disputes between the parties to the underlying contract concerning its performance cannot as a general rule justify a refusal by an issuing bank to honour a draft which is accompanied by apparently conforming documents. This principle is referred to as the autonomy of documentary credits.”¹⁸

Justice LeDain recognized an exception to this principle of autonomy in cases of fraud by beneficiaries:

“An exception to the general rule that an issuing bank is obliged to honour a draft under a documentary credit when the tendered documents appear on their face to be regular and in conformity with the terms and conditions of the credit has been recognized for the case of fraud by the beneficiary of the credit which has been sufficiently brought to the knowledge of the bank before payment of the draft or demonstrated to a court called on by the customer of the bank to issue an interlocutory injunction to restrain the bank from honouring the draft.

. . .

In my opinion the fraud exception to the autonomy of documentary letters of credit should not be confined to cases of fraud in the tendered documents but should include fraud in the underlying transaction of such a character as to make the demand for payment under the credit a fraudulent one. . . . In my view the fraud exception to the autonomy of a documentary credit should extend to any act of the beneficiary of a credit the effect of which would be to permit the beneficiary to obtain the benefit of the credit as a result of fraud.”¹⁹

An important fact to note is that Titan Warehouse and Frasmet each dealt with an application by a tenant’s trustee in bankruptcy for an injunction to prevent an issuer of a letter of credit from honouring a landlord’s draw request. That situation where a debtor who arranged for a letter of credit seeks an injunction against the issuer of the letter of credit honouring a fraudulent draw, along with the situation where an issuer of a letter of credit seeks repayment from a beneficiary who made a fraudulent draw, are the usual circumstances in which the fraud exception is plead. In contrast, Lava Systems, West Shore Ventures and 7636156 v. OMERS itself are each cases where a debtor who arranged for a letter of credit sought repayment from a beneficiary after the draw was made.

The Angelica-Whitewear principle of autonomy of documentary credits was recognized by the lower court in Titan Warehouse, but the fraud exception seems to have been found to apply because of the fact that no obligations remained to be guaranteed by the letter of credit once the lease had been disclaimed by the trustee.²⁰ The OCA in Titan Warehouse unfortunately did not consider the principle of autonomy of documentary credits or the fraud exception thereto.

In Frasmet, Justice Blair distinguished Titan Warehouse (where the application court had found a fraud exception) because there could be no fraud in the case before him as the letter of credit was called upon precisely for the purpose for which it was put in place, as security for obligations under the lease.²¹

In Lava Systems, Justice Borins for the unanimous OCA followed Frasmet and Angelica-Whitewear to the conclusion that any overpayment to a landlord on a letter of credit was for the issuing bank alone to recover, and not available to the tenant’s trustee in bankruptcy:

“On the basis of these principles, whether Clarica was entitled to draw on the letter of credit, and, if so, in what amount, is a matter between it and the bank that issued the letter of credit. In making payment pursuant to Clarica’s demand, the bank adhered to its obligations under the letter of credit. The funds which it paid to Clarica were its property, not that of Lava. Had Clarica not drawn on the letter of credit, the balance remaining available to Clarica under the letter of credit would continue to be the property of the bank. In such circumstances, neither Lava’s receiver and manager, nor its trustee in bankruptcy, would have any claim on the undrawn portion of the security represented by the letter of credit. In my view, the fact that Clarica had obtained these funds as a result of its demand under the letter of credit places Richter in no better position than it would have been in had Clarica not issued its demand. This is because the funds available as security under the letter of credit at all times were the property of the bank.”²²

In obiter dicta, Justice Borins speculated that the trustee might have had a claim against the landlord if either: (i) the issuing bank had assigned its right to pursue the landlord to the trustee; or (ii) the tenant’s estate had compensated the issuing bank for the over-payment.²³ Since there was no evidence before the OCA of either, and since there was no finding of fraud, the Angelica-Whitewear principle of autonomy of documentary credits governed. Although mentioned only in passing by Justice Borins, the need for a finding of fraud is essential on this analysis. Where assignment of the issuer’s position or reimbursement of the issuer for the amount of a draw puts the tenant into the shoes of the issuer (in the latter case via subrogation), a finding of fraud would then be necessary in order for the tenant to have any recourse from that position against the landlord. This is also consistent with our previous observation that it is normally the issuer, not the debtor who arranged for the letter of credit, who pleads a fraud exception to seek reimbursement from a beneficiary.

The starting point of the analysis in 7636156 v. OMERS ought to have been Lava Systems, not only because it is the most recent ONCA decision, but also because it was the only Ontario decision on point, where a debtor who arranged for the letter of credit sought reimbursement from a beneficiary. As previously noted, Titan Warehouse and Frasmet each dealt with an application by a tenant’s trustee in bankruptcy for an injunction to prevent an issuer of a letter of credit from honouring a landlord’s draw request and Natco Trading did not even involve a letter of credit.

Lava Systems would have required the Court in 7636156 v. OMERS to find: (i) that either the issuing bank had assigned its right to pursue the landlord to the trustee or the tenant’s estate had reimbursed the issuing bank for amounts drawn on the letter of credit; and (ii) that there was an applicable fraud exception to the principle of autonomy of documentary credits. There was no evidence in 7636156 v. OMERS of an assignment by the Bank of its rights as issuer to the Tenant. There was also no evidence that the Tenant reimbursed the Bank for the Landlord’s draws on the LC, as it would be a mischaracterization to state that the Bank reimbursed itself from the Tenant’s property, in the form of the cash collateral on deposit with the Bank. Funds on deposit with a bank become the bank’s property and the bank becomes the account holder’s debtor for the amount of the deposit (subject to the bank’s right of consolidation amongst accounts).²⁴ The cash collateral deposited by the Tenant as “security” for the Bank’s liability under the LC was no different; what the Bank took security in was not the funds on deposit themselves (which were the Bank’s own property), but rather the Tenant’s right to repayment of those amounts.²⁵ The implication is that, by drawing on the LC, the Landlord was neither realizing against assets of the Tenant’s estate nor triggering a reimbursement of the Bank by the Tenant’s estate. The only effect the Landlord’s action had on the Tenant’s estate was to cause the Bank to realize its security over, and thereby reduce, the unsecured debt owed by the Bank to the Tenant in respect of repayment of the cash “collateral”.

Just as importantly, there was also no evidence in 7636156 v. OMERS on which to find a fraud-based exception to the principle of autonomy of documentary credits. The bar is set quite high for a party alleging fraud in such situations.²⁶ As in Frasmet, there could be no finding of fraud where the Landlord drew on the LC in precisely the situation that the Lease contemplated it would be drawn upon. On essentially the same facts, there also was no finding of fraud in Lava Systems.²⁷ Moreover, the Landlord gave advance written notice (in the reservation of rights in its proof of claim) that it was going to draw upon the LC for the full amount of the obligations under the Lease. As a result, even if the Tenant had stepped into the Bank’s shoes through assignment or subrogation, on a Lava Systems analysis, the Trustee should still not have had any recourse against the Landlord in light of the autonomy of the Bank’s obligations under the LC.

The BCCA’s decision in West Shore Ventures, which unfortunately was not considered by the OCA in Lava Systems, points to a potential alternate path for a tenant’s trustee in bankruptcy to find recourse against a landlord who has overdrawn on a letter of credit. Although the Landlord in 7636156 v. OMERS did not cause the Tenant’s estate to reimburse the Bank for the amounts drawn on the LC, the Landlord did, nonetheless, cause assets otherwise available to the other creditors of the Tenant’s estate to be unavailable when it caused a reduction of the Tenant’s chose in action in respect of the cash collateral debt owed by the Bank to the Tenant. The Landlord was thereby enriched and the Tenant’s estate was deprived. If the Landlord did not have a juristic reason for its enrichment, then it was unjustly enriched. In that case, the Tenant would have a direct route to recourse against the Landlord without having to first step into the Bank’s shoes and then establish a fraud exception to the Bank’s autonomous obligations under the LC. Such unjust enrichment analysis featured prominently in both the majority and minority BCCA decisions in West Shore Ventures.²⁸ The BCCA majority’s finding of unjust enrichment did not, however, rest solely on the fact that the landlord in that case had drawn on a letter of credit in excess of its entitlements under the BIA and the applicable provincial statute; it also rested largely on the fact that, under the terms of the lease, the landlord was obligated to pay over (to the third party who had arranged for the letter of credit) any amounts drawn on the letter of credit in excess of the tenant’s obligations under the lease.²⁹ The result reached by the BCCA therefore appears to rest in contract as much as it does in unjust enrichment.³⁰

The question therefore remains open whether, on facts such as those found in 7636156 v. OMERS, unjust enrichment could be established due to an absence of juristic reason for draws on a letter of credit, even in the absence of a contractual breach. If the answer is “yes”, then Ontario courts could reach the same results as in 7636156 v. OMERS, despite the otherwise contrary binding authority of Lava Systems.

The Landlord has appealed 7636156 v. OMERS and the hearing before the ONCA has been set for April 7, 2020.