Landlord/Tenant Rights in a Bankruptcy/Insolvency Scenario

In light of the current circumstances, an increasing number of businesses may file for bankruptcy protection under the Bankruptcy and Insolvency Act (BIA) in the coming months. As we know, by the time that a commercial tenant actually files for bankruptcy, it has usually been experiencing financial difficulties for a period of time and has likely already accumulated significant rental arrears as a result.

With that in mind, below you will find a high-level overview of some of the most common questions that first arise when a landlord receives a notice of bankruptcy from a trustee for one of its commercial tenants – more specifically, how the landlord will be paid and what happens to security held by the landlord (movable hypothec, security deposit, personal guarantee and letter of credit).

PAYMENT OF RENT

The landlord will have a preferred claim for the following:

1. Arrears of rent for a period of 3 months prior to the bankruptcy

• No specific provision in the lease is necessary to be entitled to a preferred claim for this amount

2. Accelerated rent for a maximum of 3 months after the bankruptcy

• Accelerated rent MUST be provided for in the lease to benefit from this

The landlord will have an ordinary unsecured claim for any other amounts owed to it, and provided for in the lease, that fall outside of the foregoing.

Q: What does having a “preferred claim” mean for the landlord?

A: Preferred creditors are paid after secured creditors (and super priority claims), but before all other unsecured creditors. Given that the BIA does not give the landlord a secured creditor status, it must wait in line behind secured creditors to be paid for rent amounts according to its rank among unsecured creditors.

Q: What happens if the tenant has accumulated 5 months of arrears prior to the bankruptcy?

A: The landlord only has a preferred claim for 3 months of arrears. However, the landlord can claim the remaining 2 months as an ordinary unsecured creditor.

Q: The accelerated rent provision in the lease provides for 6 months of accelerated rent in the case of bankruptcy. Does this mean that the landlord has a preferred claim for 6 months of accelerated rent?

A: No. The landlord only has a preferred claim for 3 months after the bankruptcy. The landlord can still claim the remaining 3 months of accelerated rent – but as an ordinary unsecured creditor. Evidently, the foregoing also applies to an accelerated rent provision for any other amount (e.g. 9 months, or 12 months).

Q: When representing a landlord, how can I increase my client’s chances of obtaining the maximum amount under the preferred claim provisions of the BIA?

A: It’s important to remember that the landlord’s preferred claim for 3 months of rental arrears and 3 months accelerated rent only covers rent. Real estate taxes, OPEX, adjustments etc. should be included in the definition of “rent” in the lease (or “additional rent” with a clear indication that additional rent constitutes “rent” as defined in the lease) for the landlord to benefit from a preferred claim for these amounts.

LANDLORD SECURITY

Realistically speaking, the sale of the tenant’s assets rarely generates enough funds to satisfy all creditor claims – which is where security becomes important. However, not all security instruments offer the same level of protection to the landlord in the context of the tenant’s bankruptcy.

The below is in order of what typically offers the least to the most protection for the landlord.

• Movable Hypothec:

A movable hypothec granted by the tenant in favour of the landlord is not enforceable against the bankrupt tenant or the trustee/creditors of the tenant, due to the federal paramountcy doctrine (federal law (BIA) takes precedence over provincial law (CCQ)).

In terms of the reasoning behind the foregoing, the following excerpt from a key Court of Appeal decision on the subject summarizes same:

“[…] force est de conclure que le statut de créancier garanti que revendique le locateur en vertu de son hypothèque mobilière conventionnelle modifierait directement l’ordre de collocation prévu à l’article 136(1) L.F.I. en bonifiant le rang d’une créance prioritaire expressément visée par l’alinéa 136(1)f) de la Loi sur la faillite. Il s’ensuit que les dispositions du Code civil en matière de priorités et d’hypothèques ayant pour effet de modifier l’ordre des priorités de la Loi sur la faillite en conférant au locateur un statut de «créancier garanti » sont inapplicables en matière de faillite.”

[PRACTICE TIP: As an aside, if the commercial lease grants the landlord a movable hypothec on the tenant’s assets, the movable hypothec must be registered on the RDPRM for it to be opposable to third parties (it is only opposable from the date of registration). If it is not registered when the lease is signed, the landlord risks having its rights (and rank) compromised by other creditors who may register their own rights between then and the time that the landlord wants to realize on its security a few years down the line when a default occurs.]

• Security Deposit:

In general, the landlord will not be able to retain the security deposit, as it will be forfeited to the bankruptcy trustee for the benefit of the mass of creditors.

Without elaborating on the debates surrounding the following – a security deposit held by the landlord to guarantee the performance of the tenant’s obligations in the event of default is refundable at the end of the term if there are no defaults, remains the property of the tenant, and therefore becomes vested in the trustee at the time of bankruptcy (if it has not already been applied to a past default). However, the foregoing would not apply to prepaid rent, which is non-refundable and may be applied to future rent or an amount owing in the event of default. Given the non-refundable nature of prepaid rent, it becomes (arguably) the property of the landlord when the lease is signed and therefore, the bankruptcy trustee would not have the right to claim it.

Case law shows that the key distinction in determining whether the deposit in question must be remitted to the bankruptcy trustee is the refundable (property of tenant) VS. non-refundable (property of landlord) nature of same – and this, irrespective of what the clause is actually labelled as.

In any case, a security deposit often remains an ineffective form of security in the context of bankruptcy – namely because the landlord’s ability to retain it is uncertain, and in the event of contestation, is entirely dependent on the Court’s interpretation of the lease provisions as well as the intention of the parties.

[PRACTICE TIP: The best way to ensure that a security deposit is useful for the landlord is to monitor tenant defaults closely. When rental arrears are accumulating, the landlord should strongly consider applying the security deposit to the defaults early on. If you represent a landlord, this option should be evaluated and discussed with your client well before rental arrears have accumulated for multiple months given that, once the tenant has filed for bankruptcy protection – it is often too late to act.]

• Personal Guarantee:

A personal guarantee is generally a reliable way to maximize the landlord’s chances of recovering amounts due, irrespective of the tenant’s bankruptcy. The reason being is that, in the absence of specific language in the guarantee indicating otherwise, the law does not automatically release the personal guarantor from its obligations when the principal debtor (the tenant) becomes bankrupt.

However – 3 things to keep in mind:

1. If the personal guarantor is a principal of the tenant entity – Art. 2363 CCQ provides that “suretyship attached to the performance of special duties is terminated upon cessation of the duties”. Therefore, there should be a clear waiver of this article in the personal guarantee agreement annexed to the lease (not only in the lease itself).
2. Lease renewals – Art. 1881 CCQ provides that “security given by a third person to secure the performance of the obligations of the lessee does not extend to a renewed lease”. This applies to either a formal renewal or a tacit renewal under art. 1879 CCQ. However, article 1881 CCQ is not of public order so it can also be waived.
3. An important consideration when evaluating whether a personal guarantee is the right form of security for a landlord is that, from a realization perspective, this mechanism is typically quite cumbersome. First, the landlord usually has to go through the Court process to a judgment in order to collect the amounts that it claims are due and, in any case, there is no certainty in terms of the personal guarantor’s solvency when the landlord knocks on its door for payment.

[PRACTICE TIP: In terms of how the personal guarantee should be structured – while there is no issue with having a personal guarantee provision directly in the lease, there should nevertheless be a separate page annexed to the lease containing the personal guarantee agreement and a distinct signature block for same.]

• Letter of Credit:

In contrast to a personal guarantee, where the guarantor isn’t likely to hand over the full amount claimed without putting up a fight (since it is permitted to use the same means of defence that the principal debtor had against the creditor) – typically, the landlord can draw on the letter of credit upon the tenant’s default, and the bank must honour the letter of credit when presented with the documents required to trigger its obligation to pay under the terms of same.

Letters of credit are less likely be affected by the tenant’s bankruptcy given that they are not viewed as being the property of the tenant (but rather the sums are the property of the bank), and have been recognized as security instruments that are autonomous from the lease. Moreover, the basic principles of bankruptcy include the notion that bankruptcy is immaterial to third-party agreements and therefore favour the independence of the bank’s obligations under the letter of credit.

Evidently, the language in the letter of credit and the related lease provisions must nevertheless be carefully drafted for the letter of credit to survive bankruptcy.