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Though the dust has yet to settle following the economic shutdown due to the COVID-19 pandemic, businesses may be faced with the prospect of bankruptcy. Recently, the Ontario Court of Appeal decided a case concerning the rights of a commercial landlord as a creditor in the bankruptcy of its tenant following the disclaimer of the lease by the trustee in bankruptcy.

What Happened?

The landlord and tenant were parties to a lease dated May 26, 2017 for a space in Toronto. The lease was for a term of ten years and six months, commencing on July 1, 2017 and ending on December 31, 2027.

On March 29, 2018, and without being in default of its obligations under the lease, the tenant made an assignment in bankruptcy. 

The appointed trustee occupied the leased premises and paid occupation rent of $25,698 to the landlord.

On April 20, 2018, the landlord filed a proof of claim in the bankruptcy. The landlord claimed $100,558 as a preferred claim for three months’ accelerated rent, in accordance with the priority of claims prescribed by s. 136(1)(f) of the Bankruptcy and Insolvency Act (the “BIA”). Because the realization of property on the leased premises yielded an amount that was less than the preferred claim ($24,571), the landlord asserted its right to claim the balance of the unrecovered preferred claim ($75,987) as an unsecured creditor.

The landlord also advanced an unsecured claim in the amount of $4,028,111. This represented its claim for rent payable for the balance of the unexpired portion of the term of the lease, together with amounts for tenant inducements consisting of leasehold improvements provided at the landlord’s cost under the lease and free rent for a six-month period. 

In asserting its rights, the landlord relied on the tenant’s obligation under the lease to make certain payments on bankruptcy, including on termination or disclaimer of the lease.

The relevant provision of the lease provided for events of default, including the bankruptcy of the tenant. It also provided for the landlord’s remedies, which included: the payment of three months’ accelerated rent; the right to terminate the lease (with the right to obtain damages for the landlord’s deficiency for the balance of the term); and upon any termination, including disclaimer, payment of the value of the unpaid amount of any tenant inducements calculated over the unexpired term of the lease. 

On April 23, 2018, the trustee issued a notice of disclaimer of the lease. Following the disclaimer, the landlord found a new tenant for the leased premises, effectively mitigating its claim for future rent.

On September 19, 2018, the trustee issued a notice of partial disallowance of claim, allowing only the landlord’s preferred claim in the amount of $24,571 (limited to the actual value of the property on the leased premises), and disallowing the landlord’s unsecured claims.

Lower Court Decision

The landlord appealed the disallowance of its unsecured claim to the Superior Court of Justice. It confined its appeal to its claims under the lease for tenant inducements in the amount of $203,442, including leasehold improvements and free rent, and the balance of the three months’ accelerated rent of $50,289, for a total unsecured claim of $253,731.

The court dismissed the landlord’s appeal. 

At Issue

Two issues were raised in appeal:

1.   Was the landlord entitled to assert a claim for unpaid tenant inducements under the lease as an unsecured creditor in the tenant’s bankruptcy?

2.   Was the landlord entitled to assert the balance of its preferred claim for three months’ accelerated rent as an unsecured creditor in the tenant’s bankruptcy?

Court of Appeal Decision

The Court of Appeal agreed with the lower court’s finding that, in Ontario, the law on the first question was settled many years ago in the 1933 decision Re Mussens Ltd. The court explained the principle as follows: 

“As between the landlord and tenant, the disclaimer of a commercial lease by the tenant’s trustee in bankruptcy brings to an end the future or ongoing obligations of the tenant under the lease. The landlord has no right of compensation or claim as an unsecured creditor for damages in respect of the unexpired term of the lease in relation to the loss of the tenancy as a result of the disclaimer; the landlord is limited to its preferred claim for up to three months’ accelerated rent.”

However, the court did allow the appeal in part to permit the landlord to rank as an unsecured creditor for the unpaid balance of its preferred claim. The court explained that s. 136 of the BIA provides for the priority of certain unsecured claims, including, under s. 136(1)(f), priority for a landlord’s claim for three months’ arrears of rent and three months’ accelerated rent. The court explained that while s. 136 of the BIA sets out a scheme of payment priorities, the landlord’s rights on a tenant’s bankruptcy are established under provincial law. The court stated:

“The Ontario law that defines a commercial landlord’s rights on a tenant’s bankruptcy is found in the Commercial Tenancies Act. The landlord’s preferential lien for rent, and the trustee’s right to retain and to assign the lease, exercisable within three months of the bankruptcy and before the trustee has disclaimed the lease, are set out in s. 38Section 39 provides for the right of the trustee in bankruptcy, at any time before electing to retain the leased premises, to “surrender or disclaim” the lease.”

As a result, the court concluded that the landlord was not entitled to claim as an unsecured creditor in the bankrupt tenant’s estate for damages relating to the unexpired term of the lease, except to recover the balance of its preferred claim for three months’ accelerated rent, which was specifically provided for by statute.

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Baker & Company has adopted all of the COVID-19 safety precautions and vulnerable employees have been invited to work from home. We are fully operational and continuing to work on client assignments. Where possible, meetings are being held via video link or by telephone conference.

At Baker & Company in Toronto, our real estate lawyers take the time to speak with you and understand your unique needs in order to guide you through your real estate matter, whether commercial or residential. We rely on our broad base of experience and expertise to provide exceptional legal advice and risk management in a variety of leasing issues. Call us at 416-777-0100 or contact us online for a consultation.

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