Understanding the Plight of the Landlord
on the Insolvency of a Tenant
By: Timothy R. Dunn
Minden Gross LLP
(Presented at the CAIRP:
INSOLVENCY AND RESTRUCTURING FORUM 2005)
FRUSTRATION.
This is perhaps the most common sentiment expressed by
a landlord who has experienced the insolvency or
bankruptcy of a tenant. This sentiment is easy
to understand. One minute the landlord can rely
upon the carefully crafted provisions of its
lease to protect itself and its premises – the
next minute – the landlord is served with notice
that the tenant has obtained an order protecting
itself from action by its creditors or, even
worse, that it has already become a bankrupt and
a trustee in bankruptcy has been appointed to
administer its estate. In either case, unless
proactive steps have been taken by the landlord
to protect itself against this alarming turn of
events, frustration is sure to follow.
It is fair to say that the greatest source of
frustration for a landlord when faced with the
insolvency or bankruptcy of a tenant is the fact
that it is unable to resort to its usual
remedies of distraint or termination. When a
tenant seeks protection from its creditors
pursuant to the provisions of either the
Bankruptcy and Insolvency Act (Canada) (“BIA”)
or the Companies Creditors Arrangements Act
(“CCAA”), or if the tenant becomes a
bankrupt, the landlord will be prevented from
distraining and/or terminating the lease by
either a stay provision contained in the
creditor protection order or pursuant to the
provisions of the BIA which provides, among
other things, that when a tenant becomes a
bankrupt a landlord and all other creditors of
the bankrupt are stayed from taking any steps to
enforce whatever rights they may have against
the assets of the bankrupt.
The making of a proposal or plan is akin to the
negotiation of a new contract between the tenant
and its creditors. Patience and attention to
detail should be the watch words for a landlord
and its counsel engaged in the proposal
process. The landlord has two principal
interests:
(1) maximizing recovery in respect of
the indebtedness owing to it; and
(2) securing a solid tenant for its premises on a long term go
forward basis.
If the tenant’s proposed “new contract” does not
adequately address these interests, it is open
for the landlord to vote against the
plan/proposal. The overriding question for the
landlord is whether the plan/proposal offers the
landlord more than would be gained in a
bankruptcy? On a positive note, the landlord is
entitled to receive rent from the tenant during
the proposal/plan process on the terms set forth
in the lease.
In the event that a tenant’s proposal/plan is
rejected by its creditors, the tenant will
become a bankrupt – adding a whole new layer of
frustration.
On bankruptcy, the trustee has a 90 day period
from the date of the bankruptcy to decide
whether to disclaim the lease. Worse still for
the landlord, if a trustee does not actually
occupy the premises, the landlord is not
entitled to receive any occupation rent during
this 90 day period. However, if a trustee does
occupy the premises, it is personally
responsible for occupation rent at the same rate
as would have been payable by the tenant under
the terms of the lease. It comes as a great
shock to many landlords to discover that the BIA
allows a trustee, subject to certain
prerequisites, to assign the existing lease to a
third party assignee without obtaining the
landlord’s consent. Indeed, it is entirely
possible for a trustee to obtain an order of the
court assigning an existing lease to a third
party over the objections of a landlord provided
that the assignee meets certain criteria which
include the ability to honour its financial
obligations under the lease and that the
premises will not be used for a business more
hazardous or objectionable than the business
previously conducted by the bankrupt tenant.
As in all commercial transactions, forward
thinking and decisive action will usually serve
to eliminate, or at least reduce, the
frustration experienced by a client. For
example, a landlord may protect its interests
prior to the tenant taking possession of the
premises by:
(1) insisting upon
(depending upon its relative bargaining power)
the posting of a letter of credit by a third
party which may be drawn upon by a landlord in
the event of the insolvency and/or bankruptcy of
a tenant. It is important to note that the
language of this letter of credit must be
precise and not limited to damages arising from
non-payment of rent by a tenant. The language
should be broad enough to include all damages
incurred by the landlord resulting from the
early termination of the lease on the default by
a tenant with draw down satisfied simply upon
the presentation of a certificate by an
authorized officer of the landlord indicating
the quantum of damages;
(2) taking a
security deposit in a substantial sum to cover a
default by a tenant; and
(3) obtaining one or
more indemnities. Until very recently, it was
imperative that a third party indemnity be
carefully crafted to avoid characterization as a
guarantee. If characterized as a guarantee of
the obligations of a tenant under the lease,
upon disclaimer of the lease, no obligations
would remain and recourse would then not be
available. Fortunately, the recent Supreme
Court of Canada decision in Crystalline
Investments Ltd. V. Domgroup Ltd., has given
some comfort to landlords seeking to hold
indemnitors responsible after the repudiation of
a lease under insolvency law.
Above all, as is the case in most medical
ailments, the financial ill health of a tenant
rarely occurs out of the blue and it is
important that a lease contain financial
reporting covenants which will provide a
diligent landlord with forewarning of a tenant’s
impending financial difficulty.
Not too long ago, we were asked by one of our
landlord clients to represent its interests
following the demise of the King’s Health
Centre. At the time of our retainer, no notice
of receivership or bankruptcy had been served
upon the landlord but it was widely believed
that it was only a matter of time before the
same was forthcoming. Accordingly, in keeping
with the importance of being practical and
decisive, we advised the landlord to initiate a distraint upon all assets of King’s. The
distraint process requires the posting of a
warrant of distraint for a period of 5 days to
allow the tenant an opportunity to repay the
indebtedness owing to the landlord. In the
event that a tenant is unable to repay its debt,
a landlord then obtains at least two appraisals
and sells the assets for the best possible
price. King’s was unable to pay its
indebtedness to the landlord, which was
considerable, and the landlord promptly sold all
of its assets. Interestingly enough, on the day
of the sale, BACC Capital Corporation (the
parent company of King’s) was petitioned into
bankruptcy. Although, ultimately, King’s did
not become a bankrupt, it could easily have been
otherwise and then our client would have been
stayed from taking any steps to recover the
indebtedness owing to it. Timing is critical in
cases of tenant insolvency.
In this regard, this remedy of distress is often
considered by landlords to be their best weapon
against the tenant’s secured creditor and, if
exercised quickly, the tenant’s trustee in
bankruptcy.
Distress is a combination of a statutory and
common law self-help remedy entitling a
landlord, prior to the termination of the lease,
to seize, take possession of, and sell the goods
and chattels (not fixtures) of a tenant located
at the landlord’s premises to satisfy arrears of
rent.
At first blush, distress appears to be an ideal
remedy. However, there are a number of
restrictions set forth in both the Commercial
Tenancies Act and at common law which a
landlord must carefully navigate , including:
(a) while there is no requirement to give prior
notice of the distress under the legislation,
proper notice must be given to the tenant at the
time the distress is taken;
(b) after giving notice of distress and taking
possession of the chattels, but prior to
marketing the chattels for sale, the landlord
must wait five days and then must have the distrained goods appraised by two independent
appraisers;
(c) when selling the distrained assets, the landlord
must obtain “the best price available in the
marketplace for them”; there is no specific
requirement with respect to the process that
must be following for the sale of the goods;
however, the landlord can be exposed to
liability for making an “improvident” sale;
(d)
the
landlord must be careful not to seize and sell
an amount of the tenant’s property that greatly
exceeds the quantum of the tenant’s arrears then
in question. This is an onerous and ambiguous
restriction because it is clear that in order
for the landlord to recover the full amount of
rent in arrears and the cost of exercising its
right of distress and marketing and selling the
tenant’s chattels, the distress will almost
certainly have to provide a cushion and this
should not subject the landlord to damages;
however, if the distress is “excessive” (ie. the
value of the distrained goods is unreasonably in
excess of the amount in arrears) the landlord is
exposed to the risk of liability damages. The
question then becomes what is excessive in the
circumstances;
(e) distress must be levied during daylight hours,
that is, after dawn and before sunset; and
(f) chattels exempt from execution under the
provisions of the Execution Act
(Ontario) may not be distrained.
The right of distress is a unique right
available to a landlord. In order for the
landlord to lawfully exercise the right of
distress, it is necessary that the
landlord-tenant relationship remain intact until
the completion of the distress. Accordingly, the
tenant must be in possession of the premises and
there must be arrears of rent due and payable to
the landlord prior to the sale of the chattels
and the application of the sale proceeds on
account of the arrears of rent.
Although landlords and bailiffs have now become
more sensitive to this point, it was formerly
common practice for a landlord to purport to
distrain by changing the locks on the premises.
However, case law has made it clear that the
changing of the locks by the landlord is, in
effect, a re-entry into the premises and
termination of the lease, even if such action is
purportedly for the purpose of securing the
chattels on the premises. Once the lease is
terminated the landlord loses its rights to
distress and the tenant has the right to remove
the chattels.
The other issue for a landlord exercising its
right of distress is to determine who owns the
chattels located on the premises. The landlord
may not distrain on the chattels of any person
except the tenant or other “person who is liable
for the rent”. The landlord is not entitled to
chattels on the premises that were provided to
the tenant on consignment or under a true lease.
Generally
Speaking:
(i)
except for chattels on the premises which are
subject to a true lease (a lease which is not in
the nature of a financing arrangement), the race
is to the swiftest; in other words, priority
goes to the party who first seizes the chattels;
however, it must be noted that the Ontario Court
of Appeal has held that a landlord’s distress
completed within three months of a tenant’s
bankruptcy can be considered a “fraudulent
preference”, and that the proceeds of the
distress belong to the trustee in bankruptcy,
leaving the landlord with merely a preferred
claim under the BIA. This finding can
potentially require a landlord that otherwise
successfully completed a distress to repay the
proceeds therefrom to the trustee of the
bankrupt, which severely limits the efficacy of
this remedy. If a tenant becomes bankrupt
before the landlord completes its distraint or
within three months of the landlord’s completion
of the distraint, the landlord’s claim for
distress will be defeated in the chattels or
proceeds from the sales of the chattels, which
chattels vest in the trustee. This results in
wasted time, effort and expense on the
landlord’s part; and
(ii)
with respect to chattels leased pursuant to a
true lease, title to the chattels is in the lessor and the landlord cannot gain priority by
seizing the chattels.
Often, in attempting to exercise its right of
distress, the landlord or its bailiff will
encounter a difficult tenant that fervently
objects to the act of distress. Such an
uncooperative tenant may present the possibility
for a physical confrontation and/or attempt to
remove the goods from the premises.
Needless to say, in such circumstances, the
landlord must avoid physical confrontation in
order to avoid exposure to liability for
trespass and assault. The landlord also
has to be aware of its right to hold the tenant
and any other person who assists the tenant in
fraudulently removing goods from the premises to
avoid distress personally liable under the
governing legislation.
Practically speaking, the “race to the swiftest”
and corresponding incentive for the landlord on
the one hand and a secured creditor on the other
hand to seize the tenant’s assets as soon as
possible can have a counter-productive affect on
each of the landlord, the tenant and the secured
creditor, as it may result in the failure of the
tenant’s business that otherwise may have been
in a position to work its way out of its
financial difficulties through a proposal under
the BIA, plan of arrangement under the CCAA, or
some other “turnaround” measure.
It should be noted that the landlord cannot sue
for rent until the distress has been completed
(i.e. the goods have been appraised and sold).
It should also be noted that if a deficiency
remains after the goods subject to the distress
have been sold, the landlord may sue for the
deficiency, or terminate the lease for arrears
of rent as a result of the fact that a
deficiency remains.
Recently, and without any fanfare, there has
been a rather disturbing development for
landlords relative to the remedy of distress.
Indeed, this development is potentially so
important it may sound the death knell of
distress as an effective landlord remedy.
In April of 2004, the Ontario Superior Court
released its decision in The Attorney General
of Canada v. Community Expansion Inc. et. al.
However, this case was not reported until
almost a year later. Boiled down, the decision
in Community effectively characterizes
landlords who have exercised their right of
distress to be secured creditors and therefore
subject to the super-priorities created by the
deemed trust provisions of the Income Tax Act
(“ITA”)
The facts of the case are straightforward. A
landlord distrained upon the assets of its
tenant (a related party) for non-payment of rent
and, in the first instance, the assets were sold
to a related purchaser incorporated for the sole
purpose of purchasing the assets. The landlord
completed its distress by following the letter
of the law and, ultimately, the assets were sold
on by the related purchaser to an armslength
purchaser with the proceeds of sale placed into
an interest bearing account pending judicial
determination as to the priority between the
landlord and Canada Revenue Agency ("CRA").
As it turns out, the tenant had failed to remit
four months of source deduction payments to CRA
and the landlord initiated the distress to
assist the tenant in avoiding payment. CRA took
offense to the notion that distress defeats the
deemed trust provisions under the ITA and argued
that a distraining landlord should be treated
the same as a secured creditor realizing upon
its security.
The Court agreed with CRA. It was found that
although the landlord's right to distrain is not
in and of itself a "security interest", once
exercised, it creates a lien in favour of the
landlord that constitutes a "security interest"
and, as a consequence, the landlord becomes a
"secured creditor" within the meaning of the
deemed trust provisions of the ITA.
Specifically, the Court held that the trust does
not attach to any particular assets so as to
prevent their sale. Rather, the trust attaches
to the proceeds of sale.
In practical terms, the decision in Community
means that prior to commencing a distress a
landlord must be concerned with the quantum of
arrears owing by a tenant to CRA for unremitted
source deductions and to the provincial Crown
for unpaid retail sales tax. Until the ruling
in Community, landlords accepted the fact that
their distress would by subordinate to the debt
owing by a tenant to the Province but now, after
Community, a landlord must also be concerned
with unremitted source deductions. In fact, the
situation is probably even more grim for
landlords. The language of the deemed trust
provisions dealing with source deductions is
identical to the language used in the Excise
Tax Act dealing with unremitted goods and
services tax ("GST"). By extension, and
even though it is not dealt with in Community,
the remedy of distress may also be subject to
unpaid GST.
For landlords, distress was once thought to be
the best weapon in their arsenal against not
only a defaulting tenant but also, if swiftly
implemented, against a secured creditor and even
a trustee in bankruptcy of a tenant. The
decision in Community, by characterizing
distress as a security interest and a landlord
exercising distraint as a secured creditor, may
well sound the death knell for distress as an
effective landlord remedy.
In conclusion, the insolvency or bankruptcy of a
tenant can be a very frustrating experience for
a landlord, and counsel would be well advised to
minimize this frustration by making more
transparent the insolvency process in order to
facilitate the taking of proactive protective
steps and thus avoid any misunderstanding as to
the recourse available to a landlord.
Print
