New Developments Regarding Landlords and Insolvency

Certain amendments to the Bankruptcy and Insolvency Act have altered the rights of landlords with respect to insolvent tenants. These amendments affect the ability of both landlords and tenants to terminate leases upon an insolvency.

In addition, recent case law indicates that a court will be reluctant to limit the rights of a landlord as against secured creditors upon the insolvency of a tenant unless the court is clearly required to do so by applicable law.

Landlords Preferential Claim
Landlords rank sixth in priority as preferred creditors under the Bankruptcy and Insolvency Act. Once the claims of secured creditors have been satisfied, a landlord is entitled to a preferred claim for rental arrears occurring in the three (3) months immediately preceding bankruptcy. Landlords are also entitled to accelerated rent for the three (3) months immediately following bankruptcy if the lease entitles them to accelerated rent. However, the landlord's preferential claim is limited to the amount realized from the property on the premises which is the subject matter of the lease. In addition, accelerated rent is credited against occupation rent. (If a Trustee in Bankruptcy occupies the premises, it is obligated to pay occupation rent to the landlord.)

Rights of a Trustee in Bankruptcy
A Trustee in Bankruptcy is entitled to occupy the bankrupt's rented premises for three (3) months after the insolvency occurs. During that three (3) month period the Trustee may elect to retain the lease for the entire term or assign it to a third party. The right to assign the lease exists regardless of whether or not the lease prohibits assignment.

In order to be able to assign the lease the Trustee in Bankruptcy must pay all rental arrears to the landlord. In addition, the new tenant must covenant to observe the terms of the lease. In addition, the new tenant must carry on a trade or business which is not more objectionable or hazardous than the bankrupt tenant. Finally, the Trustee in Bankruptcy must apply to the Court for its approval of the assignment. Therefore, provided that the Court approves the assignment, a landlord will be obligated to accept a new tenant once the original tenant becomes bankrupt.

Landlord's Right of Distraint
When a person becomes insolvent, one of the first payments he or she will cease to make is rent owing on leased premises. The Commercial Tenancies Act provides a landlord of a defaulting tenant with very powerful remedies. A landlord may exercise a right of distress (distraint) against the tenant's goods. In addition, the landlord can disclaim the lease.

The right of distraint allows a landlord to enter into the leased premises and seize all of the tenant's chattels. This is of great concern to secured creditors since funds advanced by the secured creditors may be used to purchase the chattels against which distress is exercised. In essence, the right of distraint creates a super priority in favour of the landlord.

Once a tenant becomes bankrupt, however, all of its property vests in the Trustee in Bankruptcy. Therefore, the right of distraint is terminated once the tenant becomes bankrupt. However, the timing of distraint is a critical issue in determining whether a landlord has properly exercised a right of distress. The case law provides that if a landlord has exercised the right of distress, the tenant's goods have been seized and sold by a bailiff, and the proceeds of the sale have been delivered to the landlord prior to the bankruptcy of the tenant, then the distress will be a proper one.

However if the goods of the tenant have been sold prior to bankruptcy, but the proceeds of the sale have not been delivered to the landlord prior to the bankruptcy, the Trustee in Bankruptcy is then entitled to the proceeds of the sale of the tenant's goods. Therefore, it is often preferable for a secured creditor to petition a tenant into bankruptcy where the tenant owes significant amounts on account of rent. In addition, as indicated earlier a landlord will not be entitled to disclaim a lease once the tenant becomes bankrupt. Therefore, the rights of a landlord are significantly altered by the Bankruptcy and Insolvency Act.

Amendments to the Bankruptcy and Insolvency Act
The Bankruptcy and Insolvency Act contains provisions allowing a debtor to submit a proposal to its creditors to deal with all outstanding indebtedness. Where a notice of intention to file a proposal or a proposal has been filed by an insolvent person, a landlord will be prohibited from terminating a lease by reason only that the tenant has become insolvent, or that the tenant has not paid rent. Therefore, the landlord's right to disclaim a lease is terminated upon the mere filing of a notice of intention to file a proposal. Therefore, the amendments to the Bankruptcy and Insolvency Act severely limit the rights of a landlord which are provided under Ontario's Commercial Tenancies Act.

The amendments to the Bankruptcy and Insolvency Act in 1992 and 1997 also provided an insolvent tenant with significant rights. At any time between the filing of a notice of intention to file a proposal and the filing of a proposal, or upon the filing of a proposal, the tenant may disclaim the lease upon giving thirty (30) days notice to the landlord. Within fifteen (15) days of receiving the notice, the landlord may apply to a court for a declaration prohibiting the tenant from disclaiming the lease. However, no declaration can be made if the Court is satisfied that the tenant would not be able to make a viable proposal without the disclaimer of the lease. In the situation in which the lease is disclaimed, the landlord has no claim for accelerated rent. However, the landlord is entitled to file a proof of claim in the proposal. Therefore a proposal can be used strategically to allow a tenant to disclaim a lease without being responsible for paying accelerated rent. However, the proposal must provide that the landlord is entitled either to its actual losses resulting from the disclaimer or the lesser of three (3) years rent or the aggregate of one (1) years rent plus 15% of the rent for the remainder of the term. Therefore, although the landlord is entitled to file a proof of claim in the proposal, the new amendments to the Bankruptcy and Insolvency Act assist the tenant in creating a viable proposal without being hindered by the necessity of keeping leases current. As you may be aware, in the Eaton's restructuring, one of the most significant issues was determining a means of disclaiming leases for unprofitable locations. At that time, the current amendment was not in force. Eaton's would have been required to pay six (6) months rent to each landlord prior to being entitled to disclaim the lease. The new amendments to the Bankruptcy and Insolvency Act facilitate proposals by curtailing the rights of landlords. However, in return the amendments allow the landlord to vote on the proposal.

Judicial Trends
Despite the amendments to the Bankruptcy and Insolvency Act which limit the rights of landlords, the Courts have not been as eager to curtail the rights of landlords especially in circumstances in which they are in competition with the rights of secured creditors.

The decision of the Ontario Court of Appeal in the Canadian Imperial Bank of Commerce v. Canotek Development Corporation preferred the rights of the landlord over that of a secured creditor.

In Canotek, CIBC had a secured interest against the tenant's equipment. The landlord, as a result of default under the lease, distrained against the equipment. The landlord's distress was irregular. The Commercial Tenancies Act provides that upon a distress being made by a landlord, a sale of the distressed goods may not occur prior to five (5) days subsequent to the distress. However, the landlord failed to wait the required five (5) days and sold the equipment distrained against two (2) days after the distress.

CIBC brought an action against the landlord both as a secured creditor and as an assignee of the Trustee in Bankruptcy. Section 38 of the Bankruptcy and Insolvency Act allows a creditor to apply to the Court for an order authorizing it to commence a proceeding in its own name and at its own expense and risk in the place of the Trustee in Bankruptcy. The Act further provides that any benefit derived from a proceeding taken pursuant to Section 38 derives exclusively to the creditor.

CIBC's argument was that if the landlord had waited the required five (5) days before selling the equipment distrained against, it would not have been entitled to the proceeds of the sale because prior to the expiration of the five (5) day period, the tenant became bankrupt. As indicated previously, a landlord loses its right of distress unless it has received the proceeds of the sale prior to the tenant becoming bankrupt. In this case if the landlord had waited the five (5) days, it would have not have received the proceeds of sale prior to the bankruptcy. Therefore, CIBC argued that it was entitled to the proceeds of sale as assignee of the Trustee in Bankruptcy.

The Court disagreed however. The Court stated that while it would overturn an illegal distress, it would not overturn an improper distress. The Court found that the landlord did indeed have the right to levy distress, but the means of doing so were improper due to the fact that the five (5) day waiting period was not satisfied.

The Court found that absent a bankruptcy, the landlord would have had priority over the secured creditor and would have been entitled to levy distress against the equipment. The premature sale by the landlord would not have affected the rights of CIBC absent a bankruptcy because the landlord was entitled to the equipment in priority to CIBC. The Court refused to limit the landlord's priority merely because of the intervening bankruptcy. The Court stated:

"The Bank never did have a priority over the landlord once the landlord distrained against the goods. The artificiality of looking to the bankruptcy proceedings to give the Bank something the law never intended it to have is obvious, and should not be countenanced by the Court."

We suggest that this decision is not in accordance with the policy underlining the Bankruptcy and Insolvency Act. It is the intent of the Act that all unsecured creditors share equally in the bankrupt's property except as specifically provided in the Act. Landlords are provided with a preferential claim but only for rent arrears equivalent to three (3) months rent. The decision of the Ontario Court of Appeal in Canotek is at odds with the clear intent of the Act.

The decision of the Ontario Court of Appeal further ignores the expressed provisions of the Bankruptcy and Insolvency Act by providing that CIBC could not bring a claim against the landlord under the fraudulent preference provisions of the Bankruptcy and Insolvency Act in the place of the Trustee. Section 38 of the Bankruptcy and Insolvency Act specifically allows a secured creditor to step into the shoes of the Trustee in Bankruptcy. As such, CIBC brought an action claiming that the distress by the landlord prior to the bankruptcy was a fraudulent preference because the payment to the landlord pursuant to the distress preferred the landlord over all of the other creditors of the tenant. The Court did hold that the distress was a fraudulent preference. However, it provided that CIBC did not have standing as a secured creditor to bring the fraudulent preference claim. The Court found that only the Trustee in Bankruptcy was entitled to bring the claim. This decision ignores the expressed wording of Section 38 of the Bankruptcy and Insolvency Act. However, the Court stated that it had not been provided with any information with respect to the assignment by the Trustee in Bankruptcy to CIBC. The Court further stated that no information was available to indicate whether the assignment was taken pursuant to Section 38 of the Bankruptcy and Insolvency Act. Therefore, the Court was not convinced that the assignment was actually pursuant to Section 38 of the Act pursuant to an order of the Court. Rather, the Court appears to assume that the assignment was merely a private assignment between CIBC and the Trustee.

Therefore, it would appear that in a future case where a proper assignment was made pursuant to Section 38 and the facts of the assignment were provided to the Court, a secured creditor would be entitled to bring a fraudulent preference claim as assignee of the Trustee in Bankruptcy. However, on the facts in the Canotek decision the Court held that CIBC was not entitled to bring the fraudulent preference claim.

The decision in Canotek clearly illustrates that a Court will not allow technicalities to limit the rights of a landlord. In addition, the Court indicates that it will not honour private arrangements between a secured creditor and a Trustee in Bankruptcy unless the provisions of the Bankruptcy and Insolvency Act have been strictly complied with.

Prepared May 10, 1999 by Danielle Iampietro, Associate
Commentary is of a general nature and is not intended as legal advice. Specific advice should be sought with respect to each specific case.