An article^[1] recently appeared in the Banking & Finance Law Review that reminds us of the vulnerability of a letter of credit or guarantee (or indemnity, or co-covenantor agreement) as security. People expect that a letter of credit is “good as gold”, and that a guarantee can be relied upon when needed, but in the very situation you might most want to use it (bankruptcy or insolvency) you might be disappointed. The analysis presented in this article gives rise to a couple of comments and observations:

“Letters of credit have yet to find a comfortable place in bankruptcy law.” If a landlord takes a letter of credit to cover more than three months’ rent (the limit of the statutory landlord’s preferred claim), then the landlord is susceptible to being disappointed in the protection that the letter of credit provides;

and

“[A] landlord’s entitlement to draw on a letter of credit in any given case will depend on the particular language of the lease and the letter of credit.” Notwithstanding the Crystalline decision (discussed below), this area of law remains unsettled. Out of an abundance of caution, parties drafting commercial lease agreements should continue to incorporate a covenant (the “additional covenant”) by the guarantor (indemnitor, or co-covenantor) stipulating that if required by the landlord it would enter into a new lease on the same terms and conditions as the original lease for the remainder of the term of the original lease.

A long line of cases going back to the Cummer-Yonge^[2] case in 1965, conveniently reviewed in Cummer-Yonge Revisited: The Effect of the Bankruptcy of a Commercial Tenant on Guarantees, Indemnity Agreements and Letters of Credit Pertaining to the Lease Obligations,^[3] held that if a trustee in bankruptcy disclaims a lease upon bankruptcy then the tenant’s lease obligations are extinguished and consequently the guarantor’s legal obligations also vanish.^[4] Commercial landlords are limited to the statutory relief provided under section 136(1)(f) of the Bankruptcy and Insolvency Act,^[5] namely a preferred position for three months’ arrears or three months’ accelerated rent. But typically three months’ rent would be modest in comparison to the landlord’s actual loss. A landlord might well ask – “why do you think we took the guarantee (or letter of credit) in the first place”? It was politely observed in one of the cases that the Cummer-Yonge result is “counter-intuitive”. Even so, for many years this scenario was a trap for the unwary, and landlords (or their lawyers) had to resort to the additional covenant to achieve the intended result.

Then in 2004 in Crystalline Investments Ltd. v. Domgroup Ltd.,^[6] the Supreme Court of Canada ruled that where a commercial tenant assigns a lease to an assignee, and the assignee later becomes insolvent, the original tenant will remain liable to the landlord under the lease, notwithstanding the disclaimer of the lease by a trustee in bankruptcy for the assignee. The contractual relationship between the original tenant and the landlord remained intact, regardless of the extinguishment of the assignee’s obligations by disclaimer by the trustee in bankruptcy. [In this scenario, for this legal issue the position of the original tenant is akin to that of a guarantor, indemnitor or co-covenantor.] It appeared that with the Crystalline decision common sense was (at long last) restored.

In a recent case from the Court of Appeal for Ontario, sub nom. OMERS Realty Corp. v. 7636156 Canada Inc.,^[7] the lease stipulated that a letter of credit was to stand as security for the tenant’s obligations. The lower court applied the Cummer-Yonge reasoning (with the result that the letter of credit was not effective as security). The Court of Appeal for Ontario reverted to the Crystalline reasoning (with the result that the letter of credit was effective as security). The article in the Banking & Finance Law Review criticizes the outcome in the appeal decision. It appears that the issue may still be open to some debate. Out of an abundance of caution, it is a good idea to hang on to the additional covenant for a while longer. Most leases are pretty long already, and the additional covenant won’t make it too much longer.

Note that although this commentary focuses on the commercial lease scenario, the issue is also alive in other contexts (such as for example software licenses, distribution agreements, construction contracts, etc.) where a letter of credit or guarantee (or indemnity, or co-covenantor agreement) is given as security.