On October 28, 2020, the Ontario Court of Appeal overturned a respected Commercial Court judge’s decision on a motion affecting a range of important legal issues, including the fraud exception to the autonomy principle regarding letters of credit. In 7636156 Canada Inc. (Re), 2020 ONCA 681, Ontario’s highest court clarified the law regarding a landlord’s right to call on a letter of credit (“LC”) when its tenant becomes bankrupt. The Court of Appeal confirmed that, under the autonomy principle, a bank’s obligation under an LC is independent of a tenant’s obligations under the lease, and clarified the fraud exception that allows a bank to refuse to pay on an LC. The case also holds implications for Canadian bankruptcy law.
A commercial tenant put in place a $2.5 million LC in favour of its landlord. The tenant went bankrupt and a trustee was appointed. Shortly after, the trustee disclaimed the lease and the landlord drew down the full amount of the LC. The trustee claimed, and the motion judge agreed, that the landlord was only entitled to recover three months’ accelerated rent of as per the restrictions of the Bankruptcy and Insolvency Act, R.S.C. 1985, c. B-3 (“BIA”). The landlord appealed on the grounds that the independent obligations created by the LC between the issuer bank and itself as beneficiary were not affected by the trustee’s disclaimer of the lease. The appeal raised two issues:
- Whether the landlord was entitled to draw on the LC for amounts in excess of the landlord’s preferred claim under 136(1)(f) of the BIA.
- Whether the lease mandated that the amount of the LC be reduced.
The Court of Appeal overturned the decision of the Honourable Mr. Justice Glenn Hainey on both issues.
Banks have an independent obligation to make payment to a beneficiary
A fundamental characteristic of a standby LC is its autonomy from the underlying transaction between the applicant and the beneficiary. This is referred to as the “autonomy principle”. The obligation of the issuing bank to the beneficiary of a credit is at all times to be independent of the actual performance of the underlying contract.
Banks must pay unless there is fraud
Under the autonomy principle, an issuing bank must pay the beneficiary upon presentation of the proper documents specified under the LC, subject to very narrow exceptions, notably, fraud. The fraud exception will apply in the case of fraud by the beneficiary that has been:
- sufficiently brought to the knowledge of the bank before payment of the draft, or
- demonstrated to a court called on by the customer of the bank to issue an interlocutory injunction to restrain the bank from honouring the draft.
The Court of Appeal determined that the conduct of the landlord did not fall within the fraud exception. The trustee claimed that the documents presented by the landlord were “clearly untrue or false” because they stated that the tenant had defaulted under the lease, despite the fact that the alleged default came after the lease had been disclaimed by the trustee (there can be no default on a properly disclaimed lease). The Court of Appeal rejected this argument because the lease provided that the rights of the landlord in respect of the LC would continue in full force and effect in the event of the tenant’s bankruptcy and any disclaiming of same. Additionally, there was no evidence that the landlord acted with impropriety, dishonesty, or deceit.
Contractual interpretation can impact the value of a LC
The Court of Appeal held that the trustee’s disclaimer of the underlying lease did not render the LC unenforceable or limit it to covering three months’ rent. The Court of Appeal reviewed several decisions that examined the enforceability of an LC where a lease had been disclaimed to determine whether the law of bankruptcy and insolvency restricted the landlord to only claiming for the three months’ rent.
The precedential value of the decision will be limited somewhat by the fact the Court of Appeal noted that a landlord’s entitlement to draw on a LC will turn on the specific language of the lease and LC. In this case, the lease specifically provided that the LC was security for the landlord’s losses resulting from disclaimer in connection with any insolvency and bankruptcy, and that the landlord’s rights in respect of the LC were not affected by the disclaimer of the lease in any bankruptcy proceeding. Similarly, the Court of Appeal held that the bank’s obligation to pay on the LC was not altered by the principles of insolvency law, including, in particular, those concerning the effect of a trustee’s disclaimer of a lease.
The Court of Appeal also held that the lower court’s interpretation of the lease’s LC reduction clause was based on an error concerning an extricable question of law (thereby allowing for a less onerous standard of appellate review). The relevant provision of the lease stipulated that if the tenant had “promptly” paid rent at all times, it may be entitled to a reduction in the LC; however, the tenant had paid rent a few days late on several occasions. The Court of Appeal held that the lower court had failed to consider provisions of the lease that established that, in examining the contract as a whole, “promptly” meant payment of rent when due on the first day of the month. As a result, the tenant did not satisfy the conditions under the lease for the reduction in the LC.
- The obligation of an issuing bank is independent of the performance of the underlying contract for which credit was issued, and the bank must pay the beneficiary upon proper certification, subject only to very limited exceptions (e.g. fraud).
- The fraud exception to the autonomy principle will not be engaged absent the presenting party acting with “impropriety, dishonesty, or deceit“. A good faith disagreement on the meaning of a contract will not suffice. Moreover, assessed in the context of the specific contractual language in this case, the landlord’s statements in the certificates it presented to trigger payment were not “clearly untrue or false“.
- A landlord’s entitlement to draw on a LC will turn on the particular language of the lease and LC.
- Bankruptcy or insolvency will not affect the right of a landlord to draw on an LC for an amount in excess of the landlord’s preferred claim for three months’ accelerated rent under the BIA when the tenant disclaims the lease.
The authors wish to thank Brittany Shales, Student-at-law, for her invaluable assistance with this blog post.