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A standby letter of credit is a promise from a bank to a creditor that the bank will pay funds to the creditor in the event of a default by a debtor, so long as certain conditions are met. For example, a commercial landlord may require a standby letter of credit from a tenant’s bank to ensure payment should the tenant default on its obligations under the lease.

What the ‘Autonomy Principle’ With Respect to a Letter of Credit?

The autonomy principle holds that a letter of credit, as described above, is independent of the underlying transaction between the debtor and the creditor. This means that, even if the commercial landlord and tenant as mentioned in the above example were in a dispute over the payment of the lease agreement, the bank would still be required to honour the standby letter of credit so long as the landlord produced the necessary documentation required for payment. This principle was tested by a recent decision of the Ontario Court of Appeal (ONCA) involving a commercial landlord and tenant dispute.

Landlord Drew On Entire Value of a $2.5 Million Standby Line of Credit After Tenant Entered into Bankruptcy

In the case at hand, a question arose as to the ability of a commercial landlord to draw down on a letter of credit being used as security for the obligations of its tenant under the lease. The lease had been disclaimed by the tenant’s trustee in bankruptcy. The disclaimer of a lease by a Trustee in Bankruptcy, if properly presented, would be expected to end any default under a commercial lease with the exception of the three months of rent called for in section 136(1) of the Bankruptcy and Insolvency Act (BIA). However, the tenant had supplied security to the landlord in the form of a standby letter of credit (SLOC) valued at $2.5 million. The central question for the ONCA then, was should the landlord be able to draw down the entire value of the SLOC to satisfy the tenants’ obligations, or did the rules set out in the BIA intervene to prevent that recovery?

The commercial tenant made an assignment into bankruptcy and the Trustee in Bankruptcy disclaimed the tenant’s lease. The landlord, OMERS Realty Corporation (ORC) drew down, in full, the SLOC the tenant had posted with it as security for the tenant’s obligations under the lease. Some draws were taken before the disclaimer of the lease and some afterwards. The total draw amounted to two and a half million dollars, which was in excess of the three months’ rent provided for in the BIA following the disclaimer of a lease.

The Trustee brought a motion to recover the monies save and except for three months’ rent. A secondary position was that the lease itself restricted the amount ORC could draw on the SLOC. The Trustee was successful in Commercial Court. ORC appealed on the grounds that the SLOC was an independent obligation of the Bank upon which they were allowed to draw money beyond the three months rent restriction and for the full amount, pursuant to the autonomy principle.

Court of Appeal: Autonomy Principle is Paramount

The ONCA agreed with the ORC that it is a fundamental property of a SLOC that it remains unaffected by the transaction or legal arrangement between the tenant as the applicant, and the ORC as the beneficiary. This is called the “autonomy principle”. Therefore, the obligation of the Bank is completely independent of the legal relationship or the status of performance of the underlying contract. 

Upon presentation of the proper papers as required in the SLOC, the Bank must pay the beneficiary unless there is an exception based on fraud. That exception is a very narrow one as there must be evidence of the fraud sufficiently brought to the attention of the Bank before payment, or that can be demonstrated to a court to justify the need for an injunction.

The ONCA found that the ORC’s conduct did not fit within the fraud exception. The position of the Trustee was that the presentation of documentation was fraudulent in that it told the Bank that the tenant had defaulted under the lease when in fact the lease had been disclaimed, which had therefore extinguished any default by the tenant. The ONCA disagreed, as the wording of the SLOC made it clear that it would continue in force despite the tenant’s bankruptcy and any disclaimer of the same. There was also an absence of evidence showing any malice, impropriety or deceit.

The result is one based on the wording of this particular SLOC. Its interpretation led to that one and only conclusion. The rights it created were not defeated by the laws of insolvency under the BIA.

If you find yourself in a contractual dispute relating to bankruptcy and insolvency, fraud or otherwise, and require legal representation, contact the highly skilled  Toronto litigators at Milosevic Fiske LLP.  Our team of exceptional Toronto business law lawyers provide both proactive contract review and drafting services, as well as skillful representation of clients involved in all types of contractual disputes. We have helped businesses of all sizes across various sectors manage potential pitfalls and address them through litigation where necessary. We are the lawyers other lawyers turn to for complex commercial litigation. Call us at 416-916-1387 or contact us online for a consultation.