Enforceability of a Security Deposit Against a Trustee in the Event of the Bankruptcy of a Commercial Tenant

When negotiating a commercial lease, it is in the landlord’s best interest to require that securities be provided by the prospective tenant in order to protect the landlord against the tenant’s failure to perform its obligations under the lease. A frequent cause of a tenant’s inability to perform its obligations is its insolvency or financial difficulties. It is important for landlords to know that the tenant’s bankruptcy, or the filing by the tenant of a notice of intention or a proposal under the Bankruptcy and Insolvency Act (the “BIA”) can have the effect of negating the protection afforded by certain forms of security.

This article concerns in particular a security frequently required by landlords, namely the remittance by the tenant of a sum of money that may be equivalent to one or more monthly instalments of rent, which is sometimes referred to in leases either as a “security deposit”, or as “prepaid rent”. We will see that in the event of the tenant’s bankruptcy, notice of intention or proposal under the BIA, depending on the wording of the clause in the lease dealing with the deposit, the landlord may be obliged to remit the amount of the deposit to the trustee, even if the tenant is indebted towards the landlord.

The problem stems from the fact that in the case of a bankruptcy, a notice of intention or a proposal under the BIA, the hypothecs granted by the tenant in favour of a commercial landlord are not enforceable against the trustee.

Indeed, the Court of Appeal of Quebec in the Ocean Drive¹ decision concluded that a landlord, who is granted a preferred creditor status by Section 136(1)(f) of the BIA, must necessarily be collocated at the rank provided by said section, and cannot benefit from the priority provided in the Civil Code of Québec (“CCQ”) because of the doctrine of paramountcy which establishes that federal law prevails over provincial law when there is a conflict between them:

[TRANSLATION] “It must be concluded that the status of secured creditor claimed by the landlord on account of its conventional movable hypothec would change the order of priority assigned to landlords by Section 136(1)(f) of the BIA, by improving the priority of rank of the preferred claim expressly covered by that section. Consequently, the provisions of the Civil Code on prior claims and hypothecs that would otherwise affect the order of priority under the BIA by giving the landlord the status of a “secured creditor” are inapplicable in a bankruptcy situation.”²

Consequently, in the event of a tenant’s bankruptcy, notice of intention or proposal under the BIA, the landlord cannot enforce any hypothec it holds on the insolvent tenant’s assets, and must content itself with the priority of rank provided by Section 136(1)(f) of the BIA, which priority is nevertheless subject to the rights of secured creditors and is limited to the amount realized from the assets in the leased premises.

In the province of Quebec, a deposit granted by a tenant to guarantee the performance of its obligations under the lease constitutes a movable hypothec with delivery, also known as a “pledge”.

In order to be enforceable against third parties, a pledge does not need to be published in the Register of Personal and Movable Real Rights. A pledge is constituted by physical delivery of the property or title to the creditor or, if the property is already under the detention of the creditor, by the latter continuing such detention, with the grantor’s consent, in order to secure the creditor’s claim³. Thus, the physical delivery of movable property to the creditor and the continued detention of said property by the latter are sufficient to ensure the publicity of the pledge and its enforceability to third parties⁴.

We note, however, that some uncertainty exists with regard to a pledge granted on incorporeal (intangible) property as it applies under Article 2702 CCQ since its amendment in 2009. Article 2702 CCQ now requires the “physical” delivery of the property charged by a movable hypothec with delivery. If a claim is incorporeal (intangible), can it be physically delivered? The Court of Appeal addressed this uncertainty in the Basille⁵ case in 2014, noting that some authors are of the view that since the 2009 amendment of Article 2702 CCQ, pledging a sum of money is no longer possible because of the incorporeal (intangible) nature of money⁶. However, the Court went on to apply the decision in the Brouillette-Paradis⁷ case, which concerned the substitution of a legal hypothec, in which the Court of Appeal accepted that [TRANSLATION] “the judicial offer to assign, as security, the claim on monies deposited in substitution for a legal hypothec implies the constitution of a movable hypothec with delivery in favour of the holder of the legal hypothec”⁸.

In light of the foregoing, if a deposit remitted to a landlord constitutes a pledge, it is unenforceable against the trustee of a tenant who placed itself under the protection of the BIA. This is what the Court of Appeal decided in Expleo Global⁹, where the landlord sued the trustee for occupation rent. In its defence, the trustee admitted to owing the occupation rent, but was requesting the reimbursement of the deposit that the landlord received from the tenant and which the trustee maintained was a pledge. In its analysis on the characterization of the amount remitted to the landlord, the Court took into account that:

• a certified cheque had been given to the landlord as a replacement for the irrevocable and unconditional letter of credit provided for in the lease as security for the performance of the tenant’s obligations;
• several of the exhibits, some of which were filed by the landlord, referred to this amount as a “security deposit”;
• as at the date of the bankruptcy, the landlord had not yet applied the deposit to the amounts owing by the tenant; and
• no prior notice had been served by the landlord of its intent to realize upon its security before the bankruptcy.

Considering this evidence, the Court was of the opinion that the amount deposited with the landlord could only be considered as a movable hypothec with delivery, even if such security is of lesser value than a letter of credit. The Court added that the deposit in this case could not be considered prepaid rent. Therefore, the security constituted by the deposit was unenforceable against the trustee since the landlord had not availed itself of its right to realize said security before the bankruptcy. The Court therefore concluded that the deposit must be returned to the trustee, for the benefit of the mass of creditors.

However, if the deposit is considered as prepaid rent, it would then be enforceable against the trustee and the landlord would have the right to keep such deposit.

To determine the nature of the deposit provided, the Court must ascertain the intention of the parties to the commercial lease, taking into account the circumstances under which it was concluded, the interpretation the parties have already given it, as well as the other clauses of the lease¹⁰. Thus, particular attention must be paid to the wording of the deposit clause, to the other clauses of the lease that refer to this deposit clause, as well as to the behaviour of the parties, as the case may be.

In the case of Ébénisterie Renouveau¹¹, the Superior Court, Bankruptcy Division, had to interpret a “security deposit” clause, where the landlord was claiming rent from the trustee for its occupation of the leased premises following the tenant’s bankruptcy. The trustee was contesting the claim, alleging compensation (set-off) of the occupation rent against the amount of the deposit which, the trustee argued, should be paid to it for the benefit of the mass of creditors.

The Court concluded that the parties to the lease had intended that the deposit be non-refundable and that it be applied to future rent or any other amount owing by the tenant in default, despite the fact that the said clause was entitled “security deposit”. The main criterion on which the Court based its decision was the non-refundable nature of the deposit. It was actually a partial prepayment of rent which had become the property of the landlord upon payment in May 2005, well before the bankruptcy.

More recently, in the Alignvest case¹², the Court of Queen’s Bench of Alberta had to decide whether the landlord had to pay to the trustee the amount of the deposit which had been remitted to it by the now bankrupt tenant, further to a request by a secured creditor, Alignvest. The clause for the deposit was entitled “Security Deposit/Rent Credit” and provided that the deposit was to be applied towards future rent payments, but only if the tenant was not then in default. Although the clause contained some indication of the parties’ intention to consider the deposit as prepaid rent, the Court rather concluded that the deposit constituted a security deposit, as the clause provided that the amount was to be held by the landlord as security for the tenant’s performance of its obligations under the lease. The Alberta Court of Appeal confirmed the decision rendered in first instance by the Court of Queen’s Bench on the nature of the deposit. It also took into account the fact that the lease provided that the tenant must renew the deposit in the event that the landlord used the deposit to remedy a default by the tenant during the term, which, according to the Court, is incompatible with the notion of prepaid rent.

Considering the above decisions and in order to ensure that the amount remitted to the landlord upon the execution of a commercial lease not be considered as a movable hypothec with delivery and to ensure that it be enforceable against the trustee in the event of a bankruptcy, notice of intention or proposal under the BIA by the tenant, the lease should, in general, provide the following:

• that the amount of the deposit constitutes prepaid rent that becomes the property of the landlord upon disbursement to the landlord at the time of execution of the lease; and
• that the deposit is non-refundable;
• the term “security deposit” should not be used in the lease, nor should the deposit be referred to therein as security for the performance of the tenant’s obligations under the lease.

In conclusion, there are two opposing concepts: the security deposit and the prepaid rent. In the event of a dispute, the whole will be a matter of interpretation of the lease and the clause in question, taking into account the intention of the parties.