Canada: Hot Sublease Market? Beware Sections 21 And 39(2) Of Commercial Tenancies Act (Ontario)

Copyright 2009, Blake, Cassels & Graydon LLP

Originally published in Blakes Bulletin on Real Estate, April 2009

The ongoing uncertainty in the economy and the resultant market slowdown has tenants re-evaluating their space needs. After considering their options and weighing demand, some tenants determine that the appropriate way to shed space on a cost-effective basis is to sublet all or a portion to a third party subtenant.

A tenant will, of course, have to navigate its way through the requirements contained in a lease that are triggered in a sublease scenario. In most cases, the consent of the head landlord to the proposed sublease arrangement will have to be obtained.

One concession that a head landlord often expects from the subtenant as a condition of the head landlord's consent to the sublease is a waiver by the subtenant of any statutory and common-law rights it may have in the case of termination of the head lease. Head landlords and, indeed, prospective subtenants do not always understand what statutory rights are being waived.

This article examines issues surrounding the impact of a subtenant waiving its rights under sections 21 and 39(2) of the Commercial Tenancies Act (Ontario) (CTA). With concern over business insolvencies trending upward, a subtenant that has waived its sections 21 and 39(2) rights might want to consider a solution that will lessen the impact to its business if its occupancy of the subleased premises is threatened by termination of the head lease.

Effect On The Sublease Of Termination Of The Head Lease Due To Sublandlord Default: Section 21 Of The CTA In the absence of any direct contractual relationship (such as a non-

disturbance agreement) between the subtenant and the head landlord, the subtenant's tenure in its subleased premises is only as solid as the head lease. Accordingly, if the head lease is terminated by the head landlord due to a default of the sublandlord under the head lease, the sublease will also be terminated. This would be the case even though the subtenant may be solvent, promptly paying rent and performing the obligations of the tenant under the head lease as they pertain to the subleased space.

Of course, it might be of benefit to the head landlord to see to the continued occupancy of the subtenant of the premises it occupies if there is an event terminating the head lease. However, for a myriad of reasons, including if the subleased premises consist of part of a floor or a building or if the subtenant itself is on shaky ground, the head landlord will want flexibility to start from scratch and be in a position to lease the premises as a whole to a new tenant.

However, head landlord and subtenants alike should be aware of section 21 of the CTA – a number of other Canadian provinces have similar legislation protecting subtenants. Section 21 gives a subtenant the right to apply for an order of the court to permit it to remain in its premises as a direct tenant of the head landlord, if the head landlord is enforcing a right of re-entry or forfeiture under the head lease due to a sublandlord default. The terms of the arrangement between the head landlord and the subtenant (i.e., rent, costs, expenses, damages, giving of security, etc.) are subject to the court's discretion; however, the term of the new lease cannot be longer than the term of the original sublease. For a subtenant subleasing only a portion of the premises leased by the sublandlord under the head lease, there is a possibility that the court could require the subtenant to take on all of the premises that were the subject of the original head lease.

It is easy to see why a head landlord would wish to have a prospective subtenant waive its rights under section 21; after all, a successful application by a subtenant could leave the head landlord with a court-imposed tenancy on unpredictable terms.

Effect Of Head Tenant's Bankruptcy On The Sublease: Section 39(2) Of CTA

A termination of the head lease due to a default of the sublandlord, such as the non-payment of rent, is not the only possible event jeopardizing the subtenant's tenure. If the sublandlord goes bankrupt, the sublandlord's trustee-in-bankruptcy or receiver is entitled to disclaim the lease, resulting in the termination of the contractual relationship between the head landlord and the head tenant/sublandlord. This would, again, result in a termination of the sublease.

Section 39(2) of the CTA accords to a subtenant that occupies subleased premises pursuant to an arrangement approved or consented to in writing by the landlord, a manner of remaining in possession of its premises if there is a bankruptcy or winding-up of the sublandlord. The subtenant can elect, within three months of the bankruptcy filing or winding-up order, to step into the sublandlord's shoes under the head lease. The subtenant will have the same liabilities and obligations to the head landlord as the sublandlord had, except that the rent payable by the subtenant will be the greater of: (a) the rent paid by the subtenant to the sublandlord under the sublease, and (b) the rent paid by the sublandlord to the head landlord under the head lease.

Protecting The Subtenant If Rights Under Sections 21 And 39(2) Of CTA Are Waived

As mentioned above, the subtenant is often required to bargain away its rights under sections 21 and 39(2) as part of the process involved in securing the head landlord's consent to the sublease. What can a subtenant without recourse to the statutory provision do to protect itself?

If the subleasehold interest is wiped out, the subtenant will invariably suffer costs associated with displacement. Aside from the intrinsic value of the subtenant's tenure under the sublease for the now foregone term, the subtenant will be required to find new suitable premises, possibly at a higher rent than the subleased space. There will also be moving costs, costs of fixturing the new premises and other usual costs of relocation.

For the subtenant, these costs can be significant and, arguably, should not be borne entirely by the innocent subtenant, which could be harmed by an event over which it has no control. One possible solution is to require the sublandlord to provide the subtenant with some form of security that the subtenant could resort to if the subleasehold interest of the subtenant is terminated because the head lease has been terminated or disclaimed due to a sublandlord default or bankruptcy of the sublandlord. A cash security deposit and/or a letter of credit drawn on the sublandlord's bank for the subtenant's benefit may be the appropriate form of security. The amount of the security will inevitably be the subject of negotiation, but it should approximate the costs and expenses (perhaps on a declining balance basis as the term of the sublease elapses) that would be incurred by the subtenant if forced to vacate its premises.

A Few Words Of Caution

Whether cash security or a letter of credit is employed, it is critical that steps be taken to ensure that the language in the documentation be appropriately drafted to ensure that the subtenant will have access to the security in case it is needed and that it will not, for example, pass to the estate of the bankrupt sublandlord.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.