A commercial tenant in hopeless default—Now what?

During a lease term, there may come a time when it becomes no longer financially viable for a commercial tenant to continue its operations at the leased premises and faces the prospect of defaulting on the lease. Whether you are a landlord or tenant in this situation, there are a few considerations that you should know before taking any steps.

You should review your commercial lease agreement. The act of failing to pay rent or abandoning the premises are both considered events of default, and its consequences will be covered in the lease, including any notice periods that the tenant has to remedy the default.

Generally speaking, the landlord will have three options upon the event of a default:

1. Re-entry and re-letting the premises

The first option would be to re-enter the premises for the purposes of re-letting the premises to a third party. Under this option, the lease agreement has not been terminated, and the obligations of the tenant under the lease will remain. However, the tenant will only be responsible to cover the difference in rent, if any, between the amount that the tenant owes the landlord and the rent amount that the new tenant is paying the landlord.

If the tenant refuses to pay the difference in rent, the landlord can sue to recover the difference. The problem with this option is that if the landlord intends to sue the tenant for failing to pay the difference in rent, it would need to be made within two years of the breach in the lease and it could take several years for the process to go through the Ontario court system. It may also prove difficult to recover payment from the tenant after it has vacated the premises and especially if it has no assets to recover.

2. Terminate the lease agreement

The second option would be to terminate the lease. Under this option, the landlord can demand that the tenant vacate the premises, if it has not already done so, and notify the tenant that it intends to sue for rent for the unexpired term of the lease.

The benefit to this option is that the landlord has immediate control of the premises and it can seek to obtain a new tenancy. Damage to the premises can arise when it is vacant due to neglected maintenance, improper heating/cooling …etc. and there may not be insurance coverage in place to cover these damages.

The drawback to this option is that the landlord cannot distrain (take) upon the assets of the tenant in order to satisfy the tenant’s debt to the landlord. The landlord is required to provide the tenant with an opportunity to remove its assets from the premises.

In addition, the landlord has the duty to mitigate its damages. The landlord’s right to sue for the remaining rent obligation is mitigated by the landlord’s responsibility to find a new tenant for the premises to recover the loss in rental income. However, the landlord can still sue the tenant for any months that the premises remain vacant and the landlord has taken reasonable steps to secure a new tenant. In other words, the tenant will be liable for rent for the months that it takes the landlord to advertise the vacant premises, find a new tenant, and offer the Tenant any rent-free periods to install new fixtures, equipment, improvements…etc. In addition, the tenant will remain liable for any reduction in rent that the landlord obtains from the new tenant and any costs it incurs to relet the premises (i.e. brokerage and solicitor costs).

3. Demand the payment of rent and sue for damages

The third option would be to demand the immediate payment of the rent outstanding. The lease may have a clause that will permit the landlord to demand an additional amount equal to a few additional months’ rent. If the tenant ignores this demand, the landlord can sue the tenant for the payment of rent. If the tenant has abandoned the premises, the landlord could also sue for damages resulting from the vacant premises.

In the alternative, if the tenant has not vacated the premises, the landlord can distrain upon the tenant’s assets that are located at the premises in order to satisfy its debt. This is not an option if the landlord elects to terminate the lease.

Under this option, the landlord is not under any obligation to terminate the lease, unless stated otherwise in the lease agreement. It could choose to keep the lease agreement in place, and sue the tenant for rent and damages, or distrain upon its assets.

Similar to option one, this option is costly for the landlord as it would require it to file a claim against the tenant within two years of the breach in the lease with no guarantee that the landlord will be able recover its losses upon being awarded damages by the court.

However, the benefit of this option is that the landlord is not under an obligation to mitigate its damages unlike the previous option. If the tenant has assets that the landlord can successfully go after in court, this option could prove costly for the tenant.

If the tenant is a corporation, its directors can be held personally liable if the tenant corporation removes the assets from the premises for the purpose of frustrating the landlord’s attempt to distrain upon the assets.

Conclusion

Before a tenant considers abandoning the premises or ceasing to pay rent, it may be beneficial for the landlord and tenant to come to an agreement that would allow the tenant to assign or sublet the lease to a third party under terms that are reasonable and acceptable to each party. For the landlord, it places the onus on the tenant to find a suitable new tenant for the premises and avoids costly litigation. For the tenant, it avoids the prospect of a lawsuit, removal of its assets, and the continuous obligation to pay rent until the expiry of the lease term.