Termination of the lease by operation of law following failure to operate a business

On October 13, 2021, the Court of Appeal considered the validity of the extrajudicial termination of the lease between 9518002 Canada inc. (the Lessor) and 9745866 Canada inc. (the Lessee) following the latter’s failure to occupy and operate a commercial space more than one year after assuming possession.

 

The facts

On January 22, 2016, the Lessor entered into a lease with a third party who undertook to operate a pharmacy in a space located in a building to be constructed. In May 2016, the third party notified the Lessor that it was assigning its interest in the lease to the Lessee.

This commercial lease was part of a medical super-clinic project aimed at offering various complementary medical services. However, considering that the construction of the building had not yet begun at the time the lease was signed, the start of the pharmacy operations was not specified. Nevertheless, the lease provided that rent would begin to be paid three months after the Lessee assumed possession of the premises.

The lease, for an initial term of 15 years with renewal options, specified in particular:

[Tr.] “35 - The Lessor may, at its option and by operation of law, immediately terminate this agreement (without further notice) in the following circumstances:

[…]

i. if the Lessee changes the use of the Leased Premises without the prior written consent of the Lessor.” [End tr.]

On May 1, 2017, the Lessee finally assumed possession of the space and rent payment began as scheduled on August 1, 2017. Following the completion of leasehold improvements, the premises were finally ready to accommodate the pharmacy in November 2017, yet the premises remained unoccupied after the work was completed.

On July 26, 2018, more than a year after possession had been assumed, the Lessor opted to put the Lessee under formal notice to operate a commercial pharmacy in the premises within 10 days under penalty of termination of the lease, which the Lessee failed to do.

On August 20, 2018, the Lessor sent a notice of termination of the lease in which it gave the Appellant 10 days to vacate the premises.

Judgment of the Superior Court appealed

In the first instance, Judge Carole Therrien confirmed the legality of the extrajudicial termination of the lease by the Lessor because of the clause allowing for the termination of the lease by operation of law in the event of a change of use of the leased premises by the Lessee. Indeed, [Tr.] “the operation of the pharmacy was an essential obligation of the agreement between the parties and the failure to comply is equivalent to a change of use.” [End tr.] The Court therefore concluded that the Lessor was justified in terminating the agreement, because the absence of operation of the pharmacy by the Lessee, one year after assuming possession of the premises, constituted a significant default

Confirmation by the Court of Appeal

First, the Court noted that judicial termination is the rule in matters of leases,¹ as stipulated in the Civil Code of Québec:

1863. The nonperformance of an obligation by one of the parties entitles the other party to apply for, in addition to damages, specific performance of the obligation in cases which admit of it. He may apply for the resiliation of the lease where the nonperformance causes serious injury to him or, in the case of the lease of an immovable, to the other occupants.

However, the parties are free to contractually provide for circumstances giving rise to termination of the lease by operation of law, as was the case in clause 35(i) of the lease.

Thus a party may terminate a contract “without judicial action where the debtor is in default by operation of law” or if he fails to perform it within the time limit indicated in the notice of default sent.² However, termination will only be possible in the event of material or, in the case of a successive obligation, repetitive default.³

In its decision, the Court of Appeal confirmed that the fact that the pharmacy had not yet opened more than one year after possession of the premises had been assumed constituted a significant breach of the Lessee’s obligations, equivalent to a change of use of the premises within the meaning of clause 35(i), and justified the termination of the lease by operation of law.

Although in this case the lease did not provide for a specific date for the opening of the pharmacy, the parties had agreed on a three-month period between the taking into possession of the premises and the first rent payment, in order to allow the Lessee to complete the leasehold improvements required to operate the pharmacy. In principle therefore, the opening could take place upon completion of the work in November 2017.

Without endorsing the “Anchor tenant” theory, which allows a landlord to force the principal tenant of a building to operate its business because of the strong economic dependence between the parties, the Court of Appeal noted that the operation of the pharmacy was an essential service for the owner. By failing to comply with its obligation to occupy and operate the leased premises, the Lessee caused serious prejudice to the Lessor, as the vacancy of the premises had the effect of making the project less attractive to both customers and potential tenants.

Thus the absence of a clause obliging the Lessee to occupy the leased premises continuously was not a determining factor, since the notion of operation assumes that the pharmacy must be in operation in the leased premises for the term of the lease.

Lastly, the Court of Appeal recognized that the short 10-day period granted to the Lessee to begin operating the pharmacy was of no consequence, as it was already in default by operation of law due to its repeated breach of a successive obligation, and the fact that it had manifested its intention not to comply with its obligations.

Conclusion

As demonstrated by this decision, failure to operate a commercial space constitutes a breach of the lease obligations that may cause serious prejudice to a lessor. In such a case, the lessor will normally be able to apply to the courts to have the lease terminated. However, if there is a specific clause referring to the situations concerned, failure to occupy the premises for a significant period of time could be considered a change of use of the leased premises, which would allow the lease to be terminated by operation of law.

The full text of the decision can be consulted here (in French only).