Is Letter of Credit Better Bankruptcy Protection than Cash Security Deposit?

Q Is it true that getting a letter of credit (L/C) as a security deposit will protect my interests better than a cash security deposit if a tenant goes bankrupt?

A The answer depends on what part of the country you live in. But the current legal trend suggests that an L/C security deposit may not protect your interests any better than a cash security deposit if a tenant goes bankrupt, says Sacramento, Calif., attorney Jamie P. Dreher.

Here's why: Federal appeals courts in three circuits have now ruled that if a bankrupt tenant “rejects” (that is, gets out of) its lease, the proceeds of an L/C security deposit—just like a cash security deposit—must be subtracted from the amount of an owner's “capped” claim against the bankrupt tenant's assets for rent due after the tenant files for bankruptcy. That assumes the amount of the L/C is less than the capped claim, Dreher says. An owner's capped claim is the lesser of one year's rent or 15 percent of the remaining rent due, not to exceed three years, he explains. (Also, you're entitled to recover unpaid rent that was due before the tenant filed for bankruptcy.) Previously, some bankruptcy courts would accept an owner's argument that the L/C security deposit should be subtracted from the total amount owed, rather than from the amount of the owner's capped claim. But the three circuits' rulings prohibit that argument and significantly reduce what an owner can collect from a bankrupt tenant.

The three circuits affected by these rulings are the Second Circuit, covering Connecticut, New York, and Vermont; the Third Circuit, covering Delaware, New Jersey, and Pennsylvania; and the Ninth Circuit, covering Alaska, Arizona, California, Idaho, Montana, Nevada, Oregon, and Washington State.

What do the three circuits' rulings mean in practical terms? Suppose one of your tenants files for bankruptcy in a court in one of those circuits and then rejects its lease. Your actual damages (that is, your full claim if there weren't a cap) are $5 million, one year's rent is $2 million, and the debtor-tenant had given you a $1 million L/C as a security deposit.

In the past, the $1 million L/C security deposit would have been subtracted from the $5 million in damages, reducing your damages to $4 million. Because $2 million for one year's rent is less than the amount of your damages, your general unsecured claim would have been capped at $2 million. So you would have had a chance to recoup $3 million ($1 million L/C + $2 million capped claim) of your $5 million in damages.

But now in the Second, Third, and Ninth Circuits, the $1 million L/C security deposit, like a cash security deposit, would be subtracted from the one year's rent of $2 million—not the $5 million in damages—leaving you with a general unsecured claim capped at $1 million. So you would have a chance to recoup only $2 million ($1 million L/C + $1 million capped claim) of your $5 million in damages. That's $1 million less than the earlier result, Dreher points out.

The Second, Third, and Ninth Circuit Courts of Appeals have yet to address how much you could draw from an L/C security deposit if the L/C amount exceeds your capped claim amount, says Dreher. For instance, if the bankrupt tenant gives you a $3 million L/C as a security deposit and your capped claim is $2 million, it's unclear whether you could draw $3 million or only $2 million, he notes.

We'll update you when any of the other federal circuits rule on this issue.

Practical Pointer: Even if your building or center isn't located in any of the states covered by the Second, Third, and Ninth Circuits, you may not be safe from their L/C rulings, warns Dreher. Be aware that if the bankrupt tenant is based or incorporated in any state covered by those three circuits, it will likely file for bankruptcy there. And you'll be subject to that circuit's L/C ruling. Even if the tenant isn't based or incorporated in any Second, Third, or Ninth Circuit states, their L/C rulings could still influence the rulings of bankruptcy courts of your circuit, he notes.

CLLI Source

Jamie P. Dreher, Esq.: Downey Brand Attorneys LLP, 555 Capitol Mall, 10th Fl., Sacramento, CA 95814; (916) 444-1000; jdreher@DowneyBrand.com.