Protect Your Right to Tap Bankrupt Tenant's Letter of Credit

You may require a tenant to give you a letter of credit (L/C) rather than cash as a security deposit because you expect it to be safer and easier to draw on if a tenant files for bankruptcy. A bankruptcy court will typically consider an L/C an obligation of the tenant's bank—not the tenant's obligation—and not part of the bankrupt tenant's estate. Unlike a cash security deposit, which is subject to bankruptcy law restrictions once the tenant files for bankruptcy, an L/C can avoid the reach of a bankruptcy court. That is, you won't need the court's permission to draw on it.

But if your lease is like many we've seen, it may contain a loophole that could put the L/C under the control of the bankruptcy court at least for purposes of the damages cap that limits how much you can collect on unsecured claims. The problem is that the lease may say that the L/C is a part of the tenant's security deposit. Once the L/C is designated a part of the security deposit, a tenant may claim—and a bankruptcy court might agree—that the L/C, along with the rest of the security deposit, is subject to the damages cap, warns New York City bankruptcy attorney Michael P. Richman.

Damages Cap Applies to L/C

For example, a Texas owner's lease required the tenant to give a security deposit that consisted of both cash and an L/C. When the tenant filed for bankruptcy, it owed rent and other charges. The owner took the cash part of the security deposit and also drew down the full amount of the L/C. The court later determined that the amount of the owner's damages was limited by the bankruptcy damages cap. And the capped amount was less than the total of the cash and the L/C amount. So the tenant's bankruptcy trustee sued the owner for the amount of the L/C that exceeded the damages cap.

A federal bankruptcy court in Texas ruled that the United States Bankruptcy Code required the security deposit to be subject to the damages cap. Although the owner argued that the damages cap didn't apply to the L/C because it was an independent obligation of the tenant's bank, the court rejected the owner's argument. The court said because the lease specifically defined the security deposit to include the L/C, the damages cap applied to it. The owner had violated the lease by drawing down the L/C in an amount “over and above” the damages cap, the court said [In re: Stonebridge Technologies, Inc.].

Separate L/C from Security Deposit

To lessen the risk of having the proceeds of an L/C limited by bankruptcy law damage cap restrictions, take one of the following actions advises Richman:

Say L/C is ‘in lieu of’ security deposit. Say in the lease that you're getting the L/C “in lieu of” a security deposit, says Richman. This way, it's clear that the L/C isn't part of a security deposit, but in place of it, he explains.

To do this, consider starting your lease's L/C clause with the italicized language below, says Richman CLLI0023:

Model Lease Language

In lieu of the security deposit, Tenant may deliver to Landlord (as beneficiary), and a copy to Landlord's attorney, a standby letter of credit in form and content satisfactory to Landlord.

Practical Pointer: While saying “in lieu of” in your lease should work, there's still a chance that a court could rule that the L/C is a form of security interest, Richman warns. Because it's just being provided in place of a cash deposit, the court might decide that it should be subject to the damages cap, he says.

Require L/C to secure guaranty only. Alternatively, don't have the tenant get an L/C, says Richman. Instead, have the tenant get its guarantor to apply for an L/C as a backup source of funding for his or her guaranty obligations, Richman advises. Tell the tenant that otherwise you won't accept the guaranty, he says. This setup is a safer strategy, Richman believes, because the L/C is distanced from the tenant's security deposit. The guarantor's L/C isn't mentioned in the lease nor does the tenant apply for it. Richman hasn't encountered any bankruptcy court yet willing to apply the damages cap to a guarantor's L/C.

Practical Pointer: Keep in mind that securing the guaranty with an L/C could backfire if the guarantor goes bankrupt, warns Richman. There's a chance that the bankruptcy court might consider the guarantor's L/C to be limited by the damages cap in his case, he says. If that occurs, you could wind up with the same problems with the guarantor that you were trying to avoid with the tenant.

CLLI Source

Michael P. Richman, Esq.: Partner, Mayer, Brown, Rowe & Maw, 1675 Broadway, New York, NY 10019-5820; (212) 506-2500; mrichman@mayerbrown.com