September 2007Volume 3, Number 2
Table of Contents

How Secure Is That Lease?
Beyond deposits and guaranties, don't forget about letters of credit

By Christopher Combest

Your client, a commercial landlord, calls to tell you that its tenant has filed a bankruptcy case. Fortunately, the debtor-tenant posted security for its lease obligations, "so, we'll be paid in full; we don't have to worry about the bankruptcy. . . uh . . . right?"

The client had two primary goals in obtaining security for its tenant's obligations: (1) to ensure payment of damages and (2) to get that payment with as little delay as possible. Unfortunately, those goals can conflict with protections provided to debtors and other creditors by the U.S. Bankruptcy Code, 11 U.S.C. §§101-1532 (the Bankruptcy Code) (section references are to the Bankruptcy Code unless otherwise indicated).

This article will examine:

  • first, cash security deposits and third-party guaranties, with particular attention to (a) obstacles to executing on such security under the Bankruptcy Code and (b) such security's ability to make the landlord whole for its lease damages;
  • next, letters of credit as security, including the intersection of letter-of-credit law with bankruptcy procedures and with the Bankruptcy Code's limitation on the amount of lease damages a landlord may assert against a debtor in bankruptcy;
  • strategies suggested by recent cases for enhancing the power of letters of credit as security; and
  • finally, practice pointers for landlords' counsel in drafting lease documents and letters of credit.

At the threshold, the reason these issues challenge landlords and their counsel in the first place is the Bankruptcy Code's peculiar treatment of landlord damage claims.

A debtor-tenant may deal with an unexpired real property lease in one of two ways: The debtor may reject it — that is, surrender the leased premises and choose not to be bound by the lease — or the debtor may assume it — that is, retain the premises and choose to continue to be bound by the lease, either for the debtor's own use or for assignment to a third party.

If the debtor-tenant chooses to reject the lease, then the landlord, in addition to pre-bankruptcy arrearages, will have a damages claim against the debtor for lost future rent. Because such leases can run for years beyond the debtor's actual use of the premises, such damage claims can amount to millions of dollars.

However, the Bankruptcy Code restricts a landlord's ability to obtain payment on its full damage claim. To keep such large claims from diluting distributions to other unsecured creditors, and in recognition of a landlord's ability to mitigate its damages by re-letting the debtor's premises, Section 502(b)(6) limits a landlord's claim arising from lost future rent under a rejected real property lease to the greater of (a) one year's rent and (b) 15 percent of the rent reserved for the remaining term of the lease (up to a maximum of three years' rent) following the date of the filing of the bankruptcy petition (or, if earlier, the date the landlord repossessed the premises).

The landlord's claim also includes all arrearages existing as of the date the tenant's bankruptcy petition was filed. This capped claim is deemed a general unsecured claim; such claims receive a percentage distribution, if at all, only at the end of the bankruptcy case.

A landlord with security for its tenant's obligations will be looking to circumvent Section 502(b)(6) and to do so well before the bankruptcy case trudges to a close. Cash security deposits and third-party guaranties vary in their ability to achieve these goals.

Consider first a landlord with a traditional cash security deposit. The security deposit is a type of collateral — that is, property of the debtor-tenant's bankruptcy estate in which the creditor-landlord also has an interest, and the landlord is, therefore, treated as a secured creditor under the Bankruptcy Code.

Usually, a cash security deposit will not cover the full damages sustained by a landlord whose tenant has rejected a multi-year lease. Therefore, like any secured creditor, under Section 506(a) of the Bankruptcy Code, that landlord's claim against its debtor-tenant will be, in effect, two claims: a secured claim up to the amount of the security deposit and an unsecured claim for the remainder. As to the secured portion, the landlord might achieve reasonably quick partial payment by seeking bankruptcy court permission to take the security deposit and apply it to its claim.

But, to what "claim," exactly? In theory, the deposit might be applied to the landlord's full claim for actual damages sustained as a result of the lease rejection, leaving the Section 502(b)(6) cap to be applied to whatever damages remain after offsetting the security deposit. This rule would give a landlord its maximum capped claim — on which the landlord would receive a distribution in the bankruptcy case — plus an additional payment, from the security deposit, of some portion of its damages that would otherwise not have been paid out of the bankruptcy estate's assets.

The bankruptcy courts have rejected this position. A landlord's cash security deposit must be applied to the landlord's claim as capped according to Section 502(b)(6), because the intent of the section is that the capped claim be the maximum amount for which property of the debtor-tenant's bankruptcy estate — which property includes the security deposit — should be liable. Moreover, in the rare circumstance where the security deposit exceeds the amount of the landlord's capped claim under Section 502(b)(6), the landlord must return the excess security deposit to the estate, even though the landlord's actual damages exceed the capped claim.

Therefore, while a cash security deposit may enable a landlord to receive payment of a portion of its claim more quickly than otherwise would be the case, such a deposit will not permit the landlord to circumvent the claim cap of Section 502(b)(6).

Conversely, third-party guaranties can sidestep the landlord claim cap. Under the Bankruptcy Code, a third-party guarantor of a debtor's obligation is not discharged from its guaranty simply because the primary creditor may no longer enforce some or all of the debt against the debtor directly. Therefore, a landlord may seek payment of all amounts owed to it — up to the full amount of its uncapped damages — froma nondebtor guarantor of the debtor-tenant's lease obligations.

Note, however, that a landlord's claim against a guarantor who is also a debtor in bankruptcy remains subject to the Section 502(b)(6) cap — for example, where a parent and subsidiary are both in bankruptcy, and the parent is the guarantor of the subsidiary-tenant's obligations.

While a nondebtor guaranty might seem to promise full payment of a landlord's claim, the guarantor who pays on demand is a rare legal bird, indeed. Collecting on a guaranty may require months of negotiating, followed by litigating in state courts outside the landlord's jurisdiction. Moreover, bankruptcy courts — relying on their broad injunctive powers under Section 105(a) — have occasionally prevented claimants from suing nondebtor guarantors on their guaranties.

Though rare, such relief may be granted on a showing that the guarantor — often a key shareholder or officer of the debtor — is so critical to the debtor's reorganization that permitting a suit against the guarantor would risk irreparably harming the chances of that reorganization, to the detriment of all of the debtor's creditors.

Third-party guaranties of a tenant's lease obligations, then, may provide the opposite set of protections from those provided by cash security deposits: A landlord may obtain payment of its total damages, beyond what Section 502(b)(6) would otherwise permit, but at a significant cost in time and effort spent trying to collect. The landlord's dilemma: Should it limit its recovery on its claim or its recovery costs?

Perhaps it need do neither: Letters of credit appear designed to resolve the landlord's dilemma. The typical letter-of-credit (LC) transaction involves three parties:

  • Applicant (the customer of the issuer and the debtor of the beneficiary): the entity whose obligation is to be paid by a draw on the LC; the applicant applies to the issuer to issue the LC in favor of the beneficiary.
  • Issuer: the entity that pays when the LC is drawn on; the issuer has a claim for reimbursement against the applicant for any amounts drawn on the LC.
  • Beneficiary: the entity for whose benefit the LC has been issued; the beneficiary is entitled to draw down on the LC under circumstances set forth in the LC itself.

The genius of the LC is that it divorces the creditor-beneficiary's right to payment from the debtor-applicant's obligation — and ability — to pay. So long as the beneficiary complies with the payment terms of the LC — typically, the presentment of certain described documents — the issuer will pay, because its obligation to pay is independent of any disputes between the beneficiary and the debtor regarding the debtor's underlying obligation.

This independence principle is the linchpin of letter-of-credit law. Honoring the independence principle, courts have long recognized that LCs arranged for by a debtor-applicant, and the proceeds thereof paid out by the issuer, are not property of a debtor-applicant's bankruptcy estate. Payment to the beneficiary of the LC comes from assets of the issuer, not assets of the debtor.

For a landlord, LCs appear to provide security that is the best of all worlds. Because of the principles described above, courts treat LCs in some ways like nondebtor guaranties, in that the applicant's bankruptcy and its failure to pay the landlord's claim in full affect neither the issuer's liability on the LC nor the guarantor's obligation on its guaranty. Moreover, unlike foreclosing on a security deposit, which requires a bankruptcy court order, collecting on an LC requires no court action, because the assets that pay the LC come, not from property of the debtor's estate, but rather from property of the issuer. Finally, unlike third-party guarantors, LC issuers rarely need to be sued to compel payment (although, in unusual cases, courts have granted injunctive relief to bar a draw on an LC).

However, the intersection of LC law and the Section 502(b)(6) cap on landlord claims has been treacherous for landlords. Because LCs are essentially cash substitutes, some courts have treated LCs and their proceeds as a form of cash security deposit, requiring such proceeds to be applied, like an ordinary cash security deposit, to pay off only the capped amount of the landlord's claim and no more.

Leading cases supporting this line of analysis are Solow v. PPI Enterprises (U.S.) Inc. (In re PPI Enterprises (U.S.) Inc.), 324 F.3d 197 (3d Cir. 2003), and Redback Networks Inc. v. Mayan Networks Corp. (In re Mayan Networks Corp.), 306 B.R. 295 (B.A.P. 9th Cir. 2004). It is worth noting that in each of these cases, the court placed some reliance on the fact that the lease at issue described the LC as comprising all or part of a "security deposit" or "security" for the lease.

In Mayan Networks, however, the court also drew an important distinction between secured and unsecured LCs. The LC in that case was secured: The debtor-applicant had posted its own property as collateral to secure its obligation to reimburse the issuer for any draws made by the beneficiary.

Because a draw on the secured LC would immediately result in the issuer seeking to reimburse itself from the collateral, the Mayan Networks court found that the proceeds of the LC could be applied, like a cash security deposit, only to the landlord's capped claim. However, the court observed that unsecured LCs are more akin to third-party, nondebtor guaranties and that a landlord may draw down an unsecured LC to cover its full damages, regardless of the Section 502(b)(6) cap.

This holding suggests an important caution to lawyers who represent issuers of LCs. Once an issuer pays a landlord's claim in full under an unsecured LC, what is the amount of the issuer's claim for reimbursement? Revisions made in 1995 to Article 5 of the Uniform Commercial Code, which governs letters of credit, support the rule that an issuer is a secondary obligor on an applicant's debt, just as an ordinary guarantor would be, and that the issuer may be subrogated to the beneficiary's right to payment whenever it pays the beneficiary in full.

However, a landlord-beneficiary's right to payment is limited by Section 502(b)(6) of the Bankruptcy Code. An issuer's reimbursement claim, then, may be limited to the amount of the landlord-beneficiary's capped claim under Section 502(b)(6).

Late last year, the Fifth Circuit also had an opportunity to rule on the application of LC proceeds to landlord bankruptcy claims. The landlord in EOP-Colonnade of Dallas L.P. v. Faulkner (In re Stonebridge Technologies Inc.), 430 F.3d 260 (5th Cir. 2005), relying on the debtor-tenant's agreement to reject its lease, had drawn on a secured LC two weeks before the bankruptcy court actually entered a lease rejection order.

The LC proceeds exceeded what would have been the amount of the landlord's Section 502(b)(6) capped claim, but not the landlord's total uncapped damages under the lease. The landlord did not file a proof of claim in the debtor's case and sought to retain all of the LC proceeds.

The bankruptcy court ruled that the landlord should have applied the LC proceeds to its capped claim under Section 502(b)(6) and that it had to return the excess (some to the issuer and some to the debtor). The court also ruled that, because the landlord drew on the LC before the rejection order was entered and without providing the tenant with the default notice required by the lease, the landlord was not entitled to draw on the LC when it did and was guilty of negligently misrepresenting otherwise to the issuer.

The Fifth Circuit reversed, holding for the landlord. The appellate court found that the landlord's draw was not premature, because it was premised on payment defaults, not on the rejection of the lease, and that a motion to compel payment of rent, filed by the landlord before the draw on the LC, satisfied the landlord's obligation to provide notice of default to the debtor-tenant.

Although the Fifth Circuit ducked the issue of how to apply the LC proceeds, the court suggested what might sometimes be a useful strategy. The court noted that Section 502(b)(6) limits a landlord's claim, but does so simply by disallowing any filed claim to the extent the filed claim exceeds the cap.

The Stonebridge Technologies landlord, however, had never filed a claim in the debtor's case, which meant that Section 502(b)(6) had nothing to act on; the court held that the section does not permit a court to require disgorgement of LC proceeds, absent a filed claim. Therefore, a landlord with an LC that covers a substantial part of its damages should consider "opting out" of the debtor-tenant's bankruptcy case by not filing a proof of claim.

The Mayan Networks and Stonebridge Technologies cases suggest how landlords, with the cooperation of their tenants, might shift to issuers the risk of being stuck in a tenant bankruptcy with a statutorily capped claim for less than full damages. How issuers view that risk will depend, in part, on how generally the holdings of those cases are adopted and how other circuits deal with these issues. While it seems unlikely that issuers will eliminate unsecured LCs, they are likely to adjust the pricing of such instruments — at least when used as security for real property leases — to reflect whatever increased risk the issuers perceive to be associated with them.

From a drafter's perspective, to increase the efficacy of LCs as security for landlord clients and to avoid the strictures of Section 502(b)(6), try to negotiate leases (a) to require any LCs intended as security to be unsecured by property of the tenant; and (b) to separate any requirement or option for posting an LC from any requirement for a cash security deposit.

The lease should not describe the LC as a security deposit, but, rather, should include the tenant's acknowledgment that the LC is meant as a third-party guaranty of the tenant's obligations under the lease and is posted to protect the landlord's right to receive its full, unlimited damages, as calculated under state law. The lease should also provide that the landlord may draw on the LC without notice to the tenant (even if the exercise of other default remedies requires prior notice). Some courts may ignore such drafting as "form over substance," but some may honor the expressed intent of the parties to the contract.

If a landlord has negotiating room, it should also consider asking for the following provisions in an LC provided as security:

  • Provide for the simplest possible draw requirements — preferably, just a request stating that the amount sought does not exceed the amount owed under the terms of the lease, without any certification that notice or demand has been served on the tenant.
  • Do not require the submission of documents over which the landlord would not have sole control (for example, a certificate that must be signed by the tenant).
  • Allow for partial or multiple draws.
  • Provide for presentment of all draw documents by fax.
  • Avoid requiring documents to be signed by specific, named individuals (if such persons are dead or otherwise inaccessible, the landlord might never be able to draw).
  • Provide for automatic renewal if the issuer does not, in writing, by a date certain, decline to renew (60 days before expiration is not unusual).
  • Provide for a right to draw the LC completely if the issuer refuses to renew.

Appropriate security for lease obligations will vary with the nature of the parties, their relative negotiating leverage, and the landlord's priorities. Familiarity with the risks and benefits of various forms of security, and with the efficacy of letters of credit in particular, will help lawyers better prepare their landlord clients for the uncertainties of the bankruptcy process.

Combest is a partner at Quarles & Brady in Chicago. His e-mail is .

Originally appeared in Business Law Today, Volume 16, Number 2, November/December 2006. Reprinted with permission.

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