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Letters of Credit Offer Landlords Protection against Tenent Bankruptcies
By John D. Cromie, Stephen V. Falanga, and James F. Jacobus
The bursting of the NASDAQ bubble, the economic slow down, and struggling retailers present troubling trends for the real estate industry. Unlike the distress in the real estate industry of a decade ago, the current problems are not the result of overbuilding. Instead, economic conditions have led to a precipitous drop in the demand for space. Commercial landlords have been particularly hard hit. Recent reports in the Wall Street Journal indicate that in the year 2001 there were 117.8 million square feet in negative absorption in the office-building sector of the industry. On the retail side, in March of this year Kmart announced plans to close about 280 of its stores during the course of its on-going reorganization efforts. This follows on the heels of the closing of such other large retail chains as Sterns, Grand Union and Bradlees.
Landlord clients want to know how to structure a lease transaction to reduce their exposure in the event of a tenant bankruptcy. Increasingly, commercial landlords are turning to letters of credit for protection, which may be used in lieu of the more traditional security deposit. The benefits of using a letter of credit can be substantial. The letter of credit may represent the only liquid asset available to a landlord to recover rent arrearages and other damages. More importantly, the letter of credit proceeds are an exclusive source of funds for a landlord since they are not subject to pro rata distribution to all creditors of a bankruptcy estate. Additionally, the ability to obtain letter of credit proceeds without leave of a Bankruptcy Court allows for immediate access to funds. As such, letters of credit can serve to cushion the immediate impact of tenant bankruptcies and rising vacancy rates.
The utilization of letters of credit by commercial landlords does have some drawbacks. Letters of credit are more complex than the traditional security deposit. In addition, landlords must be cognizant of applicable state law governing leases and letters of credit as well as the way in which the federal district in which a tenant may potentially commence a bankruptcy case applies key provisions of the Bankruptcy Code.
The Bankruptcy Code establishes a broad definition of "property of the estate," which encompasses, inter alia, "all legal and equitable interests of the debtor in property as of the commencement of the case." 11 U.S.C. ¤ 541 (a) (1). The Bankruptcy Code's automatic stay provisions establish extensive protections and stay most actions that may impact property of the estate. 11 U.S.C. ¤ 362 (a). Traditional security deposits are likely to be deemed property of a tenant's bankruptcy estate. Accordingly, although a landlord will hold a security interest in the deposit, it will not be able to use such funds to cure a tenant's arrearages without obtaining relief from the automatic stay. As a result, a landlord with a tenant that has filed a bankruptcy petition may be left without an immediate source of funds to remedy pre-petition rent arrearages, taxes and other charges, pending the tenant's assumption or rejection of a lease.
Letters of credit provide a distinct advantage to a landlord in this regard. The "independence principle" holds that letters of credit and the proceeds of letters of credit are not property of a bankruptcy estate. See e.g. In re Air Conditioning, Inc. of Stuart, 845 F.2d 293, 296 (11th Cir. 1988); In re Sabratek Corp., 257 B.R. 732, 737-738 Bankr. D.Del. 2000). Therefore, the automatic stay would not impact a landlord's action in drawing upon the letter of credit. Accordingly, a commercial landlord could immediately use the proceeds from a letter of credit to cure both pre-petition and post-petition tenant defaults without first seeking the approval of the bankruptcy court. In re Farm Fresh Supermarkets of Maryland, Inc., 257 B.R. 770, 772 (Bankr. D.Md. 2001) (payment under a letter of credit is not a post-petition transfer requiring court approval).
If a landlord is to receive the full benefit of a letter of credit, and not violate the automatic stay, it is crucial that the landlord properly structure the letter of credit provisions to be incorporated in a lease. Importantly, the letter of credit provisions should be documented in both the lease and the letter of credit. The terms should specifically set forth the rights of the landlord as to the letter of credit. At a minimum, the lease and the letter of credit should define the circumstances that will trigger the landlord's ability to draw down the letter of credit, the amount of any such draw, how the proceeds of the letter of credit are to be applied and whether and under what circumstances a landlord must pay over any proceeds to the tenant. Landlords should of course seek broad rights to the letter of credit proceeds. The events that trigger a landlord's right to draw against a letter of credit should include both monetary and non-monetary defaults. Farm Fresh, 257 B.R. at 772 (draw against the letter of credit was permissible as lease and letter of credit allowed for a draw in the event of non-monetary defaults).
In drafting the terms of the lease and the letter of credit, the landlord must be careful to avoid the trap of the automatic stay. The ability to draw on a letter of credit should not be tied to tenant cooperation. A properly structured letter of credit provision will permit a landlord to draw upon the letter of credit at any time a tenant is not in compliance with the covenants of the lease. Importantly, the terms of the lease and the letter of credit should not require that notice be given to the tenant prior to a draw against the letter of credit. The automatic stay may bar the post-petition service of notices of default and/or notices of acceleration. See e.g. In re Metrobility Optical Systems, Inc., 268 B.R. 326, 330 (Bankr. D.N.H. 2001) (in accord with the terms of the lease, a draw on letter of credit was not permitted until the lease was terminated; landlordÕs post-petition termination notices were served without relief from the stay and were therefore void).
Ideally, the lease and the letter of credit will provide that a landlord may draw on the letter of credit by presenting only the original letter of credit and a certification from landlord that he or she is entitled to a draw under the terms of the lease and the letter of credit. As an additional protection, the lease should provide that in the event that the letter of credit proceeds are in excess of any actual damages, such excess remains the property of the landlord. A tenant should be required to reinstate the letter of credit at its full value subsequent to any such draw.
A letter of credit should be issued contemporaneously with the execution of the lease. A letter of credit issued subsequent to the execution of the lease may be subject to avoidance as a preferential transfer if issued during the 90-day preference period. In re Compton, 831 F.2d 586 (5th Cir. 1988) (where the debtor pledged assets to secure a letter of credit, draws against that letter of credit may be recovered as preferential payments). A letter of credit issued contemporaneously with the lease should survive attack as a preferential transfer as the letter of credit and any collateral pledged in connection therewith should be deemed to be a contemporaneous exchange for new value. Id.
Importantly, the use of letters of credit will not completely insulate landlords from the adverse impacts of a tenant's bankruptcy. The risk always exists that a bankruptcy court will use its equitable powers to enjoin a draw against a letter of credit. See e.g. Twist Cap v. Southeast Bank of Tampa, 1 B.R. 284 (Bankr. M.D.Fla. 1979) (a draw was enjoined as it would effectively convert an unsecured claim on the part of the beneficiaries of the letter of credit into a secured claim on the part of the issuer). A properly structured lease/letter of credit transaction, however, should provide a commercial landlord with advantages not available through the use of the traditional security deposit including, most importantly, immediate access to a certain source of funds in the event of a tenant default and/or bankruptcy.
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