By Jamie Altman Buggy, Partner & General Counsel
Landlords have a few tools to secure a tenant's payment under a commercial lease – most notably, personal guarantees, security deposits and letters of credit. Landlords should be aware that irrevocable letters of credit are the preferred method of security in the event a tenant files bankruptcy and negotiate their leases accordingly. While the recent spate of bank failures in 2023 caused widespread concern among holders of letters of credit with those failed institutions, landlords can take proactive measures to maintain their security interests in letters of credit even in times of lender distress.
Security Deposit vs. Letter of Credit in the Event of a Tenant's Bankruptcy
In the event of a tenant's bankruptcy, the Bankruptcy Code caps a commercial landlord's claim for future rent damages from a breached lease at an amount that is the greater of one year's worth of rent or 15% of the remaining lease term, not to exceed three years' worth of rent. The landlord's capped claim for future rent is then treated as a general unsecured claim in the bankruptcy – which is most frequently paid only pennies on the dollar.
While security deposits are the most commonly used form of security in commercial leases, and indisputably are effective tools for protecting landlords, they do not avoid the claim cap in a bankruptcy. Once a tenant files bankruptcy, a landlord is only entitled to retain the security deposit to the extent it is not greater than the capped claim. Further, a security deposit is considered part of a debtor's bankruptcy estate, and therefore once the tenant files bankruptcy, the landlord will not be able to apply the security deposit until it gets approval from the court, which can take a long time.
Letters of credit, on the other hand, are not property of the bankruptcy estate, and the majority of bankruptcy courts do not treat letters of credit as subject to the Bankruptcy Code's claim cap. As a result, a landlord holding a letter of credit can draw upon the letter as soon as the tenant files for bankruptcy – even if the amount of the letter exceeds the claims cap – provided that the lease and the letter of credit are properly drafted. Similarly, landlords are entitled to pursue guarantors for the full amount of damages under the lease, with no cap, provided the guarantor has not filed for bankruptcy as well.
For these reasons, letters of credit and personal guarantees are the more valuable means of securing a commercial lease in the event a tenant files bankruptcy. However, given recent bank failures, landlords must pay attention to the financial health of the bank that issued the letter of credit, and act immediately in the event a lender appears to be in financial distress.
Drafting Leases and Letters of Credit to Maximize Landlords' Recovery
A well-drafted lease and letter of credit is the key to a landlord's ability to draw upon the letter in the event of a tenant's bankruptcy or the lender's financial distress. There are a number of terms critical to ensuring that a letter of credit will be enforceable in the event of a tenant's bankruptcy. For example, a lease should have the following terms:
- The lease should specify that the occurrence of bankruptcy constitutes a default under the lease that triggers the provisions allowing the landlord to draw upon the letter of credit.
- A landlord should be expressly allowed to apply the letter of credit to future rent obligations, irrespective of the claims cap provided in the Bankruptcy Code.
- A lease should not require that the landlord first provide notice to the tenant before drawing upon the letter of credit, because in the event of a tenant's bankruptcy, the provision of such a notice may violate the automatic bankruptcy stay.
- The lease should allow a landlord to apply the proceeds of a letter of credit first to rent that came due before the filing of any bankruptcy – otherwise, a court could require the proceeds to be applied to rent that came due after the bankruptcy filing, which a debtor is required to pay in full regardless of the existence of any security interest.
In addition to the example lease provisions mentioned above, the letter of credit itself should also specify that the landlord is entitled to draw upon the full amount of the letter of credit for any reason or no reason at all, including in the event of a tenant's bankruptcy.
Landlords should also monitor the financial health and bankruptcy status of any guarantor of the lease. A commercial lease should allow the landlord to require additional security – in the form of a new guarantor or higher security deposit or letter of credit – in the event a guarantor files bankruptcy.
In addition to monitoring tenants' and guarantors' financial health and bankruptcy status, landlords holding letters of credit must pay close attention to any news suggesting that the issuing bank is suffering financial distress. A commercial lease should allow the landlord to require the tenant to secure a letter of credit from an alternate lender if the landlord reasonably believes that the credit quality of the issuing bank is at stake. The lease should allow the landlord to draw upon the letter of credit if the credit rating or financial condition of the issuer of the letter of credit is no longer acceptable to the landlord. As soon as any news is released suggesting that the issuing bank is suffering distress, the landlord should act immediately to require the tenant to obtain a new letter of credit or draw upon the existing letter of credit.
It is paramount for landlords to ensure that the letters of credit they have negotiated in their commercial leases will be enforceable in the event of bankruptcy or lender distress. For more guidance regarding drafting commercial leases and letters of credit, contact an experienced attorney.