Letters of Credit and Leases
Landlords traditionally protect themselves under lease agreements by obtaining cash security deposits or obtaining guaranties of the leases. In recent years, landlords have begun to require standby letters of credit as additional protection in lieu of or in addition to security deposits or guaranties. The advantages of letters of credit include the added creditworthiness of the financial institutions that issue the letters of credit, the landlords’ ease in obtaining funds under the letters of credit, and the independence of the letters of credit from the obligations under the related transactions. However, recent developments suggest that, in the context of a tenant’s bankruptcy, letters of credit may not be independent in all respects, which limits their value to some degree. This article briefly describes the use of letters of credit in leasing contexts, the traditional independence of letters of credit, the new bankruptcy law developments, and then suggests ways in which a landlord can attempt to strengthen the security provided by a letter of credit.
Letters of Credit
If a letter of credit is contemplated, a landlord and tenant will agree on the types of obligations under the lease that the letter of credit proceeds will cover and the circumstances under which the landlord is entitled to draw under the letter of credit to obtain the proceeds. The tenant will then arrange with a financial institution to issue the letter of credit for the benefit of the landlord. The letter of credit will have a maximum stated amount and a stated expiration date (although it may also contain an automatic renewal, or “evergreen” provision), and will describe the documents that the landlord must provide in order to receive funds under the letter of credit. At a minimum, the landlord will need to present a sight draft to draw under the letter of credit, and generally also must present a certificate with varying degrees of specificity to the effect that the landlord is entitled to the sum being drawn under the letter of credit.
The financial institution will charge the tenant a fee for the issuance of the letter of credit, and will make arrangements with the tenant regarding the tenant’s repayment obligations in the event the letter of credit is drawn upon. The financial institution is likely to also require collateral and/or guaranties for the tenant’s obligations. If the letter of credit is drawn upon by the landlord in conformity with its terms, the financial institution will pay the landlord the amount due and then look to the tenant for repayment. In essence, the risk of nonpayment by the tenant, to the extent of the letter of credit, shifts from the landlord to the financial institution.
Under the independence principle, the obligation of the issuing financial institution (the issuer) to the landlord (the beneficiary) is independent of any obligation between the beneficiary and the tenant (the customer or account party). The issuer must make payment to the beneficiary under the letter of credit if the beneficiary complies with the requirements of the letter of credit, regardless of any underlying dispute between the beneficiary and the account party.
A bankruptcy of the account party (the tenant in this case) is generally not a defense to payment under the letter of credit and the proceeds of the letter of credit will not be construed to be part of the account party’s bankruptcy estate, except under circumstances in which the letter of credit is deemed a preferential transfer for or on account of antecedent debt, made while the party is insolvent, and given within the applicable preference period (generally three months). Where the letter of credit is given at the time the underlying contract is entered into, and particularly if the applicable preference period has elapsed between the giving of the letter of credit and the bankruptcy, there should be no likelihood that the letter of credit or any proceeds of the letter of credit will be required to be returned by the beneficiary to become part of the account party’s bankruptcy estate. However, these principles may be altered in a lease context due to the interaction of Section 502(b)(6) of the Bankruptcy Code.
Bankruptcy Code Section 502(b)(6)
If a tenant is in bankruptcy and terminates a real estate lease, Section 502(b)(6) of the Bankruptcy Code places a statutory cap on the landlord’s claim for damages. The landlord’s claim is limited to unpaid rent due plus the greater of (a) one year of future rent or (b) 15 percent of the remaining rent under the lease, not to exceed three years. The purpose of the cap is to compensate the landlord for its loss while not permitting a claim so large as to prevent other general unsecured creditors from recovering a dividend from the estate or to provide a windfall to the landlord at the other creditors’ expense.
While a guaranty of a lease is generally not considered to be subject to the statutory cap imposed by Section 502(b)(6), the prevailing view is that a cash security deposit is part of the tenant’s bankruptcy estate and will be included within the statutory cap. If a security deposit exceeds the statutory cap, the excess must be returned to the tenant’s estate to be made available to other creditors.
Recent cases have considered whether a letter of credit taken by a landlord in connection with a lease should be subject to the statutory cap imposed by Section 502(b)(6). A letter of credit is similar to a guaranty, in that it is offered by a third party and does not directly deplete the funds of the tenant’s estate, but yet if the landlord receives payment under the letter of credit it will be recovering funds in excess of those that the Code has determined are appropriate and will be obtaining a “windfall.” Which analysis will govern?
Although the issue does not appear settled, recent cases have held that the letter of credit proceeds are in fact subject to the statutory cap imposed by Section 502(b)(6). The analysis in some of the cases relies on express language in the lease stating that the letter of credit is taken as a security deposit or in lieu of a security deposit. Since security deposits are subject to the statutory cap, the courts reasoned that the letter of credit proceeds should also be subject to the statutory cap, leaving for another day the issue of whether a letter of credit that is not stated to be a security deposit would be subject to the statutory cap. In other cases, however, the courts have not emphasized the security deposit language and instead have ruled that the letter of credit proceeds are subject to the 502(b)(6) cap even though the letter of credit proceeds are not part of the tenant’s estate, based on the windfall to the landlord and the indirect diminution of the tenant’s estate by virtue of the financial institution’s claims against the tenant.
What Can a Landlord Do?
Landlords can strengthen the security provided by letters of credit by structuring their lease transactions differently. If advances for tenant improvements and other out-of-pocket costs of the landlord, which are normally amortized and then included in the rental stream with an implicit interest rate, can be separated from the rental stream, such amounts can instead be documented outside of the lease as a loan with a separate promissory note and agreement. The loan should include traditional lending provisions, such as construction disbursement requirements, scheduled repayments, and the like. Billing under the lease and the loan would be separate. The landlord should require two separate letters of credit to secure the rent under the lease and the loan, and neither would make reference to the other. Theoretically if the transaction were structured in this manner, only the letter of credit securing the rent would be subject to the statutory cap, leaving the landlord the ability to recover the full amount of the loan under the letter of credit.
Another device that the landlord can use is to avoid any reference or implication in the lease that the letter of credit is a security deposit or in the nature of a security deposit. The lease should instead provide that the letter of credit is in lieu of a guaranty, anticipating that a court would then look for guidance to the decisions that regard guaranties as being outside of the Section 502(b)(6) cap.
As the law is just now evolving in this area, it is not clear whether in the end letters of credit will retain their independence from lease transactions and be exempt from the Section 506(b)(6) cap, or whether the recent case law imposing the Section 506(b)(6) cap will be followed or even expanded upon. In any event, at this point it would be advisable for landlords to consider implementing the strategies described above in order to protect the security of their letters of credit and increase their chances of recovery in the event of a tenant’s bankruptcy.