Letters of Credit Help Protect Landlords Against Tenant Bankruptcy

By Suzanne M. Amaducci

Published in Commercial Investment Real Estate, March/April, 2003, Vol. 22, No. 2, pp. 16-17

While the direction of the U.S. economy remains unclear, many businesses struggle to stay viable. In today's fast-paced environment, even strong companies may succumb to financial pressures more quickly and with much more disastrous results than in the past.

A company's financial problems affect outside parties in addition to its owners and employees. Landlords in particular are in danger of losing money if their tenants declare bankruptcy. Thus, commercial landlords should take measures to minimize their risk by safeguarding themselves from tenant bankruptcies. Letters of credit are one method that may protect landlords during a down economy.

Though it may seem counterintuitive, letters of credit are better than cash security deposits when tenants default and declare bankruptcy. Under current bankruptcy law, a cash security deposit held by a landlord is considered property of the debtor’s bankruptcy estate. As such, landlords must obtain a court order prior to using cash security deposits.

On the other hand, courts view letters of credit as enforceable third-party agreements between landlords, or beneficiaries, and the issuing banks - not as property of the tenant's bankruptcy estate. Tenants' collateral used to obtain letters of credit may be subject to the jurisdiction of the bankruptcy courts, but the issuer of the letter of credit assumes that risk, not the landlord or any other beneficiary of letters of credit. (For more information on tenant bankruptcies, see “Guarding Against Tenant Bankruptcy,” CIRE, July/August 2002.)

The following cases illustrate the courts' willingness to uphold a landlord's right to draw on a letter of credit when a tenant declares bankruptcy.

In January 2001, the Maryland District Bankruptcy Court specifically addressed the use of letters of credit by landlords in tenant bankruptcy situations. In Musika v. Arbutus Shopping Center Limited Partnership (In re Farm Fresh Supermarket of Maryland, Inc.), the landlord leased real property to the tenant under a written lease agreement that required a $38,000 irrevocable standby letter of credit as a security deposit, against which the landlord could draw if the tenant defaulted.

One of the tenant's monthly rent payments was returned for insufficient funds. The landlord provided the tenant written notice that it had committed a monetary default and set forth other non-monetary defaults of the tenant under the lease.

An involuntary bankruptcy petition was filed against the tenant, and the bankruptcy trustee informed the landlord that it could not use the letter of credit because it was an asset of the tenant's bankruptcy estate. Despite the bankruptcy trustee's position, the landlord followed the procedural requirements for making draws set forth in the letter of credit and drew down the entire amount of the letter of credit.

The tenant and its bankruptcy trustee subsequently sued the landlord to recover the funds it received under the letter of credit. However, the court found for the landlord and held that neither the letter of credit nor its proceeds were property of the tenant's bankruptcy estate and that the landlord had acted properly by drawing down its proceeds.

Similarly, in the case of In Re: Sabratek Corp. 257 B.R. 732, a Delaware bankruptcy court denied a debtor's attempt to obtain a preliminary injunction preventing the beneficiary of a letter of credit from making draws under a letter of credit where the debtor had filed for bankruptcy.

A similar case, In Re Prime Motor Inns, Inc. 130 B.R. 610, confirmed that the bankruptcy court has no jurisdiction to issue an injunction enjoining payment of a contract not involving the debtor.

A few exceptions exist to the general rule that letters of credit are not part of a tenant's bankruptcy estate. For instance, the bankruptcy court may void a letter of credit if a tenant provided it as a security deposit under a lease during the preference period, the 90 days prior to the debtor filing bankruptcy.

Letters of credit are preferable to cash security deposits in tenant bankruptcy situations, but they are not a panacea. Drawing down proceeds under them can be time consuming and cumbersome. Therefore, landlords should protect their interests by writing letter of credit terms precisely.

Since issuing banks strictly follow the terms of letters of credit, they must be clearly set forth. When writing letters of credit, landlords must not make drawing funds contingent upon any event or circumstance within any third party's control, and they must give precise instructions to the issuer when to disburse draws. Letters of credit should state that a draw can be made if the landlord submits the original letter of credit with, at most, a short signed note stating that the tenant has defaulted under the lease.

However, certain contingencies enable the issuer to deny the landlord's request for a draw. For example, the letter of credit should not require the beneficiary to specify the type of default or prove that it properly complied with the notice provisions in the lease. It also should not require the tenant to acknowledge that a default occurred or that it received a written default notice.

Letters of credit have firm expiration dates and easily can become worthless without landlords even realizing it. They also are negotiable instruments; thus, issuing banks will not replace them if they are lost or stolen. If landlords already have letters of credit as security deposits, they should ensure the letters are still valid and confirm the expiration dates and the location of the original letters.

Also, each letter of credit must be assigned specifically to the current landlord; a generic assignment of security deposits is not sufficient. Each issuing bank has strict assignment procedures that landlords must follow closely. If a letter of credit has not been assigned properly, the prior landlord will have to be located to formally assign or endorse it before the current landlord can make any draws under it.

Landlords only should accept letters of credit from issuers with strong credit ratings and should attempt to secure a local bank to expedite drawing funds if necessary.

These common-sense housekeeping suggestions may seem overly simplistic, but they will save precious time and prevent unnecessary aggravation when dealing with defaulting tenants.