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Protecting a Security Deposit Against the Risk of a Commercial Tenant's Bankruptcy

By Aaron Kinderlehrer

For quite some time we have been recommending to real estate owners, landlords or sublandlords that when they take a security deposit, it should be in the form of a letter of credit rather than cash. We gave this advice because, in our judgment, a letter of credit protects the landlord better than cash if the tenant files for bankruptcy. A recent decision by the Ninth Circuit Bankruptcy Appellate Panel, Redbank Networks, Inc vs. Mayan Networks Corporation (In Re Mayan Networks Corporation) 42 BCD 196 (9th Civ. BAP 2004) (hereinafter the “Mayan Case”) has confirmed that our advice was correct, but also highlights some additional precautions the landlord should take in the letter of credit transaction.

Commercial landlords generally ask for a security deposit when a tenant or subtenant is in default or otherwise has found itself in some economic hardship that makes it difficult for the tenant to pay rent. So the same situation that triggers the need for a security deposit is also an indicator that there is a real risk of bankruptcy.

When a tenant files for bankruptcy, a cash security deposit is treated as “property of the tenant's bankruptcy estate,” which means the landlord or sublandlord will be prevented from applying the cash security deposit toward unpaid rent or other charges without bankruptcy court approval. This is because of the “automatic stay” that comes into effect under § 362 of the Bankruptcy Code when a debtor files for bankruptcy. The stay prohibits any person from attempting to obtain payment for pre-bankruptcy debts without first getting approval of the bankruptcy court. A letter of credit, however, is not considered to be a part of the tenant's bankruptcy estate, because a letter of credit is a direct and independent contractual obligation of the issuing bank to the landlord or sublandlord. The bank is obligated to make the required payment to the landlord, if the technical draw requirements of the letter of credit are met -- regardless of any underlying dispute between landlord and tenant, and regardless of the tenant's bankruptcy. The automatic stay of § 362 does not apply because the bank's obligation to pay under the letter of credit is independent of the bankrupt debtor.

The Mayan case confirmed just how important it is for a landlord to use a letter of credit as security rather than cash. But Mayan also shows that it is important to structure the letter of credit properly, to account for the vagaries of bankruptcy law

In Mayan , Mayan Networks Corporation (the tenant) entered into a sublease with Redback Networks, Inc. (the landlord). Under the sublease, Mayan had to provide a $1 million security deposit, consisting of $351,033.80 in cash and a letter of credit in the amount of $648,966.20. The tenant secured its reimbursement obligation to the issuing bank with a pledge of $650,000 in cash.

When the tenant filed a bankruptcy petition, the debtor promptly rejected the sublease. Under § 365 of the Bankruptcy Code, a debtor tenant can reject a lease of non-residential real property. Upon rejection, it gives up any further rights to possession of the property, and of course need no longer pay rent. The landlord, for its part, regains possession of the premises, but is left with a claim in the bankruptcy for damages for unpaid rent. The Landlord cannot claim all the unpaid rent, though: § 502(b)(6) of the Bankruptcy Code caps the landlord's claim. The landlord's claim for unpaid rent is limited to “the rent reserved by such lease, without acceleration, for the greater of one year, or 15 percent, not to exceed three years of the remaining term of such lease . . . plus any unpaid rent due under such lease without acceleration . . .” 11 U.S.C. §502(b)(6). The purpose of the cap is to “… compensate the landlord for its loss while not permitting a claim so large (based on a long-term lease) as to prevent other general unsecured creditors from recovering a dividend of the estate.”

In Mayan , once the debtor rejected its lease, it argued that the landlord's claim for unpaid rent – which was already capped under § 502(b)(6) – should be further reduced by the amount of the letter of credit that the landlord held by as a security deposit. The landlord argued that since the letter of credit was not “property of the estate,” and the bank's obligation to pay the landlord on the letter of credit was independent of the debtor's obligation to reimburse the bank, the landlord should be able to apply the proceeds from the letter of credit to its entire claim irrespective of the § 502(b)(6) cap. The court disagreed, and held that the letter of credit proceeds could be drawn down, but should be deducted from the landlord's capped claim.

The main focus of the Court's analysis of the letter of credit was the impact on the debtor's estate. The court found that although the letter of credit and its proceeds are not property of the estate, nevertheless, because the debtor pledged cash to the bank to secure its reimbursement obligation, the draw on the letter of credit had an impact on the property of the estate. Therefore, the letter of credit had to be treated as a security deposit for purposes of calculating the amount of the landlord's capped lease rejection damage claim under § 502(b)(6) of the Bankruptcy Code. According to the Court, any other result would circumvent 60 year old case law that held that (1) a security deposit should be deducted from the landlord's capped claim, and (2) to the extent the security deposit exceeds the amount of the landlord's claim, the excess should be included in the tenant's bankruptcy estate.

The result in the Mayan case does not change our recommendation that landlords use letters of credit rather than cash security deposits. True, Mayan does show that a letter of credit does not automatically immunize the landlord or sublandlord from all further ramifications under bankruptcy law principles. As the court in Mayan said aptly, “[L]etters of credit have not yet found a comfortable place in bankruptcy law.” The Mayan case highlights, however, that despite the advantages of using a letter of credit for a security deposit, structuring the letter of credit differently can provide the landlord with better protection.

The letter of credit in Mayan was secured by $650,000 in cash. That cash would otherwise have been part of the tenant's bankruptcy estate and available to other creditors if it had not been pledged to secure the letter of credit. But, if the reimbursement obligation under the letter of credit in Mayan was unsecured, or if it was secured by a third party guaranty, or collateralized by a third party (e.g. the tenant's non-debtor parent company) without recourse to the debtor (whether by subrogation or otherwise), then the drawdown would not affect the debtor's bankruptcy estate at all. That should mean the landlord would not have to reduce its capped claims for unpaid rent, and should be able to enjoy both the full amount of the letter of credit and – for whatever it is worth – the full amount of its capped claim against the debtor for unpaid rent.

Therefore, our now further refined advice to clients is to have the letter of credit either unsecured (though banks usually want security), or secured by an independent third party (with collateral or by a guaranty), so that the likelihood of a drawdown reducing the landlord's rental claim in a bankruptcy case would be substantially reduced. Such a letter of credit would truly be an independent obligation of the issuing bank. It would be more in the nature of a guaranty because it would not directly deplete the funds of the tenant's estate, so the independence principle should prevail fully.

Using a letter of credit that is unsecured, or secured with a true third-party obligor's interest, thus should function as a powerful form of creditor insurance against bankruptcy. It would transfer part of the risk of the tenant's insolvency to the issuer (or guarantor) of the letter of credit, and away from the landlord.

If you have questions about the foregoing or any other real estate or lease related issues, please feel free to contact any of the following attorneys at our firm:

This article was prepared as a service to our clients and friends. This article does not constitute legal advice and should not be relied upon as legal advice by the reader or any other party.

Footnotes:

[1] S. Rep. No. 95-989 reprinted in, 1978 U.S.C. C.A.N. 5787, 5849; H.R. Rep. No. 95-595, reprinted in, 1978 U.S.C. C.A.N. 5963, 6309, (which is the legislative history cited by the Court in the Mayan Case)

[2] Oldden v. Tonto Realty Corp ., 143 F.2d 916 (2d Cir. 1944).