Letters of credit can be better than cash. (Law Firms).

Landlords increasingly are taking letters of credit rather than cash security deposits. Letters of credit can offer two significant advantages: (1) they are not the tenant's property and are not affected by the tenant's bankruptcy filing, and (2) they enable a landlord to collect damages for breach of a lease greater than the amount allowed by the Bankruptcy Code. However, landlords must draft and plan carefully to gain the benefits letters of credit offer.

A letter of credit supporting lease obligations generally involves three parties and three contracts. The parties are the tenant, as account party, the landlord, as beneficiary, and the issuer of the letter of credit, usually a bank. The contracts are the lease, between tenant and landlord, the letter of credit, between landlord and issuer, and the reimbursement agreement, between tenant and issuer. Each document creates discrete contractual relationships and distinct rights and obligations.

The terms and conditions of the letter of credit, the lease and applicable state law all will determine whether, when, and in what amounts the landlord will be entitled to draw against the letter of credit and retain amounts drawn.

Better than cash if properly drafted

To protect the landlord's ability to draw against the letter of credit after the tenant's bankruptcy filing, draws should be permitted (1) whenever the tenant breaches the terms and conditions of the lease; and (2) upon the commencement of the tenant's bankruptcy case. This second condition must be stated only in the letter of credit; if this provision is in the lease, the court may declare it an unenforceable prohibition against filing bankruptcy, and enjoin a draw on that basis.

Additionally, the landlord's ability to draw against the letter of credit should not be conditioned on execution of documents by the tenant; the landlord cannot compel execution by a tenant in bankruptcy. Similarly, draws should not be conditioned on the landlord's prior notice of default, notice of acceleration, or demand on the tenant for payment; upon commencement of the tenant's bankruptcy case, such notices and demands for payment of pre-bankruptcy debts are barred by the automatic stay.

The letter of credit should specify the terms and conditions on which draws can be made. It should permit draws upon presentation to the issuer of either nothing but the original letter of credit, or the original letter of credit together with a written statement that (a) the landlord is entitled to the draw pursuant to the lease, (b) the tenant has not timely provided a satisfactory replacement letter of credit before the expiration of this letter of credit, or (c) the tenant is a debtor in a bankruptcy case.

The lease should provide that the letter of credit is in lieu of a security deposit, to support payment and performance of all obligations under the lease, and should define the obligations of the tenant and the landlord with respect to the letter of credit. The tenant's obligations should include procuring (i) the initial letter of credit on terms and conditions acceptable to the landlord; and (ii) the issuance of replacement letters of credit as appropriate.

The lease also should define all payment, performance, and forbearance obligations of the tenant, and should permit the landlord to draw against the letter of credit, in part or in full, upon the tenant's failure to comply with the lease. The lease should be drafted to maximize the landlord's ability to make and retain draws. The noncompliance giving rise to the right to make draws should arise upon the tenant's nonperformance within a stated period after the due date, without requiring any prior demand upon, notice to, or cooperation of the tenant. The lease also may require the tenant to restore or procure reissuance of the letter of credit promptly after any draw, and may provide that only such restoration or reissuance can cure the default that caused the landlord's draw.

Landlord's damages far rejection

A letter of credit may enhance a landlord's ability to collect the full amount of damages allowable under a lease if the tenant rejects (i.e., breaches) the lease in its bankruptcy case.

Although the actual amount of a landlord's claim for damages is determined by reference to state law and the specific provisions of the lease, the Bankruptcy Code caps landlords' breach of lease claims at an amount equal to (i) unpaid rent due under the lease as of the earlier of the petition date and the date the tenant surrendered possession plus (ii) "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," as calculated from the earlier of the petition date and any pre-petition surrender date. These amounts are in addition to any claim of the landlord for rent accrued during the bankruptcy case and before rejection of the lease.

A landlord holding a cash security deposit in an amount greater than this capped claim amount generally is required to repay the excess amount to the debtor tenant--a result that distresses most landlords.

The letter of credit advantage

The Bankruptcy Code should not limit a landlord's recovery of damages from a letter of credit supporting a lease. The amount of the breach of lease claim still will be calculated in accordance with applicable nonbankruptcy law, and the amount of the claim that is allowable in the tenant's bankruptcy case still will be calculated in accordance with the Bankruptcy Code. However, the landlord's rights to draw and retain letter of credit proceeds in excess of the cap amount should be governed by the terms of the lease, the letter of credit, and applicable nonbankruptcy law. Where a landlord's damages, as so calculated, exceed the cap, and the lease is supported by a letter of credit for an amount greater than the cap amount, the landlord should be able to draw and retain amounts under the letter of credit up to the calculated amount. Moreover, where a landlord's claim exceeds the amount of letter of credit proceeds, the landlord should be allowed to assert a claim in the tenant's bankruptcy case for the cap amoun t, and should be able to collect distributions from the bankruptcy estate until the sum of the letter of credit proceeds plus the bankruptcy distributions equals the amount of the landlord's claim as calculated in accordance with the lease and applicable nonbankruptcy law.

Where the documents have been drafted properly, a landlord holding a letter of credit in an amount greater than the Bankruptcy Code claim cap should be able to recover more in a tenant's bankruptcy case than a landlord holding a cash security deposit in the same amount.

In conclusion, the treatment of tenant letters of credit in bankruptcy is an emerging area of the law, and some courts may reach conclusions that are inconsistent with this article. However, with care, a landlord who obtains letters of credit in support of leases should be able to emerge from its tenants' bankruptcy cases with a faster and larger recovery than a landlord who accepts traditional cash security deposits.

Ms. Winick is counsel with the firm of Mayer, Brown, Rowe & Maw in Los Angeles.