Some commercial landlords have been hit by economic conditions, overbuilding, start-up companies failing, a depressed retail sector, or other factors affecting the real estate industry.
The forecast for 2023 is for continued turbulence in the real estate industry as economic pressures and higher interest rates follow the seismic changes that the COVID-19 pandemic brought to markets worldwide.
It’s more important than ever for landlords to structure leases to reduce their exposure in the event of a tenant bankruptcy. Increasingly, commercial landlords are requiring letters of credit as protection, which may be used in lieu of the more traditional security deposit.
The benefits of using a letter of credit can be substantial:
- A letter of credit may represent the only liquid asset available to a landlord to recover overdue rent and other damages.
- More importantly, letter of credit proceeds are an exclusive source of funds for a landlord since they aren’t subject to pro rata distribution to all creditors of a bankruptcy estate.
- Additionally, the ability to obtain letter of credit proceeds without leave of a bankruptcy court allows for immediate access to funds.
Traditionally, security deposits have been deemed to be the property of a tenant’s bankruptcy estate. Accordingly, although a landlord holds a security interest in the deposit, the landlord can’t use such funds to cure a tenant’s arrearages without obtaining relief from the automatic stay. As a result, a landlord may be left without an immediate source of funds to remedy unpaid rent, taxes and other charges.
Letters of credit provide a potential solution
The “independence principle” holds that letters of credit and the proceeds of letters of credit are not property of a bankruptcy estate. Therefore, the automatic bankruptcy stay doesn’t impact a landlord’s action in drawing upon the letter of credit.
There are certain rules that must be followed in order for the landlord to benefit:
The letter of credit provisions should be documented in both the lease and the letter of credit.
- The terms should specifically set forth the rights of the landlord.
- The lease and the letter of credit should define the circumstances that trigger the landlord’s ability to draw down the letter of credit. They should also include the amount of any such draw, how the proceeds of the letter of credit are to be applied, and under what circumstances a landlord must pay over any proceeds to the tenant.
In order to avoid the trap of the automatic stay, the ability to draw on a letter of credit must not be tied to the tenant’s cooperation. A properly structured letter of credit allows the landlord to act anytime the tenant is not in compliance with the covenants of the lease.
The use of letters of credit cannot guarantee a favorable outcome. However, a properly structured lease and letter of credit transaction provides commercial landlords with advantages that aren’t available through the use of the traditional security deposit.
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