From retailers to restaurants (Nieman Marcus, J.C. Penny, Hertz, NPC International), many different businesses have filed for bankruptcy due to pressures caused by COVID-19. For some this may mean a loss of a favorite store. For others, the loss of a livelihood. But for commercial landlords these bankruptcies primarily mean uncertainty. After the bankruptcy begins, a landlord’s options are limited. But beforehand, during lease negotiations, there are many tools landlords can use to better protect themselves in the event the tenant later files for bankruptcy. This short note serves to address one of these many: the letter of credit.
What is a letter of credit?
A letter of credit is a document issued by a bank that ensures payment to the “beneficiary” under the letter. An “applicant” will apply for the letter of credit in favor of the beneficiary, often pursuant to some agreement between the applicant and the beneficiary. In our context, the tenant would apply for the letter of credit for the benefit of the landlord, to act as a replacement for a traditional security deposit.
How does bankruptcy affect commercial landlords?
Commercial tenants in bankruptcy are afforded a number of different rights and protections that they do have outside of bankruptcy. Perhaps the most well-known protection is the automatic stay. The automatic stay generally prevents third parties from meddling with the bankrupt’s assets—otherwise known as the “bankruptcy estate.” A traditional security deposit is considered part of the bankruptcy estate. In many cases, the landlord will not be able to recover security deposit without hiring an attorney and filing motions with the bankruptcy court.
How does a letter of credit help a commercial landlord in its tenant’s bankruptcy?
The key difference between a letter of credit and a traditional cash security deposit is that the letter of credit is independent of the landlord/tenant relationship. In other words, the bank follows the instructions contained in the letter of credit without regard for any third-party agreements. Because of the so-called “independence principle” of letters of credit, they are generally considered separate from the bankruptcy estate. This means that as a landlord, with a properly drafted letter of credit, you would be able to seek reimbursement under the letter of credit during a tenant’s bankruptcy.
Letters of credit are just one of many different strategies commercial landlords can implement to protect themselves from a tenant’s bankruptcy. Several other options are available, but a commercial landlord must typically take these steps during lease negotiations. Experienced counsel at this stage is key.
By: Eric Krampf
