Why Landlords Prefer Letters of Credit Instead of Cash Security Deposits

It is well established that a cash security deposit posted by a tenant under a lease is considered to be property of the tenant’s estate in bankruptcy, and it is subject to the automatic stay provisions of the Bankruptcy Code. Therefore, it may not be accessed by a landlord without court approval. Many times, the court will not allow access at all.

To alleviate this risk, landlords often ask that the tenant post a letter of credit (“LOC”) instead of cash. The argument made is that the LOC is deemed to be an obligation to pay from a third party (the bank issuing the LOC) and therefore is not part of the bankrupt tenant’s bankruptcy estate.

Once the landlord has drawn on the LOC, however, the question arises as to whether the proceeds of the LOC are subject to the statutory cap on the landlord’s damages under a rejected commercial lease pursuant to §502 of the Bankruptcy Code. Generally, §502 does not alter the entitlement of the landlord to the full proceeds of the LOC in cases where the landlord has not also filed a claim against the tenant for recovery of unpaid sums due under the lease. Therefore, a landlord holding a LOC as security for a lease should consider not filing a proof of claim in a tenant’s bankruptcy case. Of course, there are a number of other considerations that play into this critical decision, and careful analysis with bankruptcy counsel is essential to any decision.

Careful drafting of the letter of credit provisions play a pivotal role in whether and when you may access the proceeds. Appropriate bankruptcy filings are equally pivotal in protecting the landlord’s rights in any tenant bankruptcy.

Our firm’s real estate and bankruptcy attorneys have been drafting such clauses and implementing recovery strategies for our clients for more than thirty years.