LETTERS OF CREDIT PROTECT LANDLORDS IN MARYLAND

By Daniel P. Wilansky, Esq.

Landlords structuring leases of commercial space should anticipate the effects of tenant bankruptcies.  This is especially true in the current economy, in which landlords are frequently dealing with distressed tenants.  Tenant bankruptcies, among other things, affect the ability of landlords to access cash security deposits.  In a tenant bankruptcy, these deposits generally become an asset of the bankruptcy estate pursuant to Section 541(a) of the Bankruptcy Code.  Assets of the bankruptcy estate, including security deposits, are subject to the Bankruptcy Code's automatic stay under Section 362(a).  A landlord may still be able to obtain some or all of the security deposit, but it will have to enter bankruptcy proceedings in order to obtain relief from the automatic stay.  As a result, the landlord may have no immediate source of funds to deal with rent arrearages and other unpaid funds. 

To address this situation, commercial landlords are increasingly requiring letters of credit in lieu of traditional cash security deposits.  A number of jurisdictions have held that letters of credit are not subject to the Bankruptcy Code's automatic stay.  See, e.g., In re Stonebridge Techs., Inc., 430 F.3d 260, 269 (5th Cir. 2005) (letters of credit are obligations entirely separate from debtor's estate); In re Elegant Merchandising, Inc., 41 B.R. 398, 399 (Bankr. S.D.N.Y. 1984) (same).  The rationale is that letters of credit are obligations of the issuing bank that are independent of the tenant's obligations to the landlord.  Because letters of credit are not subject to the automatic stay, landlords may obtain proceeds of the letter of credit without having to enter into bankruptcy proceedings.  Letters of credit therefore provide landlords with an immediate source of payment – a source that is not subject to pro rata distribution of the bankruptcy estate.

Landlords in Maryland have comfort from a Maryland Bankruptcy Court opinion recognizing that letters of credit in leases are not subject to the automatic stay.  The case involved a commercial lease that provided for an irrevocable standby letter of credit which the landlord was entitled to draw upon in the event of the tenant's default.  In re Farm Fresh Supermarkets of Maryland, Inc., 257 B.R. 770, 772 (Bankr. D. Md. 2001).  During the lease term, the tenant committed various monetary and nonmonetary defaults, and the landlord drew down the letter of credit.  The bankruptcy trustee asserted that the act of drawing down the letter of credit without permission from the court violated the automatic stay.  The bankruptcy court rejected the argument, stating that "[t]he proceeds of the letter of credit were properly drawn down . . . pursuant to the terms of the lease and the letter of credit.  This opinion holds that neither the letter of credit nor its proceeds were property of the debtor's estate, and therefore the trustee may not maintain the instant lawsuit to recover them."  Id. 

Landlords seeking to benefit from letters of credit must be sure to incorporate letter of credit provisions in the lease.  The letter of credit and the lease should be executed contemporaneously.  In addition, the documents should state with particularity the events that will permit the landlord to draw down the letter of credit and how the proceeds of the letter of credit are to be applied.  Landlords seeking broad protection may try to negotiate a draw down even as a result of nonmonetary defaults.  Importantly, the Farm Fresh court recognized that such nonmonetary defaults can permissibly trigger a draw down.  Farm Fresh, 257 B.R. at 772 (draw down permissible as both the lease and the letter of credit permitted funds to be drawn down in the event of nonmonetary defaults).

Lawyers should be aware of a number of potential issues associated with letters of credit.  First, they are inherently more complex than traditional cash security deposits.  As a result, increased legal and transaction costs may result from their use.  In addition, letters of credit may be subject to the statutory cap on landlord's damages under a rejected commercial lease pursuant to Section 502(b)(6) of the Bankruptcy Code.  The issue has not been extensively litigated, and courts have reached differing results.  Another issue that is beginning to receive more attention involves the financial stability of the issuing bank.  For letters of credit to provide a benefit, the issuing bank must be able to honor them.  Landlord's counsel should require that the tenant agree to replace the letter of credit if the rating of the issuing bank falls below a certain level. 

Even given these issues, letters of credit remain an attractive mechanism for landlords to avoid certain effects of tenant bankruptcies.  Particularly in the current economy – and in light of the additional comfort provided by the Farm Fresh case – it is not surprising that Maryland landlords are turning to letters of credit.

Daniel P. Wilansky is an associate in the Public Finance Department and a member of the Housing and Transactional Finance Groups of the Baltimore office of Ballard Spahr LLP.

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