Landlord's Claim Puts Letter of Credit Proceeds at Risk

A recent bankruptcy decision makes clear that it is risky for a landlord to file a proof of claim in a bankruptcy proceeding when the landlord has substantial security in the form of both a security deposit and letter of credit. If a landlord has drawn down the letter of credit proceeds and withdrawn the security deposit in full after the tenant's default, filing a proof of claim in the tenant's subsequent bankruptcy proceeding may invite a bankruptcy court's consideration of whether those funds are or should be assets of the bankruptcy estate.

In 40 CPS Associates, LLC v. Villano Family Limited Partnership, 2015 U.S. Dist. LEXIS 158033 (E.D.N.Y. Nov. 23, 2015), a New York district court dismissed CPS Associates' appeal of an order of the bankruptcy court authorizing a family limited partnership to object to claims it asserted against the estate of the debtor, including its claim for payment of an administrative expense for the debtor's post-petition rent or postpetition use and occupancy of real estate. In this case, CPS Associates, the landlord, drew down a letter of credit issued to ensure payment of rent and also filed a proof of claim in the tenant's bankruptcy.

The Facts

In early 2012, The Villano Family Limited Partnership and a corporate affiliate called Majestic filed voluntary petitions for relief under Chapter 11 of the Bankruptcy Code. The limited partnership operated a bar and restaurant, and the corporate affiliate was the entity that held the lease for the business. Several months later, both of their cases were converted to Chapter 7 proceedings and a bankruptcy trustee was appointed.

Although the debtors continued to operate the bar and restaurant after filing their respective petitions, neither the debtors nor the bankruptcy trustee paid any post-petition rent to CPS Associates. Seeking to protect its right to collect unpaid pre-petition rent, damages from the rejection of its lease and rent for the debtors' post-petition use and occupancy of the premises, CPS Associates filed proofs of claim in both the Villano Family LLP and the Majestic cases. A protracted dispute arose over these claims and the Landlord spent more than three years litigating in bankruptcy court. The court ruled that Villano Family LLP could object to these claims on the grounds that there was a factual dispute concerning whether CPS Associates' draw of $146,250 in letter of credit proceeds and its withdrawal of a $65,000 cash security deposit exceeded the damages that CPS Associates claimed Villano Family LLP owed.

The District Court for the Eastern District of New York denied CPS Associates' motion for leave to file an interlocutory appeal to that court from that bankruptcy court's ruling, and dismissed the appeal. The district court let stand the bankruptcy court's order authorizing Villano Family LLP to object to CPS' Associates proof of claims.

The court's opinion makes clear that CPS Associates would have been in a stronger financial position if it had not filed a proof of claim in its tenant's bankruptcy proceeding. The court found that the decision by CPS Associates to draw down the letters of credit in the middle of its tenant's bankruptcy proceeding without seeking the consent of the bankruptcy court was problematic.

If CPS Associates had not filed proofs of claim and simply drew down the letter of credit to recoup its damages under the terms of the lease, it could have avoided becoming enmeshed in the bankruptcy proceedings and would have avoided the related costs and attorneys' fees. Further, if CPS Associates could demonstrate that it did not draw down letter of credit proceeds in excess of its actual damages for the breach of the lease, it could avoid liability to the bankruptcy trustee for turnover under Section 542 of the Code. See Two Trees v. Builders Transport, Inc. (In re Builders Transport, Inc.) [hereinafter Builders], 471 F.3d 1178 (11th Cir.2006), cert. denied, — U.S. —, 127 S. Ct. 2112, 167 L.Ed.2d 814 (2007).

In Builders, a lessee-debtor purchased a letter of credit pre-petition to secure its obligations under a lease. After a series of transactions, the landlord-beneficiary ultimately received the letter of credit proceeds. The trustee sued the landlord-beneficiary for turnover under Section 542. The beneficiary argued that proceeds of a letter of credit were not property of the estate. The Builders court stated that even though the letter of credit proceeds were not property of the estate, the lease did not permit the landlord to retain letter of credit proceeds that exceeded its damages.

Ipso Facto Clauses

Other courts have also held that a letter of credit draw is not subject to the automatic stay because the issuer has a separate and independent obligation to the beneficiary, the payment of which does not involve the debtor's property. In re MPM Silicones, LLC (Bankr. S.D.N.Y. 2014); See also John F. Dolan, Insolvency in Letter of Credit Transactions, Part III, 132 Banking L.J. 287 (June 2015). But, when the parties' agreement specifies that the creditor may draw on the letter of credit if the lender files for bankruptcy, debtors may argue that the courts should bar the draw pursuant to ' 365(e) (1) of the Bankruptcy Code, which bans so-called ipso facto clauses. At least one bankruptcy court prohibited a draw on a letter of credit that the creditor made in reliance on an ipso facto default clause in a lease. Professor Dolan notes that an ipso facto clause violates that section's prohibition on a creditor's declaring a default “ipso facto,” that is, simply because of the debtor's bankruptcy filing.

Dolan cites In re Metrobility Optical Sys., Inc., 268 Bankr. Rep. 326 (Bankr. D. N.H. 2001), for the proposition that a creditor's draw on a letter of credit after an ipso facto default violates the automatic stay. But that case distinguishes between: 1) letters of credit issued on behalf of the debtor to secure bonds, on the one hand, with 2) a letter of credit that secures a tenant's obligation under a lease, on the other.

The Metrobility court said that 365(e)(1) does not bar draws on letters of credit when the debtor is not a party to an agreement with the creditor, but does bar draws on letters of credit when the debtor and creditor are parties to the same agreement. The court issued an injunction preventing the landlord from drawing on a letter of credit that secured performance under the lease to which the debtor is a party.

The court in Metrobility distinguished In re Prime Motor Inns, Inc., 130 B.R. 610 (S.D. Fla. 1991). In Prime Motor Inns , the district court reversed a bankruptcy court's grant of an injunction preventing the indenture trustee for bond holders from drawing on letters of credit. But in that case, the debtor was not a party to the agreement between the issuer of the bonds and trustee responsible for paying the bond holders.

Likewise, Metrobility distinguished In re Zenith Electronics, 104 B.R. 667 (1989). In Zenith, the court did not bar a bank's draw on a letter of credit when bond holders, rather than a party to a transaction with the debtor, were the beneficiaries. In both Zenith and Prime Motor Inns , the debtor received financing from a government entity, which, in turn, financed the transaction through the issuance of bonds.

Sample Letter of Credit Clause

Keeping in mind the traps for unwary landlords described in these cases, landlords that are concerned about a prospective tenant's financial condition could include the following provisions in their transactional documents:

• Tenant shall deposit any and all rent, fees, fines, or other payments due pursuant to this Lease at the bank and account number listed below for the benefit of Lessor.
• If Tenant fails to deposit sufficient collectible funds when due pursuant to this Lease, in the manner specified in this Lease, Lessor shall have the right, at its option, to immediately accelerate this Lease and withdraw all funds in any security deposit and draw in full on any letters of credit that any entity holds for Lessor's benefit with respect to this Lease.
• Tenant covenants and agrees that, after its default, it shall not seek to recover any funds that Lessor withdraws from any security deposit, letter of credit, or other accounts, in any proceeding of any kind, including, without limitation, any arbitration, lawsuit, bankruptcy litigation, or equitable proceeding of any kind.
• Tenant further covenants and agrees that, if it defaults or fails to comply with any provision of this Lease, it shall not contest or object to: 1) Lessor's right to withdraw security deposit or letter of credit proceeds; or 2) Lessor's filing of a proof of claim or other claim or defense in any proceeding of any kind, including, without limitation, any arbitration, lawsuit, bankruptcy litigation, or equitable proceeding of any kind.

Conclusion

As discussed in Villano, the bankruptcy trustee may seek repayment of letter of credit proceeds from the landlord on the grounds that those proceeds exceed the damages to which the landlord is entitled. For this reason, if the landlord draws down letter of credit proceeds after the tenant's bankruptcy filing and also files a proof of claim seeking additional damages in the tenant's bankruptcy proceeding, time-consuming and expensive litigation could result in the landlord spending more in legal fees than it stands to gain from its proof of claim recovery.

And if, as in Villano, the debtor successfully objects to the filing of the proof of claim, and the trustee determines that the landlord's security deposit and letter of proceeds exceed the damages to which the landlord is entitled, the landlord might face a turnover action from the trustee seeking repayment of funds to the bankruptcy estate.

John B. Spitzer practices law in Pennsylvania, edited several editions of The Fundamentals of Bankruptcy Law, and has worked with bankruptcy attorneys in several states.