While commercial leases provide various remedies in the event of a tenant breach, there can be challenges to collecting unpaid rent or damages from an insolvent tenant. When negotiating a commercial lease for a new tenant, landlords have a number of options to secure a tenant’s payment obligations, the most common forms being security deposits, letters of credit (LOC) and personal guaranties. 

This article discusses generally the benefits and risks of each of these forms of security to the landlord in the event of a commercial tenant’s insolvency and/or bankruptcy.

Security Deposit

A security deposit is a cash payment by the tenant to the landlord. While security deposits are the most common form of security in a commercial lease, there are some risks to the landlord in the event the tenant files bankruptcy. 

Cash security deposits are considered property of the bankruptcy estate and therefore, once a tenant files bankruptcy, the landlord will be subject to an “automatic stay” and unable to apply the security deposit to cover unpaid rent or damages until the landlord obtains approval from the bankruptcy court, which can take time. Further, the security deposit may be subject to a claims cap under the Bankruptcy Code. 

Specifically, when a tenant files bankruptcy, the “automatic stay” prohibits further collection activity. This means, the landlord cannot evict or demand rent under the lease until the landlord obtains relief from the “automatic stay” through the bankruptcy court. 

Further, with a traditional Chapter 11 bankruptcy filing, the tenant has the right to “assume or reject” the unexpired lease. The decision whether to assume or reject a lease must be made by the tenant within 120 days of the bankruptcy filing, though this time can be extended up to 90 additional days by court order.

This right to reject the unexpired lease allows tenants to avoid performing future lease obligations, but leaves the landlord with a claim for “rejection damages.” Under section 502(b)(6) of the US Bankruptcy Code, a landlord’s claim for rejection damages is capped at the rent for the greater of (i) one year or (ii) 15 percent of the remaining lease term, which cannot exceed three years. The calculation begins from the earlier of the date of the bankruptcy filing and when the landlord repossessed or the tenant surrendered the premises. Further, courts are split on what type of damage claims are capped. Accordingly, collection of outstanding rent or even a significant portion of the remaining balance due under the lease can be challenging with an insolvent tenant.

Letter of Credit (LOC)

While LOCs are used less often than security deposits, they can be a more preferred form of security in the event a tenant files bankruptcy.

A LOC is a financial instrument used to guarantee a commercial tenant’s payment obligations under the lease, including payment of rent. An LOC may provide greater security to the landlord in the event of a tenant’s insolvency or bankruptcy. 

Specifically, a LOC held by the landlord as security is considered a contract between the landlord and issuing bank — the LOC essentially acts as a bank guaranty. As such, in the majority of cases, the LOC is not considered part of the bankruptcy estate. Therefore, if the tenant files for bankruptcy, the landlord may be permitted to draw down on the LOC to offset outstanding rent amounts.

Further, given various bank failures over recent years, landlords should consider taking proactive measures to maintain their security interest in LOCs by requiring the issuing bank to have a certain credit rating and, in the event the credit rating falls during the lease term, requiring the tenant to replace the LOC with a different, more creditworthy institution. Such requirements should be specifically set forth in the commercial lease.

Personal Guaranty

A personal guaranty also offers an alternative form of security for landlords. At its most basic form, a personal guaranty is a promise by another party to pay the landlord if the tenant defaults on the lease. A guaranty can be unlimited or limited as to a certain dollar amount or term. One of the advantages of a personal guaranty is that it does not require any collateral or upfront cash payment by the tenant. That said, the guarantor is exposed to financial risk if the tenant defaults under the lease. Therefore, a landlord will want to assess the financial strength of the guarantor to perform the tenant’s payment obligations when evaluating this form of security.

In addition, a personal guaranty is not property of the bankruptcy estate so long as the guarantor does not file for bankruptcy protection. A landlord can pursue its remedies against the guarantor without being subject to the “automatic stay” or claims cap on rejection damages contained in Section 502(b)(6) of the Bankruptcy Code.

Takeaways for commercial landlords

As discussed above, LOCs are not property of the bankruptcy estate and, in most cases, not subject to the Bankruptcy Code’s claims cap. As a result, a landlord holding a LOC can draw upon the LOC as soon as the tenant files for bankruptcy, even if the LOC amount exceeds the claims cap, so long as the lease and the LOC are properly drafted. For example, the LOC itself should specify an amount; it should not be a substitute for the security deposit; the duration; the circumstances under which the landlord can draw upon the LOC; and any procedures for renewal or amendment.

Similarly, landlords are entitled to pursue guarantors for the full amount of damages under the lease, with no claims cap, provided the guarantor has not filed for bankruptcy as well. In this regard, landlords should monitor the financial strength and bankruptcy status of any guarantor of the lease. 

As added protection, a commercial lease should allow the landlord to require additional security in the event a guarantor files bankruptcy or changes in the creditworthiness of the issuing bank of the LOC (e.g., a new guarantor, higher security deposit or LOC). 

This article is intended to only provide a high-level review of the most common forms of security available to landlords. It is important to recognize that leases should be drafted to maximize a landlord’s recovery in the event of a tenant’s insolvency or bankruptcy. Further, there are other means available to landlords wanting to secure a tenant’s payment obligations that were not discussed in this article (e.g., surety bonds or obtaining and perfecting a security interest in the tenant’s personal property, which can include furniture, fixtures, equipment, inventory and accounts receivable). Accordingly, landlords should seek legal advice before entering into a lease to determine which type of security is in a landlord’s best interest. Overall, the treatment of various forms of security can be complex and may depend on various factors, including the type of bankruptcy, applicable exceptions and local laws. For more guidance regarding drafting commercial leases and LOCs, contact an experienced attorney who can provide guidance based on the specific situation and jurisdiction.