LC Use in Commercial Real Estate Lease Transactions

Most issuers of, and beneficiaries under, letters of credit are familiar with the impact a tenant bankruptcy has on the continued effectiveness of draws under the LC. Assuming a “direct draw” letter of credit that does not require prior notice to the applicant, the beneficiary is entitled to draw on the LC because of the independent obligation of the issuer to honor credit- complying draws. The proceeds in the hands of the beneficiary are generally deemed funds held to satisfy “lease termination damages” and if the precipitating cause of the draw is triggered, or is proximately followed, by the applicant/tenant’s bankruptcy, the funds are subject to a claims cap under Section 502(b)(6) of the United States Bankruptcy Code.

Recently, landlords in larger, single tenant building leases (for instance, large, full building tech leases) have begun to consider requiring tenants to obtain two letters of credit – one LC that the landlord can rely on as credit support for lease termination damages and a second LC for what is referred to as “collateral damages,” the proceeds from which are not subject to the claims cap.

Motivation for this derives from a 2016 decision of the United States Court of Appeals for the Ninth Circuit, Kupfer v. Salma (852 F.3d 853), where the court did a deep dive into the lease termination damages subject and came up with a simple test for collateral damages: “assuming all other conditions remain constant, would the landlord have the same claim against the tenant if the tenant were to assume the lease rather than rejecting it”?

The practice of multiple letters of credit avoids the problems of having to draw on an LC issued for an amount greater than the bankruptcy claims cap and fighting with the bankruptcy trustee over those proceeds, while preserving an entirely separate LC to secure “collateral damages.” This court’s analysis has been followed by federal courts in other parts of the US.

Examples of “non-lease termination damages” that have been held to be collateral include:

  • acts of nuisance or waste by a tenant;
  • failure of a tenant to complete and pay for tenant improvements in building out space;
  • legal fees and costs recoverable by a landlord; and
  • reduced to judgment pre-bankruptcy which the landlord is entitled to recover under a lease.

LC issuers should be attuned to this practice in commercial real estate to require that letters of credit be governed by the International Standby Practices (ISP98).

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