Jess Bressi & Scott Brooks Cox, Castle & Nicholson LLP
In the current commercial leasing market, many of the tenants with the greatest space requirements are dot-coms and other “start-up” businesses that lack the financial strength and long-term operating history typically required by commercial landlords. To overcome the new tenants’ financial deficiencies, landlords have historically sought security in the form of guarantees from principals of the tenants. However, with start-up tenants, guarantees are generally not available, as there are typically not creditworthy “principals” willing to sign such guarantees. Accordingly, with start-up tenants, landlords have more customarily sought alternative financial incentives to “enhance” the tenants’ credit, including cash security deposits, prepaid rent, letters of credit and “key money.” While these alternative forms of security may be the only viable choice if creditworthy guarantors are not available, they are not immune to the effects of the tenants’ bankruptcy. To the surprise of many landlords, a landlord’s ability to retain the benefits of such security devices if tenants file for bankruptcy varies considerably. Consequently, landlords are becoming more creative in structuring lease transactions to provide the greatest likelihood of success in retaining these benefits.
In general, the security that a landlord receives from a tenant is governed by four principles. First, a landlord may retain that portion of the security equal to the amount of damages that is actually accrued and legally recognized at the time it elects to execute the posted security, subject to the provisions of bankruptcy law. Absent specific provisions to the contrary (which would be unusual in the context of a typical commercial lease transaction), a security deposit, whether in the form of cash or the proceeds of a letter of credit, is not liquidated damages for a tenant’s default under a lease, nor is it subject to an informal pre-judgment writ of attachment to secure payment of a future judgment.
Second, California law imposes what is typically a 30-day deadline after the date a landlord repossesses the premises for the return of the portion of the security deposit in excess of the then-defaulted amount. California law also provides that it is improper to retain or apply a security deposit in excess of the amount due 30 days after repossession to pay the amount of an eventual judgment the landlord may obtain. This requires the landlord to make a choice: Does the landlord aggressively pursue obtaining possession of the property from the bankrupt tenant, thereby triggering the 30-day deadline to turn over the excess amount of the security deposit (which may also apply to proceeds of letters of credit), or does the landlord defer obtaining possession to first obtain a judgment or permitted claim regarding its damages?
Third, both bankruptcy and state law override the provisions of a lease regarding the amount a landlord may collect in damages. Bankruptcy Code Section 502(b)(6) usually operates to limit post-bankruptcy lease rejection damages to one year’s rent reserved under the lease. In other words, while a landlord may recover unlimited amounts of pre-bankruptcy damages for unpaid rent, property damage, etc., post-bankruptcy rejection damages are typically limited to one year’s rent reserved under the lease.
Fourth, the Bankruptcy Code’s limitation of rejection damages applies to charges due under a lease that are (i) designated as “rent” or “additional rent,” (ii) related to the value of the property or the lease, and (iii) fixed, regular or periodic expenses. Upon default, most landlords prefer California’s summary unlawful detainer procedures to far lengthier breach of contract actions and, thus, a typical landlord describes most monetary obligations due under a lease as “rent.” While this may be a wise approach in state courts, this approach can lead to problems in bankruptcy, with significant amounts otherwise collectible as a landlord’s damages wiped away by the Section 502(b)(6) limitation. For example, in most cases where a landlord funds tenant improvement costs, the landlord increases the rent payable under the lease as a means of effectively “repaying” a “loan.” While resulting in a more favorable treatment under state law, the characterization of the repayment obligation as increased rent results in the landlord not being able to recover the full amount of the tenant improvement costs in a bankruptcy context.
Bankruptcy and Collateral
In light of the foregoing principles, the various security devices employed by landlords are impacted in different ways by a tenant’s bankruptcy, as discussed below:
Cash Security Deposits:
Because the cash security deposit is considered property of the tenant’s bankruptcy estate, cash security deposits are more vulnerable to refund than undrawn letters of credit, which are the independent obligations of the issuing bank. If the cash security deposit exceeds the rent recoverable by a landlord in bankruptcy, the excess is subject to refund to the tenant.
It may aid a landlord to create a security interest in the cash deposit to secure obligations under a lease. This may be accomplished simply by including a sentence in the lease stating that the tenant grants to landlord a security interest in the security deposit in accordance with applicable provisions of the California Commercial Code, since, under the existing California Commercial Code, a security interest in a cash deposit may be perfected by the landlord’s possession of the cash deposit. Bankruptcy law will recognize the effectiveness of security interests in many instances and may allow the security deposit to be applied in a manner that is more beneficial for a landlord than a tenant.
Depending on classification, various obligations owed landlords enjoy different likelihoods of being repaid and varying percentages of payout. For example, post-bankruptcy rent incurred by a debtor prior to the rejection of a lease is more likely to be paid than post-rejection rent, which is already capped by Section 502(b)(6). In successful Chapter 11 cases, post-bankruptcy, pre-rejection claims are considered “administrative priority” claims and must be paid in full. Unfortunately, post-rejection claims may only be paid a fraction of their already reduced face amounts. By applying a cash security deposit to the amount least likely to be paid (i.e., the post-rejection claims), a landlord can increase its total recovery. Debtors in bankruptcy and bankruptcy trustees have attempted to compel landlords to apply security deposits in a manner more favorable to the tenant (i.e., to the administrative priority claims), but the better reasoned reported cases have rejected these efforts and have allowed landlords to apply security deposits to the portion of their claim that is least likely to be paid.
Unfortunately for a landlord, pre-paid rent is generally treated in the same manner as a cash security deposit. California law treats advance payments of rent made to secure the execution of a rental agreement as a security deposit. As such, the pre-paid rent is only available to remedy tenant defaults in the payment of rent, to repair damages to the premises caused by the tenant, or to clean the premises upon termination of the tenancy. Like a cash security deposit, taking a security interest in pre-paid rent may enhance the treatment of pre-paid rent in bankruptcy.
Letters of Credit:
The start-up tenant often provides a letter of credit as security for the performance of the tenant’s obligation under a lease. A letter of credit is sensible for the tenant, since the cost of having the tenant’s bank issue a letter of credit is cheaper for the tenant than depositing a substantial amount of cash with the landlord. To a landlord, the letter of credit generally is also seen as preferable to a cash security deposit as the automatic stay created by a tenant’s bankruptcy filing does not prevent the landlord’s draw on the letter of credit. This is because under the so-called “independence principle” applicable to letters of credit, the payment obligation under the letter of credit is viewed to be an obligation of the payment bank (not the tenant) and thus not subject to the automatic stay.
It is not a matter of settled law whether the limitations on a landlord’s recovery under Section 502(b)(6) are applicable to amounts drawn under a letter of credit. Of course, landlords hope that they will be able to circumvent the Section 502(b)(6) limitation based on the “independence principle,” and retain the proceeds of letters of credit in excess of the capped amount. Naturally, tenants and bankruptcy trustees contend the opposite. Because there are no reported cases on point on this issue, caution is appropriate when considering the ability to retain more than would be permitted under Section 502(b)(6) as a major factor in a leasing decision where letters of credit serve as the primary security for a tenant’s obligations under a lease.
Because of the limitations imposed by Section 502(b)(6) on a landlord’s recovery following a tenant’s bankruptcy, in the case of a significant tenant improvement allowance where the landlord is obtaining a letter of credit as additional security, landlords may wish to consider an alternate structure for the transaction at the time of lease execution in order to provide a landlord with a greater opportunity for recovery upon a tenant bankruptcy. Under this scenario, rather than include the repayment of the tenant improvement allowance as a part of base rent (as is typically the case), the tenant executes a separate promissory note at the time of lease execution for repayment of the tenant improvement allowance and secures such note by a separate letter of credit. With this structure (and with carefully followed operating practices, such as separate invoicing to differentiate the repayment of the note from the payment of rent under the lease), a landlord may be able to avoid the characterization of the repayment of a tenant improvement allowance as “rent” (which would be subject to the limitations of Section 502(b)(6)) by arguing that the landlord is really a lender. In such case, upon a tenant default, the landlord would be entitled to realize upon all of the collateral posted as security for the “loan” repayment obligation without regard to the limitation of Section 502(b)(6).
In landlord-oriented markets, where demand for space greatly exceeds supply, landlords have, at times, been able to obtain substantial payments from tenants for the “privilege” of entering into a lease, often referred to as “key money.” Properly drafted, an agreement for payment of key money should be enforceable under state law, particularly if it is fully earned upon lease execution and is not in lieu of pre-paid rent, a security deposit, rent abatement, or a guaranty. The enforceability of a key money provision is questionable if it is disguised pre-paid rent or where the amount of the key money equates to rent abatement provided to the tenant in later months of the lease term.
Notwithstanding that genuine key money payments should be enforceable under state law, substantial key money payments made within 90 days of bankruptcy are likely to be attacked as “preferential” payments (i.e., payments that enable a creditor to obtain more than it would receive if it did not obtain the payment and was paid in a Chapter 7 bankruptcy liquidation). Key money payments are also vulnerable to attack as a “fraudulent conveyance.” A basic fraudulent conveyance theory is that the tenant did not receive “reasonably equivalent value” for the payment of the key money if the marketplace for similar space within the same building or nearby buildings does not demand it. In addition to typical defenses available to the landlord, documenting that key money is not a disguised form of pre-paid rent or security deposit and is fully earned upon payment may also help overcome allegations of preference or fraudulent conveyance.
With the risky nature of leasing to “dot coms” and start-up companies, landlords are likely to continue demanding additional security at the time of entering into lease transactions. But, prior to the execution of any lease, the landlord must ask “how secure is my security?” The answer depends upon the structure of the lease. To be able to retain the expected benefits from a lease transaction, it is critical for a landlord to consider the impacts that could result from a tenant’s bankruptcy.