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Tenants in Bankruptcy: Landlord’s Ability to Draw on Letter of Credit May Turn on Notice Requirements in Lease

The economic fallout from the COVID-19 pandemic has been particularly acute for commercial landlords.  As retail and other tenants fall further behind on rent and other obligations, lessors are finding themselves drawn into more and more Chapter 11 bankruptcy cases.  Yet, while it may not always feel that way to them, landlords actually have it better than most creditors in bankruptcy.  Section 365 offers an array of protections to lessors of non-residential real property that other stakeholders do not enjoy, and most commercial leases are backed by some form of cash or other security deposit. 

One common form of security is a letter of credit, which is particularly attractive in a bankruptcy case because it is not subject to the automatic stay.  But for a handful of outlier decisions that have been roundly criticized (or worse),[1] courts are nearly uniform in holding that the automatic stay does not preclude a draw on a letter of credit issued by bank to a landlord despite the tenant’s bankruptcy.[2]  The sound rationale for this principle has been explained this way:

Under the ‘independence principle’ that applies generally to letters of credit, an issuer’s obligation to the letter of credit beneficiary is independent from any obligation between the beneficiary and the issuer’s customer. The issuer must honor the letter of credit upon a proper documentary presentation by the beneficiary. The issuer’s obligation to pay under the letter of credit is not affected by any disputes between the beneficiary and the customer. As the letter of credit evidences the obligation of the issuer, the letter of credit and its proceeds are not considered as part of the bankruptcy estate and disbursement is not subject to the automatic stay.[3]

Notwithstanding the well-settled right of landlords to draw on a pre-petition letter of credit after a tenant bankruptcy, there is an important caveat.  Careful lawyers regularly counsel landlords against agreeing to provisions in a lease that require notice of default to the tenant before drawing on a letter of credit, and advise clients to tread carefully in the case of a debtor-tenant that is entitled to such notice.  This caution is grounded in a concern that even if the draw itself will not violate the automatic stay, a notice to the debtor might.  But is such caution really warranted, or does it create needless obstacles to the exercise of the landlord’s remedies?  The rationale underpinning the landlord’s right to draw on the letter of credit – that doing so does not implicate property of the estate – should apply with equal force to a notice given to the debtor that likewise does not interfere with property of the estate.  Right?

Maybe not.  Unfortunately, the scant case law addressing this question does not provide landlords with sufficient comfort to give notice of default to a debtor in bankruptcy – even if such notice is explicitly given for informational purposes only and expressly does not interfere with any property of the estate – without undertaking the risk that such notice will subsequently be ruled to violate the automatic stay.[4]  Accordingly, until more courts weigh in on the question, or until this blogger is elevated to the bench, careful landlords who haven’t dealt with the issue in the lease in the first place will negotiate stay relief with the debtor, or request it from the Bankruptcy Court, in cases where a draw on a letter of credit is predicated on notice of default, termination or some other exercise of remedies against the debtor. 

Of course, every lease is different, and the precise requirements for a draw may dictate whether compliance with the predicates for a draw will rise to the level of an infraction of the automatic stay.  But our survey of the case law does not permit us to conclude that even the most basic notice of a default, and nothing more, will necessarily escape scrutiny for a stay violation.  On the other hand, we are not aware of a single case that has held that a purely informational notice to the debtor notifying it of a draw on the letter of credit is a stay violation.  Careful drafting at the outset of the leasing relationship may make all the difference.

[1] Compare, In re Twist Cap, Inc., 1 B.R. 284 (Bankr. M.D. Fla. 1978) (Enjoining post-petition draw under pre-petition letter of credit), with In re Compton Corp., 831 F.2d 586, 590 (5th Cir. 1987) (TwistCap “has been roundly criticized and otherwise ignored by courts and commentators alike”).

[2] E.g., In re Farm Fresh Supermarkets of Md., Inc., 257 B.R. 770, 772 (Bankr. D. Md. 2001). 

[3] In re Circuit City Stores, Inc., 2016 Bankr. LEXIS 1896, at *201 (Bankr. E.D. Va. 2016).

[4] See In re Bender Shipbuilding & Repair Co., 2010 U.S. Dist. LEXIS 18544, at *12-13 (S.D. Ala. Mar. 2, 2010) (Holding that draw on a letter of credit was proper and explaining that, “[i]f [creditor] gave the notice to [debtor], it can certify that it did so. If the notice violated [debtor’s] stay, that's a separate issue between [debtor] and [creditor], not an issue for [creditor] and [the bank]. [Creditor] will merely have to suffer the consequences, if any, if [debtor] seeks relief for a stay violation.  I don't need to mix stay litigation with this letter of credit litigation.”).  Cf. In re Factory Sales & Eng’g, Inc., 2017 Bankr. LEXIS 3538, at *17 (Bankr. E.D. La. Oct. 12, 2017) (Creditor enjoined from drawing on letter of credit where contract required creditor to terminate before drawing and such termination was barred by the automatic stay).