Bankruptcy-Proofing Tenant's Security Deposit

By Benjamin F. Kursman, Esq.

Given the precarious credit situation of many tenants today, it is more important than ever that a tenant's security deposit be as secure as possible and immunized from the consequences of a tenant bankruptcy. There are several techniques owners can use to accomplish this, but a novel method—using the security deposit to secure the guaranty of the lease—reduces many risks and administrative burdens.

By Benjamin F. Kursman, Esq.

Given the precarious credit situation of many tenants today, it is more important than ever that a tenant's security deposit be as secure as possible and immunized from the consequences of a tenant bankruptcy. There are several techniques owners can use to accomplish this, but a novel method—using the security deposit to secure the guaranty of the lease—reduces many risks and administrative burdens.

Here's how it works: If there is a guarantor of the lease that is providing a full guaranty, then, in lieu of requiring the tenant to post a security deposit under the lease, instead require the guarantor to secure its obligations under the guaranty with a cash deposit in an amount that would have been the amount of the tenant's security deposit (called the “guarantor collateral”). The guarantor collateral should be funded with the cash of the guarantor and not of the tenant.

Under a well-drafted guaranty, the guarantor is guarantying all of the tenant's obligations under the lease, so, in effect, the guarantor collateral secures the same obligations that it would have secured had that cash been posted as a security deposit under the lease. And it is less likely that the guarantor—the entity with the most assets— will become insolvent or go bankrupt as compared to the tenant, which often has limited assets at best.

“Good-guy” guaranty. If the guarantor is to provide a limited guaranty, such as a “good-guy” guaranty, or even if no guaranty is to be given, then the guarantor (in addition to whatever limited guaranty it may be giving) should sign a “non-recourse” guaranty covering all of the tenant's obligations under the lease. This guaranty would: (1) be secured by the guarantor collateral; and (2) provide that the owner's sole recourse under the guaranty is to the guarantor collateral.

In many lease transactions, the “non-recourse” guarantor would typically be either a parent company of the tenant or in some instances, the individuals who are principals of the tenant. Again, a parent company or individual principals are usually less likely to file for bankruptcy than the tenant that they control.

Advantages of Guarantor Collateral Method

The advantages of using this method are as follows:

Guarantor collateral not part of tenant's estate. In the tenant's bankruptcy case, the guarantor collateral is not likely to be considered property of the tenant's bankruptcy estate. Accordingly, the owner will not be required to get the permission of the bankruptcy court to apply the guarantor collateral to the tenant's defaults under the lease, because it will be applied against the guarantor's defaults under the guaranty. This gives the owner immediate access to the security deposit, and saves the owner the time and expense of having to make a motion in the bankruptcy court to tap the tenant's security deposit.

Further, the bankruptcy court has the power to allow the tenant to use the cash security deposit in the bankruptcy case and force the owner to accept noncash security (such as a lien on the tenant's assets) as a substitute. Although this forced substitution rarely occurs, it is a risk that can be eliminated by simply having the guaranty secured by a cash deposit of the guarantor in the same amount that otherwise would have been posted by the tenant.

No damage limitation if lease is rejected. In the event of a rejection of the lease in the tenant's bankruptcy case, the owner's right to apply the guarantor collateral to defaults under the guaranty should not be subject to the limitation on an owner's damages (as a result of the lease rejection) that is imposed under the Bankruptcy Code. Under the Bankruptcy Code, an owner is not permitted to apply the tenant's security deposit to the full amount of state law damages sustained by the owner, but only to the limited damages that the owner is permitted to claim under Section 502(b)(6). Because of this limitation, the owner is required to return to the tenant's bankruptcy estate the amount of the tenant's security deposit that is in excess of the owner's capped damages.

Some courts have even held that this limitation should also apply to the owner's ability to draw on a letter of credit given by a tenant as security for a lease, so that an owner would not be permitted to draw on the letter of credit for more than the capped damages allowed under the Bankruptcy Code [see Redback Networks, Inc. v. Mayan Networks Corp., 2004; Solow v. PPI Enters (U.S.), Inc., 2003; and Faulkner v. EOP Colonnade of Dallas, LP, 2003].

An owner can avoid this limitation on its ability to use the security deposit (whether in cash or letter of credit form) by using the guaranty structure. When guarantor collateral is posted by the guarantor to secure the guaranty of the lease, the owner may use the entire guarantor collateral, up to the total amount of the owner's state law damage claim against the tenant, without being subject to the Bankruptcy Code's capped damages. If the guarantor collateral does not cover the owner's entire state law damage claim, then, based on existing case law, the owner should be able to make an unsecured claim in the tenant's bankruptcy case for the balance of the owner's state law damages, not to exceed the bankruptcy cap.

Example of How Method Works

Consider the following scenario: The tenant rejects the lease in bankruptcy court, and the owner's resulting damages permitted under state law amount to $1.3 million. If the owner holds a security deposit under the lease for $750,000, the owner first must get the court's permission to tap it. The bankruptcy code will then limit the owner's ability to tap the security deposit to $500,000.

The owner would still have a remaining state law damage claim against the tenant for $800,000, but because the owner recovered its full bankruptcy-capped damages of $500,000 by retaining the security deposit, the owner is not permitted to make any unsecured claim for its remaining damages in the tenant's bankruptcy case.

If, however, instead of the tenant's posting a $750,000 security deposit under the lease, the guarantor posts an equivalent sum of guarantor collateral for a “non-recourse” guaranty of the lease, the owner should be able to use and retain the full $750,000 guarantor collateral without being limited by the $500,000 bankruptcy lease rejection damage limitation. The owner now has a remaining state law damage claim against the tenant of $550,000, and should be able to make an unsecured claim against the tenant's bankruptcy estate for capped damages of $500,000.

Thus, by using the guaranty structure, in the event of the tenant's bankruptcy, the owner is able to: (1) use and retain $250,000 more of the cash security posted with the owner; and (2) make an unsecured claim against the tenant's bankruptcy estate of $500,000 greater than the claim that it otherwise would have been permitted.

Practical Pointer: It is advisable that the guaranty provide that the guarantor have no right to assert any subrogation or reimbursement claim against the tenant until the owner has recovered all of its damages. Otherwise, a guarantor's unsecured reimbursement/subrogation claim against the tenant in bankruptcy could compete with (and, therefore, diminish) the owner's unsecured claim for lease rejection damages.

Using Letter of Credit vs. Security Deposit

Until recently, the conventional wisdom for owners requiring a lease security deposit has been to favor a letter of credit from the tenant rather than a cash security deposit. Taking a letter of credit (rather than cash) to secure the tenant's obligations under the lease eliminates the risk that the letter of credit and the proceeds of any draw thereon are not considered property of the tenant's bankruptcy estate. Accordingly, in the event of a default by the tenant, the owner, without having to obtain permission from the bankruptcy court, can immediately draw on the letter of credit and apply the proceeds thereof to such default.

Non-bankruptcy risk. There are, however, certain non-bankruptcy-related risks associated with an owner's accepting a letter of credit in lieu of a cash security deposit. A letter of credit has an expiration date that must be closely monitored; otherwise, the letter of credit can expire before the owner has an opportunity to draw upon it, resulting in the total evaporation of the owner's security. This risk does not exist when using a cash security deposit. While a well-drafted lease gives the owner the right to draw upon any letter of credit deposited as security thereunder for the full amount thereof if it is about to expire in less than some designated time period (such as 30 days), this right does not help the owner if it forgets to make the draw.

Evergreen letter of credit risk. Some of this risk can be diminished by requiring the tenant to deliver a so-called “evergreen” letter of credit. Under an evergreen letter of credit, the initial expiration date (typically one year from the date of issuance) is automatically renewed annually unless the bank issuing the letter of credit gives a nonrenewal notice to the owner at least some period (such as 30 days) prior to the letter of credit's original or extended expiration date, advising that the bank elects not to further extend the letter of credit.

A well-drafted lease will give the owner the right to immediately draw on the letter of credit and convert it to a cash security deposit if the bank gives a nonrenewal notice. But if the owner overlooks the nonrenewal notice, or fails to draw on the letter of credit before it expires, the security deposit evaporates. Even if the lease gives the owner the right to require the tenant to replace an expired letter of credit with a new letter of credit, the tenant's financial condition may have deteriorated since the issuance of the original letter of credit, and the tenant may not be able to obtain a new letter of credit.

Bank risk. Finally, given the current crisis in the banking industry, an additional non-bankruptcy risk associated with a letter of credit is now apparent. Unlike cash security that the owner can deposit in FDIC-insured bank accounts, letters of credit are not insured by the government, and a letter of credit of a failed bank may not be honored by the FDIC. Accordingly, owners must be ever vigilant in evaluating the creditworthiness of banks issuing letters of credit. In the current financial climate, it would be prudent to reserve the right to require the tenant to replace a letter of credit if at any time the creditworthiness of the bank that issued the letter of credit did not meet the owner's standards. Some owners will find this an unacceptable burden.

Because of these risks and burdens, many owners would prefer to have a cash security deposit. The use of the guaranty structure gives the owner a better option—it eliminates the bankruptcy risks (with respect to the tenant—not the guarantor) as well as the non-bankruptcy risks and burdens simply by using a cash security deposit to secure a guaranty of a lease rather than the lease itself.

Editor's Note: Using a security deposit to secure the guaranty of a lease does not protect against the bankruptcy of the guarantor. However, if the guarantor does file for bankruptcy, the owner is certainly in no worse a position than it would have been had the security deposit secured the lease instead of the guaranty.

Insider Source

Benjamin F. Kursman, Esq.: Partner, Herrick, Feinstein LLP, 2 Park Ave., New York, NY 10016; (212) 592-1400; bkursman@herrick.com.

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