Daily Development for Tuesday, February 20, 2001

BANKRUPTCY; LEASES; RENT; SECURITY DEPOSITS; LETTERS OF CREDIT: Notwithstanding the filing of a tenant bankruptcy, the landlord may call down a letter of credit posted by a third party as security for the tenant's performance, and landlord still is entitled to demand rent for postpetition periods as a condition to landlord's consent to an assignment of the lease.

In re: Farm Fresh Supermarkets of Maryland, Inc., 2001 Bankr. Lexis 51 (1/12/01)

Prior to bankruptcy, as part of the lease agreement, a bank had posted a $38,000 irrevocable letter of credit through a third part bank. Apparently, the terms of the letter of credit provided that the landlord could call upon the letter of credit in the event of a default, either monetary or nonmonetary.

The tenant paid the rent for November, 1995, and in the middle of the month declared bankruptcy. The check bounced.

The landlord, after the filing of the bankruptcy petition, made a claim upon the letter of credit for monetary and nonmonetary defaults and drew down the entire $38,000. Soon thereafter, the tenant assumed the lease and sought permission to assign it to a third party. The landlord objected because the tenant had some postpetition defaults. The matter was resolved by settlement, pursuant to which the court ordered that, as a condition of the approval of the assignment, the tenant pay landlord one month's rent, of about $13,000. It is not clear from the opinion whether the only default was the bounced check in November (only part of which was post petition), or whether the tenant was also in default for other post petition periods.

Much later, the trustee in bankruptcy sought to recover both the $38,000 drawn on the letter of credit and the rent paid as a condition of approval of the assignment.

As to the letter of credit, the court found that the letter of credit was not the property of the estate, and the estate had no interest in it. The landlord had every right to call upon it, regardless of whether the defaults were significant or minimal, because the terms of the letter so provided. (The tenant did not claim that in fact the letter of credit proceeds were seized by the landlord as an improper forfeiture apparently they either continued to serve as security for the assumed lease or were properly applied to cure real defaults.)

As to the rent payment, the court simply noted that the settlement made it possible for everyone to get on with the transfer of the asset (the assignment of the lease) and the tenant should not be able to renege later. Since the court approved the payment, it was not improper or unjustified, even though the letter of credit might have been applied to cover the same arrearages (but, as noted, apparently was not).

The court distinguished another case involving the drawing down of a letter of credit regarding a loan commitment fee because in that case the question was whether the claim for the fee was an unjustified liquidated damages claim.

Comment: The court later commented that "the letter of credit is a side issue in a side agreement and is now being held as a security deposit on behalf of the assignee which is a benefit to the debtor's estate . . . [since it facilitated the approval of the assignment]." Presumably the court is not referring to the letter of credit itself, which had been fully funded, but rather the proceeds. Was this necessary to the court's resolution in favor of the landlord? There is no indication of that. The decision appears to stand squarely for the proposition that the drawing down of the letter of credit for prepetition defaults is entirely outside of the bankruptcy, even though, of course, the issuer of the letter of credit then has a claim against the bankrupt which it would not otherwise have.

This raises some interesting issues. If the letter of credit was secured by the bankrupt's property, would the issuing bank be able to make a claim as a secured creditor? Even if the proceeds of the letter of credit were used to pay prepetition claims that otherwise could have been avoided or discharged?

This isn't so awful a result. It simply makes certain of the landlord's claims into secured claims. But note that in this case the landlord used the proceeds to continue to serve a security for performance by the assignee. Should such use of letter of credit proceeds be so easily countenanced particularly when they represent a secured claim against the estate? Here, arguably, the use of the proceeds benefitted the estate. But the court is very sketchy in its analysis and in its evaluation of the propriety of the landlord's conduct.

Comment 2: Generally speaking a security deposit can be applied by a landlord for pre petition defaults, and is not a preference. It can also be set up for prepaid rent or liquidated damages. So the treatment of the letter of credit here isn't so unusual, so long as it is being applied for damage claims. But when the money goes on to secure performance by the assignee, this does appear to be an unusual application that the court needed to explain further.

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