Most issuers and recipients of Letters of Credit are familiar with the impact of a tenant’s bankruptcy on the continued effectiveness of LC withdrawals. In the case of a “direct draw” letter of credit that does not require prior notice to the applicant, the beneficiary has the right to draw on the LC because of the issuer’s independent obligation to honor credit compliant prints. The proceeds in the hands of the beneficiary are generally considered to be funds held to satisfy “lease termination damages” and if the precipitating cause of the draw is triggered or closely followed by the bankruptcy of the plaintiff/tenant , the funds are subject to a claim. ceiling under Section 502(b)(6) of the United States Bankruptcy Code.
Recently, landlords of large single-tenant leases (e.g., large full technology leases) have begun to consider requiring tenants to obtain two letters of credit – an LC the landlord can count on for credit support for damages related to the termination of the lease and a second LC for the so-called “collateral damages”, the proceeds of which are not subject to the cap on claims. The motivation for this stems from a 2016 decision by the United States Court of Appeals for the Ninth Circuit, Kupfer v. Salma (852 F.3d 853), where the court elaborated on the subject of damages related to the termination of the lease and proposed a simple test for collateral damages: “assuming that all other conditions remain constant, the landlord would he have the same claim against the tenant if the tenant were to assume the lease rather than reject it”? The practice of multiple letters of credit avoids the problems of having to pull on an LC issued for an amount above the ceiling for bankruptcy claims and fighting with the trustee in bankruptcy over these products, while preserving an LC entirely separate to guarantee “collateral damage”. This court’s analysis has been followed by federal courts in other parts of the United States.
Examples of “non-lease termination damages” that have been considered warranties include: acts of nuisance or waste by a tenant; failure of a tenant to complete and pay for tenant improvements in building space; legal fees and costs recoverable by a landlord; and reduced to a pre-bankruptcy judgment which the landlord is entitled to recover under a lease.
Letters of credit issuers should be aware of this practice in commercial real estate to require letters of credit to be governed by international standby practices (ISP98).