Property & the Law
By Benjamin F. Kursman
Cash Is King, Unless a Tenant Goes Bankrupt
Cash is usually king. That may not be the case, however,
when cash is used as a security deposit for a commercial lease and the tenant files for bankruptcy protection,
which would put the cash security deposit under the control of
the bankruptcy court. The owner then would have to wait and
incur legal expenses while the court decides whether the owner
could put the money toward the tenant’s defaults. The burden on
the owner could be even worse, because the court could give the
owner a lien on the tenant’s assets instead of access to the cash.
With this and the rise of corporate bankruptcies in mind,
owners of commercial properties should consider a novel tactic:
requiring guarantor collateral to secure a lease guaranty rather
than accepting a tenant’s cash as lease security—a subtle but critical difference. (Though this approach may be a sound legal and
business proposition, it is untested in the courts.)
“Owners should consider
a novel tactic: requiring
guarantor collateral to
secure a lease guaranty.”
Even if a lease does not call for a guaranty, the guarantor collateral—which most likely will be cash in the same amount as
the tenant’s deposit would have been—can then be posted with
the owner to secure a non-recourse guaranty of the lease under
which the owner agrees to look solely to the guarantor collateral
and not hold the guarantor personally liable.
The use of this structure offers four primary advantages:
• Cash that secures the guaranty should not be considered
property of the tenant’s bankruptcy estate and therefore should
remain outside the bankruptcy court’s control. This saves the
owner time and money, and insulates the owner from the risk of
the court’s allowing the tenant to use the cash for purposes other
than curing the lease defaults.
• The guarantor presumably has far greater assets than the
tenant—particularly if the tenant is a shell company or single-purpose entity—and is far less likely to go bankrupt than the tenant. That is especially true if the guarantor is a principal or parent
company of the tenant.
• If the lease is rejected as part of the bankruptcy proceedings, the owner’s right to apply guarantor collateral to defaults
should not be subject to the limitations that the Bankruptcy
Code imposes on a landlord’s damages.
• Landlords may use guarantor collateral up to the total
amount of the landlord’s state law damage claim against the tenant, without being subject to the Bankruptcy Code’s capped damages. By using this tactic, the owner can significantly increase the
amount of its unsecured lease rejection damage claim against a
bankrupt tenant.
To illustrate the advantages, consider the following hypothetical scenario: The owner’s state law damages arising from a bankrupt tenant’s rejection of a lease are $1.3 million. The owner
holds a cash security deposit of $750,000. The owner’s capped
damages for rejection of the lease under the Bankruptcy Code
are $500,000.
If the $750,000 security deposit was cash security from the tenant, the owner would have to obtain judicial permission to use the
deposit and would have to return $250,000 of it to the bankruptcy
estate because the Code forbids the owner to use any portion of
the security deposit in excess of the $500,000 cap. After keeping
$500,000 and returning $250,000 to the tenant, the owner would
still have remaining state law damages of $800,000. But because
the owner recovered the entire capped damages of $500,000, the
owner is not permitted to make any unsecured claim in the tenant’s
bankruptcy for the remainder of the owner’s state law damages.
If, however, the $750,000 was posted by a guarantor to secure
the guarantor’s non-recourse guaranty of the lease, the owner
should be able to retain and use the entire amount without being
subject to the $500,000 limit on the damages arising from rejection of the lease. The owner would then have $550,000 of remaining state law damages and should be able to make an unsecured
claim for those damages against the tenant’s bankruptcy estate
for the capped amount of $500,000.
Owners’ use of a tenant’s letter of credit instead of cash as lease
security removes the risk of having to obtain the court’s permission to use the proceeds of the letter of credit, but there are non-bankruptcy risks associated with a letter of credit—for instance,
no FDIC insurance if the bank fails. If willing to accept an LOC,
the owner should use it to secure a guaranty of the lease rather
than the lease itself, potentially enlarging the owner’s unsecured
claim for damages against the bankrupt tenant.—RENY
The views expressed in this article are those of the author and not those
of Real Estate New York.
Benjamin F. Kursman is a partner at Herrick, Feinstein LLP.
Contact the author at bkursman@herrick.com.
