Decoding The Code
Maximizing the landlord’s value proposition in a tenant bankruptcy.
Lee Collins

In Dan Brown’s best-selling novel, The Da Vinci Code, the hero explores some of Western culture’s greatest mysteries — from the nature of Mona Lisa’s smile to the secret of the Holy Grail — decoding these ancient mysteries in a journey filled with intrigue and adventure. Decoding the United States Bankruptcy Code and how it affects the retail landlord’s rights when a tenant files for bankruptcy protection is similar — only without the intrigue, adventure, and $25 retail cover price. If you have ever been a creditor in a bankruptcy reorganization involving a debtor with multiple lease locations, then you have firsthand knowledge of just how frustrating, disruptive and costly these proceedings can become.

The retail landlord is powerless to modify the terms of the lease and the respective rights of the parties without the approval of the bankruptcy court after the filing of the bankruptcy petition by the tenant. Because of this, the landlord is more likely to maximize its value proposition as a creditor by understanding how the laws affect the landlord-tenant relationship and by taking certain precautions before the filing of a chapter in bankruptcy.

Security Deposits And Letters Of Credit

The first precaution is to request and obtain additional financial security through the tenant’s posting of a security deposit or letter of credit. Even though security deposits are applied against the maximum statutory claim the landlord can assert under bankruptcy law, which, in other words, reduces the dollar value of the landlord’s claim, the loss in value is acceptable because claims are typically paid at substantially less than dollar for dollar, if even at all. The retail landlord is better off having the security deposit rather than the claim. It is also critical to obtain the security deposit at the inception of the lease. Waiting until it becomes apparent that the tenant is in financial crisis creates a risk that the security deposit may be set aside as a preference should the filing occur within 90 days of the posting of the deposit.

A letter of credit is an even better tool for maximizing the landlord’s recovery. Most bankruptcy courts allow the landlord to draw on the letter of credit in accordance with its terms even if the tenant is in bankruptcy. Under bankruptcy law, a letter of credit and its proceeds are not property of the estate but are property of the issuing bank paid on account of an independent obligation to the beneficiary. The drafting of the letter of credit should ensure that the landlord has the ability to draw on it without the tenant’s cooperation and without notice to the tenant. The posting of the letter of credit can create a preference, as in the case of a security deposit. To guard against this risk, the posting of the letter of credit should occur at or near the signing of the lease.

“Liening” On The Tenant

You should make sure your retail lease grants you a contractual lien in tenant’s personal property. The recording of a properly perfected contractual lien under the applicable state’s Uniform Commercial Code will give the landlord a security interest in the tenant’s property. Although it is unlikely you will obtain a first lien on the tenant’s property because there is usually some bank financing in place, the landlord with a junior lien may be able to use the lien as leverage to gain an advantage or to receive a greater distribution on a secured claim in a subsequent bankruptcy proceeding. If a landlord waits until the tenant has financial problems to perfect its interest in the collateral, it may be too late, and the interest can potentially be set aside as a preference, by the bankruptcy court.

Termination May Give The Landlord The Upper Hand

Every landlord should be ready to exercise its remedies under the lease and applicable law, including, if available, the right to unilaterally terminate the lease, in its entirety, and not just the tenant’s right of possession for an event of default. The retail landlord that aggressively exercises its remedies within the confines of the law, before the filing occurs, is in a better position to negotiate with the tenant when the filing occurs. Bankruptcy courts look to state law to determine if the lease has been properly terminated pre-petition and will enforce lease termination provisions that are properly drafted. Either the tenant will want the leased premises for its reorganization and will seek to assume the lease in bankruptcy or it will not and will seek to reject it. In the former scenario, the pre-petition termination of the lease is calculated to force the tenant to renegotiate with the landlord for its interest in the leased premises. In the latter scenario, the landlord is in a better position to regain possession and control over the leased premises and with less scrutiny by the bankruptcy court.

Employing the strategies set forth in this article are not meant to substitute for engaging competent bankruptcy counsel with experience in retail tenant cases upon the first signs of a tenant’s financial distress, a precursor to seeking bankruptcy protection. Understanding the bankruptcy laws and how they can impact the retail landlord’s rights does not lead to hidden treasures or secret ancient societies. Decoding the bankruptcy code and uncovering some of its meaning, however, allows the retail landlord to take precautionary steps well before a filing occurs that could, ultimately, maximize its value proposition should it become a creditor in the tenant’s bankruptcy.

Lee Collins is a shareholder at the Houston law firm of Boyar & Miller. He often represents owners of real property in all forms of disputes, including state court litigation, out of court workouts and bankruptcy.