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Business Law Today

Commercial Leases in Bankruptcy
What Happens to the Security Deposit?
By Paul E. Escobar
In the present financial crisis fueled by a tightening credit market, commercial landlords are facing an increase in the number of tenants filing for bankruptcy protection under Chapters 7 and 11 of the U.S. Bankruptcy Code (see 11 U.S.C. §§ 701 and 1101, et seq.). Oftentimes a distressed tenant—such as a newly formed corporation funded by venture capital or a retailer that expanded too quickly—has deposited a large security deposit with its landlord to secure the lease, which, at the time of the bankruptcy filing, might have several years remaining under the natural lease term. Questions that arise are whether the security deposit belongs to the landlord or the tenant and what are their respective rights to the deposit before, during, and after the bankruptcy proceedings.

This article is intended to provide attorneys who represent commercial landlords with a basic guide on how to handle security deposits after one of their client's tenants has filed for Chapter 11 of the Bankruptcy Code, under which a debtor seeks to continue as a business by reorganizing and restructuring its debt, as opposed to Chapter 7 of the Code, under which a debtor typically liquidates its assets and effectively goes out of business. All such attorneys should have a basic understanding of a landlord's rights in a bankruptcy action. A brief summary of the basics follows.

Automatic Stay
Under section 362(a) of the Code, once a tenant files for bankruptcy protection, the filing generally acts as an automatic stay on any action for past rent or eviction or termination of the lease, with limited exceptions. Pursuant to sections 362(b)(10) and 541(b)(2), however, the stay does not apply to actions to recover possession of the leased premises if the lease is terminated prior to the date the bankruptcy petition was filed, on the basis the lease would not be considered an asset of the debtor's estate at the time the bankruptcy petition is filed. The date of filing is generally referred to as the "petition date."

Lease Rejection Damages
Pursuant to section 365(d)(4), a debtor has 120 days from the petition date within which to assume or reject the lease. A debtor may seek a 90-day extension from the court prior to the expiration of that time period. Any further extensions require the prior written consent of the landlord. If a debtor chooses to reject the lease, the landlord will be entitled to lease rejection damages consisting of what the tenant owes in rent from the date of filing (the petition date) through the natural lease termination date. Section 502(b)(6) imposes a cap on those damages equal to the greater of one year of rent or 15 percent of the rent, not to exceed three years, for the remaining term. For leases with several years remaining under the term, a landlord in most cases will only be entitled to one year's worth of future rent, including, arguably, any cost-of-living increases and common area maintenance charges that typically would be charged to the tenant for that year. The court will treat or allow the lease rejection damages as a general unsecured claim, which essentially means the landlord will stand in line with other general unsecured creditors in hopes of getting paid sometime in the future after a reorganization plan is approved by the court and/or distributions from the estate are made to creditors.

Pre-petition Damages
In addition to lease rejection damages to which a landlord is entitled upon rejection of the lease, the landlord is also entitled under section 502(b)(6)(B) to any pre-petition damages consisting of rent due and unpaid as of the petition date, as well as legal fees if provided for in the lease. Notably, there is no cap on pre-petition damages under section 502(b)(6). Thus, in preparing a proof of claim form to be submitted to the court, the landlord would be entitled to both lease rejection damages and pre-petition damages as an unsecured claim. As a practical matter, it might be easier to attach an explanation of the calculations as an exhibit to the form, especially if there are any unusual issues such as multiple leases with the debtor. Attaching a separate exhibit also makes it much easier to distinguish and track the various categories of damages and/or claims to which a landlord is entitled under the Code.

Post-petition Rent
A company that has its primary business operations at the leased premises would likely want to remain there after filing for Chapter 11 protection. If the debtor remains at the leased premises after the petition date (or post-petition), a landlord would be entitled to rent during the bankruptcy under section 365(d)(3), until the tenant rejects the lease, surrenders and vacates the premises, or assumes the lease. The rent would be considered an administrative expense or priority claim pursuant to section 503(b)(1)(A). In most cases, the debtor will continue to pay administrative rent while it decides to reject or assume the lease, obviating a landlord having to file a motion for administrative rent. If the debtor accepts or assumes the lease, it should continue paying administrative rent during its reorganization. As with pre-petition damages, sections 503(b)(1)(A) and 502(b)(6) do not cap administrative rent, which, as a practical matter, means the debtor would be subject to any cost-of-living adjustments and other rent charges provided for in the lease.

If a tenant decides to remain in possession of the premises post-petition and assume the lease, it must cure any lease default and pay all rent due, including rent due at the time of filing, and provide adequate assurance of future ability to perform under the terms of the lease, pursuant to section 365(b)(1). In some instances, a tenant might not pay rent while it continues to occupy the premises, forcing the landlord to file a motion for administrative rent or, if the tenant cannot pay, a motion for relief from the automatic stay to terminate the lease and initiate summary eviction procedures. In that case, it is always advisable to contact the debtor's bankruptcy counsel to determine how best to resolve the issue of rent or determine whether filing such a motion is necessary. If either the size of the debtor's company and/or number of creditors is large, a landlord might find it very difficult to establish effective communication with the debtor or determine precisely what the debtor's intentions are. A tenant with multiple leases with other landlords (as in a retail chain) might wait to decide whether to accept or reject the lease, based upon its determination as to whether business at the premises will be profitable post-petition. In other words, a debtor might not know what its corporate objectives are with respect to the lease until the deadline for lease rejection is imminent. If the matter of rent between the petition date and lease rejection is not resolved, the landlord would be entitled under sections 502(b)(6) and 503(b)(1)(A) to assert claims for lease rejection damages, pre-petition damages, and post-petition administrative rent for damages prior and up to the date of lease rejection.

Offsetting Landlord's Claim
Pursuant to section 553(a), a landlord may use the security deposit to offset the total amount of lease rejection damages and pre-petition damages, on the basis the landlord is entitled to setoff as a secured creditor to the extent of the security deposit. Therefore, if a tenant vacates the premises before or after the date it files for bankruptcy protection and later rejects the lease, a landlord would be entitled to the total amount of lease rejection damages and pre-petition damages, if any, offset by the amount of the security deposit. Under section 362(a)(7), however, relief from the automatic stay is needed to set off a security deposit post-petition. As a practical matter, the landlord should list the amount of the security deposit on the proof of claim form as a credit or deduction from the total amount claimed.

To summarize, the claims allowed under the Code generally consist of lease rejection damages subject to a cap, pre-petition rent, and in some instances post-petition or administrative rent. Attorneys also should know how to prepare and file proofs of claims that distinguish among the various types of claims, including using the security deposit to offset the claims.

Whose Asset Is It?
In general, a security deposit is an asset of the bankruptcy estate under section 541(a). A landlord, however, has a security interest in the deposit, and courts have permitted landlords to retain security deposits to the extent of their allowable claims. In Oldden v. Tonto Realty Corp., 143 F.2d 916 (2d Cir. 1944), the court held that a landlord may deduct the security deposit from the landlord's allowed claim, but that any surplus must be returned to the debtor. Further, in ITXS, Inc. v. F&S Hayward, LLC, No. 03-3082-MBM, slip op. at 8 (W.D. Pa. Dec. 13, 2004), the court ruled that a landlord's security deposit constitutes, as a matter of law, a perfected security interest or lien in the landlord's favor. Likewise, in In re Johnson, 215 B.R. 381, 384 (Bankr. N.D. Ill. 1997), the court held that a landlord's interest in a security deposit was akin to a nonjudicial lien. And in In re Northeastern International Airways, Inc., 99 B.R. 487, 488-89 (Bankr. S.D. Fla. 1989), the court found that a creditor's possession of the security deposit perfected the security interest in the deposit.

Although most landlords hold cash security deposits, some landlords require letters of credit to secure a tenant's lease obligations. A letter of credit does not automatically constitute an asset of the debtor's estate. In In re Elegant Merchandising, Inc., 41 B.R. 398 (Bankr. S.D.N.Y. 1984), the court denied the debtor's request to enjoin a bank from making a payment under a letter of credit to another party, on the grounds the proceeds of the letter of credit did not constitute property of the debtor's estate but rather property of the issuing bank. Other courts have similarly held that letters of credit in the context of a lease fall outside the debtor's estate because they are contractual agreements involving an issuing bank and beneficiary that are independent of the obligations between the beneficiary and debtor.

For example, in In re Stonebridge Technologies, Inc., 430 F.3d 260 (5th Cir. 2005), the Fifth Circuit Court of Appeals held that a letter of credit was not subject to the Code because the letter of credit was an obligation between the issuing bank and landlord and the contractual rights and duties between those parties were entirely separate from the debtor's estate. The court also ruled that inasmuch as the landlord did not file a proof of claim against the debtor's estate and was not seeking lease rejection damages pursuant to the Code, the statutory cap was not triggered. But In re Builders Transport, Inc., 471 F.3d 1178 (11th Cir. 2006), a similar case in which the landlord did not file a proof of claim and its assignee drew down a letter of credit, the 11th Circuit Court of Appeals ruled that the assignee nonetheless was not entitled to retain the funds pursuant to the underlying lease language and because the allowed damages did not exceed the section 502(b)(6) cap. The Third Circuit Court of Appeals took a different approach in In re PPI Enterprises (U.S.), Inc., 324 F.3d 197 (3d Cir. 2003), by holding that a letter of credit was subject to the statutory cap on the basis the parties intended the letter of credit to operate as a security deposit as reflected in specific lease provisions, notwithstanding the landlord's argument that the letter of credit was not the functional equivalent of a security deposit and that he had a contractual right to the letter of credit's proceeds.

Because of the split in appellate authority, attorneys should carefully evaluate the applicable case law in the jurisdiction in which the leased premises are located (in addition to any other state law chosen by the parties in the lease), before determining how best to handle the letter of credit during a bankruptcy proceeding. Attorneys also should examine any standard form leases used by their clients that may or may not include letters of credit provisions. Depending upon the applicable case law, it might be appropriate to draft a landlord's standard lease language to maximize the landlord's right to draw down and retain the proceeds of a letter of credit for lease defaults and in the event of a tenant's bankruptcy. In general, landlords should consider requiring letters of credit in situations where the rent will be substantial, the tenant is a start-up enterprise, the landlord has concerns about the tenant's ability to pay monthly rent for a long-term lease (i.e., five years or more), and the security deposit will be large (e.g., greater than $50,000).

Turnover—Not So Fast
Another issue a landlord might face involves potentially transferring the security deposit to a court-appointed trustee, especially if the security deposit is large and appears to exceed the amount of the allowed claim. Section 542 permits a court-appointed trustee to seek the transfer (or turnover) of property of the debtor's estate held by a third party to the trustee. Nevertheless, given the interests of the landlord in a security deposit, a trustee may not automatically order or require a landlord to reimburse, pay, or turn over the security deposit to the bankruptcy estate post-petition. A landlord that contests the right to a security deposit may succeed in preventing such a turnover because section 542 permits turnover only of property that is indisputably property of the bankruptcy estate.

For example, in In re Lexington Healthcare Group, Inc., 363 B.R. 713 (Bankr. D. Del. 2007), a nursing home landlord held a security deposit of over $2.2 million at the time the tenant filed for Chapter 11 bankruptcy protection. The lease provided that the security deposit was to be applied toward any damages incurred by the landlord on account of a default by the tenant of the terms of the lease or credited against any rent due on the final month of the lease term. After filing its bankruptcy petition, the debtor rejected the lease and the landlord retained the security deposit. The case was subsequently converted into a Chapter 7 (liquidation) proceeding, and a trustee was appointed. More than three years after the case was initially filed, the trustee filed a complaint against the landlord pursuant to section 542, seeking turnover of the security deposit. The landlord filed a motion to dismiss the complaint on the grounds section 542 only permits turnover for undisputed property of the bankruptcy estate, the landlord had a bona fide dispute with respect to the security deposit, and that, as a result, the trustee's claim for turnover was precluded as a matter of law.

The court agreed with the landlord that because title to the deposit was in dispute, the trustee could not seek a turnover of those funds. The court held that where there is a legitimate dispute about the ownership of property a trustee seeks to recover, turnover under the Code is inappropriate. Moreover, the court found that the lease was silent regarding the landlord's entitlement to the security deposit if there were no damages or unpaid rent, and that the lease was not so plain and unambiguous as to provide a clear, objective basis for concluding that the security deposit was property of the estate. The court further found that it was not clear whether the landlord had a claim against the security deposit for damages or unpaid rent.

Based upon Lexington Healthcare, a landlord facing lease rejection by a tenant arguably may retain the security deposit until and unless required by court order to turn it over. A landlord's case will be strengthened to the extent there is unpaid rent and other damages, including property damage, resulting from any uncured lease default. It also goes without saying that any commercial lease should contain language entitling the landlord to the security deposit for unpaid rent and other lease defaults. Further, Lexington Healthcare suggests it would be advisable for a landlord to condition the return of the security deposit on the tenant's satisfactory compliance with all of the conditions of the lease, not just timely payment of rent.

To conclude, in light of the current financial crisis and tightening credit markets, it is increasingly important for commercial landlords and their attorneys to be prepared for an upswing in bankruptcy filings by distressed tenants. Attorneys should have a basic understanding of the types of claims their clients may assert during a bankruptcy, the limitations on those claims under the Code and applicable case law, and some of the more practical issues that might arise while a tenant is undergoing reorganization and that relate to the lease and security deposit.

Escobar is corporate counsel for Cumberland Farms, Inc., based in Canton, Massachusetts. He can be reached at pescobar@cumberlandfarms.com. The opinions expressed in this article are the author's alone and do not reflect a position or endorsement by Cumberland Farms, Inc., or its affiliates.

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