United States: Tulipmania, Redux

Many observers, including this author, have compared the recent demand for internet-related stocks to the Dutch tulip craze of the seventeenth century. In an earlier article, I commented that the price of Dutch tulip bulbs had skyrocketed 5900% before collapsing, and noted that internet companies, like tulip bulbs, had skyrocketed in price, but generated little revenue and often failed to return a profit.¹ The comparison is now even more apt, as the prices of many internet-related companies, have, like the tulip bulb prices of the seventeenth century, collapsed. In that article, I noted that prudent landlords often required substantial security deposits from internet-related companies, usually in the form of a letter of credit, to secure the tenant’s obligation under the lease, and discussed how lenders could perfect their rights and interest in letters of credit posted by internet-related companies, to protect themselves in the event the tenants failed.

Now that so many internet-related companies have failed, lenders are less interested in how to perfect a security interest in such letters of credit (and far less interested in making a loan on an office building with an internet-related tenant), and more focused on when and how to draw under such letters of credit. Landlords are facing these same issues. Many of these issues can be addressed by careful drafting of both the lease and the letter of credit, but hindsight is, of course, 20/20. In the event that a landlord or lender is drawing on a letter of credit where such problems were not properly addressed in the lease or the letter of credit, there are still steps a lender or landlord can take to increase its chances of successfully drawing on the letter of credit and retaining the proceeds thereof.

The following are some drafting tips for landlords and lenders relying on a letter of credit as security under a lease:

• The ideal letter of credit, from the lender’s and landlord’s point of view, is an unconditional, sight letter of credit, which is a letter of credit that requires only that the holder present the letter of credit in order to be paid.
• Many letters of credit posted by tenants provide that in order to draw, the beneficiary must certify that the tenant is in default and all applicable notice and cure periods have expired. If the lease provides a notice and cure period for defaults and the tenant defaults and files for bankruptcy before the landlord can give the notice required, the landlord will be prevented by the automatic stay from giving the notice, and therefore, from drawing on the letter of credit. It is important, therefore, that there be no notice and cure rights under the letter of credit before the holder is allowed to draw under the letter of credit.
• If the tenant insists upon a letter of credit where the landlord certifies that the moneys thereunder are due and owing to the land-lord, the lease should provide no notice and right to cure, particularly for monetary defaults.
• If the tenant insists upon notice and right to cure for monetary defaults, the lease should provide that the letter of credit may be drawn in the event of the tenant’s insolvency, with no notice and right to cure periods for the insolvency default.
• The letter of credit should provide that it shall be automatically renewed for successive, additional one year periods, unless, at least thirty days prior to any such date of expiration, the issuer gives written notice to the landlord that the letter of credit will not be renewed, in which case the landlord should be able to draw on the letter of credit.
• The letter of credit should not expire until at least sixty days after the expiration date of the lease, to allow the landlord or lender sufficient time to draw on the letter of credit after the lease terminates.
• The letter of credit should provide for partial draws. As discussed below, in certain situations a landlord may wish to draw on the letter of credit for each default as it occurs.

If a letter of credit has not been drafted with the above considerations in mind, the following are steps a landlord or lender may take to insure that it may still draw on the letter of credit:

• If a letter of credit or lease provides that all notice and cure periods must expire before the holder is entitled to draw under a letter of credit, the landlord must be vigilant in sending the notices required under the lease and letter of credit as soon as a default occurs.
• Because a letter of credit is not an asset of the bankrupt tenant’s estate, a draw under the letter of credit should not be prevented by the automatic stay in bankruptcy as long as any notice and cure periods expire before the bankruptcy is commenced. The holder can increase the chances it will be able to draw the letter of credit before a bankruptcy if the landlord gives a default notice at the earliest possible opportunity. The default notice need not be a three day notice to pay rent or quit under the Code of Civil Procedure, but may simply be a notice stating the default.
• Some landlords and lenders are anxious to draw on the entire letter of credit as soon as a default occurs, either because the letter of credit is about to expire, or because the landlord or lender does not wish to draw monthly on a chronically delinquent tenant. The landlord or lender should be aware, however, that once the letter of credit is drawn upon and the unused cash proceeds retained by the landlord or lender, any portion not applied by the landlord prior to a bankruptcy filing may be barred by the automatic stay from being offset against the landlord’s damages after a bankruptcy filing. In addition, once the letter of credit is drawn upon, the bankrupt tenant may attempt to obtain an order to use the cash proceeds as cash collateral in the bankruptcy. As discussed below, as an alternative, in some instances it may be prudent to leave the lease in effect and draw on the letter of credit each month as the rent becomes due, although the landlord then runs the risk of being a creditor in any bankruptcy of the tenant.

The following are some drafting tips for the landlord:

As discussed above, if the lease provides that the landlord will not draw on the letter of credit until all notice and cure periods have expired and the tenant goes into bankruptcy before the landlord gives notice, the automatic stay in bankruptcy will prevent the landlord from giving the default notice. Therefore, the lease should provide that the landlord may draw on the letter of credit immediately in the event of a default. The lease should provide that the land-lord may draw on the letter of credit not only if the tenant is in default, but if the tenant fails to renew the letter of credit at least thirty days before its expiration.

If the tenant insists on a notice and cure period for monetary defaults, the lease might provide that the letter of credit may be drawn immediately upon the insolvency of the tenant. Then, if the landlord or lender is prevented from drawing on the letter of credit by the bankruptcy because of the inability to give notice due to the automatic stay, the landlord/lender will be able to draw under the letter of credit by reason of the insolvency.

The lease should also provide that the landlord may draw upon all or any portion of the letter of credit. The lease should further provide that if the landlord draws on the entire letter of credit, but does not use the entire amount of the draw, any excess shall be held by the landlord as "collateral for lease obligations." For reasons discussed below, the excess should not be called a "security deposit" in the hope that the landlord will not be forced to comply with section 1950.7 of the Civil Code although, given the breadth of the definition of "security deposit" in section 1950.7, any such hope may be in vain. Because, as stated above, any unused portion of the letter of credit held as cash by the landlord or lender may be barred by the automatic stay from being offset against the landlord’s damages after a bankruptcy filing, the lease should provide that any unused portion of the letter of credit shall be deposited in a deposit account in which the landlord or lender has a security interest. In that situation, in the event of a bankruptcy, the lender would be a secured creditor. A security agreement should be entered into concurrently with the lease because of the difficulty of doing so after the tenant is in default.

The lease should also address Section 1950.7 of the California Civil Code. This section is troubling because it limits what a security deposit can be used for and requires that any portion of the deposit not used to cure a default in the payment of rent must be returned to the tenant no later than two weeks after the date the landlord receives possession of the premises.² As stated above, the letter of credit and its proceeds should not be referred to as a "security deposit," but as "collateral for the lease obligation" or a similar phrase. Section 1950.7 appears to have been drafted with security deposits equal to one months’ rent in mind. Now that dot-com tenants are posting letters of credit equal to several months’ rental and more, section 1950.7 fails to adequately address how a landlord can recover its full damage award from the security deposit.

Section 1950.7(c) of the California Civil Code provides that the landlord may claim from a security deposit only those amounts that are reasonably necessary to remedy (i) tenant’s default in the payment of rent, (ii) to repair damages to the premises caused by the tenant, or (iii) to clean the premises upon termination of the tenancy. Section 1950.7(c) goes on to say that where the claim of the landlord upon the security deposit is only for defaults in the payment of rent, then any remaining portion of the security deposit must be returned to the tenant no later than two weeks after the date the landlord receives possession of the premises.³

As discussed below, it may be preferable not to terminate the lease, but to keep it in effect and require the tenant to continue paying rent. The reach of the statute is broad because section 1950.7(a) defines "security deposit" as "[a]ny payment or deposit of money the primary function of which is to secure the performance of a rental agreement." Although there are no reported California cases indicating whether section 1970.5 can be waived, leases should waive this confusing and troubling section, lest the tenant make a claim that the letter of credit may be applied only to defaults in rent that have already occurred and not to damages for post-termination rent. Section 1953 of the Civil Code prohibits waiver of rights or remedies under Section 1950.5 of the Civil Code (the statute governing security deposits in the residential context) on the grounds that such waivers are contrary to public policy, but there is no corresponding statute prohibiting waiver of the rights under section 1950.7. Presumably, therefore, such a waiver would be tested under section 3268 of the California Civil Code, which permits waivers "unless such waiver could be against public policy."

Although it is difficult to judge what is or is not against public policy, because waiver of the residential security deposit section is prohibited but waiver of the commercial security deposit statue is not, an argument may be made that the waiver of the commercial security deposit section should be permitted. Finally, leases should specify that the security deposit can be applied to not only rent or any other sum in default, but any other expense, loss or damage that the landlord may suffer because of the tenant’s default.

If section 1950.7 has not been waived in the lease, a landlord or lender may still be able to draw under the letter of credit and use it to offset the damages suffered by the landlord or lender under the lease. There are two remedies available to a landlord for a tenant default under the California Civil Code.

Under Section 1951.2 of the California Civil Code, except as otherwise provided under section 1951.4, if a tenant breaches a lease and abandons the lease before the end of the term, or if the tenant’s right to possession is terminated because of a breach of the lease, the lease terminates. Upon such termination, the landlord may recover in damages the worth at the time of the award of the amount by which the unpaid rent for the balance of the term after the time of award exceeds the amount of such rental loss that the lessee proves could be reasonably avoided, provided the lease provides for such remedy or the landlord relet the property prior to the time of the award and acted reasonably to mitigate damages.⁴ Section 1950.7 appears to limit the application of a security deposit to retrospective damages, or damages occurring prior to the surrender of the leasehold only. If that is the case, the security deposit cannot be applied to prospective damages. Under section 1951.4, however, the landlord has the remedy of continuing the lease in effect after the tenant’s breach and abandonment, and may recover rent as it becomes due.⁵ This remedy is only available if the lease permits the tenant to sublet or assign, or permits the tenant to sub-lease or assign subject to express standard or conditions, or permits the tenant to sublease or assign with the consent of the landlord, which shall not be unreasonably withheld.

One possibility for the landlord or lender, if the lease allows assignment or subletting, is not to terminate the lease and to either draw on the entire letter of credit and apply an amount equal to the monthly rent as it becomes due or to make partial draws under the letter of credit each month. If and when the landlord finds a new tenant willing to lease the space, the landlord can then terminate the original tenant’s lease, and if the entire letter of credit has been exhausted by applying the rents as they came due, the landlord or lender will not risk having to return any unused portion of the letter of credit proceeds pursuant to section 1950.7. The disadvantage of this approach is that the tenant still controls the space and could sublet or assign the space until the landlord terminates the tenant’s interest in the space. A further disadvantage is that because the lease has not been terminated, in the event of the tenant’s bankruptcy, the landlord will be involved in the bankruptcy, although the landlord will have a secured claim in an amount equal to the remaining deposit. The landlord may further be subject to a motion by the bankruptcy trustee to use any remaining proceeds as cash collateral. In addition, the tenant may affirm or reject the lease in bankruptcy.

Some landlords have taken the approach that the "claim of the landlord…for defaults in the payment of rent" includes the "claim" for the present value of future rent under Section 1951.2 of the Civil Code, and within two weeks after receiving possession of the premises from a defaulted tenant, the landlord offsets from the letter of credit proceeds the amount they have calculated as their damages under section 1951.2. However, practitioners should use caution because there is no reported case upholding this procedure. If a landlord retains the deposit in bad faith, section 1950.7(f ) provides that the landlord may incur damages but such damages will not exceed $200.00 in addition to any actual damages. Although $200.00 is not a huge penalty, if actual damages includes returning any amount deemed not to be a default in rent, and if post-termination charges are held not to constitute a default in rent, the damages could be significant.

Finally, the California Supreme Court held in the residential context that a good faith failure to comply with the residential security deposit section⁶ does not bar a landlord from recovering damages for unpaid rent, repairs and cleaning.⁷ Therefore if a landlord fails to comply with section 1950.7, it may lose its security deposit, but still have a claim for damages.

The landlord must demonstrate the existence of actual damages in order to draw on a letter of credit which constitutes a security deposit. As noted above, section 1951.2 imposes a duty to mitigate on a landlord. If a tenant defaults in a market with rising, rather than declining, rents, the landlord may not have any actual damages against which the landlord may draw the letter of credit.

As pointed out above, if the lease and/or the letter of credit requires notice and right to cure and the tenant goes into bankruptcy before such notice is given and the cure period expires, the landlord or lender may be barred by the automatic stay from drawing on the letter of credit. Even if the landlord or lender is able to draw on the letter of credit, as pointed out in my earlier article, section 502(b)(6) of the Bankruptcy Code limits a landlord’s allowed claim from a termination of a lease of non-residential real property to the greater of (a) one year’s rent and (b)15% of the remaining rent reserved in the lease, not to exceed three years.⁸

Therefore, if a tenant commences a bankruptcy case and its lease is terminated, a subsequent draw upon the letter of credit in excess of the landlord/beneficiary’s allowed claim may be problematic for the landlord. Although a conforming draft should be honored under the "independence principle," which states that the payment obligation under the letter of credit is an obligation of the payment bank (not the tenant) and is not subject to the automatic stay, it is possible that the landlord, or, in turn, its lender, may be subject to attacks seeking to mandate restitution or disgorgement of the "excess amount." No reported bankruptcy court cases have addressed this issue, but a creative debtor-in-possession or bankruptcy trustee could make the argument that the proceeds were subject to limitation in section 502(b)(6) of the Bankruptcy Code. An issuer who honors a draw and an account party that reimburses an issuer are accorded rights similar to subrogation under section 5117 of the California Commercial Code, and could make the argument as well.⁹

Many landlords have come up with creative ways to attempt to evade the bankruptcy cap. Some leases require the tenant to pay for all tenant improvements and leasing commissions, and the land-lord makes a loan to the tenant for such amount. The tenant executes a note in favor of the landlord. The note may even be secured by a letter of credit. Because a landlord cannot terminate the lease for failure of the tenant to make payments on the note, the note and the lease must be cross defaulted. However, this structure may be subject to attack by a trustee in bankruptcy, who may argue that the loan payments are truly rent and therefore subject to the cap. Again, no bankruptcy court has decided the issue of whether such loan payments are subject to the cap, so the success of this structure is not assured.

In addition, some landlords have sought to evade the cap of section 502(b)(6) of the Bankruptcy Code by requiring an advance payment of rent. It is not clear whether such a strategy would be successful in evading the cap, because, again, no bankruptcy court has ruled on this issue.

Stories abound in San Francisco of tenants demanding, and receiving, from landlords termination payments so that the tenant’s lease will not be included in an impending bankruptcy. On the other hand, stories abound of landlords holding letters of credit for in excess of a year’s rent, and demanding large additional payments from the tenant to make the landlord whole for its damages. The practical solution is for the landlord and the tenant, and the lender if one is involved, to discuss how the letter of credit can best meet the anticipated needs of each of the parties. The tenant should be aware that barring a notice and right to cure issue, the landlord should be able to draw on the letter of credit even if the tenant is in bankruptcy. The landlord and lender should be aware that there is a limit to the landlord’s claim for rent due and owing under the terms of a lease in the event of rejection of a lease in bankruptcy, although there is no reported case which applies the cap to letter of credit proceeds. All parties should be aware that California Civil Code Section 1950.7 is a troubling statute, drafted for small security deposits, and does not anticipate the large security deposit posted by a high tech tenant to protect the landlord’s post-termination damage award. A common result is for a dot-com tenant to allow the landlord to retain all or a portion of the letter of credit proceeds in exchange for a termination of the lease. Landlords often insist on receiving warrants from the tenant so that if the tenant turns its financial situation around, the landlord will profit therefrom.

Only by having such discussions can the landlord, the lender and the tenant maximize the recovery of each party and avoid the fate of the seventeenth century Dutch, who were left holding merely the wilting petals of a faded bloom.

1) Janet C. Norris, Letters of Credit Posted by Dot-Com Tenants – How Lenders Can Avoid Becoming a Victim of Tulipmania, California Real Property Journal, Spring, 2000.

2) Section 1950.7(c) provides as follows:

3) In Public Employees’ Retirement System v. Winston, 209 Cal. App. 3d 205, 258 Cal. Rptr. 612, the First District Court of Appeal held that a trial court erred in failing to offset a security deposit two weeks following the date the tenant vacated the premises. The trial court had instead applied the security deposit against the money judgment rendered three years after the vacation.

4) Section 1951.2(a) provides as follows:

(a) Except as otherwise provided in Section 1951.4, if a lessee of real property breaches the lease and abandons the property before the end of the term or if his right to possession is terminated by the lessor because of a breach of the lease, the lease terminates. Upon such termination, the lessor may recover from the lessee:

5) Section 1951.4 provides as follows:

(a) The remedy described in this section is available only if the lease provides for this remedy. In addition to any other type of provision used in a lease to provide for the remedy described in this section, a provision in the lease in substantially the following form satisfies this subdivision: "The lessor has the remedy described in California Civil Code Section 1951.4 (lessor may continue lease in effect after lessee’s breach and abandonment and recover rent as it becomes due, if lessee has right to sublet or assign, subject only to reasonable limitations)."

(b) Even though a lessee of real property has breached the lease and abandoned the property, the lease continues in effect for so long as the lessor does not terminate the lessee’s right to possession and the lessor may enforce all the lessor’s rights and remedies under the lease, including the right to recover the rent as it becomes due under the lease, if any of the following conditions is satisfied:

(c) For the purposes of subdivision (b), the following do not constitute a termination of the lessee’s right to possession:

6) Section 1950.5 provides as follows:

(a) This section applies to security for a rental agreement for residential property that is used as the dwelling of the tenant.

(b) As used in this section, "security" means any payment, fee, deposit or charge, including, but not limited to, an advance payment of rent, used or to be used for any purpose, including, but not limited to, any of the following:

(c) A landlord may not demand or receive security, however denominated, in an amount or value in excess of an amount equal to two months' rent, in the case of unfurnished residential property, and an amount equal to three months' rent, in the case of furnished residential property, in addition to any rent for the first month paid on or before initial occupancy. This subdivision does not prohibit an advance payment of not less than six months' rent where the term of the lease is six months or longer. This subdivision does not preclude a landlord and a tenant from entering into a mutual agreement for the landlord, at the request of the tenant and for a specified fee or charge, to make structural, decorative, furnishing, or other similar alterations, if the alterations are other than cleaning or repairing for which the landlord may charge the previous tenant as provided by subdivision (e).

(d) Any security shall be held by the landlord for the tenant who is party to the lease or agreement. The claim of a tenant to the security shall be prior to the claim of any creditor of the landlord.

(e) The landlord may claim of the security only those amounts as are reasonably necessary for the purposes specified in subdivision (b). The landlord may not assert a claim against the tenant or the security for damages to the premises or any defective conditions that preexisted the tenancy, for ordinary wear and tear or the effects thereof, whether the wear and tear preexisted the tenancy or occurred during the tenancy, or for the cumulative effects of ordinary wear and tear occurring during any one or more tenancies.

(f ) Within three weeks after the tenant has vacated the premises, the landlord shall furnish the tenant, by personal delivery or by first-class mail, postage prepaid, a copy of an itemized statement indicating the basis for, and the amount of, any security received and the disposition of the security and shall return any remaining portion of the security to the tenant.

(g) Upon termination of the landlord's interest in the dwelling unit in question, whether by sale, assignment, death, appointment of receiver or otherwise, the landlord or the landlord's agent shall, within a reasonable time, do one of the following acts, either of which shall relieve the landlord of further liability with respect to the security held:

(h) Prior to the voluntary transfer of a landlord's interest in a dwelling unit, the landlord shall deliver to the landlord's successor in interest a written statement indicating the following:

(i) In the event of noncompliance with subdivision (g), the landlord's successors in interest shall be jointly and severally liable with the landlord for repayment of the security, or that portion thereof to which the tenant is entitled, when and as provided in subdivisions (e) and (f). A successor in interest of a landlord may not require the tenant to post any security to replace that amount not transferred to the tenant or successors in interest as provided in subdivision (g), unless and until the suc cessor in interest first makes restitution of the initial security as provided in paragraph (2) of subdivision (g) or provides the tenant with an accounting as provided in subdivision (f ). Nothing in this subdivision shall preclude a successor in interest from recovering from the tenant compensatory damages that are in excess of the security received from the landlord previously paid by the tenant to the landlord. Notwithstanding the provisions of this subdivision, if, upon inquiry and reasonable investigation, a landlord's successor in interest has a good faith belief that the lawfully remaining security deposit is transferred to him or her or returned to the tenant pursuant to subdivision (g), he or she shall not be liable for damages as provided in subdivision (k), or any security not transferred pursuant to subdivision (g).

(j) Upon receipt of any portion of the security under paragraph (1) of subdivision (g), the landlord's successors in interest shall have all of the rights and obligations of a landlord holding the security with respect to the security.

(k) The bad faith claim or retention by a landlord or the landlord's successors in interest of the security or any portion thereof in violation of this section, or the bad faith demand of replacement security in violation of subdivision (i), may subject the landlord or the landlord's successors in interest to statutory damages of up to six hundred dollars ($600), in addition to actual damages. The court may award damages for bad faith whenever the facts warrant such an award, regardless of whether the injured party has specifically requested relief. In any action under this section, the landlord or the landlord's successors in interest shall have the burden of proof as to the reasonableness of the amounts claimed or the authority pursuant to this section to demand additional security deposits.

(l) No lease or rental agreement shall contain any provision characterizing any security as "nonrefundable."

(m) Any action under this section may be maintained in small claims court if the damages claimed, whether actual or statutory or both, are within the jurisdictional amount allowed by Section 116.220 of the Code of Civil Procedure.

(n) Proof of the existence of and the amount of a security deposit may be established by any credible evidence, including, but not limited to, a canceled check, a receipt, a lease indicating the requirement of a deposit as well as the amount, prior consistent statements or actions of the land-lord or tenant, or a statement under penalty of perjury that satisfies the credibility requirements set forth in Section 780 of the Evidence Code.

(o) The amendments to this section made during the 1985 portion of the 1985-86 Regular Session of the Legislature that are set forth in sub-division (e) are declaratory of existing law.

7) Granberry v. Islay Investments, 9 Cal.4th 738, 889 P2d 970, (1995)

8) Bankruptcy Code Section 502(b) provides:

(b) Except as provided in subsections (e)(2), (f ), (g), (h) and (i) of this section, if such objection to a claim is made, the court, after notice and a hearing, shall determine the amount of such claim in lawful currency of the United States as of the date of the filing of the petition, and shall allow such claim in such amount, except to the extent that--

9) Section 5117 provides as follows:

5117. Subrogation

(a) An issuer that honors a beneficiary's presentation is subrogated to the rights of the beneficiary to the same extent as if the issuer were a secondary obligor of the underlying obligation owed to the beneficiary and of the applicant to the same extent as if the issuer were the secondary obligor of the underlying obligation owed to the applicant.

(b) An applicant that reimburses an issuer is subrogated to the rights of the issuer against any beneficiary, presenter, or nominated person to the same extent as if the applicant were the secondary obligor of the obligations owed to the issuer and has the rights of subrogation of the issuer to the rights of the beneficiary stated in subdivision (a).

(c) A nominated person who pays or gives value against a draft or demand presented under a letter of credit is subrogated to the rights of:

(d) Notwithstanding any agreement or term to the contrary, the rights of subrogation stated in subdivisions (a) and (b) do not arise until the issuer honors the letter of credit or otherwise pays and the rights in sub-division (c) do not arise until the nominated person pays or otherwise gives value. Until then, the issuer, nominated person, and the applicant do not derive under this section present or prospective rights forming the basis of a claim, defense, or excuse.

© Janet C. Norris 2001. All Rights Reserved