As stated in the July/August 2004 Journal article "Securing Payment of Rent: Are Letters of Credit Still a Viable Mechanism?," courts continue to develop the law on the extent and effect of 11 U.S.C. §502(b)(6)'s lease-rejection damages cap. The lease-rejection damages cap is evolving to limit not only a lessor's claim in the bankruptcy estate, but also what a lessor may collect outside the bankruptcy estate. Since July/August 2004, §502(b)(6)'s application, and the extent and effect of its damages cap, has further evolved by recent opinions from the Fifth and Ninth Circuit Courts of Appeals. These recent opinions clarify the proper application of letter-of-credit proceeds, and the extent and effect of §502(b)(6)'s lease-rejection damages cap from non-bankruptcy estate sources.

While generally following the trend set by other courts, the Fifth Circuit's decision differs in application. This application in itself raises additional questions and strategic issues for practitioners and lessors both before and after a lessee's bankruptcy filing.

Section 502(b)(6) and the Lease-Rejection Damages Cap

In analyzing the extent and effect of the lease-rejection damages cap, courts are examining the express language of §502(b)(6), which provides that a claim of a lessor for damages resulting from the termination of a lease of real property is limited to the rent reserved by such lease, without acceleration, for the greater of one year, or 15 percent not to exceed three years, of the remaining term of such lease plus any unpaid rent due under such lease without acceleration.

The express language of §502(b)(6) is quite intentional, as Congress sought to legislate that a lessor "will not be permitted to offset his actual damages against his security deposit and then claim for the balance under [§502(6)(b)]. Rather, his security deposit will be applied in satisfaction of the claim that is allowed under this paragraph." See H.R. Rep No. 595, 95th Cong., 1st Sess. 353 (1977); S. Rep. No. 989, 95th Cong., 2d Sess. 63 (1978), reprinted in 1978 U.S.C.C.A.N. 5963, 5787. The foregoing reference to security deposits, though not in the text of the statute, prohibits one of the means by which lessors have attempted to avoid §502(b)(6)'s cap. This language further reflects Congress' approval of pre-Bankruptcy Code case law that addressed "whether a landlord is required to deduct the amount of security held under a lease from the total damages provided by the lease or from the total claim allowable [under the Code]." See Oldden v. Tonto Realty Co., 143 F.2d 916, 918 (2d Cir. 1944). In addressing that issue, the Second Circuit held that the security deposit is deducted from the allowable claim, not the total damages. Id.

Congress acknowledged their approval of Oldden as noted by the House Judiciary Report to amended §502 by stating that:

This paragraph will not overrule Oldden, or the proposition for which it has been read to stand: To the extent that a landlord has a security deposit in excess of the amount allowed under this paragraph, the excess comes into the estate... As under Oldden, [a landlord] will not be permitted to offset his actual damages against his security deposit and then claim for the balance under this paragraph. Rather, his security deposit will be applied in satisfaction of the claim that is allowed under this paragraph.

H.R. Rep. No. 95-595, at 353-54 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6309.

Indeed, §502(b)(6) incorporates Congress' intent to "compensate the landlord for his loss while not permitting a claim so large as to prevent other general unsecured creditors from recovering a dividend from the estate." See In re Handy Andy Home Improvement Ctrs. Inc., 222 B.R. 571, 574 (Bankr. N.D. Ill. 1998) (citations omitted). Based on Congress' remarks and obvious intent in codifying §502(b)(6), courts have been quick to find that §502(b)(6)'s lease-rejection damages cap requires a lessor to apply a standby letter of credit to the lessor's claim as capped by §502(b)(6), instead of applying the standby letter of credit to the lessor's total lease-rejection damages claim and then capping any remainder pursuant to §502(b)(6). See Solow v. PPI Enterprises (U.S.) Inc. (In re PPI Enterprises (U.S.) Inc.), 324 F.3d 197 (3d Cir. 2003).

The Ninth Circuit's Interpretation

The Ninth Circuit recently considered Congress' "approval" of Oldden's holding. See AMB Property, L.P. v. Official Creditors for the Estate of AB Liquidating Corp. (In re AB Liquidating Corp.), 416 F.3d 961 (9th Cir. 2005). In AB Liquidating, a lessor of a rejected lease of real property filed a lease-rejection damages claim and asserted that proceeds from the letter of credit, upon which the lessor had drawn, should be applied to reduce the lessor's total claim. The creditors' committee, however, objected and asserted that the letter-of-credit proceeds should reduce the lessor's lease-rejection damages claim as capped by §502(b)(6).

The Ninth Circuit cited Oldden as the quintessential case regarding §502(b)(6)'s application. Id. at 964. The lessor, on the other hand, asserted that Oldden was wrong and that the Ninth Circuit should reject its holding, irrespective of Congress' express endorsement thereof. Congress' express endorsement of Oldden was irrelevant, the lessor asserted, because §502(b)(6) was not ambiguous, thereby prohibiting consideration of the legislative history.

An issue of first impression to the Ninth Circuit, though not the Ninth Circuit Bankruptcy Appellate Panel, the Ninth Circuit determined that §506(b)(6) was "ambiguous as to whether [security] deposits should be applied to a landlord's gross damages or its capped claim." Id. Due to such ambiguity, the Ninth Circuit looked to the legislative history and found Congress' "explicit endorsement" of Oldden determinative. Id. at 964-65. The Ninth Circuit, therefore, foreclosed any argument to the contrary while also excluding the lessor's argument that §502(b)(6) is not ambiguous. Id.

In so holding, the Ninth Circuit joined the growing majority of courts that have held that letter-of-credit proceeds are applied to the capped damage claim, not the total damage claim. See, e.g., Solow v. PPI, 324 F.3d 197. One such case, however, recently underwent appellate review with a somewhat surprising holding. See EOP-Colonnade of Dallas Limited Partnership v. Faulkner (In re Stonebridge Technologies Inc.), 430 F.3d 260 (5th Cir. 2005).¹

The Fifth Circuit's Interpretation

In Stonebridge, the lessor drew on its letter of credit and asserted that its proceeds were not property of a bankruptcy estate. See In re Stonebridge Technologies Inc., 291 B.R. 63, 70 (Bankr. N.D. Tex. 2003) (citing Kellogg v. Blue Quail Energy Inc. (Matter of Compton Corp.), 831 F.2d 586, 589 (5th Cir.1987); In re Originala Petroleum Corp., 39 B.R. 1003, 1014-15 (Bankr. N.D. Tex. 1984)). Letters of credit and their proceeds are not property of a bankruptcy estate because letters of credit are generally subject to the "independence principle." Stonebridge, 291 B.R. at 70. Under the independence principle, an issuer's obligation to the letter of credit's beneficiary is independent from any obligation between the beneficiary and the issuer's customer. Any disputes between the beneficiary and the customer do not affect the issuer's obligation to the beneficiary to pay under the letter of credit. See Id.

Nonetheless, the independence principal will not always save a lessor from §502(b)(6)'s application. Id., 71-2; Solow v. PPI, 324 F.3d at 209-10. Specifically, the bankruptcy court held in Stonebridge that:

the dispute here does not turn on whether the bank should have paid under the letter of credit, i.e., whether the funds should have been distributed. The independence principle protects only the distribution of the proceeds of the letter of credit. It prohibits an attack on the issuing bank's distribution to the beneficiary and does not address claims respecting the underlying contract.

Stonebridge, 291 B.R. at 70-1.

In fact, the dispute in Stonebridge was not on whether the letter of credit was property of the estate, but rather, once the lessor received the letter-of-credit proceeds, the propriety of retaining those proceeds was unfettered by the terms of the lease. Id. at 70-1. Specifically, the lease stated that the letter of credit constituted "a portion of the security deposit." Thus, "[a]lthough initially independent of the lease, the proceeds of the letter of credit must be applied as the parties bargained forÑas a security deposit for the lease." Id. at 71; see, also, Solow v. PPI, 324 F.3d at 210. In addition, as a security deposit, the proceeds from the letter of credit were applied to the lease-rejection damages claim as capped by §502(b)(6). Id.

On appeal, the lessor challenged the court's holding, asserting again that the independence principle prohibited the application of §502(b)(6) to non-bankruptcy estate property such as standby letters of credit. The independence principle was not, however, analyzed by the Fifth Circuit.

Instead, after reviewing the express language of §502(b), the Fifth Circuit held that §502(b)(6), by its own language, only applies to claims for which a proof of claim was filed. Stonebridge, 430 F.3d at 270-71. Specifically, the Fifth Circuit focused §502(b)'s reference to the filing of an objection to claim, which references "a claim or interest, proof of which is filed under §501 of this title." 11 U.S.C. § 502(a) and (b). Because §502(b) expressly references filed claims, the lease-rejection damages cap only applies to filed claims and could not apply to claims for which proofs of claim were not filed. Stonebridge, 430 F.3d at 268-69. Thus, because the lessor did not file a proof of claim, the Fifth Circuit held that §502(b)(6)'s lease-rejection damages cap did not apply. Id.

The inapplicability of §502(b)(6), based solely on the lack of a filed claim, may seem novel. However, it is the correct interpretation. After all, were a lessor to file a proof of claim in the entire amount of its lease-rejection damages, and the debtor/trustee failed to timely object, the claim would be allowed in the full amount without application of §502(b)(6). See 11 U.S.C. §502(a) and (b).

Based on the Fifth Circuit's holding, lessors with sizeable standby letters of credit may determine that not filing a proof of claim would yield a higher return, depending on the amounts involved and the net value of the bankruptcy estate. Though a seemingly good tactic for avoiding §502(b)(6), not filing a proof of claim is not necessarily the end of the analysis.

After all, Federal Rule of Bankruptcy Procedure 3004 authorizes a debtor or trustee to file a proof of claim on behalf of a creditor. Again, depending on various factors, a debtor's filing of a proof of claim, to invoke §502(b)(6), might prove beneficial to the bankruptcy estate. And though a lessor could object to a proof of claim filed on its behalf, such strategy might result in subsequent estoppel issues that could prevent collection on any portion of the lease-rejection claim. The Fifth Circuit's ruling, therefore, may have little effect on the ordinary course of bankruptcy business.

Conclusion

The law governing §502(b)(6)'s application continues to evolve as lessors attempt to protect themselves from the cap on lease-rejection damages. Lease-rejection damages, however, were considered by Congress to be a threat to a debtor's ability to reorganize, which led to the enactment of §502(b)(6). This emphasized congressional intent may continue to frustrate lessors' efforts to protect their interests. As such, potential leases will likely receive requests for third-party guarantees and/or other requirements designed to insure satisfaction of the full lease amount. Due to the amounts involved, lessors should expect challenges to those measures as well.