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Letters of Credit and Leasehold Rejection Damages

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In the past few years, a number of articles and decisions have been written relating to the impact of 11 U.S.C. §502 (b)(6) on letters of credit issued for the benefit of a landlord. Indeed, in the article "Landlords Use Letters of Credit to Bypass the Claim Cap of §502(b)(6)," 20 Am. Bankr. Inst. J. 16, (Dec. 2001/Jan. 2002), the authors suggested that a letter of credit could be used by a landlord to recover rejection damages in excess of the §502(b)(6) cap. Toward the end of 2005, the Fifth Circuit Court of Appeals added its voice to this dispute in EOP-Colonnade of Dallas v. Faulkner (In re Stonebridge Technologies Inc.), 430 F.3d 260 (5th Cir. 2005), and appears to have provided an opening for landlords to exceed this cap.

Typical Fact Pattern

The fact pattern in these cases is fairly straightforward. Prior to filing for bankruptcy, the debtor enters into a lease with a landlord and as part of the transaction, the landlord requires a letter of credit to be issued in its favor as "security" or a "credit enhancement." Upon filing for bankruptcy, the debtor rejects the lease, and the landlord draws on the letter of credit to recover some of its damages.

Statutory Background

Section 502(a) of the Bankruptcy Code provides that proofs of claim or interest are deemed allowed unless a party in interest objects. Stonebridge Technologies, 430 F.3d at 268. If an objection is made to a proof of claim, the court determines the amount of such claim under §502(b). Id. Section 502(b)(6) 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—
(6) if such claim is the claim of a lessor for damages resulting from the termination of a lease of real property, such claim exceeds—
(A) 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, following the earlier of—
(i) the date of the filing of the petition; and
(ii) the date on which such lessor repossessed, or the lessee surrendered, the lease property; plus
(B) any unpaid rent due under such lease, without acceleration, on the earlier of such dates;
According to the legislative history of §502(b)(6), this provision is—
...derived from current law, [and] limits the damages allowable to a landlord of the debtor. The history of this provision is set out at length in Oldden v. Tonto Realty Co., 143 F.2d 916 (2d Cir. 1944). It is designed to compensate the landlord for his loss while not permitting a claim so large (based on a long-term lease) as to prevent other general unsecured creditors from recovering a dividend from the estate....
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 of his claim allowed under this paragraph, the excess comes into the estate. Moreover, his allowed claim is for his total damages, as limited by this paragraph. By virtue of proposed 11 U.S.C. 506(a) and 506(d), the claim will be divided into a secured portion and an unsecured portion in those cases in which the deposit that the landlord holds is less than his damages. As under Oldden, he 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 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6309. Under §506(b)(6), a landlord is entitled to rejection damages for future rent of the greater of one year or 15 percent, not to exceed three years of the remaining term. Solow v. PPI Enterprises (U.S.) Inc. (In re PPI Enterprises (U.S.) Inc.), 324 F.3d 197, 207 (3d Cir. 2003). The landlord's cap operates from the earlier of the petition date or the date the landlord repossessed or the tenant surrendered the property. Id. Further, the landlord retains a claim for unpaid rent due under the lease prior to the earlier of those dates. Id.

Cases Decided Prior to Stonebridge Technologies

Prior to Stonebridge Technologies, three cases addressed the impact of §502(b)(6) on letters of credit issued to the debtor's landlord: Solow v. PPI Enterprises (US) Inc. (In re PPI Enterprises (US) Inc.), 324 F.3d 197 (3d Cir. 2002); In re Mayan Networks Corp., 306 B.R. 295 (9th Cir. BAP 2004); and AMB Properties 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 In re Solow v. PPI Enterprises (US) Inc. (In re PPI Enterprise (US) Inc.), 324 F.3d 197 (3d Cir. 2002), the landlord had a gross rejection damages claim against the debtor in the amount of approximately $4.7 million. After applying the provisions of §502(b)(6) to the gross rejection damages claim, the allowed claim was reduced to approximately $860,000. The landlord had been given and drew down on a letter of credit in the amount of $650,000, which was unsecured. The issue before the court was whether to apply the proceeds from the letter of credit to reduce the amount of capped claim, or to apply the proceeds to the gross claim over and above the §502(b)(6) cap.

In reaching its decision, the PPI court focused on the language of the lease that required the debtor, in lieu of a cash security deposit, to provide the landlord with a standby letter of credit to secure performance under the lease. The court reasoned, after interpreting the language of the lease, "we find the parties intended the letter of credit to serve as a security deposit. Entitled Ôcash security letter of credit,' the rider expressly provided that the letter of credit was in lieu of PPI's cash security obligation in the leasehold agreement. The rider also provided that PPI would be liable to Solow for replenishment of the security if he was forced to draw upon the letter of credit." PPI, 324 F.3d at 210. Thus, the court affirmed the court's decision to apply the proceeds of the letter of credit to reduce the landlord's claim as capped by §502(b)(6).

In In re Mayan Networks Corp., 306 B.R. 295 (9th Cir. BAP 2004), the landlord's claim against the debtor after applying the provisions of §502(b)(6) was $1.7 million. The landlord had as a credit enhancement a standby letter of credit in the amount of $650,000, which was secured by the debtor's assets. Once again, the issue addressed by the court was whether the proceeds from the letter of credit should be used to reduce the amount of the landlord's claim as capped by §502(b)(6).

The Mayan Networks court expressly declined to follow the Third Circuit's rationale in PPI. Mayan Networks, 306 B.R. at 300. Rather, Mayan Networks focused on the fact that the letter of credit in its case was secured by property of the debtor. The court noted that the letter of credit was in the nature of a security deposit and, if it is drawn, has the affect of reducing the assets available to pay unsecured creditors by the amount of $650,000. Mayan Networks, 306 B.R. at 301. Thus, the court concluded that it was "not necessary to distinguish the letter of credit in this case from the security deposit in Oldden. Here, the language of the lease described the letter of credit as security for the lease, and the letter of credit was fully secured by a cash deposit. The draw upon the letter of credit had the same effect on the estate as the forfeiture of a cash security deposit, and the purpose of §502(b)(6) will be best served if the same rule is applied in Mayan Networks, 306 B.R. at 301. Thus, the court held that the proceeds of the letter of credit should be applied to the landlord's claim as capped by §506(b)(6). Mayan Networks, 306 B.R. at 301.

In AMB Properties, L.P. v. Official Creditors Committee for the Estate of AB Liquidating Corp. (In re AB Liquidating Corp.), 416 F.3d 961 (9th Cir. 2005), the landlord's gross damages were $5 million, but after applying the cap of §502(b)(6), the landlord's claim was allowed at $2 million. To secure the obligations under the lease, the debtor delivered to the landlord a $1 million standby letter of credit. The letter of credit was fully collateralized. The issue was, once again, whether to apply the proceeds from the letter of credit to the capped claim. Because the letter of credit was collateralized, the court concluded that the proceeds of the letter of credit were properly subtracted from the capped claim. AB Liquidating Corp., 416 F.3d at 965.

Stonebridge Technologies

In Stonebridge Technologies, to secure the obligations under its lease, the debtor provided to the landlord a cash security deposit of $105,298 and a standby letter of credit in the amount of approximately $1.4 million. After the debtor filed for bankruptcy and rejected the lease, the landlord drew down on the letter of credit, but never filed a proof of claim. According to the court, the landlord had no need to file a proof of claim, because the amount of the security deposit and the letter of credit exceeded the amount of the landlord's claim as capped by §506(b)(6). Stonebridge Technologies, 430 F.3d. The liquidating trustee sued the landlord for improperly drawing on the letter of credit and for retaining letter-of-credit proceeds in excess of the amount of the §502(b)(6) cap. The bankruptcy court held in favor of the liquidating trustee and entered a judgment against the landlord for damages in amount of the letter of credit proceeds retained in excess of the capped claim.

The Fifth Circuit Court of Appeals reversed, holding that by its terms, §502(b) applies if the landlord makes a claim against the estate. Stonebridge Technologies, 430 F.3d at 269-270. Since the landlord did not file a proof of claim, the claim-limitations provision of §502(b) was not invoked and the landlord was not prohibited from drawing the full amount of the letter of credit to apply against unpaid lease damages, even those in excess of the §502(b)(6) cap. Stonebridge Technologies, 430 F.3d at 270-27. It should be noted, however, that because no proof of claim was filed, the court declined to inquire into the proper interpretation of §502(b)(6). Stonebridge Technologies, 420 F.3d at 270.

Conclusion

Stonebridge Technologies is distinguishable from PPI, Mayan Networks and AB Liquidating because in the latter cases the landlord filed a proof of claim, while the landlord in Stonebridge Technologies did not file a proof of claim. The lesson for a landlord that has letter-of-credit proceeds in excess of the amount of the claim cap is to not file a proof of claim. Thus, the landlord will not invoke the provision of §502(b) and may be able to retain proceeds in excess of the §502(b)(6) cap.

But what is the lesson for the estate? Stonebridge Technologies may be abrogated by the provisions of §501(c) and Bankr. Rule 3004, which allow the debtor or trustee to file a proof of claim on behalf of a creditor. By filing a proof of claim, the debtor or trustee invokes the claim-allowance provisions of §502(b), and thus has a basis for limiting the amount of the claim to be satisfied by the proceeds of the letter of credit. Because the Code and Rules authorize a debtor or trustee to file a proof of claim on behalf of a creditor, the opening provided for landlords by the court in Stonebridge Technologies will likely be of limited use.

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Wednesday, March 1, 2006

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