One of the most interesting and effective concepts in the Bankruptcy Code is the ability to alter a debtor's obligations under otherwise binding contractual provisions. Remove this ability, and you frustrate a debtor's ability to reorganize and obtain the underlying goal of bankruptcy: the fresh start.

In fact, but for that ability, a debtor could not discharge debts nor confirm a plan that proposed any payment other than immediate payment in full. Indeed, the Bankruptcy Code is a debtor's code that leaves creditors searching for exceptions and alternatives. It is these exceptions and alternatives that are the source of ever-expanding case law and judicial review.

For example, the Bankruptcy Code not only allows a debtor/lessee to discharge lease rejection damages, but also cap the amount of its lessor's claim despite otherwise binding contractual provisions. See 11 U.S.C. §502(b)(6). Due to §502 (b)(6)'s provisions, and in an attempt to avoid the Bankruptcy Code's damage cap, lessors have required third-party letters of credit to secure payment of rent.

However, recent cases are addressing and limiting those measures in a manner that demonstrates the long arm of the Bankruptcy Code and the willingness of courts to capture what they believe to be Congress's intent. Yet to fully understand these recent cases, one must understand the provisions and implications of §502(b)(6).

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

Pursuant to §502(b)(6), the 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. Section 502(b)(6) incorporates Congress's 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).

In fact, §502(b)(6)'s legislative history clearly states 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. As stated below, 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.

Measures Taken to Avoid §502(b)(6)'s Cap and the Disappointing Results

Courts reviewing and analyzing the various measures taken to avoid a cap on lease-rejection damages generally hold that Congress meant to create a true cap on the amount of a lessor's claim. For example, certain courts have held that treatment in a proposed reorganization plan that pays a lessor's lease-rejection damage claim in full, as limited by §502(b)(6), is the equivalent of treating that claim as unimpaired under 11 U.S.C. §1124. See Solow v. PPI Enters. (U.S.) Inc. (In re PPI Enters. (U.S.) Inc.), 324 F.3d 197, 204-07 (3d Cir. 2003). Therefore, a debtor could have a 100 percent payoff to creditors, thereby undermining objections to confirmation, even though its lessor received payment of its lease-rejection claim in the amount capped by §502(b)(6) instead of the amount calculated by the lease's provisions. See Id.

In enforcing Congress's intent behind §502(b)(6), courts have gone further than many anticipated. For example, courts have applied §502(b)(6)'s cap to the obligations of lease guarantors, regardless of their status as tenant. See, e.g., Arden v. Motel Partners (In re Arden), 176 F.3d 1226 (9th Cir. 1999); In re Farley Inc., 146 B.R. 739 (Bankr. N.D. Ill. 1992); but, see In re Danrik Ltd., 92 B.R. 964 (Bankr. N.D. Ga. 1988) (declining to apply §502(b)(6) to a guarantor/debtor whose other creditors received payment in full when the claim was not so substantial as to limit the return to other creditors).

By such application, lessors are unable to avoid §502(b)(6)'s effect if a guarantor files bankruptcy as well as the debtor. Such application, however, occurs only if a guarantor files bankruptcy. Otherwise, §502(b)(6) does not apply to a guarantor. See In re Western Real Estate Fund Inc., 922 F.2d 592 (10th Cir. 1990); In re Modern Textile Inc., 900 F.2d 1184 (8th Cir. 1990).

Furthermore, courts generally invalidate lessors' attempts to avoid §502(b)(6) through the use of security deposits. See In re PPI Enterprises (U.S.) Inc., 228 B.R. 339, 350 (Bankr. D. Del. 1998), aff'd., 324 F.3d 197 (3d Cir. 2003); In re Handy Andy Home Improvement Ctrs. Inc., 222 B.R. 571, 574 (Bankr. N.D. Ill. 1998); In re Atlantic Container Corp., 133 B.R. 980, 988 (Bankr. N.D. Ill. 1991). Thus, despite the idea that such funds were removed from the bankruptcy estate, courts have held that upon lease rejection, and upon calculation of damages as capped by §502(b)(6), the lessor can only apply a security deposit to the now-capped lease-rejection damage claim and must return the remainder. See Id. As stated above, although §502(b)(6) does not expressly address security deposits, its legislative history makes reference thereto.

Lessors determined to avoid §502 (b)(6)'s damage cap and obtain sufficient security turn to alternatives outside the bankruptcy estate—i.e., letters of credit. A letter of credit differs from a security deposit as it is an obligation of a third party to the landlord, not an obligation between lessee and lessor. See, e.g., In re Originala Petroleum Corp., 39 B.R. 1003, 1014-15 (Bankr. N.D. Tex. 1984).

However, since most letters of credit are issued by a lessee's secured lender, debtors and committees realized that the draw on the letter of credit, despite payment coming from a third party, still affected the bankruptcy estate through an increasing secured claim. As such, courts have analyzed and questioned the application of §502(b)(6) to such letters of credit.

The Application of §502(b)(6) to Letters of Credit

Lessors have relied on letters of credit as a remedy to §502(b)(6) because letters of credit and their proceeds are 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." See 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., citing Kellogg, 831 F.2d at 590.

Nonetheless, the independence principle will not always save a lessor from §502(b)(6)'s application to its letter of credit. See Stonebridge, 291 B.R. at 71-2; Solow v. PPI, 324 F.3d at 209-10. Indeed, the Third Circuit recently found that the letter of credit constituted a security deposit and was subject to §502(b)(6) because the lease defined "security deposit" as "[i]n lieu of...cash security..., [the] tenant may deliver to landlord, as security..., an irrevocable, clean, commercial letter of credit," and provided that the tenant would replenish the letter of credit with cash security in the event of a draw on the letter of credit. See Solow v. PPI, 324 F.3d at 70.

Similarly, the Stonebridge court held:

[T]he 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.

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

In fact, the dispute in Stonebridge was not over whether the letter of credit was property of the estate, but rather—once the lessor received the letter-of-credit proceeds—over the propriety of retaining those proceeds unfettered by the terms of the lease. Stonebridge, 291 B.R. 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 for—as a security deposit for the lease." Stonebridge, 291 B.R. at 71; see, also, Solow v. PPI, 324 F.3d at 210.

Thus, neither Stonebridge nor Solow v. PPI resolve whether a letter of credit, under differing facts, could survive the application of §502(b)(6). The Stonebridge court alludes that a different conclusion could occur, but does not expound on what set of facts would give rise to a different conclusion. Stonebridge, 291 B.R. at 70-1. The Stonebridge court does note that commentators have suggested that §502(b)(6) would not apply to letters of credit that are issued "in lieu of" a cash security deposit. Stonebridge, 291 B.R. at 72, fn 1, citing Winick, Kimberly S., "Tenant Letter of Credit: Bankruptcy Issues for Landlords and Their Lenders," 9 Am. Bankr. Ins. L. Rev. 733, 752 (2001). However, this is purely dicta and may not withstand subsequent judicial scrutiny.

Conclusion

Though suffering another blow from judicial review and enforcement of Congress's intent in enacting §502(b)(6), lessors will continue to seek exceptions and alternatives to protect their interests. As stated above, there is indirect support for the use of a letter of credit in lieu of a cash deposit, at least where the lease does not equate the two.

Irrespective, based on the willingness of courts to expand the reach of §502(b)(6), lessors should endeavor to find new means to protect their interests. Though courts have given little guidance, one can glean from their opinions what will not suffice.