Daily Development for Thursday, February 26, 2004 by: Patrick A. Randolph, Jr. Elmer F. Pierson Professor of Law UMKC School of Law Of Counsel: Blackwell Sanders Peper Martin Kansas City, Missouri dirt@umkc.edu BANKRUPTCY; LANDLORD/TENANT; SECURITY DEPOSITS; LETTERS OF CREDIT: Latest pronouncement from 9th Circuit BAP: Issuers of letters of credit have exposure to amount of letter for tenant defaults if issuers have not contracted to be reimbursed from assets of the estate. If there is such reimbursement right, then issuers remain liable, but are limited by 502(b)(6) limits in collecting the reimbursement. In any event, application of letter of credit is taken into account in applying the cap on landlord's claims against the debtor. In re Mayan Networks Corp. (Redback Networks, Inc. v. Mayan Networks Corp.,) BAP No. NC-0201483-JRyK (2/05/04) This case addresses the latest "gimmick" that caught the attention of landlord's counsel in seeking to deal with bankruptcy limitations on remedies when tenants file. In recent years, in particular, due to the economic slowdown, landlords have been unable to relet premises for the same return that they had counted on under the bankrupt's lease. In the Silicon Valley, where rents skyrocketed in a "red hot demand" period, and then tanked with the turn of the century, which saw hundreds of "dotcom bankruptcies," the total potential damages claims for leases that failed only a few years into lengthy terms are no doubt enormous. But under Bankruptcy Code Section 502 (b)(6), the landlord's damages claims against a bankrupt defaulted tenant who rejects the lease is capped at one year's rent (with some alternative measures). Of course, the landlord might also get administrative rent for the period that the tenant occupied the premises post filing, but we're still talking a big, and often unrecoverable loss. Remember that the damages claims, except to the extent they are secured by security deposits, guarantees, or letters of credit or some other device, are going to be general creditor's claims, so the landlord's claim, even reduced, may pay out only pennies on the dollar. But pennies are preferred to penury. Of course, landlords always require security deposits. At least, as to these amounts, they are better than unsecured creditors. Cash security deposits are regarded as property of the bankruptcy estate, and the landlord must turn them over. But the landlord can offset damages for the lost lease against the monies turned over, so that in effect the landlord has first priority at the monies in the security deposit. Can the security deposit, however, be claimed in addition to the damages permitted by the statute? Nope. The damages that can be offset are subject to the cap. And if the deposit does not equal or exceed the cap, the landlord must credit any offset deposit in collecting any further damages. If the lease is guaranteed, and the guarantor is not bankrupt, the guarantor is not protected by the cap. If the guarantor is bankrupt, however, the cap applies to caps against the guarantor as well, even though the guarantor was not a party to the lease. See below as to the rights of the guarantor against the Debtor. What if there is not a personal guarantor, but rather a letter of credit supplied in connection with the lease? There has been some speculation that, because of the "independence principle," the issuer of the letter of credit is in a different position than the guarantor. It has made an independent promise to perform the debt. Consequently, it has been argued, the landlord can collect upon the letter of credit completely and still pursue the tenant for damages that remain, all the way up to the total capped claim. The letter of credit, the argument goes, would not be applied to reduce the claim because it is an independent obligation, unlike the agreement by the guarantor. See, e.g. Landlords Use Letters of Credit to Bypass the Claim Cap of 502(b)(6)," Am. Bankr. Inst. J., December/January 2002 at 16 There have been a few recent cases that have suggested that the independence principle should not work in this way, and that monies received from the letter of credit should be used to reduce any remaining liability under the cap. In Solow v. PPI Enterprises (U.S.), Inc. , 324 F.3d 197 (3d Cir. 2003), the court held that a landlord was required to credit the tenant for the application of both a cash security deposit and the proceeds collected from a letter of credit in determining the amount available under the bankruptcy cap. This case, which was the DIRT DD for 7/10/03, rejected cases elsewhere that suggested that the letter of credit was independent of the cap. See, e.g. Farm Fresh Supermarkets of Maryland, Inc., 2001 Bankr. Lexis 51 (1/12/01). (Suggesting this result when it states that the letter of credit is not part of the bankruptcy estate.) In Faulkner v. EOP-Colonnade of Dallas LP (In re Stonebridge Technologies Inc.), 291 B.R. 63 (Bankr. N.D. Tex. 2003), the landlord drew on a letter of credit in amounts that exceeded the capped damages available to it against its bankrupt tenant, and the court order that the excess be returned to the landlord. Again, this demonstrates an erosion of the "independence" principle that landlord's lawyers were hoping to exploit. The instant case has some good news and some bad news for landlords' lawyers. The bad news is that this court, like PPI, concludes that amounts received under a letter of credit necessarily must be applied in reduction of the landlord's claim for damages. Although frustrating, however, this result will not have huge adverse consequences, because the balance of the claim not covered by the letter of credit is an unsecured claim, and the landlord doesn't lose all that much. Here, the landlord filed a claim for lease rejection damages at $2,700,000. It had a cash security deposit of $650,000, that all agreed the landlord could keep as an offset, but this reduced the amount of the capped claim. In addition to the cash security deposit, the landlord had been given a $648,000 letter of credit. Apparently on the view that there was some blood to be squeezed from the stone as an unsecured creditor, the landlord argued that its application of the letter of credit should not be credit to the capped damages. The court disagreed. The court noted that the bank, when it issued the letter of credit, obtained an indemnification right against the debtor under the agreement by which it issued the letter. Thus, if the letter's proceeds were not applied against the cap, the bank would have a claim against the debtor and the debtor theoretically would be exposed to liability beyond the cap. It cited a case predating the 502(b) amendments Oldden v. Tonto Realty Corp. 143 F.2d 916 (2d Cir. 1944), which had concluded that application of a security deposit would reduce the cap, and then indicated that, in its view of the legislative history, Congress had intended to preserve at least this aspect of the Oldden principle. This analysis was similar to the analysis of the PPI discussed above. But the good news for landlords is that the court went on to indicate that in another case, In re Condor Systems, Inc., 296 BR 5 (9th Cir. BAP 2003), involving a damage cap similar to the lease damages cap, the court had held that when the letter of credit issuer does not have any claim back against the Debtor, the amounts collected under the letter of credit will not credited to the capped claims. It suggested that the same rule would have been applied here, where there is no claim back against the debtor available to the issuer of the letter of credit. In this case, it held, the issuer of the letter of credit was a "co-obligor," and, unlike a personal guarantor, was paying its own debt, and not that of the bankrupt lessee. In an important concurring opinion, Judge Klein developed the theme much further, positing a variety of different circumstances involving application of the letter of credit to cover landlord's damage claims. Judge Klein cautions that the majority's reliance upon Oldden should not mislead practitioners to conclude that Olden controls when the letter of credit "is not part of the bankruptcy estate." In Judge Klein's view, the letter of credit is not part of the estate when there is no recourse by the issuer against the tenant. In this case, the estate's assets are not exposed when the letter of credit is called, and the landlord still can pursue damages against the tenant to the full amount of the capped claim. The same result would obtain, the judge suggests, if the security deposit were not an asset of the estate, such as when it was supplied entirely by a third person with no right of reimbursement from the tenant. If, on the other hand, either the letter of credit issuer or the personal guarantor does have a right back against the debtor, then Judge Klein would still not impose the cap on the landlord's recover from these sources, but would impose a cap when the issuer or guarantor seeks remedies back against the debtor. Comment: If the editor properly grasps Judge Klein's opinion, if the letter of credit issuer does have a recourse right against the Debtor, then, unlike the majority opinion, Judge Klein would not apply the cap to reduce the recovery against the letter of credit, but would apply it later to protect the estate from the issuer recovering back more than the cap permitted. Presumably, if the cap had already been partly exhausted by application of cash security deposits, as here, that would further limit the recovery rights of the issuer. This approach actually makes sense to the editor. But one wonders what impact it will have on the ability of tenants to obtain letters of credit. The issuer will have to be very confident that the risk is worth insuring, or else demand collateral or guarantees that are remote from the tenant and that won't be caught up with the tenant's bankruptcy. Items reported here and in the ABA publications are for general information purposes only and should not be relied upon in the course of representation or in the forming of decisions in legal matters. The same is true of all commentary provided by contributors to the DIRT list. Accuracy of data and opinions expressed are the sole responsibility of the DIRT editor and are in no sense the publication of the ABA. Parties posting messages to DIRT are posting to a source that is readily accessible by members of the general public, and should take that fact into account in evaluating confidentiality issues. ABOUT DIRT: DIRT is an internet discussion group for serious real estate professionals. Message volume varies, but commonly runs 5 15 messages per work day. 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