Being that the editor is a fundamentally lazy person, he was not going to post a DD today it being a holiday for many, but Jack Murray fired in this complete DD over the transom a day or so ago, and it is interesting enough for the editor to want to release it as soon as possible.  The editor is also interested in Jack's reaction to the Editor's analysis set forth at the way way bottom.

Daily Development for Friday, November 15, 2005
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

BANKRUPTCY; LANDLORD/TENANT; RENT; DAMAGES CAP; LETTERS OF CREDIT: Fifth Circuit reverses holdings of bankruptcy court and district court, and holds that landlord's retention of letter-of-credit proceeds in excess of bankruptcy cap on landlord's damages under 502(b)(6) is permissible because Sec. 506(b)(6) cap was not triggered where landlord did not file claim in tenant-debtor's bankruptcy case.

EOP-Collonade of Dallas Ltd. P'ship v. Faulkner (In re Stonebridge Techs., Inc.), 2005 U.S. App. LEXIS 24024 (5th Cir. Tex., 11/08/05)

This case involved a claim by the bankruptcy trustee (on behalf of the tenant-debtor in a Chapter 11 proceeding) that the Bankruptcy Code sec. 506(b)(6) cap limited the lessor's draw on a letter of credit provided as a security deposit for the tenant's obligations under the lease (Under sec. 502(b)(6), a landlord's claim for early termination of a lease is limited to the rent due under the lease for the greater of one year or 15 percent, not to exceed three years.)  Because the letter of credit draw exceeded the capped amount, the trustee sought reimbursement to the estate of the excess. 

The security deposit consisted of both cash, in the amount of $105, 298, and a letter of credit, in the amount of $1,430,065. The letter of credit was secured by a certificate of deposit from the tenant in the amount of $1,250,000, to reimburse the bank if there was a draw under the letter of credit. After the tenant filed its bankruptcy petition, the tenant-debtor and the landlord agreed that the lease would be rejected, the effective date of rejection to occur between October 1 and October 23, 2001. Prior to the court date scheduled for the court to issue its order approving the rejection (October 23, 2001), the landlord initiated a draw request against the issuing bank, and the bank in fact paid the full amount of the letter of credit to the landlord on October 30, 2001.  On November 8, 2001, the bankruptcy court entered a nunc pro tunc order approving the lease rejection and making the lease rejection retroactively effective as of October 1, 2001.  But, according the Fif!

 th Cir
cuit, "The record conclusively demonstrates . . . that [the landlord] never filed a proof of claim for its actual lease rejection damages following the bankruptcy court order rejecting the lease and approving [the landlord's] administrative rent claim." 

The bank subsequently sought relief from the automatic stay to apply the certificate of deposit it held as security for the tenant-debtor's reimbursement obligations under the letter of credit. The bankruptcy trustee and the bank reached a compromise settlement agreement whereby the trustee would allow the bank to apply the certificate of deposit in exchange for an assignment of the bank's claims against the landlord for its alleged improper draw under the letter of credit. The trustee then brought an adversary action against the landlord, claiming that the landlord had breached the lease by prematurely drawing under the letter of credit and retaining an amount in excess of the sec. 502(b)(6) cap.

The bankruptcy court ruled that because the letter of credit was part of the security deposit, it was subject to the sec. 502(b)(6) cap, and also held that the landlord had breached the lease by drawing on the letter of credit before the bankruptcy court's nunc pro tunc order had been entered. The bankruptcy court awarded damages to the bankruptcy estate (for "negligent misrepresentation" by the landlord regarding its right to draw on the letter of credit) in the amount of $180,000 based on the difference between the amount the landlord drew under the letter of credit and the amount the issuing bank received from the certificate of deposit, and damages in the amount of $2,267 for breach of the lease, based on the difference between what the landlord would have been entitled to receive under sec. 502(b)(6) (less the cash security deposit) and the amount the issuing bank collected on he certificate of deposit. The district court subsequently affirmed the bankruptcy court's rul!

 ing, o
n January 30, 2004.

The Fifth Circuit reversed the rulings of the bankruptcy court and district court. According to the Fifth Circuit, the sec. 502(b)(6) cap "prevents a lessor who files a claim against the estate from reaping an unfair share of the bankruptcy estate over the remaining pool of unsecured creditors." The court also reiterated that it is well-settled in the Fifth Circuit that "letters of credit and the proceeds therefrom are not property of the debtor's bankruptcy estate."

The court then reasoned that by its terms, sec. 502(b)(6) applies only to claims against the bankruptcy estate, and that claims under that section must be formally filed with the bankruptcy court and are not "assumed" simply because the tenant-debtor assumes or rejects a lease under sec. 365. According to the Fifth Circuit (after citing applicable case law), "Stated simply, the claim of a lessor against the assets of the estate is an essential precondition to applying the damages cap at all." Based on this reasoning, the Fifth Circuit held that no inquiry into the appropriate interpretation of sec. 502(b)(6) was necessary in this case because the landlord did not file a claim against the estate. (The court also stated, in a footnote, that "We also note that sec. 502(b)(6) does not apply to limit administrative expense claims made by the landlord based upon the continued use of the premises after the filing of the bankruptcy petition.") The court rejected the trustee's argume!

 nt tha
t the letter of credit was subject to the sec. 502(b)(6) cap because it was part of the security deposit under the lease, pointing out that (unlike preference law) the trustee is not permitted under the Bankruptcy Code to separately sue a lessor for receiving property of the estate (by bringing an avoidance action) simply because it exceeds the sec. 502(b)(6) lease cap.

The Fifth Circuit distinguished two recent security-deposit/letter-of-credit cases, In re PPI Enterprises, Inc., 324 F.3d 197 (3rd Cir. 2003) and In re Mayan Networks Corp., 306 B.R. 295 (B.A.P. 9th Cir. 2004), by noting that (unlike the present case) in each of these cases the landlord had actually filed a claim against the bankruptcy estate seeking to recover lease-rejection damages in excess of the amount of the security deposit.

The Fifth Circuit also found that the landlord had not prematurely drawn against the letter of credit because such a draw was permitted under the "Monetary Default" and acceleration provisions of the lease, and the landlord's motion for payment of rent filed in the bankruptcy proceeding constituted sufficient written notice to the tenant-debtor of non-payment of the rent owing under the lease. The court noted that "the measure used to calculate accelerated damages under the Lease is the same measure that would be used to calculate the damage to a lessor from the rejection of a lease when not applying the sec. 502(b)(6) cap." The court also ruled that lease rejection may be retroactively applied, and therefore the fact that the actual court order setting the retroactive lease-rejection date was not entered until after the landlord's draw on the letter of credit was irrelevant (especially because the tenant-debtor had approved the earlier effective rejection date).

Comment 1:  Apparently the reason why, in this case, the landlord did not file a claim against the bankruptcy estate for lease-rejection damages was that the tenant-debtor's obligations were substantially (though not totally) secured by the letter of credit, which the landlord drew upon when the tenant-debtor defaulted under the lease. According to the Fifth Circuit (in a footnote), "It is undisputed that [the landlord] would have been limited to rejection damages from [the tenant-debtor's] estate of $1,353,032.02 if it had filed a claim against the estate." This is certainly good news for landlords where the amount of the letter of credit is sufficient to fully secure the landlord's damages under the lease. Even if the amount of the letter of credit is not fully sufficient to cover the landlord's damages, it will often make sense (at least in the Fifth Circuit) to draw on the letter of credit and forego filing a claim in the tenant-debtor's bankruptcy proceeding and risk be!

 ing su
bjected to the sec. 502(b)(6) cap.

Comment 2:  The Fifth Circuit cites and quotes from, in its opinion, an impressive body of case law and commentary in support of its position that sec. 502(b)(6) applies only where the landlord has actually filed a claim against the estate in the bankruptcy court. It will be interesting to see if other courts follow the holding in this case.

Comment 3:  Interestingly, the bankruptcy court found that the landlord's breach-of-lease damages were only $2,267 (the excess of the certificate of deposit securing the tenant-debtor's reimbursement obligation to the issuing bank over the landlord's capped claim of $1,353,032, less the cash security deposit of $105,299). The difference of $180,066 between the face amount of the letter of credit and the certificate-of-deposit collateral was awarded to the trustee only as the assignee of the issuing bank (in the form of damages for the allegedly unwarranted and premature presentation of the letter of credit.) But there is no indication that the letter of credit was expiring, and the issuing bank still would have been obligated to pay the full amount to the landlord if it had presented its draft after the later entry of the bankruptcy-court order retroactively rejecting the lease.

Comment 4:  The facts in the Stonebridge case required the court to confront the other side of the issue addressed by the Third Circuit in PPI Enterprises; namely, whether a landlord can retain letter-of-credit proceeds in excess of the cap. With respect to the PPI and Stonebridge cases, an excellent article on the issues raised in these cases, "Courts Limit Benefits to Landlords under Letters of Credit," by Daniel J. Carragher, appeared in the July 2003 issue of the American Bankruptcy Journal (2003 ABI JNL. LEXIS 126). Note in particular the following excerpts from this article (which was published prior to the Fifth Circuit's overruling of the bankruptcy court and district court opinions in the Stonebridge case):

“The Stonebridge decision acknowledges the importance of the independence principle, but much more clearly attempts to preclude the use of a letter of credit to avoid the statutory cap of § 502(b)(6). As in PPI Enterprises, the court placed great emphasis on the lease provisions allowing the posting of a letter of credit as part of the security deposit. Simply characterizing a letter of credit as security, however, does not resolve the § 502(b)(6) dilemma. Where a debtor has posted the security directly, § 506(a) and (d) will limit the landlord's rights in the security to recovery of the allowed claim. Where the "security" has been provided by a third party, the issue should be purely one of contract interpretation, and one-year or 15-percent limitations of § 502(b)(6) and the provisions for claims secured by a debtor's property in § 506 should not apply. The Code is silent on the issue, and the references to security deposits posted by a debtor in the legislative history do!

  not r
equire the disgorgement of third-party letter-of-credit proceeds in excess of the cap. When a landlord has bargained for the third-party credit enhancement as a condition to entering into the lease, there is nothing in the [Bankruptcy] Code or legislative history that requires that a letter of credit be treated differently than a guaranty from a solvent third party.

The disgorgement issue in the Stonebridge and Musika cases will continue to be the subject of debate in the courts. Until the higher courts resolve the issue, landlords cannot rely on letters of credit to provide the full extent of the bargained protection in the tenant's bankruptcy. In the meantime, attention should be paid to negotiating the letter-of-credit and lease default provisions to permit the landlord to draw on the funds at the earliest possible date after the tenant's bankruptcy.”

The Stonebridge and PPI Enterprises cases provide reassurance that landlords will be free to draw on letters of credit without interference from the bankruptcy court. The requirements of the perfect tender rule still may require relief from the automatic stay to permit a landlord to give notices of default or acceleration required by the terms of the letter of credit as conditions to drawing. A carefully drawn letter of credit that permits presentment upon the tenant's bankruptcy or failure of payment should ordinarily dispense with such requirements.

Comment 5: The Fifth Circuit, in the Stonebridge case, strongly reaffirms (as does the vast majority of bankruptcy cases) the "independence principle" with respect to letters of credit. The independence principle provides that a letter of credit is an independent third-party obligation and the proceeds thereof are not the debtor's property even if the letter of credit is secured by the debtor's property. See, e.g., In re Wedtech Corp., 187 B.R. 105, 107 (Bankr. S.D.N.Y. 1995) ("When a debt is secured by collateral pledged by a third party, the security interest does not give rise to a secured claim against the debtor's estate"). See also Christopher Leon, Letters of Credit: A Primer, 45 Md. L.Rev. 432, 442-43 (1986); Kimberly S. Winick, Tenant Letters of Credit, Bankruptcy Issues for Landlords and Their Lenders, 9 AM. BANKR. INST. L. REV. 733, 740 (2001) ("Of course, if the landlord can rely on the tenant's nonperformance of other obligations under the lease, it should do so!

 . Even
 though the tenant is not a party to the letter of credit, the tenant may try to argue that terms of the letter of credit that permit a draw merely because the tenant is in bankruptcy are unenforceable ipso facto clauses. Such other obligations include, but obviously are not limited to, timely payment of rent, timely payment of common area charges, repair and maintenance of the property in conformance with agreed standards, payment of taxes, and maintenance of adequate insurance with the landlord (and its mortgage lender) named as additional insureds.  Additionally, the landlord should be able to draw under the letter of credit without the tenant's cooperation. For example, the draw should not be conditioned on the presentation of documents that must be executed by the tenant, as the landlord cannot compel execution by a tenant in bankruptcy. Similarly, draws should not be conditioned on the landlord's prior notice of default, notice of acceleration, or demand on the tenant !

 for pa
yment; upon commencement of the tenant's bankruptcy case, default notices, notices of acceleration, and demands for payment for amounts due pre-bankruptcy are stayed by section 362(a)"). 

The supposed erosion of the "independence principle" by the recent In re Mayan Networks Corp. case (9th Circuit) and AB Liquidating case applies only with respect to the specific fact situation where a landlord holds a letter of credit as the security deposit under a lease and the issuer's right to reimbursement under the letter of credit is fully secured by the tenant-debtor's collateral. (In the In re AB Liquidating Corp. case, 416 F3d 961(9th Cir 2005), the Ninth Circuit affirmed the  rule of the In re Mayan Networks Corp. case; i.e., that a landlord's application of a letter of credit as a security deposit is taken into account in computing the bankruptcy cap on the landlord's damages under sec. 502(b)(6).)

Comment 6:  To protect themselves, some landlords may require that the letter-of-credit issuer not secure the reimbursement obligation with the tenant's assets. Other suggested strategies to avoid issues involved with regard to application of the § 502(b)(6) cap include the following: separate the security deposit for the rent and other lease-performance obligations of the tenant from any tenant-improvement repayment obligations and secure that obligation with a separate secured loan and promissory note from the tenant (to avoid having it characterized as a lease-rejection claim); have a guarantor separately provide the security (although this could be problematic if the guarantor becomes a debtor in bankruptcy); and provide that the letter of credit is in "lieu of" a lease security deposit). Whether any of these suggested strategies will actually be effective, and accepted as valid by bankruptcy courts, remains to be seen. See Jo-Ann Marzullo, "Letters of Credit: No Panacea!

  for T
enant Defaults," Retail Law Strategist, Oct. 2004, p.1; Michael P. Richman, "Protect Your Right to Tap Bankrupt Tenant's Letter of Credit," Commercial Lease Law Insider, June 2004, p. 5.

Note also Judge Klein's suggestion, in his concurring opinion in the In re Mayan Networks case, that letter-of-credit issuers protect themselves "from bankruptcy risk by requiring creditworthy co-obligors or insisting that security deposits come from sources, and with refund obligations, that are not property of the estate." But it may be advisable to have any third-party guaranty of reimbursement for payment under the letter of credit contain a specific waiver by the guarantor of any reimbursement, contribution, subrogation or indemnity rights against the tenant-debtor. Otherwise the bankruptcy trustee, or other creditors, could argue that payment by the guarantor is an "indirect payment" from the tenant-debtor, and it will be uncertain who gets the first right to the statutory cap -- the guarantor or the letter-of-credit issuer. Without such a waiver, the guarantor and the letter of credit issuer likely would lock horns as to who is first entitled to the capped amount of t!

 he ren
tal claim.

Editor’s Comment 1:   The editor has set forth exactly Jack’s reportage of the case.  Based upon this description, it appears that there was a settlement between the trustee and the issuing bank, presumably approved by the bankruptcy court, that permitted the bank to collect fully its security interest in the certificate of deposit that secured the letter of credit security deposit.  Thus, the question never arose whether the bank had a legal right to collect from the tenant in reimbursement for the payment on the letter of credit in an amount in excess of the 502(b)(6) cap.  That strikes the editor as the central question in all of this, and before landlord’s lawyers start dancing all over the internet law journals, we need to recognize that in this case the application of the letter of credit to satisfaction of the landlord’s claim did not place the tenant’s estate in jeopardy in an amount in excess of the capped claim.  That question, it strikes the editor, is the central!


It is one thing to say that the landlord can collect on the letter of credit if it does not make a claim for damages in the tenant’s bankruptcy.  It is quite another to conclude that the issuing bank may seek reimbursement from the tenant’s estate in excess of the capped amount when it pays out on that letter of credit. We don’t yet have an affirmative answer to this question.  Banks will certainly now begin to draft letter of credit security agreements that will protect them from being liable on the letter of credit in excess of amounts that they can collect from the estate.  So the landlords’ victory here may be short lived. 

Editor’s Comment 2: Note that the court also permitted forfeiture of the relatively small cash security deposit, apparently on the theory that such amount did not exceed the cap. 

The reporter for this item was Jack Murray of First American Title Insurance, Chicago office.

Readers are encouraged to respond to or criticize this posting.

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