Daily Development for Friday, October 7, 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
dirt@umkc.edu

BANKRUPTCY; LANDLORD/TENANT; DAMAGES CAP; LETTERS OF CREDIT: Ninth Circuit affirms rule of Mayan, a landlord’s application of letter of credit as security deposit is taken into account in computing bankruptcy cap on landlord’s damages under 502(b)(6).

AMB Prop., L.P. v Official Creditors for the Estate of AB Liquidating Corp.(In re AB Liquidating Corp.) 416 F3d 961(9th Cir 2005)

In In re Mayan Networks Corp.  (Redback Networks, Inc. v. Mayan Networks Corp.,206 B.R. 299 (9th Cir. BAP 2004) (the DIRT DD for 2/26/04) a Bankruptcy Appeals panel in the Ninth Circuit pronounced what has become accepted as “established wisdom” concerning the relationship between security deposits in the form of letters of credit and the bankruptcy cap on landlord’s damage claims articulated in Bankruptcy Code section 502(b)(6).  Mayan put the skids to the rosy suggestions of many landlord’s lawyers that the “independence principle”  - the notion that letters of credit stand by themselves as independent obligations of the issuing bank - would insulate letter of credit security deposits from the limits of the cap.  Although, indeed, the bank is obligated to pay on the letter promptly, the court noted, this is as far as the “independence principle” takes us.  If the bank has a right of recourse against the tenant or the tenant’s assets, then in essence the obligation remains !

 an obl
igation of the tenant and the tenant deserves the protection of the “cap.”

The court went on to assert that if, in fact, the issuing lender has no recourse against the tenant or the tenant’s assets, and the bank has issued the letter pursuant to the guaranty or security provided by some third party, then the letter of credit proceeds would not reduce the amount of damages that the landlord could pursue directly from the tenant.  The limit is not on the amount of damages  that the landlord can recover, the court said, but rather than the amount to which the tenant can be exposed.  Of course, this statement was dicta in Mayan, where there was specific tenant security pledged for the letter of credit. 

Many lawyers have been convinced by the logic of the Mayan decision and have concluded that is probably the way that the issue should come out, so Mayan has influenced thinking well beyond the Ninth Circuit.  But it was still only a BAP decision.  Now we have a Ninth Circuit Court of Appeals decision that upholds Mayan against a specific attack against it and the earlier authority that supports it. 

In the instant case, the landlord had a $5 million damages claim.  The bankruptcy cap limited the landlord's allowed claim to $2 million.  Further,  the $1 million security deposit the landlord held was not applied just against landlord’s gross $5 million claim (reducing it to $4 million), but was applied against the $2 million capped claim.

Thus, landlord’s remaining allowed claim was only $1 million. Landlord could keep the security deposit, but the allowed remaining claim was only $1 million beyond that.


Reporter’s Comment 1:   Landlords have had enough experience with defaulting tenants to know they need front-end protection, which they obtain by requiring security deposits at the start. During the dot.com boom, it was common to see landlords taking letters of credit-covering from 6 to 18 months of rent-posted by tenants' lenders or investors. (Letters of credit were popular with tenants because they didn't require real money, and were attractive to landlords because it was thought that the independence principle made them supposedly more invulnerable to attachment than plain cash,

This case demonstrates  that the existence of a security deposit does not necessarily provide as much protection as the landlord would like when her tenant goes under. If tenant files bankruptcy, landlord’s recovery is capped by 11 USC 502(b)(6) at one year's rent (in most cases).

Judge Klein’s concurrence in Mayan suggests  that a security deposit consisting of a letter of credit not collateralized by the debtor's property might be treated differently, but how many issuers of such letters would be willing to do so without full collateral?)

Reporter’s Comment 2:  Under this formula, risk-averse landlords would be advised to seek security deposits equal to a full year's rent, not just six months, if they can get them. (An even larger security deposit might look nicer, but it would not do much better, because the excess over the capped claim-the one year's rent-would probably just have to be turned over to the bankruptcy trustee.)

Editor’s Comment 1: The editor is not so sure about the proposition in the Reporter’s comment 2, above.  In Mayan, Judge Klein wrote an important concurrence that suggested a more dramatic result when the letter of credit security deposit exceeds the capped rent.  His opinion appeared to stat that  if the letter of credit exceeds the amount of the tenant’s “capped”  damages (not the facts in Mayan), but does not exceed the landlord’s total damages claim, the landlord ought to be able to seek application of the letter of credit anyway, and that the party that should suffer the loss of the restriction of rights against the bankrupt tenant ought to be the lender.  In other words, if the damage claim is $5 million, as here, and the bank has issued a $5 million letter of credit as security, but, as here, the “capped” damages claim if $2 million, the landlord could make a claim on the whole $5 million, but the bank would be limited to a right of recourse against the tenant of $2 m!

 illion

The landlord in the instant case attempted to invoke Judge Klein’s Mayan concurrence as supporting a different outcome here. The court did not agree, indicating that Judge Klein’s opinion was fully consistent with the outcome in the instant case - where the letter of credit security deposit was equal to or less than the “capped” claim and where the issuing bank had recourse against the debtor tenant or its property as security.  Further, although not called upon to “buy in” to all the views expressed by Judge Klein, there was no indication that it disagreed with Judge Klein’s views.   

Of course, knowing of this risk, banks will certainly protect themselves from this happening.  But the fact of the risk will certainly alter the dynamics of the bargaining for letters of credit as security deposits.  

The Reporter in this case was Professor Roger Bernhardt of the Golden Gate Law School in San Francisco, writing in the California Real Property Report.  The editor has extensively revised the report, and truncated the comments as well.  So Roger bears no responsibility for any inaccuracies or ambiguity above. 

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