Article

Note: EOP-Peninsula Office Park (Landlord), filed a claim in a US Bankruptcy proceeding for unpaid rent and damages of US$2,173,695.47 resulting from the termination of a lease. Bankruptcy Trustee objected, allowing US$1,933,440.47 and claimed that the amount allowable was capped at 15% of the time remaining on the lease by 11 U.S.C. §502(b)(6). The United States Bankruptcy Court for the Northern District of California, Morgan, J., sustained Trustee's objections to the claim and found that the drawings on the LC were to be applied to the capped amount allowed with the final amount owed US$446,247.

Under the lease, Tenant was required to provide a LC in the amount of US$2,111,205. Landlord was entitled to draw on the entire LC amount but was required by the lease to hold the proceeds as a "security deposit." The court ruled that Landlord's pre-petition draws after on the LC security deposit provided by Issuer, after surrender of the property by Tenant, were to be applied against Landlord's allowable claim in bankruptcy. The court distinguished the present case from In re Condor Systems, Inc., 296 B.R. 5 (9th Cir. B.A.P. 2003), noted at 2004 Annual Survey 349, a case decided under 11 U.S.C. §502(b)(7) regarding employment termination damages. Noting that security deposits on real property leases were different from LCs established to secure payment of employment termination damages as was the LC in Condor Systems. The court stated "Here, the letter of credit at issue was clearly intended to be a security deposit."

The court usefully summarized the listing of prepetition draws on a security deposit LC which reduce Landlord's allowable claims:

As the Ninth Circuit has recognized, § 502(b)(6) provides no explicit guidance as to whether security deposit proceeds should be applied to a landlord's gross damages or its allowed claim and, therefore, the statute is ambiguous. In re AB Liquidating Corp. (AMB Property, L.P. v. Official Creditors), 416 F.3d 961, 964 (9th Cir. 2005). As a result, the court looked to the legislative history and its "explicit endorsement of Oldden " for assistance. Id. The House Judiciary Report on H.R. 8200 expressly refers to the Oldden case, a case under the Bankruptcy Act that concludes that security deposits should be applied against the landlord's capped claim rather than its total damages. Oldden, 143 F.2d at 920-21. The House Judiciary Report states that the proposed cap on a landlord's lease rejection damages was not intended to overrule or change the outcome of Oldden. It explained that "under Oldden, [a landlord] will not be permitted to offset his actual damages against his security deposit and then claim for the balance under [§ 502(b)(6)]. Rather, his security deposit will be applied in satisfaction of the claim that is allowed under [§ 502(b)(6)]." In light of this congressional endorsement, the Ninth Circuit refused to reject Oldden's holding and concluded that under the facts before it, namely, post-petition draws on a letter of credit security deposit, the letter of credit proceeds received by the landlord were properly subtracted from the landlord's allowed claim. AB Liquidating, 416 F.3dat 965, abstracted at 2006 Annual Survey 276. Relying on that same legislative history, the Third Circuit has held that proceeds received from postsurrender but pre-petition draws on a letter of credit security deposit also reduce a landlord's allowed claim. In re PPI Enterprises (U.S.), Inc. (Solow v. PPI Enterprises (U.S.), Inc.), 324 F.3d 197 (3d Cir. 2003). In PPI, as in the instant case, the debtor surrendered its lease several years prior to the date of its bankruptcy petition. In the interim, PPI's landlord, like EOP here, drew down the letter of credit that PPI had provided as a security deposit. The Third Circuit reasoned that under § 502(b)(6), the amount of the landlord's allowable claim must be calculated as of the date the lease was surrendered. Therefore, any proceeds received following surrender should be applied against the capped claim. I agree with the Third Circuit and conclude that, under the facts of this case, EOP's post-surrender, but prepetition draws on the letter of credit security deposit provided by Connectix are to be applied against EOP's allowable claim in bankruptcy.

[JEB/zrb]

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