Article

Factual Summary: Bank issued a US$1,430,065.74 standby LC to assure payment of rent to Beneficiary. According to the lease, the LC was part of the Security Deposit and could be drawn after notice of an Event of Default in the lease payments.

One year into the lease term, Applicant sought protection in bankruptcy and eventually confirmed a plan of liquidation. At the time, Applicant owed Beneficiary overdue rent, the current month's rent, and other charges. Beneficiary, however, had at no time given notice to Applicant of the overdue rent, and thus had not triggered the Event of Default under the lease.

Applicant and Beneficiary negotiated a settlement whereby the existing lease would be rejected (permitted disaffirmance of a contract in bankruptcy) retroactively, and the parties would enter into a new short-term lease. Prior to reaching a decision on rejection date of the lease, Beneficiary drew the entire sum of the LC, reciting that the amount was due since Applicant had failed to comply with the terms of the lease. Beneficiary was paid the full amount of the LC and also kept the cash portion of the security deposit, US$105,298.85.

Once the rejection date of the lease had been set by the court, Beneficiary's damages were capped by statute at US$1,353,031.02, which represented one year's rent from the date of the bankruptcy filing plus unpaid rent then due under the lease. Claiming Beneficiary had improperly kept the cash portion of the security deposit and had improperly drawn on the LC in violation of the damage cap, the Trustee of Applicant's liquidating trust sued Beneficiary for the balance. Judgment for the Trustee.

Legal Analysis:

1. The LC is Part of the Security Deposit: The court considered whether the LC could be considered a part of the security deposit. Beneficiary argued that the LC is an obligation of the issuer and not the applicant and, so, is not the property of the bankruptcy estate and not subject to the statutory cap on damages. However, the court relied on the lease itself which stated that the security deposit consisted of cash "and a letter of credit ... ". Thus, the LC was treated as part of the security deposit as between Beneficiary and Applicant.

2. Independence: Beneficiary argued that looking to the underlying agreement violated the independence of the LC from the underlying transaction. The court distinguished between the distribution of the LC proceeds by the issuer and the use of those proceeds by the beneficiary. While the principle of independence would prevent the court from looking to the underlying agreement in an action on the credit, the principle of independence did not protect Beneficiary from an action regarding the proceeds. Beneficiary had improperly drawn on the LC before any Event of Default or rejection of the lease and thus breached the lease agreement. The LC was, then, subject to the damages cap of § 502(b)(6), and Beneficiary wrongfully withheld any amount over the damages cap.

Comment: In this case, the court ruled that the LC was part of the security deposit because the terms of the lease itself so provided. In re PPI Enterprises, 234 F3d 197 (3rd Cir. 2003) applied the cap to an LC defined by the lease as "in lieu of security deposit". It is unclear under these decisions whether the cap would not apply were the lease to provide that the LC was not part of the security deposit. There is language in this opinion to suggest that a different result might have obtained were there to have been the notice required under the lease and if the drawing were to have taken place as a result of a default under the terms of the lease that took it outside the scope of the statutory rent cap.

[JEB/jam]

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