Article

Topics: Independence; Bankruptcy

Note: PPI Enterprises, Inc. entered into a ten-year real estate lease with Sheldon Solow, the Landlord, for an office in midtown Manhattan. By its provisions, the lease provided that "[i]n lieu of the cash security .... Tenant may deliver to Landlord, as security, ... an irrevocable, clean, commercial letter of credit in the amount of $ 650,000 issued by a bank ..., which shall permit Landlord (a) to draw thereon up to the full amount of the credit evidenced thereby in the event of any default by Tenant ... or (b) to draw the full amount thereof to be held as cash security ... hereof if for any reason the Letter is not renewed ...." The lease also provided that in the event of a drawing on the LC, "Tenant shall, promptly on Landlord's demand therefor, deposit with Landlord the amount of cash required to restore the cash security deposited with Landlord to the level specified ... or in lieu thereof, shall deliver to Landlord a Letter of Credit in the amount and complying with the requirements specified ... above."

After two years, Tenant ceased paying rent and abandoned the premises due to troubles caused by the insolvency of its UK based parent. Approximately one month later, Landlord terminated the lease and subsequently filed an action to recover the unpaid portion of the rent. Prior to a trial on damages, Tenant filed a petition for bankruptcy reorganization. Among other goals, it intended to limit the damages available to the landlord under Section 502(b)(6) of the US Bankruptcy Code.

As summarized by the appellate court:

Section 502(b)(6) caps a landlord's claim in bankruptcy for damages resulting from the termination of a real property lease. Under § 502(b)(6), a landlord-creditor is entitled to rent reserved from the greater of (1) one lease year or (2) fifteen percent, not to exceed three years, of the remaining lease term. The cap operates from the earlier of the petition filing date or 'the date on which [the] lessor repossessed or the lessee surrendered, the leased property.' The landlord also retains a claim for any unpaid rent due under such lease prior to the earlier of those dates. [Footnote omitted]."

After a hearing, the Bankruptcy Court for the District of Delaware, Walsh, J., determined that Landlord's claim was subject to the statutory cap of Section 502(b)(6) and reduced by application of the amount drawn on the LC. On appeal to the U.S. District Court for the District of Delaware, this decision was affirmed without decision. On appeal, the U.S. Court of Appeals for the Third Circuit, Scirica, J., affirmed.

The appellate court noted that applicable pre- Code bankruptcy case law that deducted the amount of a security deposit involved a security deposit given directly by the insolvent party and not from a third party. Landlord argued that it was improper to deduct the amount paid by a third person under a letter of credit and that such funds should not be counted toward the statutory cap, especially since a security deposit and a letter of credit are fundamentally different. He argued that "he never had the functional equivalent of a security deposit and instead simply maintained contractual rights to the letter of credit's proceeds, which should not affect his recovery under § 502(b)(6)."

In considering this argument, the court noted that several courts had considered the proceeds of a letter of credit as separate from the debtor's estate, citing Kellogg v. Blue Quail Energy Inc., 831 F.2d 586, 589-90 (5th Cir. 1987) (holding that "the independence principle [is] the cornerstone of letter of credit law"); Musika v. Arbutus Shopping Ctr., L.P., 257 B.R. 770, 772 (Bankr. D. Md. 2001) (determining the § 502(b)(6) cap without regard to the letter of credit). The court stated that "[u]nder this view, the independence principle should generally govern in situations where a third-party issuer, not the tenant itself, provides the letter of credit."

Observing that there was "another view," the court noted Tenant's argument that the issuer would seek reimbursement of the amount paid under the LC from Tenant. Tenant argued that "[u]nder Solow's interpretation, this means Solow would keep the $650,000 and PPIE would be liable for that same amount to [the Issuer]. In effect, this result would be an end run around § 502(b)(6), since [Landlord] would receive a windfall at [Tenant's], and other creditors', expense, and [Tenant] would be liable twice for the same amount of money."

While the court indicated its sympathy for the Tenant's position that the difference between a security deposit supplied by the tenant and a third party is "purely technical" and that the total damages should be limited in both instances in order to further the ability of the debtor to rehabilitate itself and to protect other creditors, it concluded that it did not need to make such a decision due to the terms of the lease.

In affirming the decision of the Bankruptcy Court, the appellate court looked to the terms of the lease. "Interpreting this language, we find the parties intended the letter of credit to serve as a security deposit. Entitled "Cash Security: Letter of Credit," the rider expressly provided the letter of credit was "in lieu" of [Tenant's] cash security obligation in the leasehold agreement. The rider also provided that [Tenant] would be liable to [Landlord] for replenishment of the security if he was forced to draw upon the letter of credit."

[JEB/ees]

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