Article

Note: Beneficiaries, Robert Young and John Taft, were terminated from their positions as chief executive officer and chief financial officer, respectively of Applicant, Condor Systems. As a 'golden parachute" severance package, Applicant caused two standbys to be issued for US$1.4 million and US$500,000 by Bank of America, subject to ISP98 and payable in eight equal quarterly draws. Applicant filed for bankruptcy under Chapter 11 (reorganization) twenty-one months after the LC had been issued to Beneficiary Young and eleven months after it was issued to Beneficiary Taft.

When Beneficiaries filed a claim against Applicant in bankruptcy court for other obligations resulting from their employment contract, Applicant argued that the amount of the LCs should be deducted from the maximum amount that Beneficiaries could claim against it. As provided by statute, the claims cap, as it applied to former employees and employers, equaled the employee's annual salary plus annual benefits at the time of termination. Thus, if the amount of the LC was deducted, Beneficiaries' claims against Applicant would be reduced to zero under the claims cap.

The US Bankruptcy Court for the Northern District of California, Grube, J., agreed with Applicant, ruling that the "prepetition severance payment and draws received under the letters of credit reduced the one-year total compensation caps." On appeal, the Bankruptcy Appellate Panel for the Ninth Circuit, Klein, J. reversed.

Distinguishing between a claim ("the total available under substantive nonbankruptcy law") and the cap provided by the Bankruptcy Code, Section 502(b)(7) ("how much of the substantive claim will be 'allowed' to be paid by the bankruptcy estate [which] mandates 'disallowance' of the excess"), the appellate court stated that "[t]aken together, the claim and the cap yield the 'allowed' or 'allowable' claim." It noted that the claims "span the full range of damages known to nonbankruptcy law that 'result' from 'termination of an employment contract'."

In determining whether or not prepetition payments should be counted against the cap of §502(b)(7), the bankruptcy court had analogized the allowable claims of terminated employees to the cap on amounts that were permitted to be claimed by lessors of real estate under §502(b)(6) of the Bankruptcy Code. The appellate court declined to use this analogy, noting that the plain language of the provision led to a different result.

Applicant also argued that the prepetition issuance of an LC that had not yet been entirely drawn necessitated a reduction of the §502(b)(7) cap "because the LC's draw clause becomes a liability of the debtor's estate." The appellate court disagreed, stating that "the §502(b)(7) cap is calculated mechanically as of the date of the filing of the petition and that prepetition severance payments and pre- and postpetition draws on letters of credit may affect the amount of the claim but not the §502(b)(7) cap." The appellate court stated that "[w]hile letters of credit are specialized financial instruments governed by Article 5 of the Uniform Commercial Code, there is nothing about the basic structure of the letter of credit transaction that calls for treatment different than other co-obligors in bankruptcy."

"Thus, although [Issuer] issued the letters of credit to [Beneficiaries] on the application of [Applicant], the obligation to pay is direct and primary as between [Issuer] and [Beneficiaries] and is exclusively defined by the terms of the letters of credit 'independent' of performance, or lack thereof, by anyone else, including [Applicant and Beneficiaries]." The appellate court then stated, "[i]n sum, settled letter of credit law requires Bank of America to pay Young and Taft, even if Condor is broke."

"In light of the bankruptcy limitations on the rights of co-obligors regarding claims, there is no reason to require an adjustment of the §502(b)(7) cap when a former employee is paid by way of a letter of credit or any other guarantee arrangement. Indeed, the provisions regarding coobligors make sense only if the §502(b)(7) cap is not reduced by payments from co-obligors. If such payments did reduce the cap, a co-obligor who paid the full amount of the former employee's claim would be stripped of its statutory §509(a) subrogation and §502(e) reimbursement and contribution rights, limited though they may be by the cap."

Distinguishing its decision in In re: PPI Enterprises, Inc. 324 F.3d 209 (3rd. Cir. 2003), the appellate court stated, "[w]here a letter of credit or other third-party obligation is intended to be a security deposit under a lease, it may be appropriate to analyze the situation as involving a security deposit. The Third Circuit, for example, recently addressed a letter of credit that was explicitly agreed to be a security deposit on a lease. It does not follow, however, that every letter of credit or other third-party guarantee constitutes a security deposit. Rather, even in the landlord-tenant arena, parties must intend that it be a security deposit."

[JEB/llh]

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