Article

Factual Summary: Sublessee of a commercial building provided Landlord with two forms of security: (1) a cash deposit of US$351,033, and (2) a US$648,966 letter of credit. The sublease provided that the letter of credit was delivered "as security for the faithful performance by [Sublessee/Applicant] of all of its obligations under this Sublease." To secure the letter of credit, Sublessee/Applicant pledged over US$650,000 cash to Issuer.

After entering into the sublease, Sublessee/ Applicant filed a Chapter 11 (reorganization) petition under the US Bankruptcy Code, and, pursuant to its provisions, moved to reject the sublease. After the bankruptcy filing, Landlord/Beneficiary drew on the LC. Landlord/Beneficiary filed a general unsecured claim for damages arising from the rejection of the sublease and an administrative claim for post-petition rent.

On an objection by the Debtor/Applicant and the Official Committee of Unsecured Creditors to the amount of the Landlord/Beneficiary's claim, the Bankruptcy Court ruled that both the cash deposit and LC proceedings reduced Landlord's claim. On appeal, affirmed by two judges with a concurring opinion.

Legal Analysis:

1. Bankruptcy Code Section 502(b)(6) (Damage Cap): Sublessee objected to Landlord's claim, arguing that both the cash security deposit and the proceeds of the letter of credit (which had been drawn by Landlord) reduced Landlord's allowed claim as capped by US Bankruptcy Code 11 USCA Section 502(b)(6). Landlord agreed that the cash security deposit should reduce its allowed claim but argued that the letter of credit should not. Section 502(b)(6) of the Bankruptcy Code places a cap on the damages that a landlord can claim in a bankruptcy for unpaid future rent equal to the rent for 15% of the remaining term of the lease, with a minimum of one year's rent and a maximum of three years' rent. The appellate court stated that the logic of the cap is that the creditors of the bankrupt tenant should not have their bankruptcy claims overwhelmed by an enormous claim by a landlord on a long term lease. The landlord may make a claim for the entire amount of prospective future rent under the lease but the amount of the claim which will be allowed will be limited to the Section 502(b)(6) cap.

In its decision, the appellate court noted that case law generally provides that where the landlord has taken a cash security deposit, the amount of the security deposit is deducted from the amount of the cap. Otherwise, by forfeiting the security deposit (which normally is an asset of the tenant in which the landlord has a security interest), the landlord would be able to claim a larger amount under the cap.

The appellate court further noted existing cases which involved standby letters of credit that were given as security upon a lease. In these cases, the courts ruled that the proceeds of the letter of credit should be treated in exactly the same way as a cash security deposit, and be subtracted from the Section 502(b)(6) cap when determining the amount which the landlord can claim from the bankruptcy estate.

In contrast, the appellate court noted that several courts have ruled that the "liability of a guarantor that is not in bankruptcy is not limited by section 502(b)(6)." In such situations, the landlord is permitted to keep the proceeds and they are not deducted from the cap.

The appellate court determined that these two lines of cases are distinguished by the effect the draw on security has upon the bankruptcy estate. Where the lease is secured by a letter of credit, although the letter of credit is not part of the bankruptcy estate, the estate is nevertheless depleted by the landlord's draw upon the credit. In these instances, the lessee was liable to the landlord "for replenishment of the security if the landlord were forced to draw upon the letter of credit." Thus, the assets of the bankruptcy estate would be depleted if the landlord draws down the security. However, if the lease is secured by a third party guarantor, and the landlord obtains proceeds from that guarantor, it was observed that there is no effect upon the bankruptcy estate, and, therefore, the proceeds need not be deducted from the cap.

The majority, consistent with the "cash security deposit" cases, concluded that the amount of the letter of credit proceeds should be subtracted from the cap in determining the landlord's allowable claim. In this case, the appellate court concluded that there was no "true third party obligor who bears substantial risk." The bank was fully protected by the $650,000 cash security that the lessee pledged to it; thus if the landlord drew upon the credit, the amount effectively would come from the bankruptcy estate.

2. Subrogation. The concurring opinion, persuasive to many bankruptcy practitioners, argued that the issuer's claim, not the landlord's, should be subject to the cap. It noted that, by virtue of Section 5-117 of revised UCC Article 5, issuers now have the same subrogation rights as guarantors. The letter of credit issuers should therefore be treated exactly like guarantors. The concurring opinion also invoked Bankruptcy Code Section 509(c) which subordinates claims for subrogation, reimbursement, or contribution by those entities that are liable with the debtor on a creditor's claim. In its view, Section 509(c) appears to preclude the issuer (as the equivalent of a guarantor) from obtaining reimbursement until the landlord's claim has been paid in full. The landlord should be entitled to keep the letter of credit proceeds without having them subtracted from the cap, and the letter of credit issuer would be subject to the cap in making its claim against the tenant, whether the claim is for reimbursement or is under the right of subrogation granted to the letter of credit issuer under Section 5-117 of revised Article 5.

Comments by George Hisert, Bingham McCutchen, LLP:

1. The result of applying the logic of the concurring opinion is that the letter of credit issuer, not the landlord, faces the risk of having its claim reduced under the cap. The implication that follows is that the letter of credit issuers face the risk that their reimbursement rights against tenant/applicants may be significantly limited if the letter of credit supports the tenant's obligation to pay future rent.

A third party guarantor has a reimbursement right against the tenant and is subrogated to the rights of the landlord against the tenant. In seeking payment from the tenant, whether under its right of reimbursement or under its subrogation claim, the guarantor becomes subject to the cap. If the landlord has used up the entire cap by its own claim for amounts not covered by the guaranty, then the guarantor receives nothing on its claim against the bankruptcy estate. Even where the landlord makes no claim against the bankruptcy estate (because the landlord has recovered the full amount of its damages from the guarantor), the guarantor's reimbursement claim against the tenant is subject to the cap.

As an example, assume that a standby letter of credit is issued for $5,000,000 and the issuer has cash collateral of 106%, or $5,300,000. Tenant files for bankruptcy. Landlord draws under the letter of credit and receives $5,000,000 from the issuer. The issuer then seeks relief from the automatic stay to foreclose against its cash collateral. Also assume that the cap under Section 502(b)(6) is $2,000,000. Under the concurring opinion's analysis, the landlord keeps the $5,000,000 but the letter of credit issuer needs to disgorge $3.3 million of its security and the issuer's claim against the tenant (fully secured by the remaining collateral) is limited to $2,000,000. In other words, the issuer pays out $5,000,000 but is reimbursed only $2,000,000.

It is important to note that this was not the actual result of this decision. However, the concurring opinion sets out a roadmap for landlords to use in the future. Many experienced bankruptcy attorneys believe that this logic is correct. The result may be that in future cases landlords will seek to shift the burden of the cap from themselves to letter of credit issuers.

[JEB/sal]

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