Article

Factual Summary: Lessee and Lessor entered into a lease ("Lease") in which Lessee agreed to lease space in an office building owned by EOP. Pursuant to the Lease, Lessee provided Lessor a security deposit in the form of a cash payment of US$105,298.85 and an irrevocable standby LC in the amount of US$1,430,065.74 issued by Issuer in favor of Lessor. Lessee's obligation to reimburse Issuer in the event of a draw on the LC was secured by a certificate of deposit in the amount of US$1,250,000.

On September 6, 2001, Lessee filed for relief under Chapter 11 (reorganization) of the US Bankruptcy Code. Subsequently, Lessee and Lessor entered into an agreement in which the Lease would be rejected, effective no earlier than October 1, 2001and no later than October 31, 2001. Lessor announced this agreement at a hearing on October23, 2001. The day before the October 23rd hearing, Lessor made a draw request to Issuer for the full amount of the LC. Issuer refused to pay, citing discrepancies in the drawing documents. Lessor corrected the discrepancies and made a new draw request. Issuer honored the new draw request and issued a check to Lessor on October 30, 2001, in the amount of US$1,430,065.74.

On November 8, 2001, the bankruptcy court entered a nunc pro tunc order approving the lease rejection effective as of October 1, 2001. Lessor never filed a proof of claim for rejection damages.

Issuer sought relief from the automatic stay in order to apply the certificate of deposit as reimbursement for Lessor's draw on the LC. Pursuant to an agreement between Trustee of a liquidating trust established under the confirmed Chapter 11 plan of Lessee and Issuer, Issuer applied the certificate of deposit as reimbursement for Lessor's draw on the LC in exchange for assigning to Trustee Issuer's claim against Lessor for allegedly making an improper draw.1 Trustee then commenced an adversary proceeding in the bankruptcy court against Lessor alleging that Lessor breached the Lease and made negligent misrepresentations to Issuer by prematurely drawing on the LC and retaining an amount in excess of the cap imposed by Section 502(b)(6) of the Bankruptcy Code and seeking damages.

The bankruptcy court ruled in favor of Trustee, holding that the LC was subject to the Section 502(b)(6) cap because it was part of the security deposit and that the draw on the LC before the entering of the nunc pro tunc rejection order was a breach of the Lease and a negligent misrepresentation that the full sum was "due and owing." The bankruptcy court awarded damages to Trustee as follows: (i) US$180,065.74 for Lessor's negligent misrepresentation to Issuer, calculated by the difference between the amount Lessor drew on the LC and the amount of security held by Issuer, and ii) US$2,267.23 for Lessor's breach of the Lease, calculated by the difference between what Lessor would have been entitled to under the Section 506(b)(6) cap and the amount the Bank collected on its security. On appeal, the district court affirmed the bankruptcy court's decision. On further appeal, the Court of Appeals reversed.

Legal Analysis:

1. Bankruptcy Court Jurisdiction. The Court of Appeals first addressed the issue of bankruptcy court jurisdiction sua sponte (i.e., without the litigants having presented the issue). The appeal was broken down into four claims, the first two of which arose from damages allegedly inflicted on the bankruptcy estate directly and the latter two of which were assigned by Issuer to Trustee: (1) breach of the Lease by prematurely drawing on the LC, (2) breach of the Lease for exceeding the Section 502(b)(6) cap, (3) negligent misrepresentation to Issuer that the money was "due and owing" by prematurely drawing on the LC, and (4) negligent misrepresentation to the Bank that the money was "due and owing" by exceeding the Section 502(b)(6) cap. The Court of Appeals determined that the claims for breach of the Lease were within the bankruptcy court's general jurisdiction because the Lease was property of the bankruptcy estate and any breach of the Lease would have a direct effect on the estate. The Court of Appeals held that the negligent misrepresentation claims were also within the bankruptcy court's general jurisdiction because those claims affected the Bank's reimbursement claim, which in turn affected the administration of the estate. The Court of Appealsthen determined that the bankruptcy court had corejurisdiction of all of the claims because the causes ofaction involved rights created in bankruptcy that would not otherwise have existed had Lessee not filed for Chapter 11 relief.

2. 11 U.S.C. Section 502(b)(6); Lease Damages Cap. The Court of Appeals held that Lessor's draw on the LC did not exceed the cap mandated by Section 502(b)(6) because that section was never implicated. The Court first briefly addressed the relationship and legal obligations, if any, that each of the parties had to one another. Relying on precedent within its Circuit (that is consistent with precedent from other Circuits), the Court held that an LC and its proceeds are not property of the bankruptcy debtor's estate. Moreover, citing the "independence principle," the Court recognized that the Bank's responsibility to Lessor under the LC was entirely independent of any obligations existing between Lessor and Lessee such as the Lease.

The Court based its holding on a strict reading of Section 502(b)(6), which limits its application to "claims" against the estate. Since Lessor did not file a proof of claim, and since a claim is not automatically deemed filed as a result of the rejection of the Lease, the court determined that the Section 502(b)(6) cap was not implicated.

Trustee had maintained that since the LC was part of the security deposit, Section 502(b)(6) applied. The court held that Trustee's argument would make Section 502(b)(6) essentially an unauthorized avoidance power because it would allow a trustee to bring an adversary proceeding against a landlord that drew under an LC to avoid (recover) the payment made to the landlord under the LC. The court maintained that such a position would be inconsistent with the text of the Bankruptcy Code, which limits its application only to a "claim," which did not exist in this case. The court reasoned that if Congress had intended that the cap would apply whether or not the landlord filed a claim, the Bankruptcy Code would have expressly provided for an avoidance (recovery) power for payments to landlords. The court dismissed Trustee's authority to the contrary because in each of the cases cited by Trustee a proofof claim was filed by the landlord.

3. Breach of Lease / Misrepresentation to Bank By Prematurely Drawing on LC. The Court of Appeals held that the Lease authorized Lessor to draw on the LC. The Lease contained the following language:

Landlord may, from time to time, without prejudice to any other remedy, use all or a portion of the Security Deposit to satisfy past due rent or to cure any uncured default by Tenant.

The Lease defined events of default to include:

A. Tenant's failure to pay when due all or any portion of the Rent, if the failure continues for 5 days after written notice to Tenant ("Monetary Default").

B. Tenant's failure (other than Monetary Default) to comply with any term, provision orcovenant of this Lease, if the failure is not cured within 20 days after written notice to Tenant ....

C. Tenant or any Guarantor becomes insolvent, makes a transfer in fraud of creditors or makes an assignment for the benefit of creditors, or admits in writing its inability to pay its debts when due ....

The Court of Appeals determined that there was no question that Lessee was in Monetary Default. The court further held that Lessor's motion to compel payment of post-petition rent satisfied the five day notice requirement for a Monetary Default.

The court also held that, because the Lease contained an acceleration clause that provided for accelerated damages discounted to present value in the event of default, utilizing proceeds from the LC to cover those accelerated damages was appropriate in light of the finding that an event of default existed at the time of the draw.

Finally, the court dismissed Trustee's argument that the draw was premature because the bankruptcy court did not issue its final order granting administrative rent claims and setting the effective rejection date until November 8, 2001. The court reasoned that most courts have held that lease rejection may be retroactively applied. Because Lessee had expressed in open court Lessee's preference for an earlier rejection date, which ultimately saved the estate over US$200,000 in administrative rent costs, the court held that Lessee should not be able to enjoy the benefits of the nunc pro tunc order while avoiding the legal consequence that Lessor's draw on the LC would no longer be premature. The Court of Appeals did not address Trustee's argument that the Bankruptcy Code Section 365(e) anti-ipso facto provision prohibited EOP from drawing on the LC on the account of the insolvency or bankruptcy of Lessee.

Comments by Michael Evan AVIDON, Mark N.PARRY, and Declan M. BUTVICK:

The Fifth Circuit's decision illustrates the tension between the Bankruptcy Code's statutory cap placed on landlord claims (Section 502(b)(6)), the efforts of landlords to use LCs and other third party credit support to avoid the cap, and the Bankruptcy Code's preservation of liability of third parties for the debts of a debtor (Section 524(e)). The Fifth Circuit's strict interpretation of the Bankruptcy Code provides one possible resolution of that tension.

The Fifth Circuit focused on the reference to the word "claim" contained in Section 502(b)(6). If a landlord does not file a claim against the debtor's estate, the statutory cap imposed in Section 502(b)(6) is simply inapplicable in the Fifth Circuit's view. Similarly, using the same strict interpretation of the statute, the Fifth Circuit's decision compels the conclusion that the cap contained in Section 502(b)(6) only applies to claims of "lessors." It should not apply to cap the claims of LC issuers or guarantors. In the absence of a landlord's disallowed claim, the Fifth Circuit's logic leads to the conclusion that no third party claim for reimbursement of a payment made to a landlord would be capped against the debtor's estate under Section 502(e)(1)(A). In the event that a landlord files a claim against the debtor's estate that might be disallowed to the extent it exceeds the Section 502(b)(6) cap, it is unclear why the act of filing a claim should limit the landlord's rights under Section 524 to retain any LC draw or guaranty payment. Also, in the event that a landlord files a claim against the debtor's estate that is disallowed to the extent it exceeds the Section 502(b)(6) cap, a third-party guarantor's claim for reimbursement or contribution will be disallowed to the same extent, pursuant to Section 502(e)(1)(A), although the guarantor's claim would not be directly capped pursuant to Section 502(b)(6). Interestingly, the Fifth Circuit's recognition of the "independence principle" with regard to LCs strongly suggests that reimbursement claims filed by issuers of LCs, unlike claims of guarantors, should not be subject to disallowance under Section 502(e)(1). That is because the LC is independent and, therefore, for purposes of Section 502(e)(1), the issuer is not "liable with the debtor" on the lease and has not "secured" the claim of the landlord under the lease (although the issuer has obviously provided credit support for the lessee's obligations to the landlord). But see Redback Networks, Inc. v. Judd, as the Estate Manager of Reorganized Debtor (In re MayanNetworks Corp.), 306 B.R. 295, 308 (B.A.P.9th Cir.2004) (Klein, J., concurring). However, this outcome is not certain, and the issuer's position may be weakened where, as here, the lease describes the LC as a security deposit under the lease. On the other hand, the LC issuer might argue that its claim should not be affected by how the lessee and landlord characterize the LC in a lease to which the issuer is not a party.

The Fifth Circuit repeats the questionable assertion that the purpose of Section 502(b)(6) is to prevent landlords under a long term lease from "reaping an unfair share of the bankruptcy estate over the remaining pool of unsecured creditors. . . ." In fact, the legislative history reveals that the purpose was to give landlords a claim they would not otherwise have since the prior law entirely disallowed the lease damages claim of a landlord who had retaken possession of the leased premises. The Court noted that a contrary interpretation of the statute would impermissibly convert Section 502(b)(6) into a "self effectuating avoiding power." If Congress intended to cap a landlord's ability to indirectly recover from third parties such as guarantors and LC issuers on a debt of a debtor, contrary to Section 524(e), Congress could amend the Bankruptcy Code's avoiding power to permit the debtor to avoid and to recover from landlords any amount received in excess of the 502(b)(6) cap for the benefit of the debtors' estate or any third party making such payments. While the Fifth Circuit's strict interpretation of Section 502(b)(6) provides landlords with a means of recovering in excess of the cap, unless Congress determines to provides a clear framework for applying Section502 (b)(6).

While the Fifth Circuit's approach provides some comfort for LC issuers that the Fifth Circuit will allow an LC issuer to be fully reimbursed in excess of the cap whether or not a landlord files a claim for lease damages, it remains to be seen if other Circuits will follow suit. Considering those uncertainties, a bank may want to consider protecting itself either by refusing to issue an LC as a credit enhancement for the benefit of a real estate lessor or by getting representations and warranties from its customer (in the LC application) and/or from the beneficiary (in a drawing certificate) that the beneficiary will not obtain from the LC and other sources (such as a security deposit or other credit enhancements) an aggregate amount that exceeds what it would otherwise been titled to from the debtor, pursuant to Section502(b)(6). The drawing certificate could also require the beneficiary to promise to refund any such excess (although that begs the question of whether the beneficiary or potential transferee beneficiary of the LC will be creditworthy or reliable). Moreover, an LC issuer could require the beneficiary to certify that it has not filed and will not file a claim in the bankruptcy case of the lessee. Of course, some of these options go well beyond what banks, landlords and tenants are accustomed to in the marketplace.

Finally, the controversy over the lease cap and related Bankruptcy Code provisions raises the fundamental issue whether it makes good policy sense for the Bankruptcy Code to cap large landlord claims. Other claims against a debtor's estate are not disallowed simply because they are large or arise out of long term contracts. If landlord claims do deserve to be singled out, does it make sense to allow the cap to be circumvented by landlords by the use of guaranties, LCs and other forms of credit enhancement? Does it make sense to limit the reimbursement claims of guarantors, LC issuers or other providers of credit support, and thereby effectively shift the burden of the cap from landlords to third parties? Lastly, if landlord claims do deserve to be singled out, does it make sense to stop at disallowing the excess claim or should there also bean avoiding or recovery power against landlords?

* Michael Evan AVIDON, Mark N. PARRY, and Declan M. BUTVICK are partners at Moses & Singer, LLP in New York City.

1. It is unclear from the opinion whether Trustee was aware that, if Lessor made an improper draw, the bankruptcy estate (Lessee) would have its own claim against Lessor under U.C.C. 5-110(a)(2) (breach of warranty), making the Issuer's assignment of its claims to the estate seemingly superfluous.

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