Recent decisions concerning letters of credit posted to secure lease obligations have further limited the benefits of letters of credit over traditional security deposits. While these decisions are unlikely to alter landlords' preference for this form of security, landlords protecting themselves against their tenants' potential bankruptcy should not expect to use letters of credit to recover more than the cap allowed in §502(b)(6) of the Code.

Since the publication of a prior article in the Journal, Berman, Geoffrey L., et al., "Landlords Use Letters of Credit to Bypass the Claim Cap of §502(b)(6)," Am. Bankr. Inst. J., December/January 2002 at 16, the Third Circuit has affirmed that letters-of-credit proceeds must be applied to the statutory cap. In addition, a Texas bankruptcy court has recently ordered the disgorgement of letter-of-credit proceeds exceeding the statutory cap.

In re PPI Enterprises

In Solow v. PPI Enterprises (U.S.) Inc. (In re PPI Enterprises (U.S.) Inc.), 324 F.3d 197 (3d Cir. 2003), the Third Circuit affirmed the lower court decision in In re PPI Enterprises (U.S.) Inc., 228 B.R. 339 (Bankr. D. Del. 1998), as later affirmed by the district court. There, the landlord under a New York office lease had drawn on a letter of credit for $650,000 following a default by PPI Enterprises four and a half years before PPI Enterprises filed for chapter 11 relief. In contrast to the landlord's claimed actual damages of some $4.7 million, the application of the statutory cap in §502(b)(6), limiting damages to 15 percent of the rent reserved for the remaining term following the 1991 termination of the lease, yielded a much smaller claim. According to the debtor, if the proceeds of the letter of credit were to be applied in partial satisfaction of the statutory cap, the landlord's remaining allowable claim would be only around $100,000. The bankruptcy court held, and the Third Circuit affirmed, that the letter-of-credit proceeds should be treated the same as a security deposit and applied toward the statutory cap.

Under pre-Code law, as announced in Oldden v. Tonto Realty Corp., 143 F.2d 916 (2d Cir. 1944), a bankruptcy filing limited damages for breach of a lease and required that a security deposit given directly to a creditor by the debtor be applied toward the limited claim. This principle was explicitly recognized in the legislative history to the Code:

This paragraph will not overrule Oldden, or the proposition for which it has been read to stand: To the extent that a landlord has a security deposit in excess of the amount of his claim allowed under this paragraph, the excess comes into the estate. Moreover, his allowed claim is for his total damages, as limited by this paragraph. By virtue of proposed 11 U.S.C. §§506(a) and 506(d), the claim will be divided into a secured portion and an unsecured portion in those cases in which the deposit that the landlord holds is less than his damages. As under Oldden, he will not be permitted to offset his actual damages against his security deposit and then claim for the balance under this paragraph. Rather, his security deposit will be applied in satisfaction of the claim that is allowed under this paragraph.

H.R. Rep. No. 595, 95th Cong., 2d Sess. 353-54 (1977).

Cases under the Code have uniformly required a landlord holding a security deposit at the time of a bankruptcy filing to apply the security toward the allowable claim. See In re Handy Andy Home Improvement Ctrs. Inc., 222 B.R. 571, 574 (Bankr. N.D. Ill. 1998); In re Atlantic Container Corp., 133 B.R. 980, 988 (Bankr. N.D. Ill. 1991); In re All for a Dollar Inc., 191 B.R. 262 (Bankr. D. Mass. 1996).

In PPI Enterprises, the debtor posted the letter of credit in lieu of a security deposit under the express provisions of the lease. Despite the draw on the letter of credit more than four years before the bankruptcy, the Third Circuit found that the characterization of the letter of credit as part of the security deposit under the lease placed the case within the line of cases dealing with cash security deposits. As the Third Circuit explained, it adopted the rationale in Oldden, which viewed the distinction between a third-party letter of credit and a security deposit as purely technical. In reaching its result, the Third Circuit rejected the competing line of cases that gave preferred treatment to letters of credit based on the independence principle, including Musika v. Arbutus Shopping Center Ltd. (In re Farm Fresh Supermarkets of Maryland Inc.), 257 B.R. 770 (Bankr. D. Md. 2001).² With the landlord's allowable claim reduced by the $650,000 letter-of-credit proceeds, the Third Circuit further permitted the debtor to treat the landlord's claim as unimpaired by paying the balance of the claim in cash and refused to dismiss the case as a bad faith filing on the ground that it was directed solely at taking advantage of the statutory cap on damages.

In re Stonebridge Technologies

Another recent case, Faulkner v. EOP-Colonnade of Dallas LP (In re Stonebridge Technologies Inc.), 291 B.R. 63 (Bankr. N.D. Tex. 2003),³ confronted the rarer situation where the letter of credit posted by the tenant allegedly exceeded the landlord's claim, as capped by §502(b)(6). Here, Stonebridge posted $105,888 in cash plus a letter of credit for $1,430,065 as security for its obligations under a commercial lease. To secure its reimbursement obligation to the letter-of-credit bank, Stonebridge posted a $1.25 million certificate of deposit. The debtor failed to pay its September 2001 rent and then filed for bankruptcy relief before the landlord drew on the letter of credit. Within a short time, the debtor notified the court of its intention to reject the lease, and in early November 2001, the court entered an order approving a stipulation between the landlord and the debtor that deemed the lease rejected as of Oct. 1, 2001. After the agreement was reported to the court, but before the court entered the order deeming the lease rejected, the landlord presented the letter of credit and drew the entire $1.43 million. The liquidating trustee under the confirmed plan later sued to recover the excess of the security over the capped claim and, as the assignee of the letter-of-credit bank, sued the landlord for damages arising from the allegedly false statements in the sight draft as to the existence of a default under the lease at the time of presentment.

The facts required the court to confront the other side of the issue addressed by the Third Circuit in PPI Enterprises, namely whether a landlord can retain letter-of-credit proceeds in excess of the cap. The Texas court ruled for the trustee and ordered the landlord to return the excess funds.⁴ In ruling for the trustee, the court recognized the independence principle under which "an issuer's obligation to the letter of credit's beneficiary is independent from any obligation between the beneficiary and the issuer's customer... Any disputes between the beneficiary and the customer do not affect the issuer's obligation to the beneficiary to pay under the letter of credit." Kellogg v. Blue Quail Energy Inc. (In re Compton Corp.), 831 F.2d 586, 589 (5th Cir. 1988). However, it held that the independence principle protects only the distribution of the proceeds of the letter of credit in the first instance. The court observed that it was not attacking the issuing bank's distribution to the landlord, but rather addressing an action on the underlying lease agreement and how, under the lease and the intervening bankruptcy law, the letter-of-credit proceeds were to be applied.

Erosion of the Independence Principle?

The Stonebridge and PPI Enterprises cases provide reassurance that landlords will be free to draw on letters of credit without interference from the bankruptcy court. The requirements of the perfect tender rule still may require relief from the automatic stay to permit a landlord to give notices of default or acceleration required by the terms of the letter of credit as conditions to drawing. A carefully drawn letter of credit that permits presentment upon the tenant's bankruptcy or failure of payment should ordinarily dispense with such requirements.

The letter-of-credit aspects of the PPI Enterprises decision dealt with the normal situation where the security held by a landlord was less than the statutory cap on damages under §502(b)(6), so the Third Circuit did not have to tackle the tougher issue of whether a landlord can retain the proceeds of a letter of credit in excess of the statutory cap. Yet the court went beyond the facts of the case when it cited with approval the dicta in the Oldden case, which similarly dealt with a security deposit that was less than the cap, to opine that letters of credit should always be treated the same as security deposits. However, the language the Third Circuit quoted from Oldden⁵ addressed limitations on surety or guarantee claims against parties that were themselves in bankruptcy proceedings.⁶ By expanding its discussion beyond the facts of the case, the Third Circuit has opened the door to a possible erosion of the independence principle so critical to the jurisprudence of letters of credit. Had the court limited its rulings to the facts, it still could have addressed the Code policy of preventing excessive landlord claims from overwhelming the claims of other general unsecured creditors by requiring an offset of letter-of-credit proceeds against the capped claim.

The Stonebridge decision acknowledges the importance of the independence principle, but much more clearly attempts to preclude the use of a letter of credit to avoid the statutory cap of §502(b)(6). As in PPI Enterprises, the court placed great emphasis on the lease provisions allowing the posting of a letter of credit as part of the security deposit. Simply characterizing a letter of credit as security, however, does not resolve the §502(b)(6) dilemma. Where a debtor has posted the security directly, §506(a) and (d) will limit the landlord's rights in the security to recovery of the allowed claim. Where the "security" has been provided by a third party, the issue should be purely one of contract interpretation, and one-year or 15-percent limitations of §502(b)(6) and the provisions for claims secured by a debtor's property in §506 should not apply. The Code is silent on the issue, and the references to security deposits posted by a debtor in the legislative history do not require the disgorgement of third-party letter-of-credit proceeds in excess of the cap. When a landlord has bargained for the third-party credit enhancement as a condition to entering into the lease, there is nothing in the Code or legislative history that requires that a letter of credit be treated differently than a guaranty from a solvent third party.

The disgorgement issue in the Stonebridge and Musika cases will continue to be the subject of debate in the courts. Until the higher courts resolve the issue, landlords cannot rely on letters of credit to provide the full extent of the bargained protection in the tenant's bankruptcy. In the meantime, attention should be paid to negotiating the letter-of-credit and lease default provisions to permit the landlord to draw on the funds at the earliest possible date after the tenant's bankruptcy.

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Footnotes

¹ Board-certified in business bankruptcy by the American Board of Certification. Return to article

² The Third Circuit's decision may overrule the unreported Delaware bankruptcy decision in Darwin Networks Inc. v. NPE Assets Management L.P. (In re Darwin Networks Inc.), Case Nos. 01-0095 and 01-0096, Adversary Proceeding No. A01-4601, described in Berman article, supra, but the factual distinction between recovering money from the landlord whose letter of credit exceeded the cap and limiting the landlord's general unsecured claim to the difference between the cap and the letter of credit may allow for the continued viability of this case. Return to article

³ The case record includes statements of the landlord's intention to appeal the final order, but as of the submission of this article, the appeals period had not expired on the July 7, 2003, Amended Final Judgment, and no notice of appeal had been filed. Return to article

⁴ Interestingly, the court's findings of fact set Stonebridge's direct damages at only $2,267, being the excess of the $1.25 million CD forfeited to the letter of credit bank over the landlord's capped claim of $1,353,032 less the cash security deposit of $105,299. The difference of $180,066 between the face amount of the letter of credit and the CD collateral was awarded to the trustee only as the assignee of the letter of credit bank in the form of damages for wrongful or premature presentation of the letter of credit. Findings of Fact and Conclusions of Law at 6 (No. 02-3187). However, there is no indication in the record that the letter of credit was expiring, and the letter of credit bank still would have been obligated to pay the full amount if the landlord had presented its draft after the entry of the order rejecting the lease two weeks later. Query whether the court could also have ordered the landlord to turn over the excess funds over the cap to the trustee directly, although the court took pains to distinguish the Musika case, which refused such a result. Return to article

⁵ "The difference is purely technical... In one case, the insurance is security put up by the tenant himself, while in the other it is the credit standing of a third party procured by the tenant; this difference is insufficient to justify divergent rules as to the respective allowable claims." In re PPI Enters. (U.S.) Inc., 324 F.3d at 200-01, quoting Oldden v. Tonto Realty Corp., 143 F.2d at 921. Return to article

⁶ 143 F.2d at 922-23 (Frank, C.J., dissenting). As the dissenting opinion in Oldden observed, "I see no reason to think that Congress intended that a landlord who, bargaining with a tenant of whose financial stability he is doubtful, and to whom he would not otherwise lease his property, demands and receives security is, with respect to that security, to be treated differently from other secured creditors." Id. Return to article