andlord clients often ask how they can avoid the cap on their lease rejection damage claims imposed by §502(b)(6) of the Bankruptcy Code. Section 502(b)(6) provides that the claim of a landlord against a debtor-tenant for future damages resulting from a rejected lease is capped at "the rent reserved by such lease, without acceleration, for the greater of one year, or 15 percent, not to exceed three years, of the remaining term of such lease" following the earlier of the bankruptcy filing date and the date the tenant surrendered the premises. 11 U.S.C. §502(b)(6) (2001) (the "claim cap").¹ The landlord's claim for damages is treated as a general pre-petition unsecured claim. 11 U.S.C. §502(g).

A security deposit does not avoid the claim cap. It is well-settled law that a security deposit held by a landlord with respect to a lease rejected by the tenant must be applied against the claim as capped pursuant to §502(b)(6).² Any excess security deposit must be returned to the debtor-tenant. This principle was first announced in Oldden v. Tonto Realty Corp., 143 F.2d 916 (2d Cir. 1944) (decided under the predecessor to §502(b)(6)). The legislative history of §502(b)(6) makes it clear that the claim is first capped and then reduced to the extent of the security deposit. The House and Senate Reports state that the landlord is not "permitted to offset his actual damages against his security deposit and then claim for the balance under [§502(b)(6)]. Rather, his security deposit will be applied in satisfaction of the claim that is allowed under [§502(b)(6)]." H.R. Rep. No. 595 (1977); S. Rep. No. 989 (1978), reprinted in U.S.C.C.A.N. 5963, 5787. Recent case law affirms the Oldden principle. See, e.g., In re All for a Dollar Inc., 191 B.R. 262 (Bankr. D. Mass. 1996); In re Blatstein, 1997 U.S. Dist. LEXIS 13376 (E.D. Pa. Aug. 26, 1997).

However, landlords have increasingly turned to requiring their tenants to provide letters of credit to secure their leasehold obligations. The question has thus arisen: Can a landlord effectively avoid the claim cap of §502(b)(6) through a letter of credit?

The Independence Principle

Unlike a security deposit, a letter of credit and its proceeds do not constitute property of the debtor's estate. Under the well-established "independence principle," a letter of credit and its proceeds are property of the issuing bank paid on account of its independent obligation to the beneficiary of the letter of credit. See, e.g., Willis v. Celotex Corp., 978 F.2d 146, 148 (4th Cir. 1992), cert. denied, 507 U.S. 1030 (1993) (holding that a letter of credit is not property of the debtor's estate); Kellogg v. Blue Quail Energy Inc. (In re Compton Corp.), 831 F.2d 586, 589-90 (5th Cir. 1987) (holding that the automatic stay does not prohibit a lender from drawing upon a letter of credit following the borrower's bankruptcy because the lender is receiving property of the issuer, not property of the debtor's estate, and that "the independence principle [is] the cornerstone of letter of credit law"); In re Sabratek Corp., 257 B.R. 732, 735 (Bankr. D. Del. 2000) (holding that the proceeds of a letter of credit could not be recovered in the bankruptcy case because neither the letter of credit nor its proceeds were property of the estate); In re Green, 210 B.R. 556, 559 (Bankr. N.D. Ill. 1997) ("A letter of credit is an independent obligation, and neither the letter of credit nor its proceeds are debtor's property even if the letter of credit is secured by the debtor's property."); Zenith Labs. v. Sec. Pac. Nat'l. Trust Co. (In re Zenith Labs. Inc.), 104 B.R. 667, 671 (Bankr. D. N.J. 1989); Braucher v. Cont'l. Ill. Nat'l. Bank & Trust Co. of Chi. (In re Ill.-Cal. Express Inc.), 50 B.R. 232, 235 (Bankr. D. Colo. 1985); Planes Inc. v. Fairchild Aircraft Corp. (In re Planes Inc.), 29 B.R. 370, 371 (Bankr. N.D. Ga. 1983); Page v. First Nat'l. Bank of Md. (In re Page), 18 B.R. 713, 716 (D. D.C. 1982); see, also, Stillman, James R., et al., "When the Tenant Goes Out of Business: The Letter of Credit Arranger's Reimbursement and Security Agreement," SF40 ALI-ABA 573, 581 (2001) (stating that "[t]he letter of credit is meant to be a perfect non-debtor source of repayment, truly independent from the bankruptcy estate"); 5 Collier's on Bankruptcy ¶549.04[1] (15th ed. rev. 1999) ("Property of the estate also does not include the proceeds of a letter of credit paid to a creditor of the debtor who is a beneficiary of the letter").

In addition, even though §105 of the Bankruptcy Code³ arguably gives bankruptcy courts the power to enjoin draws pursuant to letters of credit, bankruptcy courts have generally refused to do so because they do not wish to disturb the "independence principle." See, e.g., Duplitronics Inc. v. Concept Design Elecs. & Mfg. Inc. (In re Duplitronics Inc.), 183 B.R. 1010, 1017-18 (Bankr. N.D. Ill. 1995); Lower Brule Constr. Co. v. Sheesley's Plumbing & Heating Co., 84 B.R. 638, 645 (D. S.D. 1988). However, some courts have enjoined payments under letters of credit under "unusual circumstances." See, e.g., Wystco Investment Co. v. Great American Bank, 131 B.R. 146 (D. Ariz. 1991); In re Delaware River Stevedores Inc., 129 B.R. 38 (Bankr. E.D. Pa. 1991).

The net result is that while a landlord would have to disgorge the amount of a security deposit in excess of the claim cap, the landlord arguably should not have to disgorge what the landlord receives under a letter of credit. If neither the letter of credit nor its proceeds are property of the estate, then §502(b)(6) may not be applicable. Section 502(b)(6) acts to limit the amount of an allowed claim by a landlord against the debtor's estate and not against a third party's estate.

The Cases Are in Disagreement

Notwithstanding the independence principle, the cases are in disagreement. In In re PPI Enterprises (U.S.) Inc., 228 B.R. 339 (Bankr. D. Del. 1998), the landlord, Solow, had a letter of credit for $650,000. Solow subsequently drew down the letter of credit for the entire $650,000 after the tenant-debtor terminated the lease. The court held that the letter of credit was a "security deposit." Therefore, under §502(b)(6), the proceeds of the letter of credit were to be applied in satisfaction of the claim cap. See Id. at 350.

However, in Musika v. Arbutus Shopping Center Limited Partnership (In re Farm Fresh Supermarkets of Maryland Inc.), 257 B.R. 770 (Bankr. D. Md. 2001), the court ruled differently. The landlord, Arbutus, leased property to Farm Fresh, the tenant. A standby letter of credit was posted for the benefit of Arbutus in the amount of $38,000. Upon Farm Fresh's subsequent bankruptcy and default under the lease, Arbutus drew down the entire $38,000. The trustee sought to recover the $38,000 as a violation of the claim cap under §502(b)(6). The court held that "neither the letter of credit nor its proceeds were property of the debtor's estate, and therefore the trustee may not maintain the instant lawsuit to recover them." Id. at 772. The landlord was able to retain the proceeds of the letter of credit despite the fact that the proceeds exceeded the claim cap of §502(b)(6).

Recently, in an unpublished case, the U.S. Bankruptcy Court for the District of Delaware granted summary judgment for a landlord. 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), the debtor, Darwin Networks Inc., delivered a letter of credit in the amount of $275,000 to the lessor, NPE Assets Management L.P. NPE drew the entire $275,000 after Darwin filed for bankruptcy. Thereafter, Darwin filed a motion to reject the lease. Under the claim cap of §502(b)(6), the maximum allowable claim for rent was $146,684.04. Darwin filed a motion requesting turnover of the amount of the $275,000 letter of credit draw exceeding the $146,684.04. However, the judge granted summary judgment for NPE, resting its holding on the "independence principle." Section 502(b)(6) was deemed inapplicable to letters of credit, and NPE did not have to disgorge any of the proceeds of the letter of credit.

These cases are analogous to cases holding that non-debtor guarantors cannot assert the claim cap to avoid liability for damages arising out of the debtor-tenant's lease rejection. See, e.g., In re Modern Textile Inc., 900 F.2d 1184, 1191 (8th Cir. 1990); Bel-Ken Assocs. L.P. v. Clark, 83 B.R. 357, 358 (D. Md. 1988).

Conclusion

Landlords have nothing to lose and much to gain by seeking letters of credit from their tenants rather than a cash security deposit to protect themselves in the event their tenants file for bankruptcy and reject a lease. Although there is plenty of case law and legislative history holding that the amount of a security deposit in excess of the claim cap must be disgorged, the same rule does not necessarily apply to letters of credit. Although the courts are split on the issue of whether a landlord should be able to draw on a letter of credit to its fullest extent regardless of the claim cap under §502(b)(6), some courts have ruled in the landlord's favor on this issue, allowing them to move to the front of the line.

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Footnotes

¹ All statutory references are to the Bankruptcy Code, 11 U.S.C. §101 et seq., except as otherwise noted. Return to article

² This is separate from any state law provision that may limit the application of a security deposit when a lease is surrendered to the lessor. For example, see California Civil Code §1950.7(c), which limits the security deposit to those damages incurred retroactive to the surrender of the premises and does not allow for offset against any "prospective" damages. Return to article

³ Section 105 of the Bankruptcy Code states that the bankruptcy court "may issue any order, process or judgment that is necessary or appropriate to carry out the provisions of this title." 11 U.S.C. §105(a). Return to article