Are Letters of Credit Covered by the Landlords Cap

Journal Issue

Feb 2006

Column Name

Feature

Citation

ABI Journal, Vol. XXV, No. 1, p. 40, February 2006

Bankruptcy Code

501

506

Topic Tags

Real Estate

Journal HTML Content

Section 502(b)(6) establishes an arbitrary limitation on the amount of a landlord’s
claim in a tenant bankruptcy case, ordinarily one year’s rent (the “landlord’s
cap”). Case law, supported by the legislative history of the Bankruptcy
Code, provides that any security deposit held by the landlord must be applied
against the landlord’s cap, reducing or eliminating the landlord’s
claim against the bankruptcy estate.

Until recently, there had been an active debate about whether the courts would
apply the proceeds of a letter of credit against the landlord’s cap in
the same manner as a security deposit, or would reach the opposite result based
on the “independence principle” applicable to letters of credit.
A Bankruptcy Appellate Panel (BAP) and three circuit appeals courts have now
addressed the issue, the Fifth and Ninth Circuits having ruled within the past
several months. Unfortunately, they have not adopted a consistent and coherent
overall analysis, and as a consequence the decisions have only limited predictive
value.
 Summary of the Decisions
 Case law on this subject is dominated by a 1942 decision of the Second Circuit,
Oldden v. Tonto Realty Co.,2 which addressed the landlord’s cap
under the then-newly enacted Chandler Act. Without statutory, decisional or
policy support, the Second Circuit concluded that a landlord’s security
deposit should be applied against the landlord’s cap, rather than the
landlord’s excess damages (the “Oldden Rule”). In the
ensuing years, Oldden was regularly cited for its characterization of
the policy underlying the landlord’s cap, but until the decisions discussed
in this article, no subsequent circuit appeals court expressly approved or explained
the Oldden Rule. The legislative history to §502(b)(6) stated, however,
that the Code was not expected to alter the Oldden Rule. But for that
favorable citation in the legislative history, it was possible that case law
as it developed under the Code would reject the Oldden Rule as misguided.3

The first of the recent cases is a 2003 decision of the Third Circuit Court
of Appeals. In PPI Enterprises,4 the tenant defaulted, and the landlord
terminated the lease, applied its letter of credit and then pursued the tenant
for the balance of its loss. Many years later, the tenant filed bankruptcy,
proposing to pay the landlord’s allowed claim in full after application
of the landlord’s cap. Among the issues on appeal was whether the proceeds
of the letter of credit should be treated like a security deposit, reducing
the landlord’s cap. After canvassing the conflicting positions, the Third
Circuit explained that it was “not inclined to disturb the rationale”
of Oldden—that is, it was inclined to treat letters of credit in
the same manner as security deposits—but concluded that it “need
not decide the underlying question because it is clear the parties intended
the letter of credit to operate as a security deposit,” and so, like a
cash security deposit, the proceeds of the letter of credit must be treated
as reducing the landlord’s cap.5
 In Mayan Networks,6 the Ninth Circuit BAP focused on the fact that
the tenant had obtained the letter of credit for the landlord by pledging a
certificate of deposit in an identical amount as collateral for its reimbursement
obligation to the issuing bank. When the landlord drew on the letter of credit,
the bank offset the certificate of deposit, which constituted property of the
bankruptcy estate and would have been returned to the bankruptcy estate but
for the draw on the letter of credit. The BAP concluded that “the appropriate
analysis looks to the impact that the draw upon the letter of credit has on
property of the estate.”7 In Mayan Networks, the effect of the
draw on the letter of credit was identical to the application of a security
deposit (due to the pledge of the certificate of deposit), so the proceeds of
the letter of credit were treated as reducing the landlord’s cap; had
there been no pledge of property of the estate respecting the letter of credit,
the opposite result would be obtained.8 In a thoughtful and persuasive concurring
opinion, Judge Klein presented a thorough analytical framework to address letters
of credit as a species of guarantor and surety liabilities under the Bankruptcy
Code.9

Thereafter, in AB Liquidating Corp.,10 the Ninth Circuit tersely held
that the proceeds of a letter of credit reduce the landlord’s cap where
the letter of credit is supported by a pledged certificate of deposit in equivalent
amount. The Ninth Circuit expressly refused to adopt or reject the analysis
proposed by Judge Klein or to provide its own analysis.11
 Finally, in Stonebridge Technologies Inc.,12 the landlord’s letter
of credit exceeded the amount of the landlord’s cap and the bankruptcy
estate sought to recover the excess. The Fifth Circuit suggested that the landlord’s
cap should not be interpreted as an avoidance right but concluded that the landlord’s
cap was not applicable to a draw on a letter of credit where the landlord does
not file a proof of claim.
 Four Analytical Approaches

These decisions present four very different analyses for determining the interaction
between the landlord’s cap and letter-of-credit proceeds: two formal,
two substantive.
 The Name Governs. One formal approach, adopted explicitly by the Third
Circuit13 and implicitly by the Ninth Circuit,14 is to look to the description
of the letter of credit in the lease; if it is referred to as a “security
deposit,” it will be applied against the landlord’s cap.
 The Claim Governs. A similarly formal approach was adopted by the Fifth
Circuit: If the landlord files a proof of claim, the landlord’s cap applies;
if the landlord does not file a proof of claim, the bankruptcy process does
not interact with the landlord or the letter of credit.15
 The Impact on the Estate Governs. The Ninth Circuit BAP,16 the Third
Circuit17 and implicitly the Ninth Circuit18 found the treatment of the issuing
bank’s reimbursement claim against the debtor significant. The BAP concluded
that where the reimbursement claim was secured by cash property of the estate,
it effectively converted the letter of credit into a security deposit, requiring
application against the landlord’s cap;19 the Ninth Circuit apparently
adopted this view as well.20 The BAP thought the opposite result would apply
where the reimbursement claim was unsecured,21 but the Third Circuit concluded
that the existence of any reimbursement claim, even if unsecured, was sufficient
to require application of the letter of credit proceeds to the landlord’s
cap.22

Surety and Subrogation Law Governs. In sharp contrast to the rather
shallow and case-specific analyses proposed by the appellate courts, Judge Klein’s
extensive analysis in his concurring BAP decision in Mayan Networks rationalizes
the issue in terms of suretyship and subrogation law in the bankruptcy context
generally.23 The general approach of the Code is to allow the primary creditor
to assert his claim against the estate, notwithstanding collections from guarantors,
until the claim has been completely satisfied. Guarantors, on the other hand,
may assert claims against the estate only to the extent that they have satisfied
the claim of the primary creditor and the claim of the primary creditor would
have been allowed, essentially viewing the guarantor as holding the equivalent
of a subrogation right.24 Thus, ordinarily25 the bank’s reimbursement
claim would be disallowed under Judge Klein’s analysis, because the landlord
will ordinarily consume the entire landlord’s cap through its own claim
against the estate and there will be no additional allowed landlord claim to
which the bank could succeed.26 Judge Klein honors the “effect on the
estate” analysis by disallowing the bank’s reimbursement claim (to
the extent that it, together with any claim allowed to the landlord, exceeds
the amount of the landlord’s cap) and by requiring a return of the collateral
securing the bank’s disallowed reimbursement claim.27

What Was (Probably) Resolved
 The appellate courts’ failure to adopt—or even to articulate—a
consistent, coherent analysis and the implicit split in the circuits based on
their divergent approaches leave few issues conclusively resolved. A few things
have largely been resolved, though.
 First and foremost, where the tenant has pledged an equivalent amount of cash
to secure its reimbursement obligation to the issuing bank, the proceeds of
the letter of credit will be applied to reduce the landlord’s cap in determining
the amount of the landlord’s general unsecured claim in the tenant’s
bankruptcy case. Indeed, this is the only “rule” common to or consistent
with all four of the decisions.
 Second, the courts are likely generally to treat Oldden as persuasive
authority, requiring that security deposits—and probably letter-of-credit
proceeds—be applied against and reduce the amount of the landlord’s
cap. In PPI Enterprises, the Third Circuit adopted Oldden, albeit
in a lukewarm manner.28 Thereafter, the Ninth Circuit expressly adopted Oldden,
holding that the legislative history “eviscerates” any attempt to
re-think Oldden.29 (The BAP also accepted the application of Oldden
in the security-deposit setting,30 although Judge Klein’s concurring opinion
counseled against using Oldden as a “talisman.”31) On the
other hand, the Fifth Circuit did not mention the case, provided no clear guidance
on its continued vitality and adopted an analysis that contradicted aspects
of the Oldden decision.32 Thus, it is possible only to say that Oldden
is probably the law.

Finally, the analytical core of the landlords’ position was rejected
by most of the courts. The landlords’ “silver bullet” was
the “independence principle” that treats a letter of credit as a
separate contract between the landlord and the issuing bank, a contract that
is out of the reach of the bankruptcy process. Landlords argued that just as
they were free to apply recoveries from a guarantor without regard to the landlord’s
cap,33 so they should be permitted to apply the proceeds of a letter of credit
in the same manner due to the independence principle. With one exception, none
of these cases found the independence principle a particularly compelling factor
in the analysis.34 The odd man out was Stonebridge Technologies: Howard Rubin,
counsel for the landlord in that case, asserts that the critical holding of
the case is that the independence principle is alive, well and controlling in
the Fifth Circuit.35 On the other hand, the decision’s focus on whether
a proof of claim was filed suggests that where the letter of credit is less
than the landlord’s cap and the landlord seeks a recovery from the bankruptcy
estate, the “independence principle” may not drive the analysis,
even in the Fifth Circuit.
 What Is Left Undecided
 The four decisions afford little predictive value, due to the absence of a
single coherent analysis. This can be seen most dramatically by considering
two common and leading examples.
 First, assume a letter of credit in excess of the landlord’s cap backed
by a pledge of an equivalent certificate of deposit, as was the case in Stonebridge
Technologies. In the Ninth Circuit, it seems probable that the bankruptcy
estate could require the landlord to refund the excess. This is so because the
Ninth Circuit has expressly adopted Oldden, and the Oldden decision
discussed the possibility of a security deposit that exceeded the landlord’s
cap and concluded that “anything in excess should go to the trustee for
the general creditors.”36 While Oldden explicitly dealt only with
security deposits, the Ninth Circuit holds that letters of credit backed by
pledges of cash or certificates of deposit are identical to security deposits
in practical effect and hence subject to application of the Oldden Rule.
In the Ninth Circuit, the bankruptcy estate would seem clearly to have a right
to recover the excess letter of credit proceeds.37

It is not at all clear what result would apply in the Third Circuit. The Third
Circuit expressed only lukewarm support for Oldden,38 and it has not
expressly held that letters of credit are equivalent to security deposits, except
in cases where the lease defines the letter of credit as a “security deposit.”
While PPI Industries certainly suggests that the Third Circuit was not
uncomfortable with the application of Oldden to a letter of credit in
one context, it was never forced to address the seemingly anomalous circumstance
of using the landlord’s cap as an avoiding power to recover the bank’s
payment to the landlord, a circumstance that tests almost any analysis.39 The
Third Circuit could easily adopt the “landlord’s cap is not an avoidance
power” approach or Judge Klein’s analysis or some other alternative.
There is no sound basis on which to predict what it would do in response to
the “excess proceeds” fact pattern.
 Even in the Fifth Circuit, where the issue has been squarely addressed, the
dispositive factor is unclear. On the one hand, the Fifth Circuit remarked that
the landlord’s cap was not enacted as an avoiding power but as a limitation
on claims,40 a holding sufficient to bar recovery of the excess proceeds in
every case. On the other hand, the Fifth Circuit relied heavily on the fact
that the landlord had not filed a proof of claim, electing instead to remain
apart from the bankruptcy process.41 This point seems reminiscent of Katchen
v. Landy42 and Langenkamp v. Culp,43 which hold that the filing of
a proof of claim converts all litigation with the claimant into an aspect of
the “restructuring of the debtor-creditor relationship,” within
the scope of the bankruptcy court’s summary equity jurisdiction, even
when the estate seeks to recover an amount in excess of the claim from the claimant,
as was the case in Stonebridge Technologies and our hypothetical.44 If
the Fifth Circuit was really looking to these cases, the significant factor
was the absence of a proof of claim45 rather than Congress’ failure to
identify the landlord’s cap as an avoidance power.46

Second, consider a letter of credit issued as part of the debtor’s general
banking relationship, secured—along with its other borrowings from the
bank—by a blanket lien that will prove, when the bankruptcy case is ultimately
filed, to be undersecured. Must the proceeds of the landlord’s draw on
the letter of credit be applied against the landlord’s cap?
 In the Third Circuit, the answer is probably yes, the proceeds of the letter
of credit must be applied against the landlord’s cap. Although the Third
Circuit’s discussion was equivocal and, ultimately, dicta, the Third Circuit
does not seem to view the nature or extent of the reimbursement right as significant:
Whether secured or unsecured, the mere existence of the bank’s reimbursement
claim represents a potential “end run” around Oldden, and
the Third Circuit is “not inclined to disturb” the Oldden
Rule.47
 In the Ninth Circuit, the result will be much more difficult to determine.
There, the existence of a secured reimbursement right is critical, and a letter
of credit is considered equivalent to a security deposit because the issuing
bank holds a certificate of deposit posted by the debtor in an equivalent amount:
Every dollar taken from the letter of credit is a dollar that will be taken
from the certificate of deposit, which would otherwise be returned to the estate,
and hence the letter of credit is the practical equivalent of a cash security
deposit. Where the letter of credit is backed by an undersecured lien, a different
result may well apply:48 To the extent that the reimbursement right was truly
secured in the bankruptcy sense,49 it will apply against the landlord’s
cap; to the extent that it was undersecured (unsecured in the bankruptcy sense),50
it will likely not be applied against the landlord’s cap.51 Likewise,
the estate’s ability to recover proceeds of the letter of credit in excess
of the landlord’s cap is likely dependent on the bank’s reimbursement
right respecting those excess proceeds being secured by valuable collateral.
Thus, the Ninth Circuit will likely require a difficult analysis of the extent
to which the bank’s reimbursement claims were undersecured, in order to
determine the extent to which proceeds of a letter of credit are applied against
the landlord’s cap.

The Fifth Circuit is something of a cipher in this regard, since its holding
was so narrowly focused on concluding that the landlord’s cap has no application
in the absence of a filed proof of claim. The opinion makes no reference to
Oldden and, while PPI Enterprises and Mayan Networks are
cited as standing for the proposition that “other circuits...have treated
the proceeds of a letter of credit as a security deposit and capped by §502(b)(6),”
there is no hint as to whether the Fifth Circuit would follow those “other
circuits” or not.52 It is only clear that the landlord’s cap will
not be considered if the landlord does not file a proof of claim.
 Conclusion
 The extent to which the proceeds of letters of credit will be applied against
the landlord’s cap is an issue that has been the focus of attention for
more than a decade, and on which hundreds of millions of dollars are at stake.
In comparatively short order, three Circuit Courts of Appeals and one BAP have
ruled on it. Unfortunately, their insistence on resolving the issue in terms
of the specific facts of each case and their refusal to articulate an analysis
of general applicability have left the issue almost as uncertain as it was before
they spoke.

<hr>
<h3>Footnotes</h3>

1 The author was counsel for the landlord in AB Liquidating Corp. He
expresses his gratitude to Judge Christopher Klein, author of the concurring
opinion in Mayan Networks; Howard Rubin of Dallas, counsel for the landlord
in Stonebridge Technologies; and Ivan Gold of San Francisco, all of whom
provided thoughtful responses to earlier drafts of the article.

2 143 F.2d. 916 (2d Cir. 1944). 
3 In the AB Liquidating briefing, the author unsuccessfully urged that
the Ninth Circuit reject Oldden. See, generally, St. James,
“Oldden, Letters of Credit and §502(b)(6)” 26 Cal.
Bankr. J. 307 (2003).

4 Solow v. PPI Enterprises Inc. (In re PPI Enterprises Inc.), 324
F.3d 197 (3d Cir. 2003). 
5 PPI Enterprises, 324 F.3d. at 209-10. 
6 Redback Networks, Inc. v. Mayan Networks Corp. (In re Mayan Networks
Corp.), 306 B.R. 295 (BAP 9th Cir. 2004).

7 Mayan Networks, 306 B.R. at 299. 
8 Mayan Networks, 306 B.R. at 299-300. 
9 Mayan Networks, 306 B.R. at 301, et seq.

10 AMB Property L.P. v. Official Creditors for the Estate of AB Liquidating
Corp. (In re AB Liquidating Corp.), 416 F.3d. 961 (9th Cir.
2005). 
11 AB Liquidating, 416 F.3d. at 965. 
12 EOP-Colonnade of Dallas Limited Partnership v. Dennis Faulkner (In
re Stonebridge Technologies Inc.), 430 F.3d. 260 (5th Cir. 2005).

13 PPI Enterprises, 324 F.3d. at 210. 
14 AB Liquidating, 416 F.3d. at 961 (characterizing the case as
involving a “letter of credit security deposit”). 
15 Stonebridge Technologies, 430 F.3d. at 269-270. Curiously, the Fifth
Circuit did not view pursuing payment of administrative rent in the bankruptcy
case—which the landlord did in the Stonebridge Technologies case—as
having an impact on the issue.

16 Mayan Networks, 306 B.R. at 299-300. 
17 PPI Enterprises, 324 F.3d. at 209 (characterizing the reimbursement
claim as an “end run around §502(b)(6)”). 
18 AB Liquidating, 416 F.3d at 965, n. 3.

19 Mayan Networks, 306 B.R. at 299. 
20 AB Liquidating, 416 F.3d at 965, n. 3. 
21 Mayan Networks, 306 B.R. at 300.

22 PPI Enterprises, 324 F.2d at 209 (expressing concern that otherwise
the debtor “would be liable twice for the same amount of money”).
 
23 It should be noted that the Ninth Circuit expressly held open the possibility
that it would adopt Judge Klein’s analysis. AB Liquidating, 416
F.3d at 965. 
24 Mayan Networks, 306 B.R. at 307 et seq. (Klein, concurring); also,
see 11 U.S.C. §§502(e) and 509.

25 Judge’s Klein’s analysis is a concurrence rather than a dissent
because the letter of credit at issue in Mayan Networks peculiarly
required the landlord to receive, hold and apply the proceeds of the letter
of credit as though they were a security deposit. In the ordinary case, the
application of the proceeds are not likely to be so circumscribed. 
26 “Once the allowable claim (up to the §502(b)(6) cap) is paid in
full, then all other claims, including the issuer’s claim against the
estate on the reimbursement contract, are disallowed.” Mayan Networks,
306 B.R. at 310 et seq. (Klein, concurring). 
27 The “seamless web” that Judge Klein articulates so well seems
to collapse at this point through legislative fiat. Although as a general matter
of bankruptcy law where a claim is disallowed, collateral securing that claim
must be returned to the bankruptcy estate, in §506(d) Congress provided
that collateral securing a reimbursement right could not be recovered where
the underlying claim was disallowed. 
28 PPI Enterprises, 324 F.3d. at 209 (“we are not inclined to disturb
the rationale followed since Oldden”).

29 AB Liquidating, 416 F.3d. at 964. 
30 Mayan Networks, 306 B.R. at 299 (“it is clear that security
deposits are to be applied after the §502(b)(6) cap...”). 
31 Mayan Networks, 306 B.R. at 310 et seq. (Klein, concurring).

32 Contrast Stonebridge Technologies, 430 F.3d. at 270, with Oldden, 143
F.2d. at 921. 
33 In re Modern Textile Inc., 900 F.2d. 1184, 1191 (8th Cir. 1990) (“the
liability of a guarantor for a debtor’s lease obligations is not altered
by the trustee’s rejection of the lease”); In re Western Real
Estate Fund Inc., 922 F.2d. 592, 601 (10th Cir. 1990) (bankruptcy does not
“bar litigation against third parties for the remainder of the discharged
debt...[even where] the creditor’s claim is based on an executory contract
that is both rejected under §365(a) and subject to limitation in amount
[by §502(b)(6)]”; Bel-Ken Associates Ltd. Partnership v. Clark,
83 B.R. 357 (D. Md. 1988) (guarantor obligation not affected by tenant’s
bankruptcy and its invocation of §502(b)(6)); In re Empire Knitting
Mills Inc., 123 B.R. 688, 691 (Bankr. D. Me. 1991) (§506(b) does
not limit recovery against a guarantor when the debtor rejects a lease).

34 See, e.g., Mayan Networks, 306 B.R. at 299 (“the
fact that letters of credit themselves are not property of the estate is a red
herring”). 
35 “Insofar as letters of credit embody obligations between the issuer
and beneficiary, such contractual rights and duties are entirely separate from
the debtor’s estate.” Stonebridge Technologies, 430
F.3d. at 269. 
36 Oldden, supra, 143 F.2d at 921.

37 Except that under Judge Klein’s analysis, they would be recovered from
the certificate of deposit pledged to the bank. 
38 See note 27, supra. 
39 Except, of course, Judge Klein’s robust analysis that folds the treatment
of letters of credit into the treatment of surety claims in bankruptcy generally,
and thus provides a means of analyzing each of the various fact patterns. Mayan
Networks, 306 B.R. at 301 et seq. 
40 Stonebridge Technologies, 430 F.3d. at 270.

41 Stonebridge Technologies, 430 F.3d. at 269-270. 
42 382 U.S. 323, 86 S.Ct. 467, 15 L.Ed.2d. 391 (1966). 
43 498 U.S. 42, 45, 111 S.Ct. 330, 112 L.Ed.2d. 343 (1990). 
44 On the other hand, seeking recovery of administrative rent; see note
14, supra, would have constituted a submission to the summary jurisdiction
of the bankruptcy court for the purposes of Katchen v. Landy and Langenkamp
v. Culp.

45 Query whether the debtor or the bank can change the result by filing a proof
of claim on behalf of the landlord. 11 U.S.C. §501(b) and (c). 
46 Of course, the avoidance claims in Katchen v. Landy and Granfinanciera existed
independent of the proof of claim and could have been prosecuted in the absence
of a proof of claim; they would simply have been prosecuted in the district
court, where there was plenary jurisdiction. Taking the Fifth Circuit’s
reliance on the absence of a proof of claim seriously, however, suggests that
the existence of the cause of action, rather than merely jurisdiction to determine
the cause of action, is dependent on the existence of the proof of claim. 
47 PPI Enterprises, 324 F.3d. at 209.

48 Mayan Networks, 306 B.R. at 300 (noting that the opposite result
would apply where the bank’s reimbursement right was unsecured). 
49 11 U.S.C. §506(a). 
50 11 U.S.C. §506(d). 
51 The Ninth Circuit adopted this analysis in a comparable setting. In Creditors’
Committee v. Koch Oil Co. (In re Powerine Oil Co.), 59 F.3d.
969 (9th Cir. 1994), a preference defendant asserted that its release of its
claim against a letter of credit constituted new value. There, the reimbursement
right was backed by an undersecured blanket lien on the assets of the debtor.
The Ninth Circuit held that the new-value defense was limited to the secured
portion of the bank’s reimbursement claim against the debtor’s collateral,
and was not available to the extent that the bank’s reimbursement claim
was unsecured.

52 Stonebridge Technologies, 430 F.3d. at 270-71.

Journal Authors

Michael St. James

Journal Date

Wednesday, February 1, 2006 - 12:00

Bankruptcy Rule

2006

none